Friday, September 28, 2012

More austerity in Spain brings it closer to formal request for assistance

Spain has announced a further round of austerity measures aimed at achieving its revised fiscal deficit targets of 4.5% of GDP in 2013 and 3.0% in 2014.  The measures are targeted mostly at cuts in spending although some tax increases are also part of the package.

As you would expect the government is forecasting its deficit targets to be achieved, but in our view they are based on GDP growth forecasts that will ultimately prove to be optimistic.  The Government is forecasting a GDP contraction of -0.5% in 2013 whereas the market consensus is closer to -1.5%.

The most meaningful announcement today was the establishment of an independent fiscal authority, much like America’s Congressional Budget Office (CBO).  Such an independent authority adds a significant element of internal robustness to the budget-setting process.  We like that. The Government also outlined a program of structural reform of the labour market and utilities sectors that will take place over the next few months.

More interesting than the new budget measures themselves is the implication for a formal request by the Spanish government for formal assistance via the EFSF/ESM and ultimately ECB assistance via the Outright Monetary Transactions process. 

There has been some recent criticism of the Spanish government that they have not already asked for formal assistance.  We think that criticism is unfounded.  Firstly, it makes sense to know what the rules are the game are before one participates.  The details of the OMT are still being developed.  Secondly, with a budget announcement just around the corner, it also makes sense to get that out of the way before ascertaining what other measures European officials might seek in terms of reform conditionality.  In that regard it must be reassuring to the Government that EU Commissioner Olli Rehn has endorsed today’s budget announcements as positive.

A further hurdle will be cleared tonight with the release of the independent audit of the Spanish banking system that will determine the capital requirements from the 100b that has already been made available.

It’s unlikely we will see an imminent request from the Spanish government for formal assistance.  It’s more likely that over the next few weeks the terms of any support will be agreed behind closed doors and then announced to the market in co-ordinated and tidy manner.  We'll see.

Friday, September 21, 2012

Global Growth Outlook

This post is part of an Investment Insights published earlier this week.  For a PDF of the full note, including commentary on a number of the major economies, please visit

The global economy is currently in the grip of a synchronised slowdown.  In the developed world Europe and the UK are in recession, while growth in America has shifted down a gear.  While we have seen previous bouts of weakness in some of the major economies at various stages post the Global Financial Crisis (GFC), this time it has been accompanied by slowing growth in the key emerging economies of China, India and Brazil.

We put much of the blame for the current slowdown on the ongoing euro zone debt crisis.  The impact on the rest of the world has been twofold:  the direct impact through trade, and the less direct but no less important impact on reduced business confidence levels which is serving to delay investment and hiring decisions.

Countries also have their own unique circumstances.  In America the impending fiscal cliff is serving to delay investment and hiring decisions.  QE3 will make a difference to real economic activity only at the margin.  In the United Kingdom, while exports have suffered greatly from the recession in Europe, the government’s experiment with expansionary austerity is failing.

We said post GFC that the key emerging economies didn’t suffer the same structural problems as the developed world (ie high debt levels).   However, the current slowdown is exposing their structural issues.  China is moving to a lower structural level of growth which means sustained periods of double-digit growth are now in the past.  India is struggling with necessary structural economic reform.  The good news is emerging markets have greater flexibility on both monetary and fiscal policy although, as is the case in the developed world, monetary policy can’t fix everything.

The June quarter of 2012 marked the weakest period for global growth since the recovery from the GFC.  Previously we had expected a modest recovery from the second half of the year, however partial activity data suggests the September quarter will be weaker again.  From there growth in activity is likely to stabilise into the end of the year, helped largely by reduced financial tension in Europe on the back of the European Central Bank’s Outright Monetary Transactions (OMT) plan.  The resultant reduction (though not elimination) of downside tail-risks of a euro zone breakup will support improved levels of business confidence.   The modest recovery in growth is now likely to be a 2013 phenomenon.

