US
Following a string of upbeat U.S. economic reports (on employment, auto sales and non-manufacturing), the October retail sales release was a relative dud. Although core sales rose modestly, they have softened since the summer, suggesting a loss of momentum heading into the holiday shopping season. Real consumer spending looks to increase about 3% y/y in the current quarter, compared with 3.2% in Q4 of 2014. Core retail sales (ex-autos, gasoline stations and building materials) are also cruising around 3% (a little less after inflation), compared with almost 4% last holiday season.
The downshift explains the sag in retail stocks of late. Macy’s missed earnings estimates, lowered its guidance after reporting fewer foreign visitors to its stores (due to the mighty dollar) and tepid demand from other customers. Rubbing salt in the wound, earnings fell faster than sales, reflecting intense discounting due to cut-throat competition from online shops. Rising retail inventories could put a further squeeze on retail margins this holiday season. Still, there are four good reasons to expect consumers to spend at a solid 3% clip in coming quarters:
First and foremost, many more consumers have jobs. On net, there are 2.8 million more Americans working today than a year ago. The 2% increase is double the average rate of the past quarter century. That goes a long way to explaining why consumer confidence is back to normal after the trauma of the Great Recession.
Second, real wage gains are supporting spending power. While actual wage increases remain subdued, low inflation (courtesy of lower gasoline prices and, yes, intense retail competition) implies solid increases in real personal income (3.4% y/y in September). And, with the jobless rate at a 7½-year low, growing worker shortages should encourage an upturn in wages. More small businesses plan to raise wages to retain and attract workers, while holding the line on prices. Also note that the “quits” rate, though stabilizing of late, is at levels that historically point to 3% wage gains, up from the recent 2% trend.
Third, households are spending the least disposable income on debt payments (10%) since at least 1980. This means they have 3% more income to spend on other things compared with eight years ago (and more than Canadians have to spend). True, higher interest rates will slow this tailwind, but nobody expects the Fed to slam on the brakes.
And finally, households have never been wealthier. With $86 trillion of net worth, or an average of $731,000 per household, the wealth effect is alive and well (though still very much skewed toward the richest households). Rising nearly 5% in the past year, the increase in wealth is adding modestly to spending growth. The upshot is that, while Santa’s sleigh might be a little lighter this year, it will still be brimming with gifts.
On another note, the dollar has resumed its ascent following the October FOMC meeting. A combination of falling commodity prices and rising dollar weighed on U.S. import prices in October, with the import price index down 0.5% m/m and 10.5% y/y. Signs of falling commodity and import prices could also be felt in the October retail sales report. Retail sales edged up by a modest 0.1% m/m in October, below the 0.3% m/m gain expected by the market, as gasoline stations, autos, electronics and general merchandise stores posted declines.
However, since retail sales are reported in current dollar (nominal) terms, the weakness in the headline could be overstating the slowdown in the real pace of consumer spending. Case in point being that while auto sales fell in nominal terms, actual units of autos sold are near record highs. Moreover, the retail sales measure is highly skewed toward goods. Services spending accounts for only 12% of the retail sales measure, but 68% of consumer spending more broadly.
There is little doubt that the drag from a surging dollar on inflation is non-trivial. On Thursday, the Fed’s Vice-Chair Stanley Fisher stated that Fed staff estimate the dollar’s appreciation will shave between 0.25 to 0.50 percentage points from core PCE inflation this year. As such, with core PCE inflation running at about 1.3% so far in 2015, the stronger dollar is playing a significant role in holding inflation below the Fed’s 2% target.
Still, subdued inflation is unlikely to dissuade the Fed from raising rates in December. Given the nascent signs of acceleration in hourly earnings, the transitory nature of many of the price shocks, and the forward-looking nature of monetary policy, the Fed is unlikely to wait until capacity pressures become any more evident. This view was also reiterated by President Dudley, who said that he didn’t favor waiting to see “the whites of inflation’s eyes” before raising interest rates.
However, the soft inflationary backdrop and the remaining slack in the labor market diminish the sense of urgency in normalizing rates, and argue for a “gradual pace” of tightening. After a December liftoff, some anticipate rate adjustments of roughly 75 basis points in the first year – less than half the pace of a typical tightening cycle.
