Thursday, September 22, 2011


June quarter GDP came in lower than expected at +0.1%. We had expected an increase of +0.3% while the average market expectation was +0.5%. This was a marked slowdown from the revised +0.9% (previously +0.8%) in the March quarter. The December 2010 quarter was also revised up from 0.5% to 0.6%. We effectively got our +0.3, it’s just two-thirds of it came via revisions to past data!

The annual rate of growth now stands at 1.5% for the year to June. The sectoral breakdown was much as we expected with a rise in the agriculture sector and declines in both construction and manufacturing.

We are not viewing this as a loss of momentum for the New Zealand economy. Rather we believe March probably overstated the strength of the economy while June understated it. Put together, +1.0% for the six months feels about right.

Of course this is all history. The question is where to from here? We continue to think the growth outlook remains relatively positive, although risks around the global economic outlook cloud that somewhat.

On the positive side the terms of trade is at 37-year highs. While commodity prices have softened somewhat recently, he expect the terms of trade to remain at healthy levels. That provides a significant income boost to the New Zealand economy. To-date that has not shown through in economic activity as the primary sector has been focussing on debt repayment. There is anecdotal evidence, however, of increased on-farm investment activity recently which is positive.

Recent wage growth means that households are now able grow consumption while still focussing on debt repayment. That has been reflected in relatively healthy levels of consumer confidence. However, we continue to expect only modest consumption growth over the medium-term. Right now the Rugby World Cup is providing a boost to consumption which will be reflected in September/October retail sales data.

Business confidence remains at healthy levels, despite the cool winds blowing from overseas. That bodes well for investment in the period ahead. As with the outlook for all developed economies, we have looked to business investment (and exports) to be key areas of economic growth, especially while households are constrained by deleveraging.

It appears the New Zealand housing market is bottoming out. However, as with consumption, we are not expecting a strong recovery. The exception is of course in the Canterbury region where earthquake reconstruction will provide a significant boost to construction activity in 2012, although the precise timing remains uncertain.

That of course assumes that global economic and financial conditions do not take a serious turn for the worse. That is the key risk to the outlook: We would not be immune from a sharp slowdown in global growth. Already increased finance sector risk is having an impact on the cost of funds. A sharper slowdown in global growth than we currently would also have a negative impact on commodity prices.

Our forecasts currently have annual GDP growth at 2.3% for the year to December 2011, followed by 3.6% in the year to December 2012.

The Fed and "Operation Twist"

As was widely expected, the US Federal Reserve announced today that it would employ “operation twist”, whereby it will lengthen the duration of its existing balance sheet holdings by selling short-dated securities and purchase longer-dated maturities. The Committee intends purchasing $400b of Treasury securities in the 6-30 year part of the yield curve and selling an equal amount of Treasury securities with remaining maturities of 3 years or less. This programme is intended to exert downward pressure on long-term interest rates.

There had been some speculation the Fed may adopt further measures such as reducing the interest rate paid on excess reserves. They did not adopt that today. The Committee has decided to reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage backed securities.

The Fed effectively adopted a bias to ease at their last meeting in August. Statements since then, including Chairman Bernanke’s speech at Jackson Hole signalled a high likelihood that they would do something and so it quite soon. The only questions were what “it” would be and how effective “it” would be.

“Operation twist” can be seen as a compromise solution by the Fed. There is a range of opinion at the Fed about the need for further stimulus. In particular the “hawks” did not want to see further balance sheet expansion. We agree with them. As it stands, three members of the Committee voted against today’s actions.

On the question of efficacy, we remain sceptical about the ability of the Fed to do much to influence stronger economic growth. As we have said before, monetary policy cannot do this alone. That’s because monetary policy can’t do much to influence the necessary structural rebalancing in the US economy, although a weaker exchange rate is helping in that regard. Thankfully we have started to see some (small) supply-side measures in President Obama's jobs plan. More of that would be good.

Monday, September 19, 2011

India tightens

The Reserve Bank of India (RBI) raised interest rates again on Friday. The repo rate now stands at 8.25%.

There are clear signs economic growth is slowing: GDP growth was 7.6% in the year to June and growth in industrial production slowed sharply in the year to August. However, inflation remains stubbornly high. The Wholesale Price Index rose to 9.8% in the year to August.

It seems to us that of the key emerging markets, India is facing the most entrenched inflation problem. What started as a food price supply shock problem has spilled over into more generalised inflation. Also, with India less reliant on exports than the likes of China, slowing global demand will have a less negative impact on growth.