We now expect annual average global GDP growth of 3.0% in the 2012 calendar year, down from 3.3% previously.  That’s a mix of 1.2% growth in developed markets and 4.9% in emerging markets (at purchasing power parity weights).  In 2013 we expect global growth of 3.4% (1.4% developed markets and 5.4% emerging markets).  The recovery in 2013 assumes a modest recovery in Europe, further policy easing in China and a smaller fiscal contraction in the United States than current policy settings would suggest.

Thursday, September 20, 2012

NZ data better than expected

This week we saw New Zealand June quarter GDP and current account data.  Both put in a better-than-expected performance.

Production GDP came in at +0.6 for the quarter and 2.6% for the year (June quarter 2012 over June quarter 2011).  The quarterly result was better than our (+0.4) and average market (+0.3%) expectations.  Agriculture and construction were the stand-out sectors posting q/q gains of 4.7% and 3.3% respectively.  Agriculture continued to benefit from good growing conditions while in construction, the beginnings of Canterbury rebuilding efforts are starting to show through in the numbers.  Manufacturing posted a 0.8% q/q gain.

On an expenditure basis GDP posted a more muted gain of 0.3%.  Household consumption put in a modest +0.2% q/q gain.  Net exports made a positive contribution as import volumes fell more sharply than export volumes over the quarter.  The good news was the increase in gross fixed capital formation, particularly the 12.8% q/q increase in plant, machinery and equipment investment.  We continue to believe that exports and business investment will have to be key components of a strengthening of the economic recovery.

This result doesn’t have any significant impact on how we think the rest of the year plays out:  we think GDP numbers will continue to print at around +0.5% per quarter.  That is based on household consumption remaining subdued, the government sector remaining a drag on growth as fiscal consolidation plays out and solid contributions from business investment and construction (Canterbury rebuild).  That now puts our calendar 2012 GDP growth forecasts at 2.6% (q4/q4) and annual average growth a tad less at 2.5%.  By developed world standards that’s a pretty solid performance.
The June quarter current account deficit came in moderately worse than expected at $1.8b.  The market consensus was for a $1.7b deficit.  However, positive revisions of around $600m to previous quarters meant that the annual deficit as a percentage of GDP came in at 4.9%, slightly better than the market consensus expectation of 5.2% of GDP.  The deficit was 4.5% of GDP in the year to March 2012.  There were no real surprises in the deterioration of the annual deficit: the main culprit was the deterioration in the net international investment balance reflecting improved profitability of foreign-owned companies.

In normal times if the current account deficit was deteriorating and the NZD was overvalued, we would expect the NZD to come under a bit of downward pressure.  But these are not normal times.  With quantitative easing playing out in most of the developed world, the NZD is expected to remain strong especially given there are no concerns about either our willingness or ability to meet our external obligations.  However, the NZD remains vulnerable to the downside as the deficit continues to deteriorate to around 6.5-7% of GDP over the next few quarters.

Monday, September 17, 2012

China growth revised down

For a more comprehensive note on China, vist

Partial economic data points to a continued slowdown in economic growth in China.  Industrial production slowed further in August held back by weak export growth (Europe) and destocking also played a significant part in the slowdown.  On a brighter note, destocking bodes well for future production.  Recent PMI manufacturing data has been soft, particularly new export orders.  There is no sign of an imminent turnaround there.

Fixed asset investment has also slowed further.  However a breakdown of that result shows manufacturing investment was weak, but infrastructure staged a modest recovery.  That reflects previously announced new infrastructure projects now impacting the activity data.

On the positive side of the ledger, exports recovered somewhat in August but growth remains well below recent levels.  Retail sales continue to hold at around the 13% annual growth rate, and money supply and loans growth are both staging a modest recovery.  The recovery in loans primarily reflects recent reductions in the bank reserve ratio.  Finally, while the manufacturing sector is slowing, the non-manufacturing is holding up well.  New orders in the non-manufacturing PMI are still running at healthy levels.

