US
The decision by the Federal Open Market Committee (FOMC) not to lift the federal funds rate at last week’s meeting came as no surprise. However, the rationale given by FED Chair Janet Yellen for not moving and the perceived tone of her comments did. Although Yellen acknowledged that there had been an active discussion about raising interest rates, and that domestic conditions arguably justified a move, the increased turbulence in financial markets and the heightened risks surrounding the Chinese and broader emerging market (EM) economic outlook, appeared to have spooked Committee members.
Not only did they lower their growth and inflation projections but the median projected federal funds rate fell 25 basis points in both 2016 and 2017, continuing the trend that began last year. The Committee also appeared to be taking more signals from the decline in market measures of inflation expectations than was the case earlier in the year.
Some investors have interpreted the Fed’s decision as a change in its reaction function and in particular putting a higher weight on international factors, including the dollar, than in the past.
Others believe the Fed has always been clear that changes in foreign economic conditions do matter for policy if they are likely to have an impact on the domestic economy. While Yellen stated that the Committee had long expected Chinese growth to slow, she also expressed some concern that downside risks had increased and that Chinese policymakers may not be completely in control of the situation. More importantly, the US economy is more open to trade with the rest of the world than it was during previous business cycles and exports destined for final demand in EMs (including Mexico and Canada, which is now in recession) account for 63% of total goods exports, which is much higher than in the past.
Meanwhile, there has been a meaningful increase in financial stress since the spring. Projections from our internal models suggest that if stress does not abate during the winter then domestic GDP growth could be reduced by some 0.4 percentage points over the next two years. That comes on top of the headwinds for both growth and inflation already being generated by the almost 20% trade-weighted appreciation of the dollar since the beginning of last year.
In many ways the dovishness of Yellen’s press conference has been overstated. When asked whether it was now likely that the federal funds rate would not be raised until 2016, she pushed back quite assertively, emphasising that domestic conditions remain quite strong and that most FOMC members expected to raise rates before the end of 2015. The upshot is that the bar for beginning normalisation is low. A stabilisation in financial conditions, coupled with evidence of progress towards the FOMC’s employment and inflation objectives would trigger an increase in rates.
The path for interest rates is far more important than the lift-off date itself. And on that front, policy accommodation is expected to be withdrawn very gradually, especially while underlying inflation remains well below target and Yellen remains convinced that there is still considerable slack left in the labour market. The future path of inflation will dictate whether that assumption is correct.
With Yellen’s speech as a guide, there are a few things to keep an eye on going into the October and December meetings.
- First, the flow of domestic data will determine whether or not the Fed hikes. As things stand, the U.S. economy is on particularly firm footing. Economic growth is tracking at 2.5% for the year, with growth for the second quarter revised up from 3.7% to 3.9% this week.
- Second, in terms of global growth, a material deterioration above and beyond current sluggish growth is needed to delay the Fed. This could mean an unexpected slowdown in the euro area, where data continues to come in quite solid (composite PMI at 53.9 this week). Alternatively, another step down from already weak Chinese growth, one which sends oil prices below their lows of the year, could be something that sways the Fed.
On another note, with respect to durable goods orders a surge is likely for the next report for September and then will likely crash back down off in the October reading.
The reason is China’s massive airplane order that was announced recently. Timed for President Xi Jinping’s visit to the US, China announced an order for 300 planes from Boeing worth $38 billion. This includes 190 737s and 50 widebody planes plus 60 single-aisle planes. There haven’t been that many months when Boeing’s order book has come in so strong but when it does it typically leads to gains in headline durable goods orders in the several percentage point realm but not always depending on other big lumpy categories like auto sector orders.
EU
The ECB has probably played its part in recent speculation about further rate cuts. Whilst ECB President Mario Draghi previously stressed that a rate cut can definitely be ruled out, his reply to a corresponding question at the recent press conference was merely that the council had not discussed that. Moreover, ECB chief economist Praet also kept a door open, stating that there is “hardly any” room to trim back interest rates.
