Thursday, December 20, 2012

Things to watch in 2013

As we approach the end 2012, the sense of crisis that has occupied much of the last two years appears to be abating.  But there is still considerable work to be done.  Much of that work is structural in nature and therefore requires a higher level of engagement from politicians than we have seen up until now. 

Next year is shaping up to be the year in which we refocus on some of the key issues facing the global economy.  These were first talked about in 2009 but then got sidelined as the various crises, and potential crises, unfolded. Here are some of things I’ll be watching (including some I’ll be worrying about) in 2013:

1)      Locking in and building on progress in peripheral Europe.

Considerable progress has been made in some of the key worry-countries in Europe in terms of reducing structural budget deficits and moving fiscal settings onto a more sustainable path.  But there is still a lot to do.  The costs have been high with significant losses of both output and jobs.  Progress has also been made in reducing external imbalances and lowering unit labour costs.  The job now is to lock in those gains. 

2)      Further Eurozone integration

Progress is being made on Eurozone integration, but it is arduously slow.  A banking union is on the table right now.  This is a critical step towards greater financial integration.  It’s important that the recent reduction in financial market tensions, thanks to the ECB and its Outright Monetary Transactions, doesn’t reduce the urgency that is required to press ahead with these reforms.  As I’ve said on many occasions, the OMT hasn’t solved anything in Europe, but it has opened a window of opportunity for the politicians to get on with the job.

3)      Medium term fiscal consolidation plans in America and Japan

Europe has been the focus of fiscal consolidation over the last couple of years, but in 2009 we said fiscal sustainability and government deleveraging (alongside household deleveraging) would be a key issue for all developed economies at least to some extent.  In America, the current ‘fiscal cliff’ negotiations are the start of the process.  America also needs a credible well-articulated plan, which will go a long way to reducing concerns over fiscal sustainability.  The same is required in Japan.  The new government also has a significant task ahead to develop its medium term plan. 

4)      Old headwinds in America, but a couple of new tailwinds

The US has been prone to bouts of weakness and fears of a double-dip recession.  As it has turned out, the US has recorded 13 consecutive quarters of positive growth.   While fiscal drag will likely double next year, the good news is that underlying fundamentals are improving.  In particular, the housing market is turning from a headwind to a tailwind.  A stronger housing market means improved confidence to spend.  Another recent headwind has been the impact of state and local governments getting their spending under control where they have made good progress.  While spending from this sector won’t become a growth tailwind, it is becoming less of a headwind. 

5)      Monetary policy: remaining supportive, moving towards normalisation, exit strategies, and inflation targeting

Monetary policy has more than played its role over the last few years.  As growth recovers next year, and assuming less bouts of angst and downside growth risk, minds will turn to the monetary policy normalisation process.  The US has already started that process in its December statement by shifting its forward guidance from being time-specific to being tied to real economic variables, notably the unemployment rate.  The debate about the appropriateness of inflation targeting is re-emerging and has gathered momentum since the appointment of Mark Carney to the Bank of England.  More on that topic next year.

6)      Hard landing averted in China, but no double-digit recovery

As growth in China has slowed over the last 18 months we knew the slowdown was part structural and part cyclical, the only question was the proportion of each.  As it has turned out, the bigger share of the slowdown has been structural by virtue of the fact the authorities have been happy to see the economy slow.  The post-GFC policy response saw a number of excesses emerge, particularly in some parts of residential property market which the authorities have been keen to eliminate.  Another feature of the recent slowdown has been a strong destocking process which has seen the growth rate of industrial production halve over the past 18 months.  Growth looks set to recover modestly in 2013 with industrial production likely to continue the recovery that emerged at the end of 2012, although continued weak developed economy growth will constrain exports.

7)      No free lunch – structural reform in the key emerging economies

One of our main post-GFC themes was that emerging markets would be the key contributor to global growth in the period ahead.  We tempered that somewhat by acknowledging that while the key emerging economies didn’t face the same structural issues, they faced a number of their own.  China’s are well understood:  the easy gains from urbanisation have been achieved, the competitiveness gap with the rest of the world is closing and growth in the working-age population will soon start to reverse under the one-child policy.  Key reforms will be building sustainable gains in productivity to allow wage growth without generating inflation and we would like to see further progress on capital account liberalisation.  India needs to give monetary policy more room to move by pushing ahead with good market reforms.  Brazil needs to lock in recent competitiveness gains by focussing on labour productivity and being attuned to signs of inflation.  