The housing market is also showing some recovery, both in terms of prices and volumes, suggesting that Chinese authorities may have been successful in deflating the property bubble without popping it.  It means the authorities will be cautious about easing too aggressively in the period ahead and risking a renewed reheating of that sector. 

Inflation is currently low although base effects and higher commodity prices mean we are now through the low point on the cycle.  After reaching 1.8% in the year to July, the annual rate rose to 2.0% and we think it will head back to around 3.5% over the next 12-18 months.  That is still below the official inflation target of 4.0%.

This leaves room to ease both monetary and fiscal policy.  We think the People’s Bank of China will move to cut interest rates and further reduce the bank reserve ratio.  It is the reserve ratio where we think there is most room to move.  The ratio has been lowered progressively to 20% since November last year, but remains well in excess of the 10 year average of 10%.  Interest rates are likely to be cut further.

Increased infrastructure spending will continue to play a part in the stimulus.  Indeed the National Development and Reform Commission (NDRC) has just announced a number of new rail infrastructure projects.  However, we don’t expect to see a wholesale increase in spending.  That would risk reigniting criticism following the 2008/09 stimulus package that led to the speculative property bubble and build up in local government debt.  It would also be counter to the government’s aspirations of better quality growth and they will be keen not to inflate another bubble in parts of the property market. 

With continued weakness in Europe and a slow policy response we have revised our China GDP forecasts down for this year and 2013.  From 7.6% in the year to June 2012, we are now forecasting China will slow further to 7.2% in the year to September and to then remain at that level into the fourth quarter. From there we expect growth to stage a modest recovery into next year as destocking ends, the residential housing market continues a modest recovery and expected easier monetary and fiscal policy is forthcoming.  That results in annual average growth of 7.6% in the 2012 calendar year (8.0% previously), rising to 8.0% in 2013 (8.3% previously).

Friday, September 14, 2012

Fed pulls the QE3 trigger

The Federal Open Market Committee (FOMC) took a bold step today in announcing open-ended purchases of agency mortgage-backed securities.  They also extended their forward guidance from late-2014 to mid-2015.

I like the fact this program is directed again at mortgage securities; that makes it more targeted than QE2 which was solely aimed at Treasury’s.  A stronger housing market is a key component of a stronger and broader economic recovery.

Purchases will be at the rate of $40b per month.  “Operation twist”, in which the Fed is extending the average maturity of its holdings of securities, will remain unchanged and continue on until the end of the year.  This will result in total purchases of longer-dated securities of $85b per month until the end of the year.

This is brave new ground for the Fed.  Up until now asset purchases have been of a fixed quantum and duration.  This time they have said purchases will continue until economic conditions improve.  Furthermore the conditionality is aimed directly at the labour market; perhaps that should be unsurprising in the context of Bernanke’s recently stated “grave concern” about the state of the jobs market.  From the statement:

“If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”

Also unlike the first two asset purchase programs, today’s action has been undertaken when inflation expectations are rising.  QE3 can only add to those expectations of higher longer-term inflation.  That’s not necessarily a bad thing if you think higher inflation is part of the answer to America’s economic woes, but it serves to remind us once again that we should not make conclusions about the success or otherwise of quantitative easing until we have been through a full cycle and the stimulus has been exited.

I worry a bit about collateral damage.  The New Zealand dollar is at 83 cents against the USD this morning.  That makes life harder here.  I also worry about the impact on commodity prices and the extent to which stronger (soft) commodity prices may limit stimulatory policy action in some emerging economies, particularly China.

One last point before we go back to enjoying the rally.  As we said about the ECB last week – central banks can’t fix all the problems.  Maybe, like the ECB, the Fed has now created a window of opportunity for policymakers to get on with the job of building a stronger and more enduring economic recovery.  But perhaps we have to wait until after the election?

