Monday, August 27, 2012

All eyes on Jackson Hole

The key focus for markets this week will be Ben Bernanke's speech at the central bank conference in Jackson Hole, Wyoming.  This is the conference at which he effectively announced QE2 was coming in 2010.

Speculation on a third round of quantitative easing (or QE3) went up a notch last week with the release of the August Federal Open Market Committee (FOMC) minutes.  The Fed is clearly ready to pull the trigger on more easing, should it be needed.  It's the last part of that sentence that still has me still happy with the view that more quantitative easing is less than a done deal.

The minutes reflect a point in time when the committee had just witnessed a number of sub-par economic data including soft employment and retail sales growth.  Since then the data has improved, but only to the extent that it confirms the US economy is growing at around a 2% annual pace which is only sufficient for a gradual trend decline in unemployment.

Furthermore, if the Committee is concerned about business confidence, we think recent developments in Europe (assuming the ECB eventually does something) will ultimately have a bigger impact on global confidence than another round of QE will have on confidence levels in America.

There is still news to come that will be critical to the Committee’s decision in September.  This week we will see the second estimate of Q2 GDP.  Market expectations are for an upward revision from 1.5% (saar) to 1.7%.  Most critical of all will be labour market data due September 7th.

And of course before that we get Bernanke's speech from Jackson Hole.  The interesting bit in that speech will be any hints of what form further easing might take.  The fact that another round of quantitative easing will have limited impact on real economic activity is well understood.  Even Bernanke believes that successive rounds of quantitative easing face diminishing returns.  At the same time, some of the FOMC members have voiced interest in the UK’s recent “Funding for Lending” program.  Such a program might improve the cost/benefit balance by reducing the potential costs of negatively impacting Treasury market functioning (a key concern for some FOMC members) while improving the potential benefits by implementing a more targeted program.

The important point from the minutes is the Fed is clearly prepared to act.  They haven't come this far to throw in the towel now.  But that still leaves the odds of further easing in September at 50:50.

Thursday, August 23, 2012

Don't forget Greece

Amongst the recent optimism in Europe that help is at hand via the European Central Bank (ECB), it would be wrong to forget about Greece.

With the recent election turmoil, the scheduled May 31 review of progress towards Greece meeting its agreed fiscal targets is only happening now.  The Greek Finance Ministry has developed a plan for another 11.5b of fiscal measures to get the fiscal adjustment process back on track.  The troika of the European Council, the ECB and the International Monetary Fund will head back to Greece in early September to prepare its report and recommendations which will most likely go to the October Euro zone leaders meeting for ratification.

The delay in its development and implementation means Greece faces a further 10-20 billion financing gap.  With no new money likely to be forthcoming, that gap is likely to have to be closed within the existing bailout parameters.

In the meantime, Greek Prime Minister Samaras heads to Germany and France this week for talks with Chancellor Merkel and President Hollande.  He will be pushing the line that after a very unstable political period, Greece is back on track as indicated by the new fiscal plan and the fact that the privatisation plan is on track, with some sales expected this year. 

The meeting with Chancellor Merkel in Germany will be the most critical.  Some senior German politicians have recently been speculating on a Greece Euro exit with the vice-Chancellor speculating a Greek exit has “lost its terror”.  We completely disagree.  A Greece exit would still entail significant systemic finance sector disruption.

The problem with a Greece exit is, as is well understood, the problem of contagion.  A Greece exit now would raise the immediate question of, and speculation on, who will be next.   No amount of firewall building will prevent that speculation.  We remain of the view that a Greece exit can only be realistically contemplated when the rest of the Euro zone is stabilised.  That is when structural budget deficits are eliminated, debt levels are declining and the euro zone is growing sustainably.  That is still some time away, probably years.

There has been some suggestion Samaras may ask for a time-extension for Greece to meet its fiscal targets.  We have some sympathy for the argument Samaras may put to Merkel this week.  The fiscal adjustment in Greece has come at considerable cost, both economic and social.  Greek GDP has contracted 20% since the adjustment process began and the unemployment rate is 23%. 