8)     Global rebalancing

I’ve already talked a bit about external imbalances in Europe in (1) above.  However, the issue is broader than just Europe.   Global imbalances go right to the heart of the causes of the Global Financial Crisis.  The US housing market was the manifestation of the problem, but the problem was more fundamental than that.  There has been some success in reducing imbalances, but a lot of this improvement could well prove to be temporary.  The challenge is to lock in these gains. 

9)     Reform of the global regulatory environment and financial system

There’s been a lot of talk but not much action.  As appeared likely in the aftermath of the GFC, the G20 has assumed the mantle of the pre-eminent multi-lateral grouping of governments, usurping the role of the G7.  When was the last time you heard anything meaningful from a G7 meeting?  Not recently, right?  That’s not to say the G20 has been a whole lot more successful.  The IMF regularly cites cross-border resolution and supervision, the too important to fail issue, consistent implementation of the reforms in the derivatives market and closing critical information gaps as key issues still to be addressed.  We concur.

10)   Geo-political tensions

No predictions here, just a list of things to worry about.  In no particular order: North Korea, Libya, Gaza, Iran, Iraq; and China, Japan and the dispute over the islands known as Diaoyu (in China) or Senkaku (in Japan).  The world is not just fragile from an economic and financial perspective.   Any or all of these, or others I haven’t thought of, have the capacity to add uncertainty and volatility in equity, bond and commodity markets.  Same goes for natural disasters (is it just me or do once-in-a-hundred-year extreme weather events seem to be coming around with monotonous regularity??) Watch this space.

In conclusion.....

While we are hopeful of a less angst-ridden year in 2013, there are still plenty of challenges ahead.  There is still considerable work to be done to build a stronger and more resilient financial, growth and job creation environment.  Furthermore, many of the challenges are structural and supply-side.  The growth constraint facing many developed economies is not simply a problem of deficient demand.

All things considered we see a slightly stronger global growth environment in 2013.  This pickup will be driven by stronger growth in the emerging economies (particularly China, Brazil and India) which we see growing a collective 5.4% in 2013, up from 4.9% in 2012.  Developed economies are expected to grow 1.4% next year, up from 1.2% in 2012.  Japan and Europe will be the growth laggards.  That emerging/developed combination generates 2013 global growth of 3.3%, up from 3.0% in 2012, but still below the longer run average of 3.5%.


Here at home growth will remain hard work.  The headwinds are well known: soft global demand, household spending restraint, fiscal consolidation and the high New Zealand dollar.  A modest pick-up in growth next year is very much predicated on a stronger construction sector with the Christchurch rebuild and stronger residential construction activity in Auckland.  The current account deficit will be a key focus for markets next year as the Canterbury rebuild generates strong import growth.  We see annual average growth of 2.5% in 2013, up from 2.3% in 2012.


This is the final post for 2013.  Have a safe and merry Christmas.  I’ll be back from mid-January.  Between now and then this blog site is going to get a bit of a refresh and a lick of paint.  Now there’s something to look forward to in 2013! 

Friday, December 14, 2012

2012 in review

What a year that was.  We started 2012 picking that three broad themes would dominate markets: the Euro zone debt crisis, the pace of economic growth in America and whether the China slowdown would be “hard” or “soft”.  We weren’t disappointed.
 
We took a considered but ultimately constructive view on each.  Now here we are at the end of the year with the Euro zone still intact and Greece still a member of the club, America having avoided recession and, while growth in China slowed more than we initially thought, it appears to have averted a hard landing.
 
If I was to sum up the year in two words they would be “crisis averted”.  That’s a tad risky given that as I write there is still one potential crisis playing out: the US fiscal cliff.  Our view is we will most likely end the year with some components of the fiscal landscape decided on, but others kicked down the road.  I think there’s some risk of complete failure in the negotiations and the US falling off the cliff, but I’d give that a low probability.  No one wants to be blamed for tipping the economy into recession.  I imagine that’s a strong incentive for a positive outcome.
 
Central banks have played a key role over the year.  That’s important because no-one else has.  The US Federal Reserve has continued to provide liquidity and is now in an environment of open-ended quantitative easing.  The ECB finally stepped up as lender of last resort in the Euro zone but in a smart way by tying countries that ask for assistance to fiscal and structural conditionality.  The Bank of England and The Bank of Japan both stepped up unconventional easing programs with only the BOJ able to be accused of not doing enough to meet its new (positive) inflation target.
 
For the first time in what seems like many years I’m heading into Christmas thinking that global risks are abating rather than rising.  There’s still a lot of work to do. Europe may now have a somewhat more robust framework for dealing with the sovereign debt crisis and finally a lender of last resort in the ECB, but macro-economic stability and long-term fiscal/financial sustainability is still a work-in-progress.
 
