US
On the FED, FOMC participants continued to anticipate that the conditions for policy firming had been met or would likely be met by the end of the year. Nevertheless, in part because of the risks to the outlook for economic activity and inflation, the FOMC decided that it was prudent to wait for additional information to confirm that the economic outlook had not deteriorated thereby bolstering members’ confidence that inflation would gradually move up towards 2 percent over the medium term.
The outlook for the energy sector appeared to be worsening, according to the FOMC. The substantial global supply of crude oil appeared likely to maintain downward pressure on energy prices for some time, leading to deteriorating credit conditions for some US energy producers and a further reduction in their capital outlays.
It was noted that monetary policy was better positioned to respond effectively to unanticipated upside inflation surprises than to persistent below-objective inflation, particularly when the federal funds rate was still near its effective lower bound. Such considerations also argued for increasing the target range for the federal funds rate gradually after policy normalisation was underway.
There is a certain consensus there will be a first hike in December of this year. The Fed Chair Janet Yellen often emphasises the long lags in monetary policy and that appropriate policy deci-sions therefore have to be forward-looking. Thus, the FOMC is trying to base its policy decision on economic trends, rather than on the latest data realisations. However, uncertainty about the timing is significant and the Fed has backtracked from its forward guidance before. The weaker-than-expected labour market data in September, which were released after the last FOMC meeting, may be an indication that the global slowdown has affected the US economy.
Next week’s agenda features plenty of US indicators, albeit largely from the second tier. They should support the picture of the US economy in the third quarter being particularly driven by household consumption which, in turn, benefited from low interest rates, the labour market recovery as well as lower oil and gasoline prices. Favourable financing conditions have above all boosted car sales, which reached a ten-year high in September. The fact that (nominal) retail sales nevertheless appear to have stagnated month-on-month is exclusively due to lower gasoline prices which depressed gasoline station sales.
The industrial sector, on the other hand, is suffering from poor foreign demand and the strong dollar. So far this year, production only increased in July and another minor decline on the month also appears to be on the cards in September. At the same time, the outlook remains bleak: The first regional indicators for October such as the Empire State Index and the Philly Fed Index look set to remain negative, thus signalling declining business.
Of course, the much lower gasoline price is also being felt in inflation. In September, consumer prices look set to have been 0.2% lower than in August as a result (consensus: -0.2%). Excluding volatile energy and food prices, however, a 0.2% increase appears to be on the cards. The Fed considers the decline in oil prices to be temporary in nature and is therefore looking at the underlying trend in inflation. The resulting rate of inflation excluding energy and food should stick around 1.8%. On balance, there are good chances next week’s real economy and inflation data will signal no new trends and will fail to deliver.
When non-farm payrolls were estimated to have increased by just 173K in August, well below the average through the first seven months of the year, it was mostly dismissed as a fluke. After all, the economy was growing solidly and August payrolls have tended to be revised up in previous years. So, when Friday’s report showed that employment increased by just 142k in September, aggregate hours worked declined outright and the August increase was revised down to 136k, it came as quite a shock. With the benefit of hindsight, perhaps investors should not have been so surprised. Both the OECD’s and the Conference Board’s leading indicators have lost momentum in recent months, financial stress increased noticeably through the summer and corporate profit growth has slowed to a stand-still, even outside of the energy sector. Based on past relationships, both economic and employment growth should have been expected to slow.
In terms of retail sales, consumption has been very strong in recent months, growing stronger than the trend of the past few years. However, these strong periods are often followed by a softer period with growth reverting to trend. This would suggest some risk that retail sales could weaken a little in the short term. The weekly retail sales have also been downbeat lately.
EU
The focus will continue to be on how large a negative effect from the recent weakness in emerging markets with the release of the German ZEW expectations on Tuesday. The expectation is for the number to continue its declining trend, but the rate of fall should be less than the sharp decline seen in September. This mainly reflects the small change in the Sentix investor confidence in the start of the past week, as the two indicators historically have been highly correlated. Moreover, the Volkswagen exhaust scandal could put downward pressure on the ZEW.
On the other hand, there has been a slight rebound in the DAX Index since the end of September, when the survey period for the ZEW starts. Note that the ZEW indicator historically has been good at predicting turning points in IFO expectations, which are more closely related to the economic development, but recently there has been a divergence in the two sentiment indicators.
The composite Purchasing Managers’ Index (PMI) dipped to a four-month low of 53.6 in September (previously 54.3), driven by small declines in both the manufacturing and services surveys. However, this reading still suggests solid growth with the average rate of expansion in the third quarter equalling the four-year high achieved last quarter. Indeed, new business continues to increase at a decent clip, while backlogs of work are rising at the fastest pace since May 2011. Part of this resilience may stem from the fact that the Eurozone recovery has, thus far, been built on improving domestic demand rather than external trade, which has weakened most dramatically.