As we have argued many times, the balance between fiscal adjustment and economic growth has been lost.  Putting aside the fact that Greece is the primary architect of its own problems, the question to us seems to be how best to implement a solution that provides a positive outcome for Greece and Europe. Good luck, Prime Minister.

Tuesday, August 14, 2012

Stubborn weakness in China

The weakness in China activity data is proving to be disappointingly stubborn.  As his been the practice of the last few months, the monthly data dump of partial activity data surprised on the downside.  Industrial production, retail sales, investment, exports and new loans all printed weaker than expected. 

While the monthly increase in new loans came in below expectation, we prefer to watch the annual percent change which is nudging slowly higher, suggesting at least a stabilisation of new lending.  It is in the loans data that we would expect to see earliest signs of a recovery in activity given that most of the easing to date has centred on the bank reserve ratio.  
The biggest disappointment was export growth which came in at 1% for the year to July, significantly undershooting market expectations of 9% growth.  Recession in Europe and slow growth in America are taking their toll on Chinese exports.

The good news in the data was the further decline in inflation in the year to July.  CPI inflation is now at 1.8% for the year to July.  While the bottom of the cycle is approaching (August?), inflation is still likely to come in well below the official target of 4% for the year.  That provides ample room for further easing in monetary policy with further reductions in both the bank reserve ratio and interest rates likely in the period ahead.  One caveat to that is the authorities will be conscious of not reigniting a property bubble.  If it wasn’t for that concern, they would have already eased more by now.

Friday, August 10, 2012

NZ labour market disappoints

The June quarter New Zealand Household Labour Force Survey (HLFS) was disappointing on nearly all fronts.  The unemployment rate rose, employment fell as did the participation rate.  The only bright spot was a shift in composition away from part-time jobs to full-time.

The HLFS was also disappointing in the context of other partial economic data supporting the story of modest economic recovery, especially the more upbeat Quarterly Employment Survey released earlier in the week which had me thinking that, if anything, the HLFS might surprise on the upside rather than the downside.

In terms of the detail employment fell 0.1% over the quarter to be up only 0.6% in the year to June.  That’s down on the 0.9% recorded for the year to March.  The unemployment rate rose from 6.7% in March to 6.8% in June.  Average market expectations were for a 0.4% gain in employment and a drop in the unemployment rate to 6.5%.  To cap off the weakness the participation rate fell from 68.7% to 68.4%. 
On a more positive note, while part-time jobs fell 18,000 over the June quarter, full-time jobs rose 13,000.  This data is not seasonally adjusted so there will be an element of seasonality here.  The good news is that the June quarter recorded the strongest gain in full-time employment since the March quarter of 2010.
The real surprise was the weakness in the Canterbury data.  Admittedly anecdotal evidence suggests that rebuild activity is starting to pick up in Canterbury yet the region recorded a 5.5% decline in employment over the year to June.  That also comes with a 5.1% decline in the working age population in the region which is an indication of the extent of migration out of the region.

The implications of this result for monetary policy are a tad challenging.  In its last set of projections the Reserve Bank of New Zealand (RBNZ) was expecting employment growth of 2.6% in the year to March 2013, with the unemployment rate down to 5.5% by that time.  Both now seem unlikely.  We think employment growth will be around half that level with an unemployment rate around 6.0% by that time.

However, that does not mean there is scope for an interest rate cut.  Wage data is already trending up.  Soft employment and rising wages is consistent with our story of higher structural unemployment and early-cycle capacity constraints emerging.  However, we are not at that point yet.  That has us continuing to believe the next move from the RBNZ is a tightening in monetary conditions, the only question is when.  We are still happy with our view they can wait till June next year.

Sunday, August 5, 2012

The ECB and the Fed: don't be disappointed

Lack of action from both the Fed and the ECB this week was no real surprise.   More action from the Fed is still not certain and it was simply too soon for the ECB to act.  We are still optimistic of something meaningful from the ECB, but QE3 is not a done deal yet.

