Thursday, July 21, 2011

All eyes on the politicians (2)

European leaders are about to meet to discuss the next step in the continuing Greek (indeed Europe) debt saga. We have been somewhat critical of actions taken to-date. They have largely amounted to increasingly austere liquidity measures that have done little to solve what is fundamentally a solvency problem. These measures have variously been described as kicking the issue for touch and kicking the can down the road. All appropriate (but now seriously over-used?) descriptions.

The signs are positive. Possible measures that have been floated prior to this summit include using the European Financial Stability Fund (EFSF) to fund a Greece bond buy-back plan. Such a plan, should it gain favour, could also be used by Portugal and Ireland. This particular measure is favoured by ECB President Jean-Claude Trichet. It would address the fundamental issue that Greek debt is simply too high to be paid back.

Also being discussed will be the extent to which the private sector should participate in the next bailout. Various options put forward by both France and Germany have been threatened by being ruled “selective default” by the rating agencies.

Whatever the measures agreed, we are looking for this next plan to provide a more enduring solution. In hindsight, the initial bailout was too small and it was unrealistic to assume that Greece would be able to return to raising funding in global capital markets as early as next year. As that has become clear, and as politicians have continued to kick the can down the road (sorry, last time, I promise), fears have grown about the debt levels in other European countries, most notably in Italy.

We flagged at the start of the recovery in 2009 that fiscal consolidation was going to be a constraining factor for growth in developed countries with both high structural budget deficits and debt levels. It was, and still is, important that as the plan was constructed in each of those countries, that they achieved the appropriate balance between attaining fiscal sustainability and supporting economic growth. Getting that balance right remains critical. Higher economic growth remains the preferred long-term solution to avoiding default for countries such as Greece.

Wednesday, July 20, 2011

All eyes on the politicians

Over the next few days the big news will be the politics of debt – both in the United States and Europe (more on Europe tomorrow). The US is perilously close to breaching its $14.3 trillion debt ceiling. Indeed it has already been breached, but via accounting measures employed by the US Treasury, more time has been secured to find a solution.

The US Senate is to remain in session until a solution is found. It is necessary to find a solution in the next few days so that legislation can be passed before the August 2 deadline. President Obama has described a new plan put forward by the so-called “Gang-of-Six” as being broadly consistent with what he is seeking.

Fiscal consolidation was never going to be easy. Many politicians don’t like cutting spending and many don’t like raising taxes. None of them like doing both at the same time. The politics are undeniably challenging, especially given the Democrats don’t control the House of Representatives.

That’s why at the end of last year following the US mid-term elections we wrote that markets should be careful what they wish for. You will recall markets responded positively to Obama losing control of the House. The theory was it would curb Obama’s supposed regulatory inclinations. We argued at the time that over the next few years, as tough fiscal decisions had to be made, it was desirable to have a strong US President, regardless of political affiliation so that the hard fiscal decisions would get made.

Whatever the make-up of the fiscal consolidation plan, fiscal policy is going to provide a significant negative impulse to economic growth in the US and many developed economies for a number of years to come. That will be exacerbated by the good work that households are doing to reduce debt levels.

The good news that comes with that is two-fold. Firstly, it reduces the amount of work that monetary policy will need to do as economies hit (lower) capacity constraints. Secondly, while economic growth will remain soft for a significant period of time, important repair work is happening behind the scenes that makes the recovery, albeit soft, increasingly sustainable.

Monday, July 18, 2011

Early exit from the insurance policy?

I know - it's expectations of FUTURE inflation that is supposed to guide the setting of monetary policy. However, today’s higher-than-expected June inflation result can’t be ignored. The CPI came in at +1.0% q/q and +5.3% y/y. The Reserve Bank was forecasting +0.7% q/q and +5.0% y/y.

As with last week’s GDP result, this result makes us more comfortable with our long-held view of a +50bp hike in the Official Cash Rate in December. If anything, the odds on an earlier hike have shortened somewhat.