For that reason, combined with the fact that fiscal policy remains stimulatory, the RBI stands alone amongst the BRIC economies in pursuing tighter monetary conditions. China has paused on monetary policy tightening while Brazil and Russia have cut interest rates recently. While we think the RBI has done the bulk of its tightening work, we wouldn’t be surprised to see rates move up again in October.

Thursday, September 15, 2011

New Zealand Monetary Policy

As expected the Reserve Bank left the Official Cash Rate (OCR) unchanged at 2.5% at todays Monetary Policy Statement. The press release was quite different from the one released at the time of the July OCR Review which signalled the imminent removal of the 0.5% earthquake “insurance” cut. Indeed that insurance policy has now been swapped for one against another potential disaster: a sharp slowdown in the global economy.

Reading the Statement highlights the challenge for the Bank in setting monetary policy right now. On the one hand the domestic economy is performing well. GDP growth appears to be gathering momentum, the terms of trade is at a multi-decade high and is likely to remain elevated, and spare capacity is being absorbed. Skill shortages are emerging in the labour market and inflation expectations have risen recently (although the Bank expects that to moderate). All of those are inconsistent with an OCR at 2.5%.

However, like us, the Bank is worried about the world. All of the positive domestic economic indicators count for nothing if the world takes a serious turn for the worse. For that reason the Bank left the OCR unchanged today and isn’t flagging an increase until early next year. Furthermore, higher bank funding costs and a higher projected exchange rate has the Bank projecting a lower interest rate track with 90-day Bills now peaking at 4.3% in 2013/14, rather than the 4.9% forecast in the June MPS.

On the back of today’s Statement we are shifting our expected first interest rate hike from December 2011 out to March 2012, but still expect that first increase to be 0.5%. Once the time is right, the Bank will have to get on with the job. Of course it is possible that global economic conditions improve before then in which case the Bank could well tighten earlier than this. We are keeping to our expected OCR peak of 4.5%, even though the Bank’s interest rate forecasts imply a peak of 4%.

Wednesday, September 14, 2011

Keeping an eye on Europe

It’s been a big few days in the ongoing European sovereign debt saga. There have been heightened fears of an imminent default by Greece, a high profile resignation from the European Central Bank and both Italy and Greece have agreed to new austerity measures.

The impending departure of Jurgen Stark, who resigned last week as the Central Bank’s unofficial chief economist, was viewed negatively by the market. This can be mostly attributed to the fact that it underscores the lack of unanimity at the ECB about measures being taken to stabilise financial markets. Stark was not a supporter of recent actions taken by the ECB to purchase Italian and Spanish bonds which we believe were a helpful part of the stabilisation process.

Italy and Greece have confirmed Budget measures that will help them meet agreed budget targets. In the case of Greece, these measures will help close a significant Budget gap that was threatening to derail the payment of the next €8 billion tranche of the first Greek bailout.

It was during this process that rumours started circulating that Germany was preparing for a default by Greece. It seems prudent to us that Germany should be prepared for such an eventuality, in fact the only surprise to us in this news is that they weren’t already prepared for such an outcome!

You will recall it is our view that Greece will default at some point. The debt burden is simply too high and increasingly austere near-term budget measures are simply pushing the economy into an ever deeper recession. Deep and potentially protracted recession makes a long-term solution to Greece debt sustainability all the more difficult.

None of this means, however, that a Greek default is just around the corner. At the announcement of its most recent budget measures the Greek Prime Minister said his government remained committed to avoiding default.

It’s also not all about budget cuts: asset sales and a debt swap programme are also part of the plan. Asset sales will take time and it is questionable whether the target €50 b will be raised. September 9 was the deadline for banks and insurers to signal their participation in the debt swap programme whereby holders of Greek debt will swap bonds for longer dated ones. It’s unclear what the take-up is at this point. It’s unlikely these programmes will solve the problem, but at least they are moves in the right direction and deal with the fundamental problem of solvency.

There is little doubt a premature disorderly default would have serious contagion implications for other countries, particularly Portugal and Ireland. It would also have serious implications for currently undercapitalised banks. A more orderly process at a later date would allow Portugal and Ireland to demonstrate success in moving towards a more fiscally sustainable position and for banks to be better capitalised.

