US
As Americans got busy picking the perfect turkey and making Black Friday shopping lists, financial markets were rather quiet in a holiday-shortened week. Despite thin markets, economists did have some interesting new data to sift through, most notably a nice upward revision to GDP growth in Q3.
The good news was tempered somewhat by other indicators that suggested somewhat weaker momentum heading into Q4. As expected, real GDP growth was revised up to 2.1% annualized (initially reported at 1.5%), helped by a better inventory accumulation, and stronger business investment. That said, the drag from trade now is larger than previously reported, reflecting a weaker global backdrop and the competitiveness hit from a stronger US dollar. The most commonly cited GDP figures are calculated by tallying up all of the spending in the economy. But, growth can also be measured by adding up the income earned in the economy, largely made up of wages, business profits and taxes. This measure, referred to as gross domestic income (GDI), should in theory equal GDP. But, in reality, measurement errors and gaps lead to sizeable differences between the two measures. Case in point, during Q3, real GDI grew by a more robust 3.1% annualized pace. The Bureau of Economic Analysis prefers the GDP measure because it best distinguishes between a growing and a shrinking economy. But, some economists have argued that GDI better represents business cycle fluctuations, and that GDP has a number of shortcomings, like incomplete measurement of output in the services sector. As a result, the BEA has recently begun quoting an average of these measures, which registered a robust 2.6% during the third quarter.
Having said that, we are now well into Q4, and so far, the indicators aren’t pointing to a vigorous pace of growth. The housing sector missed a beat in October, with existing home sales down a disappointing 3.4% on the month, although sales are still up 3.8% from last year. Still, the expectation is to continue to expect the resale market to continue grinding higher in the coming months, buttressed by job gains, improving household formation, rising rents and only a modest increase in interest rates. October data suggested that consumers are being cautious with smaller-scale purchases too. Personal spending rose only 0.1% on the month, despite a strong 0.6% m/m gain in personal income which saw the savings rate continue to rise higher. As such, Americans appear to be stashing the money in their piggy banks, perhaps waiting for the Black Friday sales. Should this theory materialize, it would go a long way to boosting what is currently shaping up as a modest Q4 for consumer spending. One encouraging piece of news for Q4 came from the durable goods orders report. Nondefense capital goods orders excluding aircraft, which is a commonly used guidepost to business investment, posted a solid 1.3% monthly increase in October. That’s the second month of gains after a choppy 2015, with core orders being held back by sharp contraction in business investment emanating from the downturn in the oil and gas sector. The October report is a positive indication that capital spending may be solidifying in Q4. Overall the pace of growth may have moderated at the end of 2015. But solid income gains for consumers and early signs of a pickup in capital spending suggest that the domestic engines of growth still have plenty of gas left in the tank to drive the economy forward during 2016, helping justify the notion that the U.S. economy may be ready for slightly higher interest rate. Nonetheless, there are two key reasons why the economy should strengthen in the new year:
- The first is that household spending power is rising the fastest (on a sustained basis) in nearly a decade. Real personal disposable income is up 3.9% y/y in October, and not just because of cheaper gas. Employee compensation is 4.6% higher amid sturdy job growth and, importantly, a recent upturn in wages, which can only gather pace as the unemployment rate grasps a 4-handle likely before Christmas. Despite spending at a healthy 3% real rate, households are stashing away more income for a rainy day, lifting the personal saving rate to a three-year high of 5.6%. It was only half this rate during the credit boom ten years ago. Perhaps shoppers are just waiting to pounce on the big discounts offered up this holiday season.
- The second reason why the economy should strengthen is that the strong dollar and energy sector cutbacks appear to be losing their bite on American manufacturers. After declining in the first half of the year, factory output is up 2.1% annualized in the six months to October. Over the same period, machinery orders have shot up 10%, signaling firmer factory shipments ahead. Even if business capex steps back a bit in the current quarter, after a honking 9.5% gain in Q3, it should rebound in the new year. Despite the recent loss of momentum, the US economy is growing a respectable 2.6% in 2016. This would be a mild step up from 2015’s estimated rate (2.5%) and would be tops among the G7. Importantly, the economy should continue to outrun its potential rate (thought to be around 2.0%), putting more Americans back to work. That will pull more discouraged workers back into the labour force to fill the shoes of retiring baby boomers. More jobs will translate into more spending, but also higher interest rates. If that’s what’s needed to prevent the economy from eventually overheating and sparking inflation, it’s not a bad thing for the expansion.