Think about it this way. The Bank delivered a 50bp easing in March following the second and more devastating Canterbury earthquake. This was communicated as an “insurance policy”. We didn’t disagree with the move, but we warned the Bank would have to be vigilant about taking it back at the right time, especially given our view that the economy was on the improve.

With it now clear that the economy is on the mend and having withstood the earthquakes well, at least in numerical GDP terms, the time to take the insurance policy back is fast approaching.

As you will be recall we believe that, managed well, we could see a lower interest rate cycle this time around. Constrained household budgets and deleveraging, particularly in households, is likely to keep growth in the interest rate sensitive sectors of the economy subdued for some time.

On the other side, given the structural nature of the recession, the New Zealand economy’s capacity to grow is not as high as it once was. High structural unemployment in particular means the economy will hit capacity constraints earlier in the cycle this time.

A big part of the low interest rate cycle story is the requirement the Bank is sufficiently pre-emptive in (re) starting the tightening cycle. That became especially important after the March easing because we were all of a sudden we were 50bps further away from where-ever neutral is now.

So – 50bps in December seems to us to be a “done deal”. We would not be disappointed with an earlier move.

Headache for the Fed

June US inflation data shows the challenge ahead for the Fed. Headline inflation fell 0.2% in June for an annual rate of 3.6%, but the news was the 0.3% m/m rise in the core rate for an annual rate of +1.6%. That result was accompanied by further soft economic indicators, industrial production and consumer confidence.


It’s no wonder then that Ben Bernanke sought to clarify perceptions of further imminent quantitative easing last week. After the release of the June FOMC minutes, the doves had decided that QE3 was just around the corner. That was always going to prove to be wrong.

As we have said before, while the Fed has a dual mandate of full employment and price stability to deliver, we think they will always err on the side of the inflation objective. That’s especially the case when core inflation is rising and they believe recent weakness in the economy will prove to be at least partly transitory.

The most telling Bernanke quote of late was his reference to monetary policy not being a panacea. The Fed can’t fix every problem in the economy.

That doesn’t completely rule out further quantitative easing, but what it does is highlight the fact the Fed will only take action to ease further if they think the weakness in the economy is becoming entrenched to the extent it threatens price stability on the downside.

Our view is the current weakness in the US economy is partly transitory, with growth likely to pick up again later this year. That means the next move for the Fed is a tightening, but continued soft growth will see them not having to act until well into 2012.

Friday, July 15, 2011

NZ GDP number supports December tightening

March quarter New Zealand GDP came in better than expected. We had been forecasting a small positive increase, reflecting the improving underlying fundamentals at the start of the year offset by a negative shock from the February 22nd Canterbury earthquake. But in the end, the 0.8% q/q increase was twice what we had forecast. Furthermore, the December 2010 increase was revised up from +0.2% q/q to +0.5%. That puts the annual rate of growth at +1.4%.

While the quantum of the number was a surprise, the make-up wasn’t. The increase in consumption was modest at 0.4% q/q for an annual increase of 1.5%. As we know, households are deleveraging and it’s hard to grow consumption at the same time. On a more pleasing note business investment (plant and equipment) showed strong growth with export volumes up modestly over the quarter. These are the two areas we need to drive the recovery given constrained household budgets.

Looking further out, it’s tempting after a positive surprise to pull the next quarter forecast back a bit to simply reflect volatility in the data. We haven’t done that this time, but neither have we taken this result as a sign of higher growth in the quarters ahead. We have “banked” the positive surprise, but left our quarterly forecasts unchanged. That means we still expect a +0.5% q/q for the June quarter.


With regards to monetary policy, you will recall that after the Reserve Bank lowered the Official Cash Rate to 2.5% in March, we believed they would have to take it back by the end of the year. This GDP result reinforces our view that the Bank will hike the OCR by 50 bps to 3.0% in December. There is a risk they start to tighten even earlier.

Wednesday, July 13, 2011

Still plenty to worry about...

There is still plenty to worry about out there at the moment. Collectively these issues support our actions over recent months to "derisk" our portfolios.