EU
For many months, ECB representatives categorically ruled out a further key interest rate cut but a reduction of the deposit rate is now en vogue again. According to ECB chief economist Praet there are no taboos when it comes to monetary policy instruments, while his executive board colleague Coeuré said in the context of a deposit rate cut that a discussion had begun but the outcome was open.
Three weeks ago, ECB President Draghi startled markets when he declared that the central bank would “re-examine” the degree of monetary policy accommodation needed at their next policy meeting in December. There was some expectation that he would sound dovish, but to come right out and communicate that to financial markets was a surprise.
There is no guarantee, however, that new measures will be introduced next month. It depends on the “strength and persistence” of the factors that are holding back the return to the 2% inflation target. There are also downside risks to growth from weak external demand, mainly due to emerging markets, and “more particularly, China”.
Since then, China’s economy continued to slow (at least into October), despite the government’s efforts to support growth over the near and longer term (via rate cuts, balancing population growth by allowing two children per family, and strengthening the social safety net, for example). In the background was news that Shanshui Cement declared bankruptcy despite having enough cash in the bank to pay down their debt.
The Euro Area economy has not exactly been a picture of health either. Real GDP grew 0.3% in Q3, the slowest quarterly gain in a year (although the 1.6% y/y pace was still the best in four years). There were also a few ECB officials hinting at more QE. Council member Visco declared “The appropriate degree of monetary accommodation has to be maintained to fulfill our mandate” and that “This may imply… a change in the size, composition and duration of the APP.”
The ECB’s Coeure concurred and stated that the “debate is open” to boosting QE but warned that they will decide “based on the economy and not on financial markets”. Then President Draghi acknowledged that “Signs of a sustained turnaround in core inflation have somewhat weakened” and that “Downside risks stemming from global growth and trade are clearly visible”.
The bottom line seems to be that given the factors holding back inflation, slower economic momentum from emerging markets (namely China), and not to mention political instability (again, in Greece and Portugal), look for the ECB to cut the deposit rate next month. But increasing the pace of QE may prove challenging… which bonds to buy?
Looking at KPIs, next week in the euro area is quiet in terms of data releases. On Tuesday, the German ZEW expectations figure for November is released, and it is expected to increase in line with the improvement in the Sentix investor confidence at the start of last week. Interestingly, the ZEW expectations indicator has undershot the economic indicators (IFO and PMI) recently, but this should be over for now. The forecast of an increase mainly reflects the fact that the financial stress has eased due to signs of stability in China and Draghi opening the door to a deposit rate cut.
On Friday, data for the euro area consumer confidence will be released, and the falling trend should continue as the boost from the lower oil price has been factored in. Note that although the consumer confidence has been trending downwards since March 2015, the indicator is still the highest it’s been for several years.
UK
British retail spending stagnated last month, as mixed weather and the later-than-usual date of a public holiday hit sales of furniture and school clothing and equipment. The British Retail Consortium said retail spending decreased by 1.0% on a like-for-like basis from August 2014. One reason for the low sales was that a late August bank holiday, which typically brings back-to-school spending on children’s clothing and discount-driven furniture sales, fell outside the survey’s four-week window this year.
Muggy weather towards the end of August also hurt demand for new autumn and winter fashion collections, especially boots. Online sales of Non-Food products in the UK grew by 6.5% in August versus a year earlier, when they had grown 19.8% and had established the 2014 best performance. This was the slowest growth registered since April 2013. The Non-Food online penetration rate was 17.2%, up from 16.3% in August 2014.
The UK factory output fell by 0.5 per cent in July compared with June, according to figures released today by the Office for National Statistics, as firms continue to battle against a strong pound and weak economic growth in major export markets. Total industrial production, which includes mining and quarrying as well as manufacturing, dropped 0.4 per cent. “July’s industrial production and trade figures highlight that the strength of the pound and weakness in demand in key export markets held back the recovery in the manufacturing sector,” said economist Paul Hollingsworth from Capital Economics.
The value of UK exports dropped 5.2 per cent in July compared with March. Imports rose 0.6 per cent. The goods/visible trade deficit widened to GBP 11.1 billion in July, beating the estimate of GBP 9.5 billion. The total trade deficit widened to GBP 3.4 billion. The surplus in services increased to GBP 7.7 billion. In the second quarter, the total deficit narrowed more than previously estimated to GBP 3.4 billion. Exports plunged 12.6% in July due to falling shipments to the US, Switzerland and China.