Despite these statements, the barrier to another rate cut remains high. Draghi has in the past reiterated that interest rates are at their lower bound. Faith in the ECB could thus suffer considerably, if the central bank decided in favour of yet another rate reduction. Moreover, the room for lowering rates is very limited, though not zero, which would make a cut rather ineffective. If interest rates were to slip more deeply into negative territory, an increasing share of banks would debate whether it is in fact cheaper for them to hold central bank money in the form of cash. Due to these considerations, the ECB probably maintains that further policy action will focus on adjustments in the volume, composition and duration of the bond-buying programme. Nonetheless, another rate reduction cannot be entirely ruled out. One argument supporting this view are the grounds for reaching the lower bound, which ECB Member of the Executive Board Coeuré cited in a speech delivered in May: “The ECB does not intend to cut rates further, primarily because other, more effective instruments, namely asset purchases, are at the bank’s disposal”.
If this is the key reason, it remains to be seen whether the ECB will not, after all, decide to slash interest rates further if it sees the effectiveness of its bond purchases at risk. This largely depends on the deposit facility interest rate, because the central bank had decided that bonds are only eligible for purchase as long as their yield is above the deposit rate. If, as in the spring, the yield on many bonds slips below this level, it will become increasingly difficult for the ECB to find enough bonds to purchase and doubts as to whether the central bank can achieve its goals would increase.
Going by the ECB’s own statements, there is no shortage of bonds to purchase so far. It hence does not come as a surprise that Draghi for a long time firmly stuck to his statement that interest rates are at their lower bound. But in the spring no one expected the ECB to think aloud about an extension or prolongation of the bond-buying programme after such a short time. The higher the total volume of the programme, the higher is the risk that the ECB does not find enough holders willing to sell to it.
Against this backdrop, a further reduction in the deposit rate cannot be entirely ruled out despite it is unlikely given the moderately rising euro zone yields in 2016. The main reason arguing for this view is the Fed’s lift-off, which forms a key part of our forecast, and which should give US yields a lift, prompting a moderate rise in euro area yields. As long as yields do not reach the critical level for bond purchases of -0.2%, the ECB ought to stick to its view that key rates are at their lower bound.
Another point of concern for the ECB is that there was weak take up on its TLTRO programme (targeted long term repo transactions designed to encourage business lending). The fifth installment of the ECB’s TLTRO programme didn’t fair that well. Take up was €15.5bn vs. €73.2bn in June of this year and close to €100bn in March.
Why is take-up on the ECB’s offer of essentially free financing petering out? Explanations can range from a weak European economy to a saturated loan market (which isn’t that different from chalking it up to a weak economy) to simply bad timing (July and August aren’t known as major months for doing business in Europe and so perhaps there will simply be stronger take-up next quarter). The saturation argument seems strongest as the Q4 2014 TLTRO saw roughly €130bn taken up by banks, and the sums have been falling ever since. Indeed, the first two TLTROs had a threshold of €400bn on offer, and only €212bn was in fact demanded by banks, pointing out the extent to which the ECB might well be “pushing on a string”.
The Eurozone PMI composite proved slightly more robust in September than expected, as it only decreased slightly to 53.9 from previously 54.9. The decline was evenly distributed between manufacturing and service PMI. So the sentiment survey again proved more stable/ optimistic than the investor confidence surveys. Additionally, it is a bit surprising that the eurozone manufacturing is unscathed by the global weakness, especially that seen in China and the US. It appears that it has profited from the weaker euro during early 2015 (new export orders only fell slightly) and the lower oil prices. Meanwhile the PMI service index is fairly stable, supported by falling unemployment and the new bout of oil price declines.
UK
The highest August budget deficit for three years was reported in August, as the tax take from individuals and companies fell. Spending exceeded revenue by GBP 12.1bn, compared with a deficit of GBP 10.7bn a year earlier. Government income fell by 0.6 percent and spending rose by 1.6 percent. The statistics office cautioned against reading too much into the increase in borrowing, saying that it reflected a drop in self-assessed income tax payments from the large amount paid in July. Taking the two months together, the GBP 8.5bn received was the highest on record.