The latest retail sales data suggest that this impetus is still in place, with volumes increasing by 2.3% over the past 12 months. However, data will have to be monitored closely to ensure that the weakness in EM growth and associated financial stress does not start to undermine this domestic demand story. On this note, it was a concern to see deterioration in the employment component of the PMI survey to an eight-month low in September. Any interruption in labour market repair would pose a major blow to the Eurozone recovery.
The emerging market shock has generated a more immediate effect on Eurozone inflation. Headline HICP inflation slipped back into negative territory at -0.1% year-on-year (y/y) in September according to flash estimates. This decline was driven by an additional leg down in energy prices, which are now a full 8.9% y/y lower than this time last year. While the dip into negative inflation rates grabbed headlines, it will prove transitory.
Headline inflation is expected to rise going forward as the effects of falling oil prices late last year drop out of the annual calculation. Meanwhile, core inflation was stable at 0.9% y/y, with services inflation actually accelerating slightly to 1.3% y/y (previously 1.2% y/y). The stabilisation in measures of underlying inflation has been positive and there have been some tentative signs of a rise in some components, including non-energy industrial goods. However, it will take a prolonged period of above-trend growth to bring inflation back to target on a sustainable basis.
The ECB will be watching all of this with interest. President Draghi has already made the point in his testimony to the European Parliament that more time is needed to assess the severity and implications of deteriorating emerging market activity. On the growth side, he will probably be relieved that there has been no large initial knock to sentiment. However, there will be little room for complacency. Activity rates have softened slightly, while downside risks have undoubtedly increased. If growth were to slow further in coming months, then the ECB would be forced to revise its growth forecasts down again. This would almost certainly prompt further policy easing from the central bank, either in the form of a faster pace of asset purchases or a commitment to extend the programme for a longer period of time.
UK
The UK recovery has, perhaps, not received the credit it deserves over recent years. Part of this reflects the gradual process of upward revisions to national accounts data from the ONS.
According to first estimates by the statistics office, GDP growth averaged 1% annually between 2010 and 2014. The latest data released last week suggest that the UK economy grew by double that pace. Given this tendency to adjust GDP growth higher over time, how seriously should one take signs that activity has softened over recent quarters? Growth has been running at a 2% year-on-year (y/y) rate over 2015, noticeably slower than the 2.9% figure achieved last year. Survey data provide a useful alternative source. Over recent years, there have been conflicting signals between survey measures of activity and official data, with these contradictions often addressed by upward revisions to the latter. Indeed, a number of members on the Monetary Policy Committee (MPC) highlighted this divergence at the start of this year, signalling that they were more inclined to trust the survey data than initial GDP estimates.
Sadly, survey data are providing less comfort at present. The UK composite Purchasing Managers’ Index (PMI) has tumbled over recent months to a 30-month low of 53.3. Weakness has been apparent in the manufacturing survey for some time, with this external sector feeling the strain of a weak global trade cycle and an appreciating currency. More alarming has been the deterioration in the critical services sector, which has fallen steadily from 58.5 in June to 53.3 in September.
New business is still growing, albeit at a considerably slower rate according to the survey, making it less surprising to see backlogs of outstanding business starting to dry up. What might have caused this sudden and pronounced deterioration? The deterioration in emerging market growth and associated volatility in global markets provides something of a smoking gun.
First, the weakness in the connected manufacturing sector could be feeding through to other parts of the economy. Second, the sharp escalation in financial stress seen over August may be denting business confidence. Indeed, it was interesting to see chief financial officers (CFOs) list concerns over emerging markets as the second biggest risk to their business in the Q3 Deloitte survey. More broadly, this survey reported a decline in risk appetite among UK CFOs, with the proportion responding that now is a good time to take risk down to 46%, from 59% last quarter and 72% a year ago. Accordingly, respondents have become less inclined to invest or hire as the outlook has become more uncertain.
Will this stumble prove to be a temporary soft patch or something more malign? Much will depend on conditions in the emerging world and feedthrough of any associated stress into developed markets. The composite PMI is currently close to its long-run average, with GDP growth having averaged 0.5-0.6% quarter-on-quarter (q/q) over the same period. Therefore, the economy looks to have slowed, rather than stalled at present. Going forward, the UK may have to get used to these more tepid growth rates. Confidence has softened in the large services sector; the outlook for exports is undermined by a stronger pound and weak global trade, while fiscal policy is set to tighten markedly. This is likely to reduce the pressure on the MPC to raise rates quickly, although recalibrated market expectations for no interest rate hikes next year look to be too pessimistic.
Sources: Commerzbank, Handelsbanken, Standard Life Investments, Danske Bank