Economic Outlook – 17 June 2018

US

• In the May US retail sales report, headline sales surged 0.8% following an upwardly revised 0.4% in April. Much of the recent strength in retail sales has been attributed to rising gasoline prices. However, excluding gasoline station sales, sales increased an impressive 0.7%. Moreover, the relatively strong print in automobile sales is, perhaps, the realisation by American consumers that higher interest rates are an increasingly likely reality and that they should move ahead of higher future interest rates. After a disappointing performance for the US consumer in the first quarter, spending strength has returned in Q2.
• CPI inflation was reported for April and was largely in-line with expectations. Consumer price inflation continues to gradually pick up, which adds further support to the Fed’s plan to hike rates at its September and December meetings. Higher core inflation continues to be driven by the service sector, and is rising at the fastest pace since January 2017.
• Likewise, producer price inflation (PPI) continues its upward momentum. As pipeline pressures have picked up in May, input costs for processed and unprocessed goods as well as services have increased more than 3.0% over the past year and suggest further upward pressure on final selling prices in the months to come.
• The Federal Open Market Committee (FOMC) voted to raise the federal funds target range to 1.75% to 2.0% on Wednesday, the seventh hike of the tightening cycle. In comments following the meeting, Fed chairman Jerome Powell was extremely upbeat on the outlook for the US economy, pointing to record-low unemployment and still-low inflation. The improving outlook prompted FOMC members to raise their forecast of the number of 2018 rate hikes from three to four and to increase their economic growth and inflation forecasts. The committee now forecasts that the US economy will expand by 2.8% in 2018, up from a 2.7% projection in March. Core inflation is expected to rise 2.0% this year. That’s up from the FOMC’s prior 1.9% estimate. Additionally, Powell announced that he would begin holding press conferences after each meeting, starting in January. The Fed chair currently meets the press every other meeting. Since the tightening cycle began in December 2015, the Fed has raised rates only at meetings including a scheduled press conference. The shift will allow the committee a bit more flexibility when it comes to the timing of rate moves. Powell cautioned that observers should not read any policy change into the action, such as a faster pace of rate hike.
• On Thursday, President Donald Trump approved tariffs on $50 billion in Chinese imports, with the levies set to go into effect on 6 July. China is expected to counter with a similarly sized package of tariffs on US goods. Markets have been remarkably tranquil despite the growing trade friction, with many analysts seeing the tit-for-tat duties as part of a larger negotiation that will ultimately end with a comprehensive agreement. While NAFTA (North American Free Trade Agreement) negotiations have faded from the headlines, Canadian foreign minister Chrystia Freeland said that discussions would continue throughout the summer. It should be noted that trade tensions are not limited to those between the US and its trading partners. This week, the new Italian government said it might veto the EU/Canada free trade pact because it does not offer Italy’s specialty products enough protections.
• The major indexes ended mixed. A drop on Friday erased gains for the Dow Jones Industrial Average and the S&P MidCap 400 Index, while the technology-heavy Nasdaq Composite and small-cap Russell 2000 indexes were able to remain in positive territory. The S&P 500 Index was virtually unchanged. The Nasdaq, S&P MidCap 400, and Russell 2000 all managed to set new record highs during the week before falling back Friday. Within the S&P 500 Index, consumer discretionary and utilities stocks performed best, while energy, financials, materials, and industrials shares recorded steep losses.
• Stock prices fluctuated within a small band for most of the week, a notable contrast to the volatility of recent months, as investors seemed largely unmoved by a series of important macroeconomic events and data. In particular, the summit between North Korea and the US on Monday seemed to have little impact on markets, perhaps because details of North Korea’s promised denuclearisation remained to be finalised.
• The yield on the benchmark 10-year Treasury note briefly broke through the 3.0% threshold following the Fed meeting but ended slightly lower for the week. New issuance was limited again in the municipal market, prompting investors to search the secondary market in their hunt for yield and resulting in aggressive bidding for higher-yielding deals. Longer-term issues came under pressure early in the week, however, as demand was light even with dealer concessions.
• The most interesting release is the preliminary Markit PMIs for June due out on next Friday. The service sector looks in good shape and it is likely PMI services remains above the 56 mark, with an unchanged print of 56.8. On manufacturing, the indices are likely to peak soon but so far it has been difficult to see in either Markit PMI or ISM.