The main release next week is the index of services in July. As production and construction figures released so far in Q3 have been weaker than expected, a strong growth in index of services through Q3 is needed to have above- trend GDP growth. The expectation is to have growth driven mainly by domestic demand and in particular by private consumption which should be reflected in the index of services. PMI services have declined recently but is still at a high level indicating continued solid growth in the service sector.
Looking at the UK recovery, it can be noticed it has been uneven over recent years, driven by robust domestic consumption as opposed to improving export performance. GDP has expanded by 7% since the start of 2013, with only 0.3 percentage-points of this growth driven by net trade. The recent deterioration in EM conditions suggests that these imbalances will remain.
The share of UK exports to non-advanced economies, measured in terms of final demand, has increased from 22% in 1995 to 31% at present. Exposures to individual emerging markets tend to be small (China takes the largest share at just 3.7%) but broadly distributed across the globe. Weak global growth, particularly among emerging markets, and an appreciating currency will raise concerns that trade could weigh on the UK recovery.
The UK conducts almost 70% of its business (as measured in terms of final demand) with developed markets where the growth outlook is generally more upbeat. In total, 36% of trade by final demand heads to the recovering Eurozone and 18% to the healthy US economy. Additionally, it must be emphasised that the UK remains a household consumption-dominated economy. Exports as a share of GDP have remained remarkably stable over the past 20 years and currently stand at 28%, less than half of the share accounted for by consumer spending (62%). This would require a much more severe shock from the trade channel to derail the UK economy.
Risks from the emerging world do not only flow through trade channels; the non-trade exposure could be more powerful. This point is well illustrated by the FTSE 100 Index, which has been one of the worst European performers in year-to-date terms. In part, this reflects the exposures of the largest UK companies, with 75% of revenues coming from abroad, of which an estimated 35% originates from markets outside Europe and the US. The index has a large concentration of stocks in the commodities and materials sectors which have certainly been vulnerable to the downturn in EMs since they tend to use these products more intensively. This suggests that trade flows may understate the sensitivity of the UK economy to emerging market demand.
The bank channel also requires close consideration given the size of the sector in the UK. According to the Bank of England, UK bank exposure to EMs stands at USD 820bn or 150% of the sector’s aggregate core tier 1 capital. Exposure to China alone is currently estimated at USD 540bn or 100% of core tier 1 capital. These aggregate figures are not far shy of the exposure to the Eurozone (USD 960bn) and at times the sovereign debt crisis in this region has had an effect on the UK financial conditions.
It is important to monitor how stress in emerging markets evolves and if there are any signs of this feeding through to the domestic economy. The worst case scenario is that rising leverage, low commodity prices and tightening dollar liquidity leads to a 1990s-style systemic crisis in the emerging world.
The good news is that this seems to be unlikely. Some analysis suggests that financial imbalances among these countries are smaller than they were in the 1990s, while higher stockpiles of reserves provide a safety blanket for many countries. Shall this be wrong, then UK’s trade exposures to the region would be the least of the problems which need to be dealt with.
China
While the debate continues over China’s true economic growth rate, what is clear is that slowing demand from China is having a large spill-over effect on emerging markets. GDP growth rates across many developing countries have slowed below expectations in 2015 and exposure to China is one of the primary reasons.
However, China is only one element of EM demand weakness. Over the past 15 years emerging market countries have become increasingly interlinked, and developing countries have grown into an ever larger portion of EM final demand. Historically, a large share of intra-EM trade was intermediate goods destined for reprocessing along supply chains, but value-added data now show that the EM share of final demand has increased significantly.
The implications are important as EMs will no longer be able to rely on improving developed market demand to lift them out of their malaise. With growth weakening across most of the developing world, EM countries will be forced to rely on domestic drivers of growth rather than an external boost.
