Tuesday, April 21, 2015

Quarterly Strategic Outlook - April 2015

This week we released the April edition of Quarterly Strategic Outlook.  The executive summary is posted below or you can find the full document here

The first quarter of 2015 has been another solid one for diversified investors. The start of the year is looking like 2014 déjà vu as US first quarter growth has come in weaker than expected, central banks have eased more than expected, and bond yields have moved lower while equities have rallied.

The key theme for investors last quarter was the divergence in monetary policy expectations. The European Central Bank (ECB) and other central banks have eased more than expected while the US is still on course to commence rate hikes. This has driven the US dollar (USD) higher and most other currencies lower. Because the US Federal Reserve (the Fed) has trimmed its expected policy tightening the net effect has been lower US bond yields as well as lower global bond yields. An unprecedented level of quantitative easing, lower rates and lower oil prices have been a boon to share markets so far, especially Eurozone and Japan shares. Eurozone shares are also benefiting from a pick-up in growth and the long-heralded recovery in earnings.

New Zealand share returns have also been healthy with reasonable earnings and higher dividends contributing to the positive economic backdrop. Following a relatively weak 2014, Australian shares started the year well. A lower Reserve Bank of Australia (RBA) cash rate, combined with a weaker currency and increased dividend payouts, are all playing a part. Commodities continued to decline in the first quarter on rising inventories in key sectors and generally softer China data, but it looks like oil prices may have found a bottom at current levels. The stronger USD saw the New Zealand dollar (NZD) modestly lower against the MSCI-weighted basket of currencies over the quarter, but this masks strong gains against the euro, yen and Australian dollar (AUD).

The outlook for the global economy continues to be best described as “uneven”. Despite a weak start to the year, underlying economic fundamentals continue to improve in the US. That should see the US along with New Zealand remain one of the stand-out performers amongst the developed economies. Economic and financial conditions continue to gradually improve in the Eurozone and Japan, but growth is expected to undershoot the stronger performers by a still considerable margin.

Central banks are looking through current low headline inflation and appropriately remain focused on the outlook for core inflation. Along with the divergent growth outlook, monetary policy is on a divergent path too. We expect the Fed will soon be raising interest rates while the Bank of Japan and the ECB, along with the RBA, are continuing to ease. The Reserve Bank of New Zealand (RBNZ) is on hold for now, although we continue to believe higher interest rates may still be required.

The outlook for the major emerging economies has become similarly divergent. The trend slowdown in the Chinese economy is continuing but we still expect growth of close to 7% this year. India is undergoing an economic resurgence, but Russia and Brazil are both likely to be in recession this year.

We see global growth of 3.4% this year, the same level as 2014, although the mix is different with stronger growth in developed economies but lower growth among the emerging economies. Growth then accelerates to 3.7% in 2016 as the growth performance of the emerging economies improves.

Our key asset calls remain essentially the same as last quarter. We expect bond yields to move modestly higher over the next twelve months as the US takes the first small steps toward policy normalisation. Bond purchases by the Japan and Eurozone central banks should limit the rise in yields globally.

We also expect the subdued inflation backdrop to be around for some time so US hikes will only occur if growth remains reasonably robust. Solid growth will help underpin earnings and share prices given valuations are not overextended. The Fed rate hikes could cause a ‘reset’ in US shares, but we expect this to be a temporary setback and would represent a buying opportunity.

Tighter US monetary policy can be (but is not always) a trigger for bigger issues in emerging markets. This time around our expectation is for emerging markets to wobble but not collapse, given the expected modest nature of the US tightening cycle and the overall better shape of emerging markets with regards to currency regimes, international reserves and current account positions.

We expect the USD to continue to move higher on the back of US rate hikes, which implies further weakness in the NZD. Given the adjustment we have seen so far, however, the NZD could stay around these levels for some time before trending lower again. Finally, we think a modest improvement in global growth, together with large cuts in supply capex, is setting the scene for a recovery in commodity prices, but this may be a 2016 story.

Thursday, April 16, 2015

China GDP on expectations but strong headwinds remain

China GDP growth slowed further in the year to March, coming in on market expectations of 7.0% yoy and stronger than my forecast of a dip below 7.0%.  However March month activity indicators were much weaker than expected highlighting the headwinds the economy is facing, making further broad-based easing measures seemingly inevitable.

The GDP result seemed inconsistent with the sharper than expected decline in industrial production, fixed asset investment, exports and retail sales but strong growth in the services sector provided a welcome offset.  It still remains to be seen the extent to which the current activity weakness is a reflection of Chinese New Year distortions, which came later than normal this year.

