Friday, December 31, 2010

Highlights of 2010

I couldn't possibly let 2010 end without picking some highlights from yet another momentous year for the global economy. You will be pleased to know I have managed to keep it to just five...

1) Global growth. At the start of 2010, the consensus for global growth was around 3.5%. The year looks like finishing with a result perhaps a tad over 4.5%. Not bad, all things considered. Within that overall result the surprises were, firstly, emerging market growth. The surprise wasn't that EMs were the driving force of the recovery - we knew they would be - the surprise was they look like posting around 8.5% for the year. Special mention goes to China, Brazil and India. The other surprise was the modest resurgence in consumption in the US towards the end of the year. Perhaps that reflects some deleveraging fatigue setting in in the run-up to Christmas?? That question will answered early on in 2011. We still don't expect the US consumer to become a driving force of the recovery. The labour and housing markets remain too strong a headwind. Equity markets have responded well to the improved growth outlook and survived the double-dip scare mid-year with most major markets at 2-year highs.

2) Sovereign debt issues. Some people thought we were a tad premature when about a year ago we starting talking about the need for governments with high debt and big budget deficits to start articulating their plans for fiscal consolidaton. It was the absence of such plans that saw sovereign debt in Europe become a key focus for markets throughout the year. The key lesson is there is a boundary to prudent fiscal policy, and that boundary is currently being tested. Markets have forced governments to articulate and begin implementing tough fiscal austerity plans. Arguably those plans could have been less austere had governments taken the lead earlier. At the end of the year the combined efforts of the EU/ECB and IMF are just keeping up with the isuue. Sovereign debt and fiscal policy will remain a key issue for markets in 2011 - and not just in Europe. In Europe, the issue will continue to widen into the broader topics of the survival of the Euro and EU governance.

3) The willingness of central banks to do whatever it takes to support growth was another highlight of the year. Perhaps it wasn't as much to do with supporting growth as it was to do with avoiding deflation. You know the line: its easier to stay out of deflation than it is to get out of it once you're in it. We saw QEII in the US - even though in our opinion it won't do much to cure the fundamental problem in the US which is the lack of demand. It did however help restore confidence and gave the sharemarket a bit of a boost. Fortunately that market boost has been justified by the improving data. Also the ECB continued to provide lifelines to countries in need of assistance. US 10-year Treasury's reached an historical low of just under 2.5% during the year - benefitting from deflation and double-dip fears, the old flight to quality (that's right, "quality") out of Europe, and the expected second round of asset purchases. By year-end, they had sold off considerably as the growth outlook improved and inflation expectations rose, but will likely remain low by virtue of a short-end of the yield curve that remains anchored at zero.

4) The changing world order. the withering of the power and influence of the US (and more broadly, the G7) is becoming increasingly obvious. To offset the US decline in the balancing act of global politics we are winessing the emergence of China as a genuine geo-political powerhouse. Along with that we have seen the rise in influence of the multi-lateral agencies such as the IMF. In my view, the IMF will become an increasingly important player in the new world order, but more on that next year.

5) Finally, New Zealand growth undershot even our miserly growth forecasts at the end of 2010. Sure there are weather and earthquake factors impacting, but it underlines the fact that it will remain tough going for the New Zealand economy next year. This is a non-traditional recovery. We've talked about wanting export led recoveries in the past - this time we need one. The (only) encouraging point of the GDP data out just before Christmas was the strong increase in plant and equipment investment. We contine to look to investment to drive the next stage of the NZ recovery. The interesting thing about that is that it will challenge the very reasons for New Zealand's long-term underperformance in measures such as productivity. 2011 looks like it will be quite fascinating.

Happy New Year!!!!!!!!!!!!!!!!!

Wednesday, December 29, 2010

US housing and consumer confidence

US housing continues to buck the trend of improving US data - and while that's the case, US consumers will remain cautious and economic growth will remain subdued.