Recent developments in Italy demonstrate in the starkest fashion that current problems in Greece are not so much about Greece itself, but about the risks of contagion to other debt-strapped countries.

There has been some good news, however. The just concluded meeting of Eurozone ministers has produced a proposal to increase the flexibility and scope of the European Financial Stability Facility (EFSF). This would include lengthening the maturity of loans and a lowering of interest rates. Importantly, it could lead to the EFSF buying government bonds in the secondary market which would help stem the rise in bond yields. It could enable Greece to retire its debt at a discount.

These measures would at least start addressing the sustainability of debt, rather than imposing increasingly restrictive liquidity measures that are just serving to push countries such as Greece into deeper recession. The finance ministers have given themselves until late August to work out the second bailout plan, but we like where this is heading (finally).

That news was tempered, however, with Moody’s Investor Services decision to downgrade Ireland’s credit rating to Ba1 (the highest speculative grade rating), with a negative outlook. This follows a similar move on Portugal last week. Indeed the same reasons were stated: that private sector participation which is likely in future bailouts will raise the costs of borrowing for peripheral countries.

The rating is less in dispute than the timing of the moves. Ireland, better than any of the “crisis” countries, seems to be turning the corner towards recovery. In particular it now has a current account surplus showing it is starting to pay its way in the world.

The next piece of news will be the results of bank stress tests due on Friday.

Meanwhile, in the United States, the political posturing around raising the debt ceiling continues. We expect a deal will be reached, but it will go close to the wire. Markets will become increasingly angst-ridden as the deadline approaches in about two weeks time.

The minutes from the June Federal Open Market Committee (FOMC) meeting held no surprises. The Fed continues to expect the US economy to recover in the second half of the year, as we do. The prospects of a further round of quantitative easing was openly debated, with some members stating that if “growth remained too slow to make satisfactory progress…it would be appropriate to provide additional monetary policy accommodation”.

While the Fed appears ready to take further action, we don’t believe conditions at this point warrant QE3. The fed has a dual mandate of full employment and price stability, but we believe it was the risks of deflation that won the cost/benefit argument for QE2. Right now the costs of QE3 would outweigh the benefits.

Sunday, July 10, 2011

Around the World by Central Bank

It was a busy week for central bank meetings last week:

The Reserve Bank of Australia left its cash rate unchanged at 4.75%. That’s largely due to the RBA conceding their expectations for economic growth this year are too high. They are forecasting 4.25% growth this compared with the Treasury’s pick of 4%. Both are probably too high in our view. Household spending has been more subdued than expected and risks to global economic growth have re-emerged. While growth may well prove to be lower than expected this year, potential growth is most likely also lower than previously. That means excess capacity may not be as large as some expect. We believe interest rates will move higher in Australia this year, but the strong exchange rate is buying the RBA time.

The People’s Bank of China raised rates interest rates again with the one-year Yuan lending rate raised 25bps to 6.56% and the one-year deposit rate raised to 3.5%. This was against our expectation. We believe that while inflation in China increased again in June, it is close to peaking. Furthermore, there are clear signs the Chinese economy is slowing. Further interest rate increases from here risk losing the necessary balance between controlling inflation and avoiding a hard landing. Our preference is for a faster appreciation in the exchange rate which has the added benefit of supporting the necessary rebalancing of the economy. Exchange rate appreciation shifts some of the burden to the export sector while at the same time delivering a boost to real household incomes as imports become cheaper.

The European Central Bank raised rates a second time with the benchmark interest rate being raised 25bps to 1.5%. As we said at the time of the first rate hike in April, we believe the ECB has embarked on a risky strategy. While it is certainly the case that growth in some parts of Europe (Germany, France) warrants somewhat less accommodative monetary policy, other parts (Greece, Portugal) are struggling under the weight of increasingly austere fiscal policy and recession. In these latter countries the competitiveness boost from a weaker exchange rate is about the only growth respite as domestic demand contracts. Interestingly, at the time of the announcement on interest rates, ECB President Jean-Claude Trichet conceded the global and European growth outlook had deteriorated in recent weeks. It appears likely, however, that the ECB will continue on this gradual tightening path. But don’t expect another tightening until September.

