Monday, July 30, 2012

Soft US GDP, but is it soft enough for QE3?

US second quarter GDP came in at a seasonally adjusted rate (saar) of 1.5%, in line with market expectations which had been built on generally soft partial activity data over the quarter.  Of more interest than the June quarter itself was revisions to GDP data back to the first quarter of 2009.  In particular the fourth quarter of 2011 and first quarter of 2012 were revised up.  While other quarters were revised down, the overall picture is one of a recovery that is now slightly stronger than initially reported.
The components were all broadly as expected.  Consumer spending rose 1.5% (saar), held back by durables spending which declined on the back of weaker automotive sales.  Spending of business equipment and software picked up over the quarter to a 7.2% annual pace.   Exports were up 5.3% while imports rose 6.0%.  We still look to exports and business investment to be the leading sectors in the period ahead, although exports face global growth headwinds. 

The acceleration in inventory building over the quarter does not bode well for production in the period ahead.  An initial stab at Q3 GDP growth suggests it may well come in modestly weaker than Q2.

The Fed is clearly concerned about the slowdown in growth and the impact this has had, and may continue to have, on new job creation.  There is therefore nothing in this result to preclude them from pulling the trigger on more easing, should they of course decide the benefits outweigh the costs (see post below).  We will know more later this week.

Friday, July 27, 2012

QE3 – a fine balance (and some very helpful comments from Mario Draghi)

The US Federal Reserve meets next week: market attention will focus on whether the Fed is ready to pull the trigger on more quantitative easing (QE3).  We think it’s still a line ball call whether the Fed does more; furthermore next week might be tad too early to expect action.

It was in Ben Bernanke’s 2010 speech from the annual Fed symposium in Jackson Hole that he signalled that QE2 was on the way.  In that speech he also emphasised the rigorous cost-benefit approach the Fed was taking to its unconventional monetary easing.   Yes, quantitative easing is still unconventional!

In the case of both QE1 and QE2, the benefits outweighed the costs.  The first QE program in 2008 was about restoring market functionality.  QE2 was announced at the time in which the annual rate of core inflation was on a steep downward trajectory and under 1%: deflation was to be avoided at all costs.  However, for QE3 the cost benefit analysis is more finely balanced.

The direct impact of quantitative easing on the real economy is far from certain.    A lower exchange rate is certainly helpful for the necessary rebalancing of the US economy towards exports.  Apart from that, we think the greatest real economy impact is on inflation expectations rather than final demand.  Right here right now the bigger problem is the weakness in final demand, not inflation.  While US headline inflation is currently falling, core inflation is comfortably stable over 2%.

Along with its dual mandate of price stability and full employment, the Fed also has a responsibility to ensure the efficient functioning of markets.  It is this that is giving cause for contemplation especially at a time Bernanke himself has conceded that more QE faces diminishing returns.  In the June FOMC minutes some Fed members were concerned that continued purchases of long-term securities may “lead to deterioration in the functioning of the Treasury securities market that could undermine the intended effects of the policy.”  It is likely the Fed has room to institute more quantitative easing, but they are right to be considering how much is too much.

The Fed also needs to be mindful of the risks at the other end of the QE experiment and the potential for damage to its inflation-taming credentials.  The QE exit strategy is yet to be determined, let alone deployed.  The more QE put in place, the more there is to be exited.  That makes the timing of the start of the exit strategy quite critical to reduce the risk of unintended inflation consequences at the other end.

More QE is not the only option open to the Fed; they will be contemplating other tools.  They could extend the “extended period” over which interest rates are expected to remain low.  Some members of the FOMC also appear to be quite taken, as we are, with the UK’s recent “Funding for Lending” program.  That approach seems to us to be likely to have a more direct impact on lending to households and businesses and real economic activity than straight quantitative easing.  There is also speculation the Fed may make greater use of the discount window.

Those of you who have read our July edition of Quarterly Strategic Outlook will recall a discussion on another problem with continued reliance on central banks to fix the problem of disappointing economic growth: central banks can’t fix structural problems.  Our concern is that continued (and increasingly ineffective) monetary policy action is lulling policy makers into a sense that something is being done, just when it is a broader predominantly supply-side policy response that is required.   That complacency will lead to continued policy procrastination and paralysis.

We think QE3 is currently a 50:50 bet.  Weak jobs, weak manufacturing and weak retail sales won’t be ignored, but we think the Fed will be prepared to wait for a bit more data before deciding whether the benefits outweigh the costs.  Watch this space.