Possible distortions aside the Chinese economy is facing considerable headwinds from the continued decline in the property market, high real interest rates and strength in the Chinese Yuan.  The good news is the decline in the property market is showing early signs of bottoming out and there is plenty the Government can do to ease financial conditions.  We expect further interest rate cuts and reductions in the Reserve Requirement Ratio in the months ahead.

Remember though that a slowing China growth rate is not necessarily a bad thing.  We remain of the view that slower growth is necessary for longer term stability.  At issue right now is the pace of the slowdown.  Further easing measures will be implemented to manage the slowdown, not reverse it. 

The official growth target is 7.0% for calendar 2015.  Given the starting point and the headwinds that target appears unlikely to be met, even with additional easing measures.  But I think it will be close – I’m still happy with my forecast of 6.8% growth in 2015.  

Thursday, April 2, 2015

New Zealand's neutral cash rate - think "spread" not absolute level

In this post our Head of Investment Strategy Keith Poore argues that in a small open economy such as New Zealand it's useful to think about the neutral cash rate as a spread to the global neutral cash rate rather than the absolute level. 

Determining the neutral cash rate is a challenge. This is because it is not directly observable and it is difficult to estimate precisely what the current level should be. This note takes a look at why for a small open economy such as New Zealand the neutral rate may be better interpreted as a spread to the global cash rate, rather than some absolute level or number.  We also discuss how current economic and policy settings can be reconciled when viewed through this spread lens.

What is the neutral cash rate?
To set the scene, it is worth reflecting on exactly what the neutral cash rate is.  The neutral cash rate is rate that neither adds nor detracts from inflation when the economy is growing at potential (i.e. there is a zero output gap) and inflation is at target.

Global influence
A small open economy (SOE) like New Zealand should be heavily influenced by offshore developments.  This is primarily through the trade channel, but is also through financial sector linkages, shared technological advances as well as business and consumer confidence spillover effects.
Annual GDP

Source: IMF, AMP Capital

Given the trade and other linkages, it is fair to assume that global and SOE inflation will generally move together and share periods of higher and lower inflation.
Annual inflation

Source: IMF, AMP Capital

If major global central banks are responding to the main drivers of inflation, it is also fair to assume a SOE central bank will want to respond to those same drivers given inflation’s international co-movement.

Global monetary policy rates

Source: Bloomberg, AMP Capital

Think ‘spread’, not level
Given the strong evidence of international synchronicity, a neutral policy rate for a SOE may be better interpreted as a spread to the global neutral cash rate, not an absolute rate in and of itself.
For example, if global policy rates are at historic lows for an extended period because of global spare capacity it may not be useful to think of a SOE cash rate as stimulatory or not relative to some absolute neutral level that presupposes the global cash rate is at its long run neutral rate.
This is because, in a world of free capital movements, money will soon find a home in a SOE that offers a higher interest rate spread than usual, which will drive up the currency and subsequently lower inflation.
Therefore, even if the SOE cash rate is below some absolute neutral level, a higher than average spread could prove to be far from stimulatory (or at least not as stimulatory as expected).  This is the situation New Zealand finds itself today. 

The current situation
Since the introduction of New Zealand’s Official Cash Rate (OCR) in 1999, the average spread to the five main developed market policy rates has been 2.4%[1]. The current spread is 2.9%. 

New Zealand policy rate spread

Source: Bloomberg, AMP Capital

Viewed through an absolute neutral lens, the current domestic situation of a positive and rising output gap and rates on hold a full 1% below the Reserve Bank of New Zealand’s estimate of the neutral rate looks a little puzzling.
Viewed through a spread lens, however, a positive and rising output gap and cash rates on hold is reconciled, given the higher spread than average. Of course, if and when the US Fed lifts interest rates, a higher domestic rate may be needed to maintain the higher spread if New Zealand’s output gap is still positive and inflation is rising as the Reserve Bank expects.. 

A persistent spread
One reason New Zealand has a persistent cash spread is we need relatively higher rates to attract short term foreign capital to fund persistent current account deficits. Another interpretation is the current account deficit simply reflects New Zealand’s low level of saving relative to investment, and a higher interest rate is needed to contain inflation in the face of high domestic spending.
Either way, there should be some risk premium for investing in a small, concentrated, less liquid market versus a globally diversified, more liquid one.

Back to the future
New Zealand’s monetary conditions index (MCI) regime that was in place in the late 1990s placed a greater emphasis on international linkages. In this regime the ‘neutral’ cash rate depended on the level of the currency, which of course is heavily influenced by the global interest rate spread. The MCI failed because it introduced unwanted volatility into markets. Also, a strict rule based system can miss many economic and market nuances.
No-one is advocating a return to the MCI regime, but defining the neutral rate as a spread not a level could be a step back in the right direction.   