Thursday, September 13, 2012

German court gives go-ahead for ESM

The euro zone debt crisis cleared another hurdle last night with the German constitutional court ruling that Germany can go ahead and ratify the European Stability Mechanism (ESM).  The ESM is the permanent bailout fund that will replace the European Financial Stability Facility (EFSF) from mid 2013.

The court’s clearance came with conditions.  In particular the court has ruled that Germany’s financial liability should be capped at 190b with the Bundestag having veto powers over future increases in the Fund.  Chancellor Merkel has already said as much so there is nothing really new here.

Once Germany has signed there is only Estonia still left to ratify the Treaty.  Once that has occurred the signatories can then go ahead and raise the first tranche of paid-up capital of 80b.

This ruling clears another potential roadblock to a full solution of the euro zone debt crisis.  More important than the bailout funds is the fact that the ESM is the first step in the process of euro zone debt mutualisation which we think will be an inevitable part of the future of Europe’s fiscal landscape.

Monday, September 10, 2012

US jobs data makes more Fed action a done deal

When a Federal Reserve Chairman articulates “grave concern” about the weakness in the labour market and that comment is followed by weaker than expected jobs growth, further Fed action must be close to a done deal.  All that’s left to consider is what form said action might take.

August payrolls data was disappointing.  Market expectation was for a payrolls increase of +130k: the number printed at +96k.  To add to the disappointment revisions knocked 41k off June and July.  The separate household survey showed the unemployment rate declined to 8.1% in August from 8.3% in July.  That was driven primarily by a drop in the participation rate from 63.7% to 63.5%.

The Federal Open Market Committee is therefore almost guaranteed to do something when it meets later this week (Sept 12/13th).  While action is close to guaranteed, it remains to be seen what form that action might take.  The easy option, and least aggressive, is to use its communication policy and signal an extension to the “extended period” over which interest rates will remain low.  The current guidance is late 2014; they could easily shift that out to 2015.

They could opt to be more aggressive.  We’ve previously put the odds of more quantitative easing at 50:50 with changes to those odds dependent on how activity, and particularly labour market, data pans out.  Given the recent data the odds of QE3 being announced this week has risen to 75%. 

Why not 100%?  The Committee could choose to wait for more data.  As we’ve said before, much of the current slowdown in global activity is Europe-related.  The ECB has only just announced its Outright Monetary Transactions plan.  We think that will go a long way towards reducing financial tensions in Europe and improving global business confidence.  It also seems reasonable to assume that fear of the “fiscal cliff” is delaying hiring and investment plans in America.  The Committee might keep its powder dry and see how fiscal policy plays out.  Having said that, we know fiscal policy will be contractionary next year, we just don’t know how much.  The Committee might take the view that any fiscal contraction next year warrants further monetary policy action now.  The final reason they could wait is the fact that the second tranche of “operation twist” runs through to the end of this year.

If we get QE3 this week it’s unlikely to be in the same form as QE1&2.  Asset purchases are likely to be focussed on Mortgage Backed Securities, with speculation also that the Fed may opt for an open-ended program with no quantum or time-frame announced. 

Friday, September 7, 2012

Super Mario delivers

European Central Bank (ECB) President Mario Draghi this morning outlined the details of the ECB’s bond buying plan which will be known as Outright Monetary Transactions (OMT).

As had been previously flagged, the OMT will allow the ECB to buy unlimited amounts of short-term (1-3 year) paper in secondary markets of countries that have previously applied to the EFSF/ESM for assistance.  The ECB did not commit to any yield or asset purchase target which we think is a good thing: the key word in the previous sentence is “unlimited”. Also consistent with earlier signals is the fact that the ECB won’t have seniority over other bondholders and that the purchases will be sterilised.