Underlying economic fundamentals are improving in America which makes it better able to wear a bit more fiscal contraction in 2013.  In China indications are that the recent slowdown in growth bottomed-out in the third quarter of 2012.  The slowdown had both cyclical and structural elements.  In the end it was more structural than cyclical by virtue of the fact the authorities were quite happy to see the economy slow after the excesses of the post-GFC stimulus program. We expect annual GDP growth blipped higher into the fourth quarter of the year, but we continue to believe the recovery in growth will remain modest.
 
At home we weren’t disappointed with our view that growth would remain hard work in New Zealand.  The first half of the year exceeded expectation, but the second half is proving to be more challenging.  The combined headwinds of household deleveraging, fiscal contraction and the high New Zealand dollar will continue to make the going tough.
 
As the various potential crises have played out markets have been volatile.  However, well-diversified multi-sector portfolios have performed well, at least compared to the prognostications of some media headlines (and even some reputable economists) of imminent global economic catastrophe at certain points through-out the year.
 
Next year we will continue the voyage of discovery into the ethereal concept of the “new normal”.  That journey will still be challenging and it will no doubt continue to have its ups and downs, but hopefully not the same degree of angst.   Next week:  Ten things to watch out for in 2013.

Merry Christmas from the Fed

This morning the US Federal Reserve announced an extension of its outright asset purchase programme to compensate for the end of “Operation Twist” at the end of the year. Operation twist was the process by which the Fed was purchasing $45 billion per month of long-dated Treasury’s, funded by sales of short-dated Treasury’s. That will be replaced by outright Treasury purchases of $45 billion a month which is in addition to the $40 billion per month of Mortgage Backed Securities announced in September. This was widely expected, as anything else would have been deemed a tightening in policy.

The more interesting point in the Fed’s statement this morning was the change in the forward guidance on interest rates from a time-specific indication to one tied to a real economic variable – the unemployment rate. The previous guidance indicated that exceptionally low interest rates would be warranted until mid-2015. Here’s the important paragraph:

“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.”


The Fed argues that the date-specific and unemployment rate guidance are consistent. That seems reasonable. The important innovation is that the Fed has now bought some flexibility into an approach that previously hinged on a specific date with an arguable degree of flexibility around it. Under that arrangement communication was always going to be a challenge, especially if economic (and more importantly inflation) indicators warranted an earlier move. The Fed has bought extra flexibility by also specifying it will look at additional measures of labour market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. (Isn’t that the way CONVENTIONAL monetary policy used to work???

This transparency and flexibility is essential for Fed communications in the future. As we move inevitably toward the need for some reduction in the degree of stimulus being provided to the economy, the Fed now has the appropriate guidance apparatus to manage future monetary policy expectations. That’s an essential and smart innovation, especially in a world of “new normal’s” where effective central bank communication and transparency will continue to be important.

Tuesday, December 11, 2012

Modest China recovery underway

The release of China November activity and price data confirms an upward trend is emerging in activity while inflation remains benign.

Headline industrial production growth accelerated to 10.1% in November, up from 9.6% in October.  That result provides further evidence that the headwinds from the destocking cycle are abating and that production growth will now move back in line with overall growth in activity.
 
Retail sales growth also accelerated in nominal terms, although the growth rate in volumes was flat at 13.5% y/y.  Retail sales have held up well during the slowdown, a reflection that the labour market remained relatively stable.  Remember the recent slowdown in growth was in large part engineered by the authorities to remove some of the post-GFC stimulus excesses.  They would have been under more pressure to respond policy-wise had the labour market weakened.
 
The disappointment in the data was in a flat result for fixed asset investment and a decline in the growth rate of exports.  In terms of investment transport continues to play a significant role given much of the recent fiscal stimulus has been aimed at road and rail.  Residential investment is also stabilising in line with other housing market data.  Export data can be very volatile, but the drop down from 11.6% y/y growth in October to 2.9% in November was significant.  Global growth (especially the ongoing recession in Europe) will continue to be a headwind for export growth.
 
CPI inflation came in at 2.0% for the year to November, up from 1.7% in October.  Inflation has clearly bottomed out, but remains well below the official target of 4.0%.
 
This data, along with the November PMI data released last week makes me comfortable with the view that GDP growth bottomed out in the third quarter and that a modest reacceleration is underway.  Our annual average GDP growth forecast for calendar 2012 is 7.7%, rising to 8.0% in 2013.