EU

• At its policy meeting, the ECB announced an end to QE at the end of the year following a tapering of purchases to EUR 15 billion from October. This was in line with expectations in the market. Simultaneously, the ECB sharpened the forward guidance on interest rates, saying that it expects the key policy rates to remain at their present levels at least through the summer of 2019, and in any case for as long it takes for inflation to evolve with the expectations of a sustained adjustment path. Taking this literally, this cuts off the expectations of earlier rate hikes; as a consequence, the EUR weakened and market interest rates decreased.
• Most European equities ended higher, boosted earlier in the week by bank, mining, and energy shares. Trading volumes were muted as investors apparently awaited news from the planned ECB meeting. The pan-European STOXX 600 Index finished nearly 2.0% higher, logging its biggest daily gain since last April, according to FactSet data, aided in part by a tumbling euro. By the end of the week, most key indexes lost ground as investors’ concern about an escalating trade dispute between the US and China intensified. The UK blue chip FTSE index ended the week flat.
• In the euro area, PMI figures are due on Wednesday. Manufacturing PMI has fallen for five consecutive months. After peaking at 60.6 in December 2017, it fell to 55.5 in May 2018. A further fall to 54.8 in June is possible. Service PMI has seen a similar development, declining from 58.0 in January to 53.8 in May. Service PMI is expected to fall to 53.7 in June, as well as a further decline in PMIs as a consequence of Donald Trump’s imposition of steel/aluminium tariffs on the EU, with the lingering threat of more to come and the less optimistic economic sentiment as observed in IFO and ZEW figures, also on the back of the Italian turmoil.

UK

• The Monetary Policy Committee (MPC) of the Bank of England (BoE) will meet Thursday next week, with its decision due to be released at 13:00 CET. Minutes from the monetary policy meeting will also be released. At its meeting in May, the MPC decided to keep the bank rate unchanged; it was a split decision (7 to 2). Despite the minority still wanting to raise the bank rate, the MPC struck a less hawkish tone in May than in February. In May, the MPC just said that if the economy were to develop broadly in line with expectations, an ongoing tightening of monetary policy over the forecast period would be appropriate. However, the MPC also said that there was particular uncertainty around the near-term outlook given the weakness in Q1, both in the UK and abroad. The conditioning path for the Bank of England forecast implies that the bank rate will be lifted two to three times by the end of Q1 2021. Since the May meeting, data have been mixed.
• UK gilt yields moved lower over the week as law makers voted on amendments to current Brexit legislation. Elsewhere, inflation in May came in at 2.4%, which was in line with the April level but shy of the 2.6% forecast. The inflation numbers, which have fallen from their peak, lessened chances for an interest rate hike by the Bank of England in August. Retail sales were stronger than expected, with the May reading coming it at 1.3%.
• British retail sales jumped for a second month in a row in May as a royal wedding and warm weather helped shoppers put a winter slump further behind them, according to data that showed much stronger spending than expected. The last figures pushed up the value of sterling as investors took them as a sign that the economy was recovering from a sharp slowdown in the wintry start to 2018 which put the Bank of England off an interest rate hike.
• Rather than battling with European Union officials in Brussels this week, British prime minister Theresa May faced turmoil within her own Conservative Party. Rebel anti-Brexit lawmakers labeled as unacceptable a compromise to give members of parliament a meaningful vote on whatever Brexit package May’s government negotiates with the EU. The clash comes amid the lengthy legislative process that will lead to the severing of ties with Brussels in March. Given May’s narrow working majority in the House of Commons, she can ill afford many defections.

China

• Following a surprising pick-up in growth at the beginning of the year, the weak May activity data suggests that China’s economy is now slowing. Industrial production growth undershot expectations as growth fell from 7.0% year-on-year in April to 6.8% in May. But since growth jumped in April, the May decline does not look that worrying. However, the slide in retail sales growth from 9.4% year-on-year in April to only 8.5% against expectations of a slight increase indeed looks bad. Similarly, growth of fixed asset investments slid dramatically, driven primarily by a slowdown in infrastructure investments whereas property investments and investments in the manufacturing sector held up. It is however somewhat assuring that infrastructure is behind the decline. Infrastructure projects remain an important economic policy tool and the slowdown is very likely policy driven, which also means that it can fairly easily be reversed by the authorities, if needed.

Sources: Wells Fargo, T. Rowe Price, Handelsbanken Capital Markets, Reuters, Danske Bank.