US
Overall conditions in the US economy continue to show improvement. With labor market conditions back on solid footing, attention has now turned to the second half of the Federal Reserve’s dual mandate, stable inflation. This week, the pulse of consumer prices was taken, which are increasing at a much faster pace than the Fed’s preferred inflation gauge, the core PCE (Personal Consumption Expenditures) deflator. Consumer prices rose 0.2% in October, pushing the year-over-year reading up to 1.9%.
Core inflation, which excludes energy and food, also firmed during the month with solid readings in shelter, airfare, lodging away from home and medical care services. Weakness was seen in apparel, personal computers, and vehicles. The inflation story is still largely unchanged, with the service component still showing strong gains, while goods prices continue to be weighed down by weak global growth and a stronger dollar.
What is somewhat befuddling on the inflation front is the discrepancy in inflation indicators. Stronger readings in consumer prices are consistent with other inflation gauges including the Dallas Fed’s Trimmed Mean PCE, which is up 1.7% over the past year. In fact, the core PCE deflator is the only inflation index that has slowed over the past year. The divergence in these indicators is critical, especially given that most market participants expect the Fed to begin normalizing its short-term target rate at the December FOMC meeting.
The most notable differences in the PCE deflator and Consumer Price Index (CPI) are the changing composition of spending, and component weights. In particular, the steady rise in residential rent, which has a much smaller weight in the PCE index than CPI, is partly responsible for the variance in the two inflation indicators. Firming in medical care inflation, which is less important in the CPI than PCE Index, is also causing some of the divergence in the two indicators. Shelter and medical inflation have steadily increased in recent years and are up 2.1%, and 3.2%, respectively. Although the PCE deflator is the Fed’s preferred gauge, it is likely the committee will look at a wide assortment of inflation measures to ascertain the trend in prices.
Housing starts were also released during the week. Housing starts tumbled 11.0% to a 1.06 million-unit pace in October, with declines registered in both single- and multi-family starts. Before reading too much into the monthly headline result, much of October’s drop was in the volatile multi-family component, which plummeted 25.1%. Permits increased during the month, and now show the level running ahead of starts, which suggests some payback could be in store in the coming months. Moreover, the trend in starts still shows an upward trend, with the three-month moving average registering a 1.13 million unit pace. Despite the sizable decline in multi-family starts, apartment demand remains strong, even given the recent ramp up in new construction, which is expected to put some upward pressure on the apartment vacancy rate. Favorable demographics should continue to support apartment fundamentals.
On another note, a closer look at fundamental data seems to show three underlying dichotomies in the US economy:
Industrial production dropped 0.2% in October, registering its seventh monthly reduction this year and eroding the annual change to a measly 0.4% y/y. This time last year, the annual change was 10 times stronger at 4.0% y/y. The stalling trend reflects the stark contrast between America’s contracting energy sector and (moderately) expanding non-energy sector. Non-energy output grew 1.7% y/y in October, partly driven by a double-digit gain in motor vehicle and parts production, but energy output dropped 3.9% y/y. Part of the latter was the weather; last month was the warmest October in 52 years, dialing down energy consumption for heating (utilities output fell 1.5% y/y). However, a key culprit was oil and gas drilling, which plummeted 57.6% y/y, in the wake of the collapse in crude oil prices. Note that the drop in drilling is finally starting to have its negative impact on crude oil output, which peaked at record levels in June.
The New York and Philadelphia Fed’s regional factory surveys suggested America’s manufacturing sector is still knocking at recession’s door. The Empire State index, recasting the survey results in an ISM-like metric, was 47.0 in November, better than October’s 46.3, but still well in contraction territory. Philly Fed fared a bit better, with a recast index of 48.1 in November versus 44.9 in October, but still negative overall. The national ISM index sat just 0.1 points above the 50 “boom-bust” marker last month and November, at least at this stage, is not looking much better. However, while the manufacturing sector is teetering on contraction, the nonmanufacturing sector is expanding at an above-average pace. The nonmanufacturing ISM index was 59.1 in October. Factory output is being stung by the stronger U.S. dollar along with the ripple-effect of lower energy-sector output.
Meanwhile, non-factory activity is being buoyed by consumers and construction. Finally, consumer prices posted a puny 0.2% y/y annual change in October, as a huge 17.1% drop in energy prices almost fully offset a 1.6% rise in food prices and 1.9% increase in core prices. This kept core CPI inflation running in its recent range (a tenth or two around 1.8% since the summer of 2012). However, this stability masks a stark contrast between continuing mild deflation in core goods prices and up-drifting inflation in core services prices. Core goods prices dropped 0.7% y/y in October, largely reflecting lower import prices owing to a strong U.S. dollar along with the ripple effect of lower energy (input) costs. Core services prices rose at a seven-year high pace of 2.8% y/y, hoisted mostly by rents but uptrends are evidence in areas wherever skilled or specialized workers are getting paid more.