On the monetary side, unless something really bad happens, the Fed is likely to start raising rates on December 16th. If the Fed follows the average tightening trajectory of past cycles, it will raise rates by 270 basis points through early 2017, the long end of the curve will rise by close to 80 basis points and the next recession would take place in mid-2019. But of course, this is not going to be an average trajectory. In all likelihood, the Fed will pause after say, the first 50 basis points and probably won’t start hiking again until the third or fourth quarter of 2016, making its last move by early or mid-2018. That would make it the gentlest tightening path in the post-war period. In the past five cycles, the Fed averaged just under 20 basis points of tightening per month over the duration of the tightening cycle. This time the Fed will average just 8 basis points of tightening. The Fed will have to be creative in its language on December 16th. After all, Yellen is trying to do a difficult thing, that is, to raise interest rates without raising interest rates. How do you start a tightening cycle without spooking the long end of the curve? A user friendly translation of the press release that will be attached to the move might be something along these lines: “Yes, we’re raising rates, but we aren’t very committed to it and, in fact, if you don’t like it we’ll take it back”. It’s not easy to start hiking after almost a decade. There are many things to fear, but a stronger US dollar might not be one of them. One of the main arguments against a Fed tightening is that the move will lead to an even stronger dollar. That would not only further hurt domestic manufacturing, but perhaps more importantly, it would add to the pain being felt in emerging markets as dollar-denominated debts weigh even more heavily. But history suggests that the greenback would flunk Economics 101, since it hasn’t really followed what the textbooks teach. Looking at the trajectory of the trade-weighted dollar during the first six months of the past five tightening cycles, the dollar, in fact, lost ground in three of them, and the two that saw the dollar appreciating happened to be the most aggressive of them all. If history is any guide, the coming gentle hiking cycle will also be gentle on the US dollar.
EU
“We will do what we must to raise inflation as quickly as possible!“. Given these clear words from Draghi, there is much to suggest that the ECB will ease monetary policy again this coming Thursday despite surprisingly positive sentiment indicators of late and a slight rise in the core inflation rate.
Draghi is focusing primarily on the asset purchase programme (QE). This is a powerful and flexible instrument, as it can be adjusted in terms of size, composition and duration to achieve a more expansionary policy stance. Any concerns about negative side-effects have not yet been confirmed. It would thus be surprising if the ECB decided not to use this instrument after Draghi expressly emphasised its effectiveness in his speech.
It is fairly likely that the ECB will delete the reference to “September 2016”, and stress instead that the purchases will be made “for as long as necessary”. The ECB staff forecasts for core inflation in 2016 and 2017 are likely to be reduced which is an argument in favour of purchases being continued for longer than expected so far.
However, such an extension implies that monetary policy will in effect only become more expansionary next autumn and will have no effect on inflation in the near-term. Many have been predicting for some time that an increase of the monthly buying volume is likely to be the core measure in December, as it is only as a result of such an increase that the degree of monetary expansion can be achieved immediately. Another reduction in the deposit rate from a current level of -0.2% to somewhere around -0.4% is likely in view of what Draghi said last Friday. The ECB president argued that a lower deposit rate could increase the efficiency of QE. He thus confirmed a shared long-held view that a rate cut by the ECB only appears to make sense as a supporting measure to QE.
That said, the expectation is for an even lower deposit rate to have negative side effects. In Switzerland for example, the (strongly) negative key interest rate led to a rise in lending rates. If the ECB decides in favour of a rate cut nevertheless, despite the fact that ECB representatives never tire of stressing the importance of continually falling lending rates in the euro zone, this could be because Draghi and other supporters of major steps want to put together a comprehensive package of measures to impress the market. However, as they do not have a majority for their preferred strong expansion of QE volumes, they might resort to a further rate cut which is easier to implement. Support for such an interpretation can be found in a news agency report which suggested that four unnamed ECB Governing Council members emphasised that there is a consensus in the council for a lower deposit rate, as this is the least contentious measure.
It is quite possible, however, that the council will merely make a decision in principle on Thursday and defer the clarification of further details to a later meeting:
- Allowances at negative rates: If the ECB lowers the deposit rate further, it would be likely to introduce allowances, i.e. no penalty interest would have to be paid on a part of the surplus liquidity. In countries like Switzerland and Denmark, with a strongly negative key interest rate, this is already the case. The introduction of such allowances would be a further indication that the ECB primarily wants to weaken the euro further to stimulate the economy and increase the inflation rate. Indeed, the reaction of money market rates, and thus also of the euro, would not be influenced by such an allowance; what would be decisive is that banks are affected by the higher “penalty interest” on part of their surplus liquidity, not necessarily all of it, and would therefore look for a more attractive (or less unattractive) investment opportunity. Consequently, the ECB can weaken the euro with an even more negative deposit rate by introducing allowances and at the same time limit the negative side-effects; the costs for the banks would not rise as sharply and they would consequently increase their lending rates to a lesser degree and would be less likely to demand a negative deposit rate from their clients. On the other hand, if it were the central bank’s objective to stimulate lending with a lower deposit rate, as ECB president Draghi signalled last Friday, the ECB should avoid high allowances; this would mean banks would incur high costs by holding surplus liquidity, which in turn would increase their incentive to reduce surplus liquidity by granting additional credit. Clearly, the introduction of allowances would be counter-productive if the strategy is aimed at boosting lending.