House prices were down a seasonally adjusted 1.0% in October according to the Case-Schiller Index. That gives us an annual rate of -0.8%. That's worse than the market was expecting the average forecast picking an annual decline of 0.2%. The decline was broad-based with 18 of 20 cities recording declines.

It's perhaps not surprising then that consumer confidence fell to 52.5 in December. That's below the bottom end of expectations which had picked, on average, a rise to 56.3 from a (revised) level of 54.3 in November.

The drop in confidence seems at odds with reported strong retail activity over the Christmas period. But the bottom line is this: the US consumer cannot be expected to be a driving force of this recovery until confidence recovers and that requires at least some degree of stability in the housing market. We are not seeing that yet.

Those of you who have read our latest QSO will be aware we have lifted our US GDP forecast for 2011 from 2.5% to 3.0%. We're still comfortable with that - but note the increase was made largely on the back of the announcement of cuts to payroll taxes i.e. new stimulus. The US is still a long way short of a robust self-sustaining recovery. That's especially the case when you consider that next years stimulus needs to become future fiscal consolidation!!

Tuesday, December 28, 2010

China tightens

China raised interest rates on Christmas day with the benchmark lending rate raised 25bps to 5.81% and the deposit rate also raised 25bps to 2.75%.

We expect monetary conditions in China to tighten further over the course of 2011, with most of the work likely to occur in the first half of the year. The battle will be faught on three fronts -further increases in the required reserve ratio, further appreciation in the Yuan and further increases in benchmark interest rates. The benchmark lending rate is still 166bps below the rate that prevailed before the onset of the GFC, so there is plenty of upside relative to recent history.

This is the right course of action for China to take. As we have said on many occassions, we prefer the People's Bank of China to tackle inflation head-on. The consequence is lower growth, but we would prefer lower, stable growth to boom and bust. Growth indicators in China are still strong, so the inflation battle is being faught from a high-growth base.

The likely course of monetary policy next year in China highlights the differing challenges in 2011 between emerging and developed economies. In emerging economies the challenge will be to slow down overheating economies and keep inflation in check. The challenge in developed markets will continue to be the weakness of domestic demand, persistently high unemployment as economic growth remains insufficient to dent unemployment and inflation that remains too low for comfort.

Thursday, December 23, 2010

Reflections on the challenges facing the New Zealand economy

The traditional pre-Christmas release of key New Zealand GDP and Balance of Payments data contained a few salutary reminders of the challenges facing the New Zealand economy as we head into 2011. Add in the half-year fiscal update from last week and the messages are even more clear…and worrying.

In particular:

* This is a non-traditional New Zealand recovery. Consumption and residential construction, the more traditional drivers of recent growth, are subdued and will, in our assessment, remain subdued for some time.

* This recovery needs to be driven by real productive effort. That productive effort needs to be export oriented. If exports don’t drive the recovery, nothing else will.

* We need a positive contribution from net exports. Recent strength is export values has been price driven rather than volume. There is nothing in this for us to pat ourselves on the back for.

* Our recent export success is more due to the vagaries of global commodity prices. We remain of the view that if we don’t have an export led recovery this time around, we simply won’t have a recovery.

* The structural nature of the recession (and the recovery) means that potential GDP, or the rate at which the economy can grow without generating upward pressure on inflation, is now lower. In particular we believe the higher unemployment rate includes a higher level of structural unemployment – skills shortages and upward pressure on wages will emerge earlier in the cycle this time around.

* We continue to look for a strong business investment cycle to drive the next wave of the recovery and to build the capacity of the economy to produce stuff the world wants to buy. In that regard the increase in plant and equipment in the September quarter was the only really good bit of news.

* We cannot rely on just the economic cycle to close, what is in the Treasury’s own assessment, a large structural budget deficit. Higher savings is part of the answer and we look to the Government to make its contribution in Budget 2011. There are structural changes required to government expenditure, especially entitlements such as New Zealand Superannuation and Working for Families.

