US
Third quarter GDP growth looks like it is shaping up to be a bit of a disappointment in light of rather stiff headwinds from inventories and international trade. However, economic data this week indicated that once again the consumer sector is poised to support greater consumer spending in Q3. Real consumer spending in August rose to 3.5 percent on a three-month annualised basis, while personal income growth remains solid. September’s NFP (nonfarm payroll) numbers and the sharp downward revision to August’s job growth suggest that the momentum behind the recent trend in consumer spending may downshift in the coming months. Construction spending continued to improve in August; however, there are still signs that manufacturers are struggling.
NFP rose at a disappointing pace in September and job gains for August were revised lower. The unemployment rate held steady at 5.1 percent. Average hourly earnings were flat for the month, while average weekly hours also fell to 34.5 from August’s 34.6 hours. The continued pace of job growth over the past several months has contributed to much stronger growth in consumer spending as reflected by August’s 0.4 percent rise in personal spending. August’s reading of personal income showed that income growth continued to accelerate. Combined with the low inflation environment, real disposable income rose 0.3 percent for the month. Consumers continue to benefit from lower overall prices. The PCE (personal consumption expenditure) deflator posted a flat reading in August with core prices rising just 0.1 percent. Core inflation now stands at just 1.3 percent on a year over year basis. With lower prices, stronger income growth and better job growth, it is not surprising that consumer confidence posted a sizable jump in September to 103.0 from August’s 101.5 reading.
Construction spending edged higher by 0.7 percent in August following a 0.4 percent rise in July. The construction spending report suggests that building activity should again be a support to third quarter GDP growth. Private residential construction activity climbed 1.3 percent, as multifamily activity jumped 4.8 percent. Pending home sales data for August showed that the pace of home sales may face some slight downside risks in the near-term; however, sales are still up 6.7 percent from last year.
ISM’s manufacturing index for September showed that the sector continued to decelerate. The measure fell to 50.2 from August’s 51.1 reading. Order backlogs, inventories and new export orders within the survey all remained in contraction territory reflecting the ongoing challenges of a stronger U.S. dollar, modest domestic business spending and slow global growth. Given that many of the headwinds facing manufacturers are not likely to subside in the coming months, it would not be a surprise if the manufacturing sector continues to downshift over the coming quarters.
On Thursday the minutes from the September FOMC meeting will be available. Dovishness of Chair Yellen’s comments at the press conference in September were surprising. In her speech last week, she did modify the message, saying that she also saw it likely that the Fed would increase rates later this year. It will be interesting to read the discussion at the meeting and get a feel of how much a ‘close call’ the September decision was. In particular whether the decision to hold rates unchanged was due to ‘risk management’ or a more fundamental worry about the health of the US economy.
In addition to the minutes, there is a lot of Fed speeches on the agenda, kicked off by the Boston Fed’s conference on macro-prudential monetary policy this week. The coming week, the list of speakers includes Williams, Bullard, Lockhart, Evans and Kocherlakota. So far comments from the most influential members of the FOMC suggest that the Fed has set course towards a rate hike later this year but the list of factors that could potentially postpone the hike is relatively long. Further, the communication from Yellen is that the pace of hikes following the initial rate hike will be very slow.
In the final hours of Wednesday night, the president signed into law yet another continuing resolution (CR) that will keep the federal government funded until December 11. The bill, which maintains the lower funding levels established by the Budget Control Act of 2011 cleared Congress after a down to the wire fight that could have resulted in another partial government shutdown. The CR sets the level of federal funding at $1.017 trillion on an annualized basis but for the most part prohibits new defense department procurement projects. In addition, the bill included additional funding for overseas military operations and emergency funds for wild fire suppression. In total, the Congressional Budget Office estimates that federal discretionary outlays for FY 2016 will total around $1.186 trillion. From the perspective of affecting GDP growth, the CR is not likely to materially affect the overall pace of government spending and thus GDP growth. The key to understanding the economic impact of federal spending on growth over the next several quarters, however, will depend on the funding levels that are established for the rest of the federal fiscal year, beyond December 11.