- Additional purchase of regional government bonds: It is believed that besides a higher volume and longer duration of purchases, the ECB will opt for several changes to the composition. For example, regional government bonds could be included in the Public Sector Purchase Programme (PSPP), which would somewhat ease shortage concerns for Bunds. It is also possible that corporate bonds could play a role in future.
The ECB’s main objective is probably to achieve the strongest possible effect on the markets. To do so, the markets must be convinced that the ECB is doing all it can to achieve its inflation objective, only then would the financial markets be expected to react by driving money market rates and the euro lower on a more sustainable basis rather than simply as a knee-jerk response.
One way of sending out such a strong signal is the strategy followed by the ECB at the beginning of the year when it announced the current asset purchase programme and exceeded market expectations with the announced monthly purchase volume. The alternative is to more or less meet market expectations with the measures but also announce further steps in the case that its objectives run the risk of not being achieved.
The second strategy is more likely as we believe that the ECB will not revise its projections downwards massively, which argues against a more significant step.
According to agency reports, some 20 different packages of measures are being discussed at the central bank. All in all, the risks that the ECB will exceed expectations or act more cautiously are evenly spread:
The surprisingly clear negative stance of some Governing Council members and the recent surprising data on the positive side could lead to the package of measures falling short of expectations. It would be unclear though why Draghi reaffirmed market expectations on Friday if he was not certain beforehand of a solid majority in the Council.
Even if ECB projections are revised downwards, they are still probably much too high. Should the ECB correct their estimates more sharply to the downside, a larger package of measures would then also be more likely.
There are reasons to stick to the shared forecast that the euro will depreciate further towards parity with the dollar amid diverging monetary policies in the euro zone and the USA. How quickly the euro will retreat in the near term will depend on how convincingly the ECB manages to convey the message of possible further steps.
Yields should fall further initially on account of the package of measures and the prospects of more to come.
UK
There is a downside risk to domestic demand in the UK, according to the latest CBI survey. The volume of monthly sales within retailing fell significantly in November, compared with a year ago. However, the volume of sales within wholesaling improved. Expected sales are forecast to increase in the month ahead, as the Christmas holiday is approaching. Looking ahead, sales should be boosted by high employment, strong wage growth and no inflation in sight.
The Chancellor of the Exchequer presented the Autumn Statement on Wednesday. The main surprises came from increased capital spending, less austerity in departmental budgets (at least in the short term) and no major cuts to the police budget. Instead the focus was on protecting spending in real terms. Overall, the Autumn Statement signaled a little less austerity in the short term. However, the big picture remains; there will be more cuts in the next fiscal year.
GDP increased by 0.5% in Q3 compared to Q2 and by 2.3% compared to Q3 last year. The driver of the economy is strong domestic demand, while net exports continue to act as a drag to overall GDP. The negative contribution from net trade was its weakest contribution on record. The trade balance deficit widened due to increasing imports, while exports grew less. GDP per head in volume terms was estimated to have increased by 0.3% between Q2 and Q3 2015. Between 2013 and 2014, GDP per head increased by 2.2%. Looking ahead, the economy will continue to have a solid base from which to grow, as higher purchasing power will keep private consumption at current levels. The challenge for investments in the short term will depend on the EU referendum and the consequences thereafter.
Savvy UK consumers are taking advantage of low inflation while they can. According to GfK’s monthly consumer confidence index, a measure of Britons’ outlook for the economy over the next 12 months dropped in November to its lowest level for more than two years. However, with inflation stagnant and wage growth picking up, consumers’ outlook for their personal finances is holding up and they are becoming more inclined to spend this Christmas. The survey reflects how consumers remain the bulwark of economic growth and reinforces the Bank of England’s view of robust domestic demand. The beginning of the holiday shopping season (marked by Black Friday this week) may encourage consumers to buy big-ticket items. GfK’s consumer sentiment gauge slipped by one point to 1 in November, according to the report published on Friday. The measure of how Britons see their personal financial situation remained at 6 and the major purchase index jumped to 9 from 7 (Bloomberg).