* Monetary policy can’t solve this for us. I find it fascinating that whenever we have a conversation about economic growth in New Zealand, we very quickly end up having a conversation solely about the Reserve Bank and monetary policy settings.

* The best contribution monetary policy can make is to keep inflation under control. To use an old phrase (thank you Ruth Richardson): Monetary policy needs mates. That support needs to come from fiscal policy. Where the government does spend on growth oriented policies, it needs to be focussed on the strength and interconnectedness of the innovation system.

* Government can’t make businesses more productive or more innovative. The only contribution policy can make is by creating the right environment for businesses to be more innovative or productive, should they choose too.

I think that's about all for now. These are all things to keep thinking about, worrying about, debating and working on in 2011. In the meantime, Merry Christmas!!

Tuesday, December 14, 2010

NZ Half-Year Fiscal Update

The New Zealand Treasury has, not unexpectedly, taken an axe to their New Zealand economic growth forecasts. The implication is that operating balance expectations are commensurately lower and public debt forecasts higher.

Economic growth forecasts are significantly weaker in the short-term. Treasury is now expecting 2.2% (annual average % change) growth for the year to March 2011, down from the May forecast of 3.2%. This is broadly in line with our forecast of 2.1%. Weak household spending is the main difference between the May and December forecasts.

The March 2012 forecast of 3.4% is stronger than the May forecast of 3.1%, but this is due to the generally weaker growth environment being offset by the rebuilding activity following the devastating Christchurch earthquake. This is slightly stronger than our forecast of 3.1% for the March 2012 year.

Further out, Treasury is expecting 2.9% growth in the year to March 2013, again slightly stronger than our 2.6%, but in line with our expectations of a modest economic recovery that will take some considerable time to build any significant momentum.

The fiscal implications are significant. Treasury expects an operating deficit (OBEGAL) of 5.5% of GDP in FY2011. This compares with a forecast deficit of 4.2% of GDP in May. This deterioration had been well flagged in recent monthly out-turn data.

As in the Budget, this is expected to be the low point in the cycle, with deficits gradually reducing in size in the out-years with a surplus being projected in FY2016. Despite the lower starting point, this is a year earlier than expected at the time of the May Budget.

Net public debt is higher through-out the forecast track by just over 1 percentage point of GDP. Net debt is expected to be 27.8% of GDP in 2014, compared with the earlier forecast of 26.5% of GDP.

Even though the Treasury’s view of the near-term economic outlook is now broadly in line with our own, I can’t help but worry that the expected improvement in the key fiscal indicators is going to be somewhat more difficult to achieve. The recession was structural, the recovery is proving to be hard work, and by the Treasury’s own admission, the budget deficit is largely structural.

That doesn’t sound like an easy fix. We need to take a hard look at spending and start to deal with some of our longer-term structural fiscal issues like entitlement to New Zealand Superannuation. Pressures to spend will only grow over the next few years, with healthcare, education and infrastructure springing immediately to mind. We need to make sure we spend in the right places, especially if the Government is serious about building the capacity of the economy to grow.

Monday, December 13, 2010

China house prices, inflation and monetary policy

China raised the Required Reserve Ratio (RRR) a further 50bps on Friday, following the release of house price and inflation data for November. The increase in the RRR is effective from December 20.

House prices continue to rise. Prices were up 0.3% in the month and 7.7% in the year. That’s a slowdown in the annual rate, but the monthly rate of increase was the third in a row after increases of 0.5% in September followed by 0.2% in October.

Inflation leapt again in November with the annual rate hitting 5.1%. This is up from 4.4% in the year to October and 3.6% in the year to September. Food prices are the main culprit yet again, but there were signs this month of inflation pressure becoming more broadly based. Food price inflation was 11.4% over the year, while non-food inflation rose 1.9%. Over the month, however, “clothing” and “residence” prices also recorded significant increases.

There is speculation this may be a peak in annual inflation as flood-related vegetable prices begin to retreat, but the broader base of price increases shouldn’t be ignored.