Footnote on Europe: Comments from ECB President Mario Draghi over night were very helpful.  Draghi said the ECB will do “whatever it takes to preserve the Euro, and believe me it will be enough”.   As we have discussed previously we see bond purchases by the ECB as being justified on monetary policy grounds because the usual monetary policy transmission mechanism has broken down.  Bank funding costs are not currently determined by the ECB overnight interest rate, they are determined by the funding costs of the country in which they are based.  In particular Draghi said: “To the extent that the sovereign premia hamper the functioning of the monetary policy transmission channels, they come within our mandate”.  That’s good stuff.  To us that means a stepping up of the Securites Markets Progamme rather than full QE, but all that’s left to say is just do it.

Tuesday, July 24, 2012

More angst in Spain: time for the ECB to step up

Bond yields have moved sharply higher in Spain as a fresh wave of angst centred on the deepening recession and a formal request of financial assistance from the Valencia region to the central government.

The formal request from Valencia is the first to make use of the 18 billion liquidity fund for regions (the FLA).  The regions collectively have 35.7b of maturing debt this year which needs to be refinanced.  Valencia is unlikely to be the only region that seeks assistance.

This development came on top of a hectic week for Spain in which the government announced a further 65 billion in deficit reduction measures (spending cuts and an increase in the rate of value added sales tax) to meet its (revised) deficit reduction target of a deficit of less than 3% of GDP by 2014.  Last week’s bond auction was disappointing and the Bank of Spain announced the economy contracted 0.4% in the June quarter (c.f. -0.3% in Q1) and is likely to remain in recession until 2014.  Finally, EU finance Ministers approved the 100 billion bank bailout at the end of last week with the first tranche of 30 billion being made available at the end of the month.

The financial challenges in the regions should come as no surprise.  Indeed it was mainly failure on the part of the regions to meet budget targets last year that led to Spain missing its target.  It is also the case that central government has reserved all of the new flexibility in deficit reduction targets for itself, keeping the pressure on the regions to get their own houses in order.

In the meantime, bond yields are back in unsustainable territory.  Once again we make the observation that the inevitable answer to unsustainable yields lies in further bond purchases.  The European Stability Mechanism (ESM) will not be ready to take this action anytime soon, which leaves it to the European Central Bank to step up and reinstitute its Securities Market Program (SMP).

Tuesday, July 17, 2012

NZ inflation at lowest since 1999

New Zealand June quarter inflation came in at 0.3% for the quarter and 1.0% for the year.  That’s softer than average market expectations of 0.5% and 1.2% respectively.  This result doesn’t change our view that the next move from the RBNZ is a hike in interest rates, but they can wait until next year before pulling the trigger.

The dominant feature of the lowest annual CPI inflation rate since 1999 has been the strong disinflationary effect of the strong New Zealand dollar.  Indeed annual “tradeable” inflation fell to rate -1.1% in the year to June.  By comparison “non-tradeable” inflation came in at +2.4%.

With regard to implications for monetary policy from this result, there are none.  It does not alter our view that there is no scope for an interest rate cut (unless things go from bad to worse in Europe), that the next move in interest rates is up, but that the RBNZ still has time in its side. 

Low current inflation is not a reason to leave monetary conditions unchanged: monetary policy is about where inflation is going, not where it has been.   There are sufficient signs pointing to higher core inflation over time.  These include capacity utilisation and difficulty in finding skilled labour which are already consistent with a tick-up in core inflation pressure.  Also remember that potential growth is now lower than it was pre-GFC.

A key area of interest for the RBNZ will be construction costs given indications of a modest recovery underway in the housing market.   Constructions costs rose 0.9% over the quarter to be up 2.8% over the year.  That’s not insignificant, especially with a known and significant increase in activity in that sector yet to come.

We still have the first hike in the OCR pencilled in for mid-next year with a gradual increase to 4.5% by late 2014.  That is a modest tightening in monetary conditions by historical New Zealand standards.

Friday, July 13, 2012

Is China at the bottom of the cycle?

As was widely expected annual China GDP growth slowed further in the year to June.  The rate of growth slowed from 8.1% in the year to March to 7.6% in the year to June, broadly in line with market expectations.  Other partial activity data was also released today, mostly slightly better than expected although industrial production was a tad weaker. The good news is that inflation is cooling rapidly with the annual CPI now sitting at 2.2% for the year to June.  That provides scope for further stimulus. 
Slowing growth and inflation vindicates recent actions to ease both monetary and fiscal policy.   This includes several cuts to the bank reserve ratio requirement (RRR) and two reductions in interest rates.    In the latest interest rate reduction last week the People’s Bank of China lowered the one-year financing rate to 6.0% and the one-year deposit rate to 3.0%.  There has also been a number of new infrastructure projects announced recently.