In the meantime, financial stability is important. There are two mechanisms for stability: the European Financial Stability Facility (EFSF) and the ECB’s balance sheet. First the EFSF. The July 21 Eurozone summit proposed increased powers for the EFSF. These proposals allowed the EFSF to use its funds to buy distressed sovereign bonds at a discount on the secondary market, issue precautionary liquidity loans to euro zone members and to ecapitalise banks in difficulty.

These proposals need to be ratified by the various Euro zone member parliaments. The French parliament passed the measures last week. In Germany, its constitutional court last week rejected challenges to the Euro zone financial packages that were agreed last year for Greece and other Euro zone countries. This has paved the way for the passing of the EFSF measures by the German parliament at the end of the month.

In the meantime, the ECB has been exercising its role as the lender of last resort. Through the Securities Market Programme (SMP) the ECB has purchased around €130b of peripheral Euro zone debt. With the ECB’s balance sheet already at €2 trillion, the inevitable question is: How far can the ECB’s balance sheet stretch? We think quite a bit. The ECB has considerable capacity to increase the size of its balance sheet by issuing non-interest bearing and non-redeemable debt. We are not concerned about the ECB’s ability to stand behind Euro zone sovereign members and banks, even in the face of a default by Greece.

In a more recent development, the BRIC economies are meeting in Washington next week to discuss how they can assist.

Ultimately we are waiting for the politicians to come up with the long term plan for the management and sustainability of Euro zone sovereign debt. We remain of the view that this involves a high degree of “fiscal federalism” in Europe i.e. a common fiscal policy. This inevitably leads to the issuance of Euro zone bonds. The creation of the European Stability Mechanism (ESM) to succeed the EFSF in 2013 will provide the institutional framework for such an outcome. Until that political reality dawns on Europe’s political leaders, we believe Europe has the capacity to muddle through.

As for the investment outlook, equity valuations remain at attractive levels. Over the longer-term this has historically meant a greater chance of positive returns, or at least a lower risk of negative returns. Our longer-term economic growth outlook is positive (in a “new normal” way), so the longer term return outlook for equities is positive.

But there is always a risk-return trade-off. The evolution of the European sovereign debt crisis has resulted in a higher awareness of tail risks, and it doesn’t take much thought-experiment to foresee an unhelpful turn of events. The question is the degree to which you look through this. For now we remain cautiously optimistic on the outlook for growth assets and retain out neutral growth vs. income asset allocation position. We will continue to closely monitor economic and financial market conditions, particularly in Europe.

Sunday, September 11, 2011

RBNZ on hold...for now.

It was only a matter of a few weeks ago that a 0.5% hike in the Official Cash Rate (OCR) at the September Monetary Policy Statement (MPS) looked like a done deal. Following the July OCR review it became universally expected the RBNZ would remove the March 2011 “insurance” interest rate cut in this week’s MPS.

The key phrase in the July statement was: “Provided current global financial risks recede and the economy continues to recover, the Bank sees little need for the March 2011 “insurance” cut to remain in place much longer.”

This sentence highlights the challenge for the Bank. Global financial risks have not receded; in fact they have increased since July. There are renewed concerns about the growth outlook in the United States and Europe and the risk of a return to recession in these key economies has increased in recent weeks. Financial risk is also elevated given increased fears of sovereign default.

At the same time, however, the New Zealand economy is continuing to recover and appears to be gathering momentum. At the same time the inflation risks are increasing. Most worrying of all is the rise in inflation expectations which will be a problem if they become entrenched.

Given the international backdrop, and the risks that entails for the New Zealand economy, it is prudent for the Bank to stay on hold on September 15th. But we don’t think they will stay on hold for long. The New Zealand economy appears to be withstanding recent global jitters well with business confidence at healthy levels. Of course that would change should the US and Europe return to recession, but that is not our expectation.

We have shifted the first interest rate increase back to December (where it was prior to the July OCR review). We still expect a first move of 0.5%. Some will still see that as too early, but if the Bank is to be sufficiently pre-emptive, then it probably should feel early!

From there we continue to expect a relatively aggressive tightening cycle that will take the OCR to 4.5% by late 2012. All that’s really changed for us is the start of the tightening. When the time is right, there is still a lot of work for the Bank to do.

Monday, September 5, 2011

US stalling, not going backwards

There has been nothing in the recent flow of data out of the US to change our view that the US economy is in another weak patch, rather than a return to full-blown recession. Recent activity data (retail sales, durable goods, manufacturing ISM) have generally surprised on the upside, although it is all unambiguously weak. But neither do the indicators paint a picture of an economy that is going backwards.