We believe further tightening in monetary policy is desirable. This can take a number of guises, but we believe a combination of further RRR increases, an increase in benchmark interest rates and faster appreciation of the CNY are all necessary.

It is essential the authorities take the need to keep inflation in check seriously. Regular readers of our research know we believe the biggest threat to rising emerging market prosperity is any lack of commitment on the part of monetary authorities to take whatever action is required to tame inflation. Growth is holding up well in China. We believe inflation can be tamed with a soft landing.

That view is not without risks. It is also important not to overdo the tightening and damage growth prospect unnecessarily. But that requires early and pre-emptive action. Leave it too late and the tightening in monetary setting may have to become more aggressive, which would be more damaging to growth prospects.

Thursday, December 9, 2010

RBNZ December MPS

As was widely expected the Reserve Bank of New Zealand (RBNZ) left the Official Cash Rate (OCR) unchanged today at 3.0%. The surprise was the dovish tone of the accompanying statement with the Bank shaving about 30bps off its forecast interest rate track and pushing out the timing of the first hike out to June compared with March previously, with which we concurred.

To some extent we shouldn’t be surprised given the lower starting point to growth. The RBNZ was expecting 0.9% GDP growth in Q2 which came in at 0.2% and have revised down their Q3 forecast from 0.8% to 0.3%. But while the starting point is lower, we know that growth will be stronger later next year and into 2012 on the back of the Canterbury rebuild. The cumulative change across the growth forecast path is only of the order of 0.5%.

In terms of monetary policy, it appears they are relying on their ability to “look through” one off events and are setting policy in terms of what we might call an “underlying” growth rate.

As you will recall we have been quite comfortable with the concept of a lower interest rate track this cycle. This is on the back of the structure of the economic recovery (less consumption and residential housing) and its continued overall subdued nature. But part of our low interest rate story has been the expectation that the RBNZ will front-foot the inevitable inflation fight, stay in front of the problem and not get into the same situation as the last cycle when the OCR ended up at over 8%.

I’m quite happy to shift the starting point of the next phase of the tightening cycle out to June. But I also believe that once the time comes to start removing the stimulus, the hike in rates will be more aggressive than the Bank is currently forecasting. The new risk to add into the New Zealand economic landscape is that they take a too sanguine view of inflation, leave the tightening too late and we end up with a higher OCR than would be the case if the Bank took earlier action.

We agree with the message to the Government to get spending under control. When the time comes to remove the stimulus, it is desirable that fiscal policy does its share of the work. This will reduce the work needed to be done by interest rates and in turn take pressure off the exchange rate thereby support the necessary rebalancing in growth.

Tuesday, December 7, 2010

NZ Budget Deficit: It’s structural!

This week the New Zealand Government reported a weaker than forecast fiscal position for the first four months (July to October) of Fiscal 2010/11. The deficit is $1.9 billion behind forecast, much of this due to a lower tax take on the back of weaker than expected economic growth. The Minister of Finance has announced another review of public spending for the New Year.

In my view, the Government isn’t going to achieve much in the way of fiscal consolidation until it accepts that a large part of the fiscal problem is structural, not cyclical. At the time of the May Budget we gave the Government high marks for the structural changes to the tax system (lower income taxes and higher consumption taxes), high marks for making further progress in reining in the deficit and public debt, but low marks for recognising the structural nature of the post-GFC fiscal challenge.

Twice in New Zealand’s history, Government’s have brought down challenging and difficult Budgets, the nicknames of which have found their way into the Kiwi lexicon: Arnold Nordmeyer’s 1958 “Black Budget” and Ruth Richardson’s 1991 “Mother of all Budgets”.

All around the developed world, Governments are grappling with large structural deficits and high and rising levels of public debt. They are making politically challenging decisions as the reality of lower living standards hits wallets. Fortunately, New Zealand isn’t in the same boat, but this is primarily because of difficult decisions that have been taken earlier.