Congress now has to find a way forward in the wake of the resignation of the Speaker of the House, John Boehner, to pass a funding bill for the rest of the 2016 federal fiscal year, re-authorize transportation programs and lift the nation’s debt ceiling. While it is too early to tell how much progress will be made on these issues, the initial signs are looking promising. Republican leaders have requested formal budget talks with the White House in an effort to establish federal funding levels for the next two federal fiscal years. If successful, these talks would go a long way toward averting the threat of a partial government shutdown until after the 2016 presidential elections.
Progress on the above policy issues will need to be made before the next Speaker is installed or the probability of another partial government shutdown or even a potential partial default is much greater.
EU
Next week in the Eurozone the Sentix investor confidence is released. It will be followed for indications of how hard investments will be hit through weaker sentiment from the market unrest in emerging markets. The figure is expected to be on the weak side in line with the previous observation.
However, this should not necessarily translate into the same degree of weakness in the economic indicators as there has been a divergence in the sentiment indicators after the unset of the emerging market stress. The financial indicators (Sentix and ZEW) have weakened, while the economic indicators (IFO and PMI) are broadly unaffected.
The Eurozone economy has had a tough time in recent years. Any respite from the financial crisis was quickly dashed as the currency union slid back into recession in 2011. This double-dip recession means that the Eurozone is tracking behind many of its developed market peers from a cyclical perspective. The level of GDP in the Eurozone is still below its pre-crisis peak, whereas the UK and USA are currently some 5 and 9 percentage points respectively above theirs. This also means that the Eurozone is currently standing at an earlier stage of its inventory cycle.
The financial crisis triggered large and rapid changes in stocks. At the peak of this adjustment in Q2 2009, inventory cuts were subtracting 1.6ppts from annual growth in the Eurozone, contributing to a 5.6% year-on-year decline in GDP. The initial rebound from this shock was surprisingly powerful. The new orders-to-inventory ratio in the Eurozone manufacturing Purchasing Managers’ Index (PMI), which measures business confidence, shot up rapidly from a record low of 0.5 in late 2008 to 1.2 a year later. This rapid rebound in demand encouraged a rebuild of heavily depleted stocks across the region.
In mid-2010, inventories were adding 1.3ppts to Eurozone growth, accounting for more than half of the 2.2% growth rate. This restocking proved premature. The Eurozone sovereign debt crisis pushed the region back into recession in 2011, forcing firms to again reassess their inventory positions.
Inventories provided a drag on growth for five consecutive quarters, subtracting in total 1.2ppts from Eurozone GDP. The strength of the inventory cycle has differed across many of the largest Eurozone member states. Germany, with its large manufacturing sector (accounting for 22% of domestic activity), has seen the largest swings in inventories. At the worst point, the stock adjustment in Germany subtracted 2.3ppts from annual growth rates. These shocks in Italy, France and Spain peaked at a smaller, but still extremely painful, 1.6ppts negative contribution.
The Eurozone moved out of recession in mid-2013 and has now been growing for nine consecutive quarters. However, the pace of this recovery in the early stages was relatively tepid, with the region only having achieved a period of sustained above-trend growth over the past three quarters.
Many firms remain cautious from an inventory perspective, perhaps reflecting this initially muted upturn. Since moving out of recession in the middle of 2013, the average impact of inventories on quarterly growth rates has been neutral. Worse, in three of the last four quarters inventories have provided a drag on growth. This could have been due to upside surprises in demand, which have been met by a forced reduction in inventories. This caution could be storing up good news in the future.
If the Eurozone recovery is sustainable, and that conditions in emerging markets (EMs) do not deteriorate markedly, then Eurozone firms will need to start returning inventories back towards more normal levels. This effect could prove strongest in Germany, where the most recent data show inventories subtracting a full 1.1ppts from annual growth.
