Economic Outlook – 4 November 2018

US

• US personal spending rose a solid 0.4% in September, consistent with the robust pace of consumption reported in last week’s Q3 GDP release. Spending was driven by a surge in durables, which, at least in part, was due to replacement demand after Hurricane Florence.
• The FED’s preferred gauge of inflation, the PCE deflator, came in right on top of the Fed’s 2.0% target for both the headline and the “core” measure. With inflation still squarely on target, the Fed remains on target to raise rates at its December meeting.
• Boosting the case for additional Fed rate hikes was another cycle high in the Consumer Confidence Index, which hit 137.9 in October. The index is now only about seven points below the all-time high reached in January 2000 at the peak of the tech bubble. Encouragingly, the gain was driven by increases in both the present situation and expectations component. Consumers were more upbeat about job availability and income expectations, consistent with the ever-tightening labor market.
• US labor market tightness was also evident in the Employment Cost Index release last week. Labor costs continued to climb over the third quarter, with the ECI increasing slightly faster than expected at 0.8%. Over the past year, the ECI is up 2.8% versus 2.5% this time last year. Compensation costs grew faster in Q3 due to a pickup in the wages component. Wages and salaries strengthened 0.9% over the quarter, and private sector wages are up 3.1% over the past year, which is the strongest pace of the expansion. Despite it being a slow grind higher, wage growth in the United States is clearly on an upward trend.
• ISM manufacturing index was softer-than-expected: both the production and new orders components fell in October, as did the employment component. At 57.7, the index still signals that output growth in the factor sector remains solid, but the index has slipped below both its 6-month and 12-month moving averages. The strong dollar and trade tensions are likely offsetting some of the boost provided by the healthy domestic economy.
• US employment growth was 250,000 in October, surpassing already lofty expectations for a 200,000 job gain. Average hourly earnings also increased over the month and rose above a 3.0% year-on-year pace for the first time since 2009. Job growth was broad-based, with strong gains in manufacturing, education & health services and leisure & hospitality. Through the monthly noise, the tightening labor market is evident across a number of metrics. The prime age employment-population ratio, which measures what percentage of the US population age 25 to 54 is employed, continues to move higher on trend and is nearing the peak reached in the previous cycle.
• US president Donald Trump tweeted on Thursday that he had had a very good telephone conversation with Chinese president Xi Jinping and that trade discussions are moving along nicely ahead of talks between the two leaders at the G20 meeting in Buenos Aires later this month. Market expectations for a deal have been very low ahead of the meeting, but Trump’s tweet raised hopes that the trade impasse, which has been weighing on financial markets in both the US and China, could be broken. Hopes were raised further on Friday after Bloomberg News reported that Trump hopes to reach an agreement when he meets with Xi in Argentina and has instructed cabinet secretaries to draft a potential deal.
• US stocks recorded solid gains for the week, helping the market regain ground lost over a period of prolonged weakness and bringing most of the major indexes back into positive territory for the year to date. The smaller-cap benchmarks performed best and broke a streak of six consecutive weekly losses. Within the S&P 500 Index, the materials sector posted the strongest returns, while utilities shares lagged. The large information technology sector also under-performed, held back by a sharp drop in Apple shares on Friday after investors appeared to react negatively to an announcement that the company would no longer break out sales reports for its smartphones, computers, and tablets. The tech giant also warned that holiday sales might fall short of forecasts. Value stocks, which typically trade at relatively low valuations, outperformed higher-valuation growth shares. The Cboe Volatility Index (VIX) hit a new eight-month high on Monday but declined over much of the rest of the week.
• The strong jobs data helped push up longer-term bond yields, which had already risen earlier in the week alongside equity prices. Increasing Treasury yields put pressure on municipal bond prices, particularly longer-term issues. New municipal issuance was met with solid interest, however. Investment-grade corporate bond credit spreads (the additional yield offered over comparable-maturity Treasuries) widened early in the week, in part because of a lack of market liquidity as many investors attempted to lower their exposure to riskier market segments. Credit spreads narrowed later in the week, helped by the stock market’s rebound, month-end buying, and decent flows into the asset class. Investment-grade corporate issuance for the week was in line with expectations.
• The November FOMC meeting is scheduled for this week. It is one of the small meetings without updated projections and a press conference. The Fed is not expected to increase the target range, and no signals in the statement are expected either, as they often do not change it much from meeting to meeting.
• On Monday, ISM non-manufacturing is due for release, which will provide more information about the current growth momentum. In September, the index printed the second-highest value since the series began in 1997.
• Tuesday is Midterm Election Day. Counting starts as soon as the polls close and we should have the results early morning Wednesday (CEST). A divided US Congress is the most likely outcome, which means that Trump would be unable to push his domestic policy agenda through. Therefore, the mid-term elections should have limited implications for markets and the economy, as there will likely be no changes to economic policy.