Thursday, December 6, 2012

RBNZ retains tightening bias

The Reserve Bank of New Zealand (RBNZ) left interest rates on hold at the December Monetary Policy Statement (MPS) today and retained its bias to tighten.  I think that’s entirely appropriate. 
The key question for this MPS was the extent to which the Bank would see recent soft economic data (particularly September quarter HLFS, retail spending and inflation) as a sign of general or likely-to-be-sustained weakness in activity and inflation.  The answer is not at all, other than to alter the starting point.  While the Bank has lowered its GDP growth forecast for the second half of the year to +0.6% from +1.1% previously, they have not changed their view of annual GDP growth rising to between 2.5% and 3.0% over the next two years.  They see this leading to a gradual elimination of spare capacity in the economy and an increase in the inflation rate towards the 2% target mid-point over time.  That is consistent with our own view.
Balancing the recent weakness in some domestic data, the Bank sees the global economic outlook as “less threatening” but still “soft”.  In particular the risk of a significant deterioration in euro zone has diminished and they recognise the recent improvement in the data out of China.  With respect to America they acknowledge the growth-constraining impact of the fiscal uncertainty, but also the recent improvement in the housing market.
The only concession to recent calls for interest rate cuts was the acknowledgment that retail interest rates have fallen recently so that monetary conditions have effectively eased recently without the Bank needing to reduce the OCR.  This has enabled them to come up with a set of projections that builds in the recent data weakness, sees inflation returning to the mid-point of the target band and leaves the projected interest rate track largely unchanged from that in the September MPS.
I’m in broad agreement with most of the Bank’s forecasts, although I think they will prove to be a bit light on their current account deficit projections.  The Bank sees the current account deficit at -5.5% of GDP by March 2015.  My own forecasts are closer to 7%.  Importantly, the Bank also expects the NZD to remain strong over the foreseeable future. Yep. 
The Bank continues to flag the first interest rate increase for the end of 2013/beginning of 2014.  I recently shifted my expected tightening out from June 2013 to the somewhat less definitive “second half of 2013”.  I’m still happy to be expecting an earlier tightening than the Bank largely due to the fact that I think inflationary pressures will emerge somewhat earlier in the cycle, especially in the labour market.

Tuesday, December 4, 2012

China and US PMIs

PMI surveys out of China and America support the stories of modest recovery in China and a high level of caution from American businesses ahead of the "fiscal cliff".

China’s PMI continued its recovery into November, although fell slightly short of market expectations.  The index rose from 50.2 in October to 50.6 in November.

The continued recovery in new orders is further indication of the modest China recovery story.  The new orders index rose from 50.4 to 51.2 while export orders rose from 49.3 to 50.2.  The main near-term theme is the end to the destocking cycle.  Both the finished goods and raw materials inventory indices rose in November but remain well south of the 50 benchmark at 48.8 and 47.9 respectively.  Industrial production has slowed sharply as the destocking part of the inventory cycle has played out but it appears a turning point has been reached.

Exports are still a critical part of the China growth story.  Here the recovery story is likely to be more troublesome.  Europe remains critical to China exports; while demand conditions there appear to be getting no worse, neither do we expect an imminent recovery.  Our Europe GDP forecast for 2013 is +0.3%.  

The gradual recovery in the manufacturing sector, the recovery in the housing market and the continued strength in private demand (retail sales), which has been relatively immune to the slowdown, gives me confidence to bump my December China GDP forecast to 7.8% (7.4% previously) giving annual average calendar year growth of 7.7%, just ahead of the official target of 7.5%.  I continue to expect the recovery to be modest: I’m happy my 2013 forecast of 8.0%.

In America the manufacturing PMI dropped back under 50 in November to 49.5.  That’s down from 51.7 in October.   The production sub-index rose over the month, suggesting little or no impact from super-storm Sandy. 

The weakness in the survey appears to have more to do with an element of caution from businesses in the face of the fiscal cliff.  The new orders index fell from 54.2 to 50.3, the employment index fell from 52.1 to 48.4 and the customer inventories index fell from 49.0 to 42.5.  That’s consistent with anecdotal evidence and other indicators that suggest businesses are holding back until the fiscal landscape becomes more certain and adds to expectations of some recovery in activity and employment once fiscal cliff issues are resolved. 

As a result we’re expecting softer GDP increases in the period ahead.  From a recently upwardly revised Q3 GDP increase of 2.7% (seasonally adjusted annual rate) I’m expecting 1.6% in Q4 and 1.2% in Q1 2013, followed by a bit of catch-up activity from Q2.