In this note we have put the case that the neutral policy rate in New Zealand is best viewed as a spread to the global neutral cash rate rather than an absolute rate.  We believe the current domestic situation of a positive and rising output gap and cash rates on hold is better able to be reconciled when viewed in relation to this global spread.

[1] Using a simple average or approximate five TWI weights of 30% US, 20% Australia, 25% Euro, 15%, Japan and 10% UK.

Monday, March 30, 2015

US rates to rise only gradually - Yellen

In a speech delivered over the weekend US Federal Reserve Chair Janet Yellen reaffirmed the likely start of US interest rate hikes this year and an only gradual pace of increases thereafter.  There’s not a lot new in that but the speech makes an interesting read in highlighting the FOMC’s thinking about the factors likely to determine the interest rate cycle this time around.

On the outlook for the economy Ms Yellen’s comments were mostly in line with the March FOMC statement.  Lower energy prices continue to get most of the blame for recent inflation weakness with those effects likely to prove transitory.  She acknowledged the impact of the strength in the US dollar in restraining net exports and appears unconcerned about recent weakness in retail sales, expecting consumer spending to grow at a “good clip” this year.  With respect to the labour market she says there has been considerable progress on the maximum employment leg of the dual mandate but “appreciable slack” remains.

On interest rates Ms Yellen says the appropriate time for increasing interest rates has not yet arrived but conditions may warrant an increase sometime this year.  She points out that policymaker cannot wait until they have achieved their objectives to begin adjusting policy.  Leaving interest rates too low for too long risks over-shooting their objectives of maximum sustainable employment and 2% inflation as well as creating risks for financial stability.

Furthermore Ms Yellen stated that neither a pick-up in wage growth nor core inflation are needed before the FOMC decides to begin raising rates.  As I’ve said before, waiting for that to happen may leave the Fed having to play catch-up with more aggressive rate hikes  The Committee “simply”(my emphasis)  needs to believe that conditions are in place for its dual mandate to be met before hiking rates.  That said were core inflation or wage measures to weaken, or were inflation expectations to soften, she would be left “uncomfortable” in raising interest rates.

Ms Yellen is clearly attempting to deflect focus from the timing of the first interest rate increase to the shape of the interest rate cycle.  Indeed the most important aspect of the interest rate cycle for businesses and households is the cost of capital over the cycle, not the timing of the first hike.

In that respect she spends a considerable part of the speech alluding to the reason why an only gradual rise in the Fed funds rate is likely:

  • Firstly, the equilibrium fed funds rate may not recover as quickly as anticipated.  That means the ability of the economy to adjust to higher interest rates is uncertain.  Ms Yellen highlights the experience of Japan with a tightening of monetary conditions when the equilibrium rate remains low has considerable costs.
  • The second factor is the asymmetry in the effectiveness of monetary policy in the vicinity of the lower bound.  While interest rates are expected to move higher as the economy improves, should the economy falter as rates rise, there is limited room to stimulate the economy without resorting to further asset purchases with all the risks that would entail.
  • Third, she makes the observation that a prompt return to the FOMC’s 2% inflation could be advanced by allowing the unemployment rate to decline below its long run sustainable level for a while.

While all of these are valid reasons for the Fed to move only gradually, it wouldn’t be a balanced speech without highlighting the risk of proceeding too slowly, letting inflation get away, thus undermining the Committee’s inflation fighting credibility.  That seems to me to especially relate to the third point above.

In short there’s nothing in this speech to alter our view of a likely September “lift-off” for interest rates in the US and an only gradual removal of monetary accommodation thereafter.  But the speech is a more than useful dissertation of what the Fed is thinking about and what they will be watching as the cycle unfolds and the uncertainties that entails.

Regular readers may recall the point we made before the start of the interest rate tightening cycle last year that to some extent the RBNZ (and markets) were on a voyage of discovery with a number of uncertainties about the post-GFC New Zealand economy including the level of the neutral cash rate, the rate of potential GDP, the level of the equilibrium unemployment rate and how businesses and households would respond to higher interest rates.

Ms Yellen concludes her speech with similar thoughts.  She reiterates the Committee’s decisions will be data dependent, but that “We cannot be certain about the underlying strength of the expansion, the maximum level of employment consistent with price stability, or the longer run level of interest rates consistent with maximum employment. Policy must adjust as our understanding of these factors changes.”  New Zealand’s experience certainly supports that.