As the largest and most influential emerging market, Chinese demand continues to be the single largest source of final demand among EM countries. As with other EMs, China’s role in final demand has also greatly increased over recent years, which makes the slump in Chinese imports all the more alarming for EM growth. Over the first two quarters, China’s imports fell in volume terms by an average of 8% in Q1 and 3% in Q2, the first such contraction since the financial crisis. Most importantly for other EM countries, specifically those that have relied on Chinese demand over the past decade, this trend does not appear cyclical.
In China, investment is the most import-intensive component of GDP and investment spending is the main driver for raw materials and capital goods import demand. With investment slowing as part of China’s structural rebalancing, and domestic consumer demand mostly satisfied by domestic manufacturers, import demand will likely remain sluggish. The extent of China’s slowing domestic demand can be seen in its widespread import contraction. Imports across a range of commodities, raw materials, and intermediate goods are down sharply year-to-date. In volume terms, coal imports contracted 31% year-to-date, cotton imports are down 37%, vehicle and chassis imports decreased 24%, machine tool imports declined 14%, and high technology materials imports contracted 18%.
Speaking of monetary policy, since mid-2014, China’s foreign reserve assets have fallen by 11%, latterly at an accelerated pace. This new situation has been triggered by net capital outflows, which have been enabled by continuous financial account liberalization. To prevent crisis-like depreciation episodes, the PBoC will likely have to continue the policy of reserve drainage for quite a while.
This fundamental change was not caused by a change in the current account. Due to its large trade surplus, China is still running a significant current account surplus, which generates Chinese claims against the rest of the world, i.e. creates an “export of capital”. But the composition of capital exports has changed. In the past, the Chinese were largely banned from investing abroad, with few exceptions. The bulk of foreign currency amounts earned via net exports therefore ended up at the PBoC, which used them to accumulate FX reserves. After the gradual liberalization of opportunities for cross-border capital transfers by Chinese investors, they now have considerable legal opportunities to invest abroad. Furthermore, rumours about capital leaving the country through illegal channels are abundant.
The effect is clearly visible in China’s balance of payments: capital exports are larger than capital imports (i.e. the financial account, which counts both types of transactions, is in deficit). But the effect is also visible in the rest of the world; for example, Chinese investors frequently buy property in metropolitan areas around the world.
Currently, demand for capital outflow creates demand for foreign currencies which exceeds the foreign currency inflow from exports. The result is CNY-depreciation pressure. One reason is that the liberalization of the capital account opened up new investment opportunities, which offers the chance of diversification. Furthermore, it is also due to the fact that a large stock of domestic over-investment, created during decades of high domestic savings which were restricted to domestic investment, has made domestic investment opportunities very expensive.
In the short run, the PBoC seems to have no alternative to its current strategy of reserve selling. However, if capital outflows were to eat up too much of the reserve portfolio or if they would inflict excessive damage to the domestic economy, China’s central bank might be tempted to roll back the liberalization of cross-border capital transfers by Chinese residents. For example, the Chinese authorities have decided to impose a reserve requirement on financial institutions that purchase USD-CNY forwards for clients; additionally, financial institutions need to hold 20% of past month purchase as reserves, to be held at zero interest and frozen for one year. So far these measures don’t have to be interpreted as a policy shift.
There are fears that the selling of reserve assets by the PBoC would have negative effects on global asset markets. But that is not true in general. As long as China runs a current account surplus, it will export capital to the rest of the world. In the old regime it was the PBoC that was exporting capital, now it is households and companies. Effects on capital markets therefore result only from differences in the allocation behaviour of the PBoC and the new Chinese global investors.
In conclusion, it is safe to assume a reversal of capital-flow liberalization would only be a measure of last resort. The new situation should not put general pressure on global financial markets, but only result in a shift in relative demand for different asset classes.
Sources: Commerzbank, Handelsbanken, Standard Life Investments, Scotiabank, TD Economics, Danske Bank