NIESR estimates of GDP suggest that output grew by 0.5 per cent in the three months ending in Au-gust, after growth of 0.6 per cent in the three months ending in July 2015. Despite the slight softening, growth remains close to the estimated long-run potential of the economy, but below the average rate of growth (0.7 per cent per quarter) observed since the start of 2013.
The RICS house price indicator reached a 15-month high in August, with a net balance of 53%. More respondents reporting price-rises, and firm growth were being seen across all areas of the UK.
Bank of England policymakers voted 8-1 to keep interest rates at their record-low 0.5 per cent this month, and judged that it was too soon to decide if market turmoil sparked by China will affect Britain much. Ian McCafferty, one of the nine members of the Monetary Policy Committee, voted to increase rates to 0.75 per cent, but the majority of policymakers appeared in no rush to raise rates, according to minutes released on Thursday.
The central bank said it expected Britain’s economy to maintain healthy growth. Some rate-setters saw a risk of inflation rising more quickly than forecast, although better productivity was offsetting the effect of higher wages. “Although the downside risks emanating from overseas had risen, it would be premature to draw strong inferences from this month’s events for the likely path of activity in the United Kingdom,” the MPC said in minutes of its monthly policy meeting.
Inflation expectations for one year out fell slightly in August, but expectations for two years out remained broadly unchanged, a survey released on Friday shows. The August GfK Inflation Expectations survey for the Bank of England showed median expectations for the rate of inflation over the coming year were 2.0%, compared with 2.2% in May.
In terms of data release, CPI inflation for October is due on Tuesday. Although it has been argued argued that the bottom for inflation was reached in September, many were caught by surprise as gasoline prices have declined further despite the stabilization of oil prices in GBP terms. Therefore, the estimate foe the headline CPI inflation fell to -0.2% y/y in October. The very low inflation is explained by a combination of low commodity prices and the appreciation of GBP which weighs on inflation through lower import prices. Only services inflation contributes positively to inflation.
CPI inflation is expected to pick up early next year as the base effects from the drop in oil prices in H2 14 begin to drop out.
Retail sales for October are due on Thursday. Retail sales were very strong in September which the Office for National Statistics attributed to the hosting of the Rugby World Cup. Thus, a downward correction is likely and there could a decline of 0.7% m/m. Overall, retail sales should not be over interpreted as they account for less than 6% of GDP. There are reasons to remain optimistic on the outlook for private consumption due to a combination of high
Japan
Large swings in oil prices and the yen have driven a wedge between industrial production (IP) trends and corporate earnings in recent quarters. Unsurprisingly then, confirmation last week that industrial activity had contracted for a second successive quarter, down 1.3% q/q through Jul-Sept compared to a 1.4% q/q fall in April to June, proved little cause for concern. Instead, the 1% m/m increase in the September IP, which came in noticeably above the market consensus of -0.6%, was seized on as justification for the Bank’s decision later in the week to hold policy steady.
This logic may be flawed. Certainly, there are signs of a bottoming out in the manufacturing sector, with the Japanese manufacturing PMI for October rising 1.5pts to 52.5, but the BOJ is likely to remain cautious over the risks emanating from China and the US. A better attempt to rationalize the Bank’s policy decision rested on the fact that, while the Bank’s primary measure of inflation remains negative, CPI ex-fresh food and energy was up 1.2% y/y.
The argument here is that a temporary energy price shock is behind the Bank’s inability to meet its target and that domestic demand-generated inflation is emerging. There are problems with this interpretation too. Last year, the BOJ prioritized core CPI including energy prices (when energy was a big price positive), so a switch of focus to core CPI ex-fresh food and energy (when energy is a big negative) seems opportunist.
Perhaps more importantly, the divergence between these two measures is likely to narrow as the impact of yen depreciation on core-core measures fade, while energy price base affects dampen the drag on core prices. The risks of a slowdown in core-core measures of inflation were already evident in the October Tokyo core-core CPI measure, which fell to 0.4% from 0.6% in September.
Of course, inconsistencies within the BOJ’s policy framework would be nothing new. Its timeframe for commitments have repeatedly slid from 2% in two years, to mid-2016, and now end 2016/start 2017. It has altered its logic on inflation expectation changes too and reacted erratically to economic and price data; last October’s 0.2 ppts downgrade in its price and growth outlook one year ahead triggered easing; this year’s 0.5 ppts downgrade in price and 0.1 ppts growth downgrade yielded nothing. All of this has made understanding the BOJ’s reaction function increasingly difficult. However, one must refrain from interpreting last Friday’s events as a turning point.