Firms could be acting particularly cautious given the rise in risks around EMs. This should be at least partly alleviated by rising domestic demand, while at present there are few signs that the deterioration in EMs is materially harming growth, according to the latest PMI and IFO business confidence surveys.
UK
The main event next week is the October meeting in the Bank of England’s Monetary Policy Committee. The Bank Rate and stock of purchased assets are likely to remain unchanged at 0.50% and GBP375bn, respectively.
Additionally, the expectation is for another 8-1 split vote on whether to keep the Bank Rate unchanged against to increase it immediately. The tone in the minutes will be more or less as in the minutes from the September meeting. The MPC members will be positive about the domestic development (especially about the labour market) but slightly worried about the global market turmoil and the slowdown in China.
The PMI services in September is expected to stay around the same level as in August and thus we are looking for another 55.6 reading. This level suggests solid growth in services output in Q3.
The manufacturing production is expected to rebound by 0.5% m/m in August following the sharp decline in July. That said, the manufacturing sector is still suffering from the appreciation of the GBP and the slowdown in the manufacturing sector globally and it is likely that production dragged down growth in Q3.
From an inventories perspective, the cycle can generate large impacts on economic growth. This is perhaps best illustrated by taking a look back at the financial crisis, during which time huge swings in activity triggered a rapid adjustment of stock piles (UK inventory data includes an alignment adjustment in order to make the expenditure breakdown of GDP match the output and income approaches, although this should not distort the longer term trends in stockpiles).
On the eve of the crisis, UK firms were still building inventories, albeit at a moderate pace. During 2007, inventories increased only marginally in real terms, with this slowdown in accumulation providing a small drag on growth. This drag got a lot worse as the crisis struck. The ratio of new orders to inventories in the manufacturing Purchasing Managers’ Index (PMI), an indicator of business confidence, provided an early warning signal, plummeting from 1.2 in late-2007 to a series low of 0.74 a year later – illustrating the realignment in demand conditions.
In response, firms slashed inventories aggressively over the course of 2008 and 2009, subtracting 0.6 percentage points from UK growth in both years as production stalled. The rebound in activity in 2010 was impressive, but in retrospect too early. The PMI orders-to-inventory ratio surged to a record high of 1.43 as confidence returned to the global economy. The resulting surge in inventories contributed a full 1.5ppts to 2010 GDP. Unfortunately, this was something of a mirage and growth disappointments in 2011 and 2012 led to more cautious stock accumulations in these years. This started to change as the recovery gained traction through 2013 and 2014, encouraging firms to build stockpiles more rapidly and contributing a combined 0.5ppts to growth over this period.
Where is the UK now in its inventory cycle following all these swings? Stocks have been increasing for five years in a row, with the rise in inventories in 2014 the largest as a share of GDP since 2001. It certainly seems fair to say that stockpiles have recovered from the dramatic falls during the financial crisis and should exert a far less pronounced impact on aggregate growth during the rest of the business cycle. The PMI order-to-inventory ratio has been bumping around its long-term average over the past 12 months, suggesting little requirement for any radical adjustment in inventory dynamics. If anything, there is a risk that the pace of inventory accumulation slows slightly over coming years as the cycle matures.
This does not implies the lack of significant volatility in quarterly inventory data. Inventory management is challenging in the face of short-term fluctuations in demand. Last quarter, inventories dragged 1.1ppts from quarter-on-quarter growth – the largest negative contribution from this component since 2009.
There may be a couple of explanations for this. First, this could reflect the impact of the alignment adjustment on the expenditure breakdown of GDP. Second, there was an unusually large contribution to growth from trade over the quarter, with exports clearly exceeding imports and eating into existing stockpiles.
There is reason to believe that inventories will rebound in Q3, although the growth impulse from this channel may be slightly dampened by a simultaneous rise in imports over the quarter.
Sources: Commerzbank, Handelsbanken, Standard Life Investments, TD Economics, Danske Bank