Given most of the easing to-date has centred on reductions in the RRR, we have been looking to loans growth to provide the early signs the easing is starting to have an impact.  It was therefore pleasing to see new loans come in at RMB 920 billion in June, up from RMB 793 billion in May. 
With inflation heading down and now well below the official target of 4% there is scope for more easing, particularly with respect to further reductions in the RRR. Authorities will however be conscious of not wanting to inflate another property bubble.  The RRR is currently at 20%, while the historical average is closer to 10%, so there is plenty of room to move. 

We expect further interest rate cuts and further fiscal stimulus.  However, we don’t expect the same degree of fiscal stimulus as we saw during the GFC, some of which was possibly wasteful:  authorities will remain committed to their current 5-year plan objective of better quality growth and economic rebalancing.

On the back of this latest result we have shaved a bit off our calendar year GDP forecast.  We continue to expect GDP growth to recover modestly over the second half of the year, but 8.5% (q4/q4) looks like a bit of a stretch.  We now expect an outcome around 8.2%.

Monday, July 9, 2012

Another slow month for US jobs

US payrolls expanded by 80k in June, making for a soft June quarter.  Payrolls growth averaged 73k per month in the June quarter, down on the 225k per month achieved in the March quarter.  While some of this was related to seasonal conditions, there was also a moderation in underlying jobs growth over the quarter.  The unemployment rate remained at 8.2% in June.
Private payrolls expanded at an average 91k per month over the June quarter with Government sector jobs providing its now familiar offset.  Private sector job growth remains relatively broad-based, but low overall.  That continues to be consistent with a non-robust economic recovery. 

Aggregate hours worked were up over the quarter, but well below the pace in the March quarter.  With productivity growth having slowed recently, that supports our view that Q2 US GDP growth will come in below the already tepid March quarter pace of 1.9%. With hours worked up modestly and average hourly earnings rising at around 2% incomes are also growing, but again at a relatively modest pace.

The good news in this result is that payroll gains seem to have settled at around the 70-80k level rather than pushing lower, which was our concern for this result.  However, this rate of jobs growth, if continued, would be insufficient to make a meaningful dent in the unemployment rate. 

The extent to which the recent slowdown in jobs growth is due to seasonal factors, a drop in confidence on the back of Europe concerns, or a genuine slowdown in economic growth will become clear over the next few months.  At the same time that we are concerned about jobs growth, there is better news coming out of the housing market which is an important factor for stability and confidence, so its not all bad news at the moment.  At this point our view remains that the US economy continues to grow, but at an unexciting pace.

Friday, July 6, 2012

Coordinated uncoordinated monetary policy action

Last night saw a burst of seemingly co-ordinated but officially uncoordinated monetary policy action out of a number of central banks.  The European Central Bank (ECB) cut its main financing rate to 0.75% and its deposit rate to zero, the Bank of England (BoE) increased its asset purchase program by £50 billion to £375 billion, and the People’s Bank of China cut both their one-year lending and deposit rates to 6.0% and 3.0% respectively.  Denmark and Kenya were also in on the act with reductions in interest rates.

The action comes in the midst of a noticeable mid-year slowdown in economic activity in many of the world’s major economies, which we mostly attribute to the prolonged confidence sapping European sovereign debt and banking crisis.  In fact the June quarter of this year is likely to mark the weakest point in global growth since the recovery from the GFC started.  In particular the slow-down in the euro zone is spreading to other countries in the area, although latest factory orders data out of Germany surprised on the upside.

The key question is the extent to which further monetary accommodation is in any way helpful.  We think not much.  Last weeks’ EU summit outcomes, although still short of a comprehensive solution, will prove to have had a greater positive impact on confidence than the ECB’s actions last night. 

As we have discussed before, the monetary policy transmission mechanism has broken down in Europe.  The answer to higher growth there lies in direct action to lower sovereign bond yields in countries under financial stress, an extension of time to meet agreed fiscal targets in countries contracting under the weight of harsh front-loaded austerity measures and further moves toward fiscal integration.  In the UK we believe last month’s “Funding for Lending” program will have a greater impact on the real economy than more quantitative easing.  Quantitative easing probably has its greatest impact on inflation expectations, not final demand.  It’s weak final demand that is currently the problem.