The above three data dichotomies have the fingerprints of oil prices and the greenback all over them. To the extent crude and currency influences will eventually wane, the current tone of U.S. economic indicators appears poised to improve. And, it appears the Fed is finally prepared to start betting on that happening.
EU
Looking at fiscal policy, the Eurozone has been among the worst offenders when it comes to misguided fiscal tightening. Between 2010 and 2013, the structural budget deficit was reduced by some 4.1% of GDP. In Spain, this tightening amounted to a full 6.8% of GDP. Austerity proponents would point to extremely high debt burdens across many member states and stressed bond markets as justification. However, the effect on already struggling economies was profound. Aggregate Eurozone GDP averaged 0.2% annually over this period. Of course, fiscal tightening cannot take the full blame for this poor performance. This policy mistake was exacerbated by inappropriately tight monetary policy and impairments in the financial sector. However, in this environment, elevated fiscal multipliers amplified the economic effect of austerity. Indeed, austerity was used as a mechanism to avoid addressing institutional shortcomings in the region. These include fragmented banking regulation, a lack of mechanisms for fiscal transfers between member states, and self-imposed restraints on central bank policy responses. Setting fiscal targets may seem like an easy solution in the short term, but it does not address some of the underlying problems across the monetary union.
The good news is that fiscal policy settings have become more appropriate of late. Structural budgets were tightened by a modest 0.3% of GDP over 2014 and are set to loosen this year, albeit by a modest 0.1% according to the latest OECD forecasts. This represents a subtle shift in direction, illustrated in the looser budgets submitted to the European Commission by both Spain and Italy. Furthermore, the actual fiscal expansions may be larger in those Eurozone economies that are absorbing the highest numbers of migrants. The European Commission has estimated that increased spending on these newcomers could amount to 0.2% of GDP next year. Even taking this into account, the pronounced fiscal stimulus is still away. Nevertheless, it is clearly positive that the headwind from fiscal austerity has now abated. Indeed, we have seen a clear rebound in government consumption and tentative increases in public sector employment over recent quarters. Furthermore, with the ECB having eased monetary policy aggressively over recent quarters and financial sector’s health improving, the Eurozone environment looks much more growth friendly. It is no coincidence that the recovery has taken hold over this period.
What if the shift in fiscal policy went further, from broadly neutral to outright expansionary?
This would help to strengthen the recovery, particularly at this early stage of the cycle and with unhelpful headwinds emanating from abroad, notably emerging markets. Furthermore, this could ease the burden of deleveraging, which is taking place in parts of the private sector. Opponents of any stimulus would point to elevated debt levels across many member states and warn that expansions at this stage could prove unsustainable. This would be a fair criticism if the loosening were to be squandered on day-to-day spending. However, the equation changes if the money is spent on long-term growth-boosting investment. This case is strengthened by the long term government borrowing rates being at record lows. While a fiscal expansion among highly indebted countries may look scary, it could actually boost debt sustainability if it raises long-term growth prospects.
In terms of data, next week will the release of the PMI figures will be made available. The figure should improve moderately mainly due to the signs of stabilisation in the Chinese PMI. Moreover, the effective Euro has been weakening, which will support exports while the financial stress has also eased off.
On Tuesday, data for the German IFO expectations is due to be released, which it also expects to improve slightly for the same reasons as mentioned above. Historically, the German manufacturing PMI and the IFO expectations have been highly correlated. Note that the financial survey indicators (Sentix and ZEW) have undershot the economic survey indicators (IFO and PMI) in recent months but this development should be temporary and fade away soon as improvements in the financial indicators will become visible.
Besides IFO expectations, data for the German GDP components is due to be released on Tuesday. The headline figure released last week was better than expected, most likely due to strong growth in private consumption. The data for the decomposition could still attract some attention, as it will reveal the degree of weakness in exports and investments.
On Thursday, money supply figures for October are due to be released. The expectation is the recent strong growth to continue but is also waiting to see if the decline in growth in loans to non-financial corporations in September continues. This is one of the transmission mechanisms of the ECB’s QE purchases, and if the upward trend has reversed, this will be a concern for the ECB.
