Tuesday, February 28, 2012

Stronger Europe “firewall” still needed

While it is positive that Greece has secured its second bailout, there is a lot of work to do and considerable pain to be endured. In particular, deficit reduction targets need to be met with a starting point of an economy that is already in deep recession.

Should Greece meet all its targets and obligations, its debt to GDP ratio will be 120.5% of GDP by 2020. That’s a tall order and is based on a number of assumptions, including the successful implementation of the debt restructuring (private sector haircut) and asset sales. Hmmmm. Should that plan go off the rails for any reason at any time, a bigger, better, stronger firewall still needs to be in place. As we have said before, that requires all of the European Central Bank (ECB), European governments via the European Stability Mechanism (ESM) and the IMF to come to the party.

This week the European Central Bank (ECB) undertakes the next step of its role by launching the second tranche of Long-Term Re-financing Operations (LTRO). This is part of the strategy of providing “unlimited liquidity” to the European banking sector.

The first tranche in December saw banks take up €489b in cheap ECB funding, some of which found its way back into short-dated (3-year) government debt (a.k.a. intermediated quantitative easing). This has resulted in a sharp reduction in yields in countries such as Italy and Spain and has been a significant contributor to reducing financial tension in the region. The market is expecting a similar take-up in the second tranche this week.

With regard to Europe and the IMF, Europe received a knock-back from the G20 finance ministers who were meeting in Mexico over the weekend. There was some expectation amongst European leaders of an imminent increase in IMF bailout resources which was not supported by the G20 collective. The G20 finance ministers (not unreasonable) expectation is that Europe should boost its own resources first. Paragraph 4 from the Communique:

“G20 members have been actively engaged in taking the steps needed to safeguard the global financial system and to avoid adverse scenarios. At Cannes, our Leaders asked us to review the adequacy of IMF resources. This review is particularly important against the backdrop of continued downside risks. Euro area countries will reassess the strength of their support facilities in March. This will provide an essential input in our ongoing consideration to mobilize resources to the IMF.”

So, further G20/IMF support first requires a greater contribution from Europe itself first. That seems fair enough to me. It would require boosting the €500b capacity of the European Stability Mechanism (ESM) when it is launched mid-year. Germany has previously resisted such a move but will most likely need to backtrack. A commitment to greater ESM resources is unlikely before or during the upcoming March 1-2nd European Summit, but will most likely be in place before the next IMF meeting in April.

The Greece problem has not gone away. Access to the second bailout and the private sector debt haircut hasn’t solved the problem, it has simply been parked for a few months. Importantly that allows vital structural economic reform time to be implemented – stronger economic growth remains the long-term answer to Europe’s debt woes. In the meantime Europe must continue to put the resources in place to cope with what will most likely prove to be renewed Greek economic and fiscal angst at some point in the not too distant future.

Friday, February 17, 2012

Europe GDP

Eurozone GDP came in slightly stronger than expected in the fourth quarter of 2011, contracting -0.3% q/q compared with an expected -0.4%. That's not exactly a good news story, "less bad" is probably a more apt description. Annual growth for the eurozone stood at +0.7% for the 2011 year.

The biggest surprise was the "strength" in France over the quarter. We thought France would probably hold up better than Germany given its lesser reliance on exports, but it was stronger across the board. France grew 0.2% q/q, compared with -0.2% q/q in Germany. Over the year Germany posted growth of 2.0% with France coming in at 1.4%.

Countries facing harsh austerity measures are in deep recession. Annual growth in Greece was -7 .0% in 2011, while Portugal contracted -2.7% over the same period. Of the larger economies, Italy posted growth of -0.5% for the year with contractions in activity in the third and fourth quarters.

The overall result fits nicely with our expectation of a mild recession in Europe. But it’s important not to get carried away with recent good partial activity data including manufacturing (see post below). That data has some commentators talking about the eurozone returning to growth in the current quarter, thereby avoiding a technical recession. We're not that optimistic. Our expectation is we will see further mild contractions in the first quarter of this year and possibly the second mostly led by weakness in the periphery and Italy. Into the second half of the year we think Europe will return to very modest growth with full-year 2012 GDP of around -0.5%.

Further out growth will remain constrained by fiscal contraction especially in the periphery where harsh austerity measures have already lead to deep recessions. Furthermore, weakness in Europe generally generates a negative feedback loop to Germany where exports make up 40% of GDP with the bulk of those going to its European neighbours.

