Friday, October 28, 2011

US "muddling through" ok

Third quarter US GDP came in at a seasonally adjusted annual rate (saar) of 2.5%. This was bang on market expectations, but stronger than we were expecting.

The surprise for us came in the strength in consumption which posted a saar of 2.4%. We had expected something closer to 2%. Even that would have been a significant improvement on the 0.7% recorded in Q2.

This result doesn’t change our view of a generally tough environment for consumption. Indeed the 1.7% decline in real disposable incomes over the quarter means the growth in household expenditure over the quarter was “funded” via a decline in the savings rate to 4.1%, a percentage point lower than Q2. The combination of weak employment and income growth, soft consumer confidence, and a housing market that is still struggling to form a base is not a recipe for a continuation of consumption growth at this level into Q4.

On the bright side the sectors we have looked to lead the recovery in the US chimed in well over the quarter. Exports were up a saar of 4.0% and business investment (equipment and software) was up 17.4%. We like that.

Stocks (inventory accumulation) subtracted 1.1% over the quarter. That tells us that firms responded quite rapidly to the increase in uncertainty over the quarter and the subsequent slowdown in growth. That bodes well for stronger production ahead.

This result doesn’t change our view of a fragile debt constrained recovery in the US. But it does support our view that, rather than a return to recession, the US will continue to “muddle through”. Indeed we are still happy with our Q4 GDP pick of a saar increase of 1.5%.

Thursday, October 27, 2011

Some progress in Europe...finally

For the first time since the European debt crisis emerged, European leaders have today announced plans that start to head in the direction of a sustainable solution. The key components of the package include a 50% “haircut” for private investors in Greek bonds, a recapitalisation program for the banks and a scaling up of the remaining funds of the EFSF (around €200-250bn) to €1000bn.

We have long highlighted the three elements of the plan as being essential in tackling the fundamental problem of Greek solvency and containing the impact of an inevitable write down of Greek debt. Increasingly austere near-term budget measures were simply pushing Greece (and others) into deeper recession. This was never going to lead to a long-term solution.

In taking this approach, the balance was lost between finding a pathway to fiscal sustainability and supporting economic growth. Indeed building higher sustainable growth remains a key component of the long-term solution to reducing structural budget deficits and debt levels across the developed world.

Much of the detail of the plan is sketchy and some of the assumptions are somewhat optimistic. For example, Greece is required to raise a further €15b in asset sales to repay into the EFSF. This is on top of what was, in our view, an already optimistic €50b privatisation program. It will also remain to be seen whether the estimated €106b required for bank recapitalisation will be sufficient. In terms of the EFSF, it is uncertain how it will be scaled-up and whether €1000b will be enough.

So the details need considerable work, but we now have the key elements of a framework to address Europe’s debt issues. We still have to worry about politics however: there are still some hard calls to be made. Let’s also remember that fiscal austerity is going to be a key feature of the economic landscape in many countries for many years. But hopefully policymakers take the opportunity to strike a more appropriate balance between achieving fiscal sustainability and supporting economic growth.

Tuesday, October 11, 2011

Looking for a "durable" solution in Europe

Recent positive noises out of Europe have been, well, positive. Particularly pleasing has been French President Sarkozy’s commitment of France and Germany to “a global and durable solution to the Euro zone’s difficulties” before the G20 summit in Cannes in early November.

The key word for us in that commitment is “durable”. That’s the bit that has been missing thus far. The fundamental problem in Greece is solvency: its debt to GDP ratio at around 150% of GDP is simply too high and therefore unsustainable. Increasingly deep budget cuts that have pushed Greece into ever deeper recession are not a durable solution to a solvency problem by any definition.

There have been glimpses of a solvency solution. The July 21 Euro zone agreement included a “haircut” for private sector bondholders. However, it was never going to be large enough to bring Greek debt back to a sustainable level.