It’s in China where we believe easier monetary policy is likely to be more effective, although the surprise timing of the move has us worried now about next week’s second quarter GDP data.  The first easing last month preceded the release of a batch of weak economic activity data.  We think annual GDP growth will print at around 7.5%, down from 8.1% in March.  CPI data is also out next week.  It is falling inflation that is creating room for the PBoC to ease policy.  We continue to expect a modest recovery in the annual growth rate into the end of the year.

Tuesday, July 3, 2012

June PMIs disappointing

It’s been a poor trot of PMI data for the June month with ongoing debt (and political) issues and recession in Europe impacting many other countries export orders in particular.

In the US the PMI dropped from 53.5 in May to 49.7 in June with new orders declining from 60.1 to 47.8.  Mind you, we thought the 60.1 in May was a bit “toppy” given our view that GDP growth is running at around a 2% annual pace, but we didn’t expect a decline of this magnitude.  The export index fell from 53.5 to 47.5 over the month.
This result doesn’t change our view that the US economy will continue to grow at a modest pace, although it supports our expectation that June quarter US GDP will come in weaker than March quarters tepid 1.9% annualised pace.  The prices paid index dropped from 47.5 to 37.0 which is good news for (headline) inflation and those who think another round of quantitative easing will make a difference.  We also like the decline in the inventories index to 44.0 from 46.0.  We would be more concerned if orders were weak and inventories were rising, although that pattern is still a risk.

In China the official PMI index dropped further from 50.4 to 50.2.  That was actually better than the market was expecting and importantly represents a slowing in the rate of decline: a turning point would be better, however!  The good news is that China has room to ease monetary and fiscal policy further: we expect further cuts to bank reserve ratio requirements and interest rates in the period ahead.  It’s also the case that it’s too early to expect any sign in the data of the easing measures that have already been taken. The services sector is performing better with the index for that sector just released at 56.7 for June up from 55.2 in May.

In Europe itself the PMI posted a second consecutive month at 45.1, indicating the economy remains in recession and that we will most likely see a further contraction in GDP in the June quarter.  Later this week the focus of attention turns to the ECB and the likelihood of a cut in the benchmark interest rate, reflecting the weakened growth outlook and perhaps a reward for the politician’s good efforts last week.

The key question right now is the extent to which the drop in new orders and the PMIs generally represents a genuine slowing of demand or Europe-related confidence factors.  We expect it’s both but the extent to which it is the latter, we should see some improvement in the months ahead given the positive reaction to the outcome of last week’s EU Summit.

Monday, July 2, 2012

EU Summit: necessary progress, but not sufficient

Last week’s European leaders Summit took some important and necessary steps forward, but didn’t make any real progress on the underlying structural problems.

The major positive was the creation of a single banking supervisor.  This role will most likely be played by the European Central Bank (ECB) with possibly some role also for the London-based European Banking Authority (EBA), although that will depend on coverage (euro zone or European Union).  There is considerable work to be done which will take some months.

A single supervisor paves the way for direct recapitalisation of banks from the European Stability Mechanism (ESM).  That will break the negative feedback loop between lenders and sovereigns as we saw with the Spanish bank bailout recently.  Insistence the funds are channelled through the Government simply meant that Spain’s debt to GDP ratio would rise and markets simply shifted their angst from the Spanish banking sector to the sovereign.  Another positive step was the agreement not to subordinate other creditors in the bank recapitalisation.  That reduces concerns for private sector bondholders.

In a major concession from Germany, the ESM is also to be allowed to purchase sovereign bonds directly.  That is a clear sign of the shifting political sands in Europe as Italian Prime Minister Monti led the charge, supported by French President Hollande and Spanish Prime Minister Rajoy, on the need for some short-term measures to ease financial stress.  Chancellor Merkel was at pains to point out that such action would not come without strict conditionality and formal adoption of a Memorandum of Understanding should such action be sought by any government.  The key question now is whether the 500 billion available to the ESM will be sufficient.

Unfortunately Germany gave no ground on its refusal to contemplate Euro bonds.  Some form of debt mutualisation remains a key element of broader fiscal union.  However, Germany did demand that Leaders negotiate the steps necessary to building a more fulsome fiscal union, including full banking and budgetary union and closer economic policy co-ordination.  As we have said before, these have been the key missing ingredients in the euro experiment.

Leaders also committed to a 120 billion growth package.  This is clearly the concession to the lack of progress on allowing a greater balance between growth and austerity.  Markets will see this for what it is – no more than a bit of window dressing to suggest that something is being done about economic growth.

In summary some important steps have been taken that again show the capacity and willingness of Europe’s leaders to do whatever it takes to hold the euro together.  However, progress on the real structural issues remains arduous.  That means there will be further periods of stress and angst ahead.