We have, however, moderated our view on further interest rate cuts by the ECB. At the end of last year we thought it was highly likely the ECB would cut rates further. However with the recent better-than-expected activity data and improvement in finance sector risk indicators, further interest rate cuts have become less likely. That’s not to say the ECB is doing nothing: the provision of unlimited liquidity to the banking sector has played a key role in reducing financial stress in the eurozone.

Of course the major risk still playing out in Europe is that of a disorderly default in Greece. While we still think a deal securing the second bailout will get done, the risk is it doesn't. However, we think that in 2012 Europe is better placed to cope with such an outcome than it was in 2011.

Thursday, February 16, 2012

Japan extends asset purchase program: will it work?

The surprise move this week by the Bank of Japan (BoJ) to extend its asset purchase program came just a matter of days after weaker than expected GDP growth for the fourth quarter of last year: the quarterly result came in at an annualized -2.3%, compared with a consensus expectation of -1.4%. The BoJ added ¥10t (US$130b) to their asset purchase program, which will be used to purchase long-dated JGBs.

It's hard to fault the Banks intention: to achieve sustained economic growth under stable prices. Japan has been battling deflation for the last two decades. More recently, the Japanese economy has had to cope with the consequences of the March 2011 earthquake and tsunami and the high Yen which has hit the export sector hard.

So will it work? Quantitative easing (QE) aimed at achieving higher inflation is likely to be more successful than QE aimed at higher employment or stronger economic growth. However, the reality is this increase in the quantum of the program is not likely to be sufficient to have any discernible long-term impact on the exchange rate, or inflation for that matter. Japan is facing larger structural economic (demographic) problems than QE will be able to fix.

In terms of inflation, we think the BoJs adoption this week of a formal inflation target of 1% has the potential to have a more significant impact on longer-term inflation. Inflation expectations are an important determinant of inflation outcomes: the adoption of a formal target helps guide expectations. In New Zealand the setting of an inflation target of 2% in the 1980s was an important factor in the achievement of that goal, and significantly earlier than was originally anticipated.

The BoJs move comes at the same time the European Central Bank is expanding its balance sheet via the provision of unlimited liquidity to the banking sector and just a few days after the Bank of England extended its asset purchase program. The US Federal Reserve is also actively considering a further asset purchase program. Despite its increased use and place as a post-GFC "new normal" central bank policy tool, the success of this approach cannot be fully judged until the cycle is complete, including its eventual withdrawal.

Wednesday, February 15, 2012

NZ retail sales surprise on the upside

New Zealand fourth quarter 2011 retail sales surprised on the upside with a real seasonally adjusted increase of 2.2%. That’s good enough to bump our Q4 GDP forecast up to 0.8% q/q. The strong December quarter sales result follows a similarly robust increase of 2.4% in the September quarter and takes the annual rate of growth to 6.8%. Core sales (see chart below) are rising even faster.

There’s clearly a good dose of Rugby World Cup spending in this result, but our judgement is there’s a bit of underlying strength as well. The increase in sales was broadly-based both in terms of region and store-type: it wasn’t just the hospitality sector in Auckland that showed strength.

While we think there is some underlying strength in the result, it’s important not to get carried away. We expect retail sales for the current March quarter to show a small decline. Growth in household spending generally is likely to remain hard work, especially given the still only modest gains in employment. Last week’s drop in the unemployment rate was mostly driven by a decline in the participation rate.

While we’re on the subject of retail sales, January month US retail sales came in weaker than expected at 0.4% m/m. The market consensus was for an increase of 0.8. Core sales were stronger, but automotive sales pulled the overall result down. This result supports our view that strong consumption growth in the fourth quarter of last year was unlikely to be sustained in early 2012. Go the non-linear recovery.

Thursday, February 9, 2012

Go manufacturing!

One of the most pleasing aspects of the recent run of good activity data has been the recovery in manufacturing Purchasing Managers Indices (PMIs) in just about every country you care to mention. The world PMI has now recovered from a recent low of 49.7 in November last year to 51.2 in January. Remember a reading under 50 suggests manufacturing is contracting while a number over 50 suggests manufacturing is expanding.

A quick trip round the world shows, firstly, a January PMI of 54.1 in America. Importantly the new orders index came in at 57.6. You know the story – today’s new orders are tomorrow’s production. More generally we are looking for exports (along with investment) to be one of the strongest sectors for the American economy in the foreseeable future: the exports index stood at 55 in January.