To meet the definition of durability, the next solution must include a couple of things. It must deal with the unsustainable level of Greek debt and it must prevent contagion by ring-fencing Greece form the other at-risk countries in Europe, particularly Italy and Spain.

It is quite likely we will see a deeper restructuring of Greek debt. The question then is whether the expanded €440 billion European Financial Stability Facility (EFSF) is sufficient to provide the necessary recapitalising of European financial institutions and further likely sovereign bond purchases. We think probably not, in which case we would also expect to see a further expansion of the EFSF, the use of leverage has been suggested, or an increase in the European Central Bank’s Securities Markets Program (SMP).

More broadly, we would also like to see the key principles of stronger governance at the European level, especially with regard to fiscal policy. No pressure!! The institutional framework for that solution, the European Monetary System, is already on the drawing board. Suggestions have been made recently that its implementation will be brought forward from 2013 to 2012. That’s a positive development.

The good news is we will start to see some detail perhaps as early as the next EU Summit which has been pushed out a week to October 23rd to allow more work to be done. The bad news is we think financial markets will treat anything less than a durable solution harshly. We think Europe’s politicians have got that message.

Even after we know what the plan is, there will still be considerable politics to play out. It will still have to be ratified by the various Euro zone parliaments. That could take some time. The Slovakian parliament is still debating the expanded power of the EFSF proposed back in July.

In the meantime business and consumer confidence in Europe (and indeed around the world) is suffering on the back of the ongoing uncertainty and political intransigence. Risk of recession in Europe is growing the longer this uncertainty goes on. We are expecting modest Europe GDP growth in Q3, but the outlook beyond that is less certain as firms delay hiring and investing.

Ongoing political uncertainty in Europe was a key driver of the de-risking of our portfolios in recent months. A genuinely durable solution to Europe’s debt issues and a more stable economic environment that will flow from that will take us a long way towards developing a more healthy risk appetite.

Monday, October 10, 2011

America "muddling through"

Recent data out of the US has surprised with its strength. Mind you, that strength is relative to concerns the economy was slipping back into recession. We’re more confident with our call the US avoids a dip back into recession and continues to muddle through.

The ISM manufacturing survey printed stronger than expected in September rising to 51.6 from the August reading of 50.6. The production, export and employment indices were all stronger over the month. The improvement in the production index continues the rebound from the supply chain disruptions following the Japanese earthquake in March.

Only the new orders index was disappointing, but that’s a not insignificant disappointment. We need to see new orders recover before we can be sure of a more sustained lift in production. The non-manufacturing ISM also held up better than expected in September, slipping from 53.3 to 53.0.

Jobs growth was also stronger than expected in September with payrolls expanding by 103k. Private payrolls rose 137k. The prior two months saw revisions totalling +99k, however the unemployment rate remained stuck at 9.1% for the third consecutive month. We need to see payroll expansion of around 150k per month for the unemployment rate to track down.



Our theory was that firms were delaying hiring during the uncertainty created by the acrimonious debt ceiling debate and the subsequent credit rating downgrade. The revisions to the prior months was especially pleasing in that regard as employment actually held up better during that period than it previously appeared.

The household employment survey showed stronger employment growth than the payrolls data, but that was offset in terms of its impact on the unemployment rate by an increase in the participation rate. An increase in the participation rate is good news – it suggests people have confidence to return to the labour market, even though jobs growth remains soft.

So this week we’re happier with our call the US avoids a dip back into recession and manages to muddle through. Overall, however, the recovery remains debt-constrained and fragile. It has been our view right from the start that the sectors that were most likely to grow fastest as the economy came out of recession were business investment and exports. Indeed final Q2 GDP data showed a 1.3% increase at a seasonally adjusted annual rate (saar) with consumption at 0.7%, exports at 3.6% and business investment at 6.2%. That’s a pattern we expect to persist.

We’ve got a 1.5% (saar) US GDP increase pencilled in for both Q3 and Q4 of this year. Recent data puts the risk to the Q3 result to the upside.