The Bank of England left its benchmark rate at 0.5%. Again, in a theme that was common in most central bank meetings this week, the weaker global growth outlook was discussed. The Monetary Policy Committee conceded “the current weakness of demand growth was likely to persist for longer than previously thought.” The minutes of the meeting suggest there is some support for extending the £200 billion Gilt quantitative easing program. It should not be ignored that the UK is embarking on one of the most aggressive fiscal consolidation programs in the OECD. This means monetary policy can remain more accommodative for longer. While tighter fiscal policy will impact negatively on domestic demand, there are more positive signs on business investment and exports. While that remains the case we don’t believe we will see further QE in the UK. But as with the US, we don’t expect any tightening in conditions until well into 2012.

Tuesday, July 5, 2011

Global Supply Chains Repairing

Global supply chains are gradually being restored following the devastating Japan earthquake and tsunami. Japan industrial production rose 5.7% in May, the fastest monthly gain since 1953. Production is still below pre-quake levels after falling 15.5% in March and a modest rise of 1.6% in April, but the turnaround is pleasing to see.





This is giving credibility to Ben Bernanke’s (and our) theory that at least some of the recent weakness in activity data in many countries would prove to be earthquake related and therefore transitory. Indeed the US ISM manufacturing survey showed a modest improvement in June against average expectation of a further weakening.


That June recovery was centred largely in inventories, just as the weakness was centred in May. Inventories were clearly run-down in the immediate aftermath of the quake, but have since been restored.



There was a modest improvement in the New Orders index. That soft recovery in the key forward-looking index tells us, as we suspected earlier, that there is perhaps more to the recent softness in US activity indicators than just the quake-related supply disruptions.



On a brighter note the employment index moved higher (from 58.2 in May to 59.9 in June), and the prices paid index fell again (from 76.5 to 68.0). The decline in the prices paid index indicates some cost-relief to manufacturers on the back of softer commodity prices.

Monday, July 4, 2011

Greece: Crisis postponed…again.

Parliamentary votes in Greece last week to endorse a further €28b in tax increases and spending cuts paved the way for discussions on a second bailout to begin and to allow the release of the next tranche of bailout funds over the weekend. This will be sufficient to meet Greek financing needs over the next few months.

However, this is not the end of Greece’s debt problems. All we have had so far is a series of liquidity measures to treat what is essentially a problem of solvency. The only part of the austerity package so far that treats the underlying problem is the €50b privatisation programme, although it remains to be seen how successful that will be.

While moving Greece onto a more sustainable fiscal path (the liquidity, deficit reducing part of the plan) is important, I think we have lost sight of a critical element of any fiscal austerity program – balance.

We have argued for some time now that while fiscal austerity programs would be a critical part of convincing markets that there is a plan to achieve fiscal sustainability, such programs needed to strike the right balance between fiscal consolidation and supporting economic growth. Following the passing of the latest austerity measures, the European Council has revised its forecast for Greek GDP growth this year to -3.75%, followed by 0.6% growth in 2012. I think that’s optimistic.

Political failure to resolve Greece’s solvency problem has simply resulted in harsher liquidity measures being taken. The second bailout needs to allow some time for all of the measures taken to date to have some impact. Indeed the recent proposal from France to rollover Greek debt held by banks into 30-year bonds and a special purpose vehicle will be helpful in this regard, assuming it gains traction.

It’s probably also a good time to remind ourselves that sovereign debt issues in Greece and other European countries are symptomatic of a larger issue – the huge economic diversity that exists within the countries that are member of the European Monetary Union.

It is widely expected that the ECB will raise interest rates again this week. We have talked about that being a risky strategy before. That’s because while Germany may need higher interest rates, higher interest rates and the inevitably higher exchange rate will constrain the necessary export-led recovery in Greece.