Understandably markets have reacted favourably.  There has been criticism of the ECB not having done enough over the period of the Euro zone debt crisis.  That’s only partly justified.  As I’ve said on many occasions the ECB can’t fix the Euro zone’s problems: that role lies solely in the hands of politicians.  That’s why the conditionality that will come with countries first applying to the EFSF/ESM is so important.

The speculation is that Spain will be the first cab off the OMT rank.  I’m not surprised they haven’t applied for assistance already: it makes sense to see what the rules of the game are before asking for help.  Even now there’s a couple of other hurdles to cross before we see Spain ask for help, not the least of which is the September 12th ruling from the German constitutional court on Germany’s participation in the ESM. 

Even with today’s announcement the ECB hasn’t fixed any of the fundamental problems behind the euro zone debt crisis.  What they have done in effectively announcing they are prepared to act as lender of last resort is to reduce market tensions, thereby opening a window of opportunity for euro zone politicians to get on with the job of fiscal consolidation and structural economic reform.  Let’s hope they take that opportunity.

Monday, September 3, 2012

US monetary policy: after Jackson Hole

Fed Chairman Ben Bernanke’s speech at Jackson Hole made a more impassioned case for further easing than I had expected.  When the Fed Chairman talks of “grave concern” about the continued weakness of the labour market and the potential human and economic costs, further easing seems more likely than not. 

Of course this speech was not a policy announcement.  Setting monetary policy remains the purview of the Federal Open Market Committee (FOMC) which meets next on September 12/13th.  Bernanke was therefore careful to qualify his comments on further monetary policy action with the key phrase “as needed”.   That continues to leave the same questions as before: whether it will be needed, what options they have for easing and when it might happen?

Dealing with the options first, we know from earlier FOMC deliberations there are a number.  These include communication (such as forward guidance on interest rates); a cut in interest rates on excess reserves; a UK-type “funding for lending” program; or more asset purchases (quantitative easing).   Of course a package of any of the above is also possible.

Bernanke spent a large part of his speech addressing the cost/benefits trade-offs of quantitative easing.  He described the costs in some detail.  These include: possible impairment of market functioning; a reduction in public confidence in the Fed’s ability to exit smoothly from its accommodative polices at the appropriate time (i.e. a rise in inflation expectations); risks to financial stability; losses to the Fed if interest rates rise.  He argued, however, that quantitative easing has had a net positive effect on economic activity and employment.

I’d add another cost. As I’ve mentioned before, I think America’s economic (and labour market) woes warrant a broader policy response than just monetary policy.  Bernanke says as much in his conclusion: “...Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve...”.  I worry the more the Fed does the less action we are likely to see from other policymakers.

The “whether it will be needed” and “when” are linked.  The FOMC’s deliberations in two weeks time will focus on a number of things.  Firstly, the data news has improved since their last meeting in August, although not universally so.  Having said that, it appears economic growth has slipped to a new level of around 1.5% per annum from an apparent 2% previously.   There is more important data to come before the Committee next deliberates including the manufacturing ISM and labour market data for August.

Secondly, they need to consider what is driving the current weakness in the economy and what events are coming up that might turn some of that weakness around.  Key amongst those are concerns about the so-called “fiscal cliff” and what action may be about to be undertaken by the European Central Bank in Europe.  As I’ve mentioned before, much of the current weakness in global growth is due to Europe, either directly through trade flows or less directly through its impact on business and consumer confidence.  I think an easing of financial tension in Europe would have a more significant impact on business confidence globally than more easing by the Fed is likely to have on confidence in America.

That suggests to me that if the Fed is ready to do something at its September meeting, it will be at the less aggressive end of the spectrum, most likely via communication of its interest rate guidance.  We should also remember that the Fed is currently easing via the second tranche of “Operation Twist”, which isn’t scheduled to end until December.  Seems to me the Fed should keep its QE3 powder dry to see how things play out in Europe, have a better indication of the likely path of fiscal policy, and of course how the domestic data plays out.  Watch this space.