Disappointment the ECB didn’t act is misplaced.  Any action taken by the ECB needs to be in conjunction with politicians and use the financial resources that have already been put in place.  Furthermore, there is still some scepticism the ECB should be doing anything at all, especially from the Bundesbank.  That means it’s going to take a bit of time to get the plan in place.   Furthermore, the ECB can't solve Europe's debt crisis, but it can assist in relieving market tensions that enable continued progress towards a full solution.  After his comments in London where he promised action that would be enough, the challenge for Draghi last week was to give the market confidence that a plan was being developed.  I think he did that.

Draghi’s main point was that "risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner".  The fundamentals are the same as they always were: fiscal consolidation and structural economic reform.  However, there is still the problem of financial tension and instability as progress towards those broader objectives unfolds over time. 

The financial tension is indicated by unsustainably high bond yields in Spain and Italy.  Draghi has indicated the ECB will work with governments to buy bonds in sufficient quantities to bring yields back to more sustainable levels.  That will mean countries under stress such as Spain and Italy applying to the EFSF for help in the first instance.  That would then result in the EFSF purchasing bonds in the primary market and the ECB in the secondary market.   EFSF assistance comes with conditions and the signing of a formal Memorandum of Understanding with appropriate setting of fiscal and structural reform targets and monitoring of the achievement of those targets.  That ties ECB assistance to progress on more fundamental issues.

Another important comment was "The Governing Council, within its mandate to maintain price stability over the medium-term and in observing its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective".  Setting bond purchases in the context of maintaining price stability is directed primarily at Bundesbank concerns that the ECB is stepping outside its mandate.

Draghi also stated that concerns of private investors about seniority will be addressed.  That's very positive for private bondholders.  He also said that the ECB may consider undertaking further non-standard monetary measures to repair monetary policy transmission.  It was interesting that Draghi said no decision had been made on whether bond purchases would be sterilized, opening the door to quantitative easing.

This is all very positive.  It's not the solution to the euro debt crisis, but it's a mechanism that may allow a reduction in market tension while the real solution of fiscal consolidation and structural reform plays out.

Market disappointment the Fed didn’t act this week was also misplaced.  The Fed has made it abundantly clear they are prepared to do more in light of the recent deceleration in economic momentum.  However, they don’t think things are yet bad enough to act.  I think that’s actually good news (once again declaring my scepticism that the Fed can do much more to influence real economy outcomes in any meaningful way).

Whether they go ahead and do more will be dependent on how data plays out between now and the next Fed meeting mid-September.  In the interim we also get Bernanke’s Jackson Hole speech at the end of this month.  That speech will no doubt be analysed by Fed-watchers word-by-word.

Payrolls data will be especially critical.  The rally in the US equity market following the release of July payrolls data on Friday meant one of two things; either payrolls had surprised on the upside, or payrolls surprised on the downside and more QE was a done deal.  Thankfully if was the former and therefore a vastly better story than the alternative.

Payrolls expanded 163k in July, more than the average market expectation of 100k.  Private payrolls rose 172k with the manufacturing sector posting a gain of 25k.  The unemployment rate rose to 8.3% on the back of the drop in employment in the separate household survey which was payback for a larger than expected gain in May.
That level of payrolls growth is better than the last few months, but still soft and well short of a robust recovery.  Other recent data has been mixed.  The US manufacturing PMI remained under 50 for a second consecutive month while the services PMI rose to 52.6 in July.  Personal incomes rose 0.5% in June, but spending was flat.  Perhaps Americans are saving their pennies for the holidays?  Also the Case-Schiller house price index rose 0.9% in May, but still down on year ago levels.

On balance we think the data points to a further slowdown in US GDP growth in the third quarter: we’ve got a seasonally adjusted annual rate of 1.2% pencilled in, down from 1.5% in Q2.  But that doesn’t make further Fed action a done deal.  Watch this space.