EU

• The flash real GDP for the euro zone disappointed when quarterly growth halved in the third quarter to a moderate 0.2% from 0.4% in the second quarter. This result was even lower than consensus forecast of 0.3%. Growth is now the slowest in more than four years, as seen by a slowdown in sentiment barometers as well as soft and hard data. The GDP figures came without details, but both private consumption and fixed investments re likely to have slowed, as suggested by soft numbers on retail sales and industrial production. This is probably partly due to some temporary effects such as warm weather and the new emission test requirements in the auto industry. Net exports are also expected to be somewhat weak, as in the second quarter, while there is some scope for a positive contribution from an inventory buildup.
• Italian growth ground to a halt in Q3 amid an ongoing battle between Rome and Brussels over Italy’s proposed 2019 budget, a framework the European Union has rejected and called unsustainable because of Italy’s high debt-to-GDP ratio.
• After a very poor showing by her Christian Democratic Union in a series of recent state elections, German chancellor Angela Merkel announced that she is resigning as head of her party and that she will not stand for reelection as chancellor when this Parliament ends in 2021, or sooner if there is a snap election. The resignation comes amid a rising tide of populism in Europe and a backlash against a surge in immigration.
• European stocks turned higher, with the pan-European STOXX Europe 600 Index gaining 3.6% on the week. However, October was the index’s worst month since January 2016. European equity markets managed to reverse direction in the middle of the week, as a rise in U.S. markets and an easing of global trade tensions fuelled a more upbeat mood. Gains by Asia-focused companies and luxury goods sellers helped markets turn around, as did gains in basic resources stocks, which benefited from stronger-than-expected corporate earnings.
• There are no market movers due out in the euro area this week.

UK

• The British pound rose against the US dollar amid reports that a tentative Brexit deal had been reached and after the Bank of England (BOE) seemed to take a more hawkish stance on interest rate increases. The BOE kept its key interest rate unchanged as expected at 0.75% but adopted a moderately hawkish stance, noting that rates might have to rise faster than expected to keep the rate of inflation under control if Prime Minister Theresa May is able to negotiate a smooth Brexit deal. However, a disruptive exit would also raise the risk of further interest rate hikes if there is disruption to the supply side as the UK economy is running at full capacity. Governor Mark Carney said that the bank did not expect a no-deal Brexit but would be in uncharted territory, as it is unclear what effect such a Brexit would have on the balance of demand, supply, and the exchange rate, and it is impossible to predict if rates would need to rise or fall in response.
• Britain’s construction sector recovered last month from a slowdown in September thanks to a bounce-back in civil engineering projects, but confidence in the outlook slumped to a near six-year low ahead of Brexit. Data firm IHS Markit’s purchasing managers’ index for the construction industry rose to 53.2, its second-highest level in 16 months. That was up from a six-month low of 52.1 in September and above all the forecasts in a Reuters poll of economists.
• British factories suffered their worst month since just after 2016’s Brexit vote in October, due to concerns about the country’s approaching departure from the European Union and increased global trade tensions. In the clearest sign to date that Britain’s economy is slowing after a strong summer, the IHS Markit/CIPS Manufacturing Purchasing Managers’ Index (PMI) fell sharply to 51.1, its lowest since July 2016, from a downwardly revised 53.6 in September.
• On Monday, the PMI service index for October is due, which will provide more insight into growth momentum in the beginning of Q4. While the Lloyds Business Barometer suggests a sharp fall is on the cards, the DG ECFIN service confidence indicator says it probably remained unchanged. The latter is usually a better indicator but the service index may have declined slightly to 53.3, given the manufacturing index fell as well.
• On Friday, the first full estimate of Q3 UK GDP growth is also due. Given strong base effects, quarterly GDP growth could come out as high as 0.7% quarter-on-quarter. This will probably not last, because the base effect is temporary and as survey indicators have deteriorated.

China

• The official Chinese manufacturing PMI fell more than expected, from 50.8 in September to 50.2 in October, close to the threshold for expansion versus contraction. Manufacturing PMI from Markit dropped to 50.0 already in September but rebounded marginally to 50.1 in October. The drop in sentiment among manufacturers very likely reflects the escalating trade war with the US. This is emphasised by the fact that the sub-index in the official PMI for new export orders fell dramatically another month, from 48.0 to only 46.9.
• Because of this, the Chinese government announced another package of targeted stimulus measures to try to prop up demand and counter the cyclical downturn. Data from South Korea and Taiwan, both important parts of China’s supply chain, showed this week that they, too, have been caught in the regional downdraft, with industrial production figures and purchasing managers’ indices pointing to slower growth amid flagging global demand.
• China’s main stock market indexes and the yuan rallied on dissipating fears about the US and China trade war following a report that President Trump wants to reach a deal with China’s President Xi Jinping when they meet later this month. The Shanghai Composite Index rose 3.0% for the week, while the CSI 300 Index (a gauge of large-cap stocks) added 3.67%. On Thursday and Friday, the yuan notched its biggest two-day advance in more than 11 years, after hitting its weakest level in more than a decade versus the US dollar earlier in the week. China’s yuan has been pressured lower in recent months as signs of slowing growth and the trade impasse with the US have weighed on its outlook. The rally in Chinese assets came after Bloomberg reported that Trump is interested in reaching a trade agreement with Xi at the G20 summit in Argentina that starts on November 26 and has asked US officials to start drafting potential terms. However, on Friday, after the Chinese market had closed, Trump’s economic adviser Larry Kudlow stated on CNBC that the US is “not on the cusp” of a trade deal with China.
• This week the main focus in China will be trade balance and FX reserves. When it comes to trade balance, exports are likely to attract attention due to the trade war and the sharp drop in PMI export new orders lately. However, the hard data on exports may stay up in Q4 as Chinese companies are pushing forward sales to the US before the potential tariff increase from 10.0% to 25.0% on goods worth USD 200 billion.
• The FX reserve will reveal how much the People’s Bank of China (PBoC) have intervened in October to dampen the CNY depreciation. The FX Reserve has edged lower this year as the PBoC has sold currency to support the CNY and a further small decline in October is possible, but it should stay above USD 3 trillion (it was USD 3.087 trillion last September).

Sources: Wells Fargo, T. Rowe Price, Reuters, Danske Bank, MFS Investment Management, Handelsbanken Capital Market.