Net migration to the UK rose to the highest on record in the year ending June 2015, according to new data from the Office for National Statistics. Immigration to the UK totalled 636,000 in the period (up 62,000 compared to a year earlier) driven by an upswing in arrivals of European Union citizens. Emigration amounted to 300,000, down 20,000, leaving a net figure of 336,000. The ONS data showed that a rising number of people are fleeing war and poverty in the Middle East and Africa to reach the EU. Asylum applications increased by 19% to about 29,000 in the year through September, with the largest number of applications coming from Eritrea, Sudan, Iran and Syria. The figures pose a challenge for David Cameron, with businesses seeking easier access to skilled foreign workers and the UK Prime Minister wanting to appear strong on immigration before a planned referendum on EU membership. One of his proposals is to restrict benefits to migrants from other countries in the EU, a measure that European Commission chief spokesman Margaritis Schinas says amounts to “direct discrimination”.
Bank of England Governor Mark Carney said policy makers are debating when to remove emergency policy settings, almost seven years after benchmark borrowing costs were cut to their lowest-ever level. “The question in my mind is: When is the appropriate time for interest rates to increase?”. Carney told law-makers in London on Tuesday. External Monetary Policy Committee member Kristin Forbes, speaking alongside the governor, said the next move will probably be upward. With the Federal Reserve moving toward a rate increase as soon as December, the focus is on when the UK central bank will follow suit. While BOE officials trimmed their growth and inflation forecasts this month and signaled that Britain needs low interest rates for a while longer, the risks from emerging markets are easing and the domestic economy remains robust. Carney also said the UK will have low interest rates for some time and the pace of tightening will be limited. That carries certain risks, including excessive risk-taking.
The markets that are most susceptible are real-estate markets, particularly housing. “There are a number of fundamental issues in the housing market, in demand relative to supply” Bank of England Financial Policy Committee member Donald Kohn says in an interview published on the Kent Online website on Monday. “There are constrictions on supply and there is a difficulty getting permits. That is putting upward pressure on house prices throughout the UK. Our goal is not to constrain lending but to make sure the lending terms do not deteriorate and get so loose under the pressure of rising house prices that there are problems coming down the road which would affect the stability of the system”.
Japan
The labour market is often thought of as a key barometer of inflationary trends. When supply is tight, the typical outcome is higher price pressures; when the workforce is under-utilised, inflationary pressures are usually restrained. However, Japan’s experiences do not appear to tally up very well with this rule of thumb. Over the last two decades, prices have been falling by an average annualised rate of close to 0.3%. However, there has been no ballooning out of unemployment during this period, averaging just 4.4%, compared to 6.0% in the US and 7.6% in Germany. The explanation for this trend partly relates to Japan’s unique employment practices during this period. Due to the wage bargaining system and the orientation of labour unions, which upheld a preference within Japanese society for employment security, companies were incentivised to use wage cuts, rather than redundancies, to reduce costs. Hourly wage growth slumped into negative territory on an annualised basis in the late 1990s and has struggled since. Unsurprisingly, even moderate productivity growth resulted in a sustained period of negative unit labour cost growth.
While this helped reinforce deflationary expectations at home, it should have been more supportive for Japan’s external position. Unfortunately, the improvement in global competitiveness that one would expect to accompany such a trend failed to materialise. In fact, Japan has performed extremely poorly vis-à-vis its international competitors with its share of global trade more than halving since the early nineties. Of course, this was partly an issue of yen strength but also reflected a lack of product innovation, born out of subdued risk-taking activity within corporate Japan. Indeed, the preoccupation with labour costs to drive earnings growth came at the expense of the pursuit of riskier growth opportunities, capable of enhancing earnings over the longer term. It also meant that corporate profits began to serve as a buffer to absorb shocks, with the labour share of income rising during economic recession phases and declining during recovery periods. Finally, it exaggerated already weak domestic demand trends and contributed to the steady decline in the nation’s growth potential.
To remedy these problems, Prime Minister Abe originally promised a third arrow capable of changing perceptions about growth in Japan. Unfortunately, this has not been the case, with both short and medium-term growth expectations still below the level that they were in 2011. Unsurprisingly, in the absence of a credible structural reform programme, corporates have been reluctant to raise wages, despite significant profitability improvements. This raises questions about whether policymakers’ hopes for another year of record wage growth during the Spring Shunto wage negotiations are realistic. Unit labour cost is once again negative, falling 0.5% y/y in the most recent quarter versus 0% in the first quarter. In addition, core CPI is negative. In this environment, it may be no surprise that the Bank is trying to gain greater credence for its new core core CPI inflation measure, which hit 1.2% in September. However, there seems to be little prospect that base wages will improve on the 0.7% y/y growth achieved 12 months ago.
Sources: Commerzbank, TD Economics, BMO Capital, Danske Bank, Handelsbanken Capital Markets, Standard Life Investments, CIBC