A strong, even resurgent, US manufacturing sector will be an important part of the US economic rebalancing equation. Manufacturing currently accounts for 10% of the US economy: we expect that proportion to rise over time after many years of decline. It’s also where we expect jobs growth to be strongest. On the downside, it’s also where we expect skills shortages to first become evident.

In Europe the PMI stood at 48.8 in January which is less bad than the recent low of 46.4 in November. That still represents a contraction in manufacturing overall, but the index for Germany blipped back into positive territory at 51. The weakness is still, as you would expect, centred in the periphery.

Nevertheless the improvement in the Europe-wide index was pleasing to see and supports our expectation of a relatively mild recession in Europe. The broader story here is much the same as in America: manufacturing will be a key part of the European recovery story. However Europe starts from a position of relative weakness given poor productivity and high unit labour costs (Germany excepted).

I wrote about the China PMI in a post below so I won’t revisit those points here, other than to reiterate we remain comfortable with our soft landing story in China.

Saturday, February 4, 2012

Strong US employment reduces odds on QE3

January employment data out of the US overnight was pretty good: employment rose +243k, there was a further +60k of revisions to previous months and the unemployment rate dropped to 8.3% from 8.5% in December. That’s a great result in the context of a debt-constrained structural recovery.

This result puts a different complexion on the QE3 discussions. As you know from a couple of posts ago (see below) we are not hugely enamoured with the concept of a third round of quantitative easing. That is, however, just the “should they, shouldn't they?” part of the discussion. The more important question is “will they, won’t they?”

As I said before the answer to that is going to be data dependent. The employment data and the manufacturing PMI are both supportive of the “won't” case. The Case-Schiller house price index for November (-0.7% m/m, -3.7%y/y) supports the “will” case, especially for a more housing-focussed QE.

We should also remind ourselves that economics is the dismal science – that being the case it’s important not to get too carried away by a couple of good numbers. Remember our line about the non-linear recovery: that one of the new post-GFC normal’s would be developed economies going through periods of good news followed by periods of not so good news. We are currently in a good patch, but I’m still happy with my pick of US GDP growth of 2% this year.

Given my natural inclination to worry I feel obligated to also remind you of some old points we raised in about 2010, but then shelved as growth slowed, particularly in the US. They are that given the structural nature of the GFC recession and the subsequent recovery, potential growth is now lower in many countries, spare capacity isn’t as large as we currently think and structural unemployment is now higher (7% in the US?). If this run of good data continues it won’t be just the prospects of QE3 we will be musing on, we will also have to start thinking about the Feds pledge to keep interest rates low until the end of 2014. Perhaps not just yet though....

Thursday, February 2, 2012

China PMI

China’s January PMI came in stronger than expected at 50.5 with New Orders at 50.4. Put that together with Q4 2011 GDP that also surprised on the upside and you’d be right in concluding that China is holding up well in face of the turbulence in Europe and slower global growth.

We’re at the optimistic end of the forecast range for China GDP growth this year: consensus is about 8% while we are at 8.5%. The trajectory for the year is that growth will most likely dip below 8% in the current quarter, but be staging a recovery by year-end as Europe returns to fragile growth and as the easing in monetary conditions we expect to see in the next few months starts to impact.

Key to that view is how the inflation unfolds over the next few months. Inflation has already fallen sharply from a peak of 6.5% to 4.1% as at December. We expect it to fall further as the year progresses.

The authorities are taking a cautious approach to easing which has thus far been limited to one reduction in the reserve ratio requirement and, more recently, a number of open market operations. That caution is entirely appropriate. As we have said before, the biggest risk to long term prosperity in the emerging markets is any lack of commitment to keep inflation in check.

Part of the answer to the growth and inflation outlook is to disentangle cycle from structure. That’s easier said than done. While the cycle is clearly turning down on the back of prior tightenings in monetary policy, China is also facing structural challenges as it rebalances its economy away from a reliance on exports to domestic demand. As that occurs, potential growth is also lower.

So where does that leave the risks to our view? Conventional wisdom tells you that if growth surprises on the downside, so too will inflation which will allow a greater degree of monetary accommodation. My primary concern is that growth surprises on the downside and inflation surprises on the upside. Don’t ya love structural change.