The MPB maintained its medium-term scenario in which the headline CPI goes up to 2% y/y amid an improving GDP gap, continued tightening of the labor market conditions and steady and elevated expected inflation rates. In addition, the Bank has been too optimistic in the past and it will be difficult to achieve its forecasts, auguring for further easing. The biggest change is that April and October are no longer the only ‘live’ policy meetings, as the Bank is clearly comfortable with the inconsistency of a downgrade in its price outlook without adjusting policy.
There is less clarity, though, on what the thresholds for further easing may be. Would a collapse in core CPI trigger easing? What role now for inflation expectations measures? Are wages the trigger? Unless the BOJ moves to restore some sense of order, volatility will remain high. Unfortunately, in the absence of a massive improvement in its communications strategy, the only conceivable way for the Bank to do this is through further easing.
China
Internal migration has played a massive role in China’s economic development over the past three decades. To fuel growth, the Chinese government relaxed Maoist restrictions on the flow of labour, allowing surplus rural workers to fill the booming coastal factories. However, the government has continued to keep in place the household registration (hukou) system that assigns a permanent residence at birth. Although allowed to work in cities, migrant workers are prevented from permanently settling in urban areas. This group of floating labour has grown rapidly over the last 30 years, increasing to 273.95 million in 2014, and make up as much as a third of China’s total workforce. Without an urban hukou, these internal migrants often lack access to basic services, such as healthcare, social security, education, housing, and decent job opportunities. This lack of access to services is often cited as a reason behind China’s high savings rate and low consumption share of GDP.
Migrant wages have begun to converge on urban incomes, as China’s labour surplus diminishes. However, large gaps continue to exist between migrants and urban residents; and the continued use of the hukou system will only exacerbate the inequality. The government recognizes that this system is untenable for a modernizing economy but has, so far, failed to introduce any serious solutions. Reforms introduced last year failed to remove restrictions on cities where people actually want to relocate but, instead, opened up migration to cities where restrictions were already relaxed and scant migration demand exists. The bulk of migrants are located in first-tier cities and have no interest in moving back to their village or relocating to a tier-three city. Removing discriminatory policies would increase their disposable income and, thus, further the goal of rebalancing through consumption-led growth. However, full removal could lead to a backlash from urban elites, one of the CCP’s strongest constituencies.
In the short term, migrant labour flows and wages are a good indicator of economic and labour market conditions. Given the flexibility of hiring and firing migrant workers, short-term fluctuations in economic growth are often exhibited in migrant flows. Weakness in real estate or manufacturing would be clearly exhibited in slower migrant worker flows as they are the most vulnerable employees when business slows.
According to the IMF, growth in migrant flows is strongly correlated with GDP growth, with a 2 ppts growth in GDP reflected in 1 ppts growth in migrant flows. Migrant flows have been structurally slowing over the past four years, reflecting both the decline of surplus labour but, also, structural shifts in the economy. However, the sharp drop in Q1 and weak rebound in Q2 suggest migrant workers are finding fewer opportunities in the cities and/or dismayed at the higher living costs.
This massive pool of underserved, floating labour provides an interesting window into the Chinese economy. As China attempts to rebalance, it will be the fate of this young, often-educated urban underclass that could decide the outcome of China’s reform plan. Well-calibrated policies can unlock new sources of domestic demand but continued marginalization of migrants could stymie progress and increase social tensions.
Looking at data release, it is a very quiet week in China next week with only house prices (Wednesday) released on the economic front. House prices have recovered in recent quarters on the back of stronger demand and a reduction in the down payment for first-time house buyers.
Otherwise, the focus is increasingly on the IMF decision on the inclusion of the renminbi in the SDR. There is no formal date for the decision yet but November has been mentioned. It is close to a done deal that it will be accepted. The key question is whether the currency is “freely usable” but following the FX reform this year and commitment to keep the CNH and CNY close to each other, indications have been that China will be included. If so, the IMF has signalled that it will take effect from 1 October next year.
Sources: TD Economics, BMO Capital Markets, Danske Bank, Handelsbanken Capital Market.