UK
The consumer price index (CPI) fell by 0.1% for the year up to October 2015, the same drop as for the year up to September 2015. Upward price pressures for clothing and footwear and a range of recreational goods were offset by downward price pressures for university tuition fees, food, alcohol and tobacco, thereby resulting in no change to the overall rate of inflation. Core inflation (excluding volatile food and energy prices) increased to 1.1% in October from 1% in September. The reading in October represents the third time this year that the economy has faced price decreases. The upward pressure from clothing and footwear posted its highest increase between September and October since records began in 1996. However, this was offset by larger decreases elsewhere. The Bank of England expects inflation to remain low into 2016 before accelerating toward its 2% target. BoE Governor Mark Carney has highlighted core inflation as an important measure for policymakers who are determining when to begin interest rate increases after keeping them at a record low for more than six years.
Year-on-year estimates in the quantity bought in the retail industry show growth for the 30th consecutive month in October 2015, increasing by 3.8% compared with October last year. The underlying pattern in the data, as suggested by the three-month on three-month movement in the quantity bought, showed growth for the 23rd consecutive month. The amount spent in the retail industry increased by 0.5% in October 2015 compared with the same period last year and decreased by 0.7% compared with September. The value of online sales increased by 11.2% in October 2015 compared with October 2014.
Factory executives expect production to drop over the coming three months due to continued weakness in foreign demand, according to latest survey from the Confederation of British Industry. The manufacturing sector is dampened by a strong sterling and weakening global growth outlook. Index for business optimism and export optimism within the manufacturing sector both fell, reflecting the imbalance within the economy as the industrial sector continues to face headwinds from abroad.
Public finances in October recorded a deficit of GBP 8.2bn. The widening of the deficit was due to a combination of lower growth of tax receipts and higher government spending compared with October last year. The government will have difficulties achieving its goal for this fiscal year, and in a longer-term perspective, difficulties ensuring that there will be a surplus in public finances in 2019-2020. Will borrowing increase or will there be more fiscal austerity ahead? The Chancellor will announce the Autumn Statement and “spending review” next week.
Japan
In terms of fiscal policy, the ‘Bizen Heart Hisei Big Bridge’ is the quintessential bridge to nowhere. Opened in April 2015, it spans 765 meters (longer than both Tower Bridge and Tyne Bridge) and connects the Japanese mainland to a 10.2 km island with a population of 11. Such projects serve as a reminder of Japan’s partiality to public works programmes. Government construction investment notoriously reached 76% of GDP in 1993, before being dramatically scaled back as debt levels surged and the true cost of Japan’s ageing population became more apparent. However, it has been rising again, up 10 ppts between 2008 and 2014. The question, as always with such public works plans, is who is paying for it.
While central bankers elsewhere have bemoaned an over-reliance on monetary policy (at the expense of fiscal policy) to drive growth, the Bank of Japan (BoJ) has been steadfast in its calls for fiscal prudence. Governor Kuroda was a vocal opponent of plans to delay the VAT hike, and has repeatedly stated that the government should fulfil its commitment to a primary surplus by 2020. His zealousness seems peculiar, given recent economic performance. GDP contracted again in Q3, down 0.8% q/q on a seasonally adjusted annualised basis, and has pushed Japan into a technical recession. Perhaps more strikingly, the economy is smaller now than it was two years ago, a damning indictment of the transmission of monetary settings to economic output. The reluctance on Kuroda’s part to embrace greater fiscal largesse likely reflects more selfish considerations.
The BoJ is already acutely aware of the challenges of any future attempt to normalise policy. The prospect of the Bank not only ending its policy stimulus but actually starting to tighten financial conditions by selling-off accumulated assets already seems remote. Given the country’s poor fiscal dynamics, there would be even less chance the BoJ would reign in its efforts to keep real interest rates low, particularly if it raised the risk of pushing the country into insolvency. When fiscal considerations trump monetary ones, a situation known as fiscal dominance, it becomes extremely difficult for the central bank to wrest back control of policy. Hence, Kuroda’s insistence that an improvement in the country’s fiscal position be a priority.
In response, the Ministry of Finance has promised big spending cuts to social services, with elderly healthcare and pension provisions to be slashed. There are reasons to remain skeptical that this is feasible, given Japan’s demographics, which are likely to continue to see the social security payments outstrip insurance revenues. The Ministry of Finance insists that the spending cuts will be deep enough to meet its interim target of cutting the primary deficit to 1% by 2018 but it has also left the door open for further cuts if this is not met. The prospects of an improvement in the revenue side of the equation are somewhat better. Higher nominal growth pushed Japan’s tax take higher for five consecutive years through FY2013. The improvement in the corporate sector has been dramatic, with tax revenues jumping nearly 20% y/y in 2014. By comparison, approximately 70% of corporates did not pay tax in 2011. For this to continue, though, the government will need economic growth and corporate profitability to stay high. For that reason, the latest GDP contraction suggests further policy easing will be required.
Sources: Wells Fargo, BMO Capital, Danske Bank, Handelsbanken Capital Markets, Standard Life Investments.