We view Friday’s payrolls data similarly, even though it printed at the low end of expectations. No change in overall payrolls and anaemic growth of 17,000 in private payrolls is certainly indicative of an economy that has stalled. Weekly hours worked and hourly earnings were also down. The only bright bit of news was that the separate household survey showed a gain in employment and the unemployment rate was unchanged at 9.1%. The key question is: Where to from here?

It is the confidence readings, particularly consumer confidence, that have taken the biggest battering in recent weeks and remain the key to near-term activity. It remains to be seen the extent to which the knock to confidence from the farcical debt ceiling debate and the sovereign credit downgrade is reversed in the weeks ahead. At this point we still have a 1.5% (saar) GDP increase factored in for Q3. That will prove to be optimistic if the drop in confidence becomes entrenched.

The good news is the Fed is poised ready for action. Market attention seems to be focussing on the Fed employing “the twist” rather than further balance sheet expansion, at least at this point. The twist involves lengthening the duration of their security holding by selling the short end of the yield curve and buying longer-dated securities, effectively lowering Treasury yields at the long end of the curve.

However, we remain sceptical of the Fed’s ability to have any further meaningful impact on the real economy, jobs growth in particular. It remains debatable what impact QE2 had on jobs growth.

We have long-held concerns about the labour market in many developed countries. That’s not just because of the slow rate of jobs growth, but more because we believe that given the structural nature of the recession and subsequent recovery in many countries, they now face a significantly higher level of structural unemployment.

That could end up being a serious constraint to growth at some point for many countries (including here in New Zealand). In that regard a well-developed skills policy is perhaps more important than anything the Fed can do. Fed Chairman Ben Bernanke has, at times, dismissed this being a risk, but it’s interesting that in the last set of FOMC minutes one of the “participants” raised this as a possible reason for recent weak labour market growth. I don’t think it’s a reason yet because the cycle is not yet strong enough to expose the problem.

As we have said before, a return to full employment in the “new” US economy requires something a little more innovative than just a monetary policy response. In that regard President Obama’s speech later this week is important. Not because we expect any meaningful policy announcements this week: all we would really like to see is a signal from the President that he understands the ball is in his court and that monetary policy has limitations. It is good that the President’s nominee to head the White House Council of Economic Advisors, Alan Krueger, is a labour market expert. That's a positive sign that a broader policy response may be forthcoming.

Friday, September 2, 2011

Developments in emerging markets

India annual growth came in at 7.7% for the year to June 2011, down slightly on the 7.8% recorded for the year to March and slightly better than market expectations of 7.6%. This is well down on annual growth rates of over 9% in the first half of 2010.

This is a good result. Growth in India has been slowing over the course of the past 12-months on the back of an aggressive tightening in monetary conditions. This was in response to growth that was running hard up against capacity constraints and had taken annual wholesale price inflation to over 9%. However, growth in excess of 7% is still robust. We expect annual growth to come in at around 7.5% for the calendar year.
Annual inflation now appears to be drifting lower, but remains well ahead of Reserve Bank of India (RBI) comfort levels. The RBI has raised interest rates 11 times since early 2010, with the last two being 50 bps each as they realised they risked getting behind the problem.

The next policy meeting for the RBI is September 16. With growth slowing nicely and inflation appearing to be peaking, the issue is how much more tightening the RBI has to do. We think the tightening cycle is close to being over but we wouldn’t be surprised to see another 25bps tightening on the 16th.

The China manufacturing PMI staged a minor recovery in August, rising to 50.9 from 50.7 in August. This result is indicative of a stabilisation in industrial production in China and supports our view of soft landing. We continue to expect GDP growth of 9% this year.

The Chinese authorities continue to highlight taming inflation as their policy priority. We believe the activity data suggests they have done enough. We don’t expect any further interest rate increases, nor do we expect any further increases in the required reserve ratio following the recent moves to broaden the reserves base. However, continued appreciation in the exchange rate is desirable.

Finally on Brazil, the central bank cut interest rates by 50bps this week, taking the benchmark Selic rate to 12%. This was a surprise. The bank cited the renewed fragility of the global recovery as the rationale. If anything, the cut is more likely a response to the Government announcing a few days before that they would raise their projected budget surplus this year. Tighter fiscal policy and easier monetary policy taking pressure off the exchange rate? Whatever the reason we think the cut in rates is premature and potentially wrong unless growth is going to slow more dramatically than we currently think.