At Budget 2010 the Treasury’s economic growth projections were higher than ours, but given the uncertainty in the outlook, they were not outside the bounds of possibility. The lower growth outlook is becoming entrenched as households focus on getting their balance sheets back into order. That has clear implications for tax revenue, budget deficits and public debt.

It is time for a really hard look at government expenditure. This is not the time for tweaks; it’s time for another Budget to earn a nickname.

Saturday, December 4, 2010

US jobs: Yuck

The "muddle through" theory for the US economy remains firmly on track. US non-farm payrolls rose a disappointing 39k in November. This is well below average market expectations of around 160k. The unemployment rate edged up to 9.8% from 9.6% in October.

The data was weak on all fronts. With government jobs falling 11k in the month, private payrolls only expanded by 50k, but even this was driven by education and health. Construction, retail and my beloved manufacturing sector (where the US recovery needs to come from) all recorded declines.

Hours worked were flat in the month and annual wage growth continued to slow. The only good news was a revision up to October data from an increase of +151k to +172k.

As with the ISM data earlier in the week, data is pathchy and subdued overall. As I said with the ISM data, i'm increasingly convinced the double-dip scenario has been averted, but it's way too early to be expecting any uptick in growth. "Muddle through" still remains the best descriptor of the next few months for the US.

Thursday, December 2, 2010

US and China Manufacturing

After the stellar result in October, it was not surprising to see some pull back in the Institute of Supply Management's US Performance of Manufacturing Index in November. The October reading of 56.6 was 0.3 percentage points below Novembers 56.9. For an economy that is only meant to be "muddling through" the second half of 2010 and early 2011, the US seems to be muddling through pretty well at this stage.

Most of the sub-indicies that drove the increase in October reversed to various extents in November. In particular the Production index fell to 55.0 from 62.7, New Orders fell from 58.9 to 56.6, and Exports fell from 60.5 to 57.0.

The overall index really only managed to hold up so well on the back of increases in the Inventories index (from 53.9 to 56.7) and the Supplier Deliveries index (from 51.2 to 57.2). These indices are two of the least forward looking of the sub-indicies.

This result does not change our "muddle through" scenario for the US economy over the next few months. Pick your favourite sub-index and the data is consistent with GDP growth of anything between 2% and 3.5%. We are increasingly confident the US avoids the dreaded double-dip scenario, but growth over the next few months is going to remain patchy and subdued.

Meanwhile in China, both PMI indicies rose in November. The official index rose from 54.7 to 55.2 while the Markit index rose from 54.8 to 55.3. This tells us that despite the slowdown in annual growth over recent months, underlying activity remains strong. In particular, forward orders are strong which bodes well for future production. Even better, the new orders appear to be largely domestic activity - which is good for global rebalancing.

Data like this makes us more confident that growth in China is sufficiently strong for the authoirities to continue their fight against inflation and strong housing market activity without seriously dampening the growth outlook.

Australia Q3 GDP

The Australian economy expanded by a weaker than expected 0.2% (s.a.) in the third quarter of 2010. The market had been expecting an increase of around 0.4%. The lower than expected result and revisions to past data has put the annaul rate of growth at 2.7%, lower than the expected 3.4%. By developed economy standards, this is still a good result.

Weaker exports (-2.4% q/q) and a decline in inventories were the biggest contributors to the weaker than expected result. The weak exports number came after some pretty strong esults in previous quarters - we are not seeing this is as a new trend but rather a temporary pull back after a pretty strong run of numbers. Construction was down 0.9% in the quarter.

Consumption was still soft at 0.6% q/q, but that shoudn't come as a surprise. As with most of the developed world, Australian households are repairing balance sheets and addressing high debt levels. On the other hand (don't ya just love it when economists use both hands), strong employment growth and booming tems of trade will help underpin spending and business investment.

With China looking increasingly likely to engineer a soft landing to its current attempts to rein in inflation and housing market excesses, the outlook remains good for Australia. It is a two-speed econony at the moment, but the fundamenatls for households to start making a meaningful contribution to growth remain stronger than most other developed economies.