Tuesday, January 15, 2013

While I was away...

Yes, I had a great holiday.  Thanks for asking.  It was quite an action-packed three weeks with fiscal cliff negotiations, FOMC minutes sending shivers through bond markets and a raft of data out of China, supporting our suspicions that GDP activity recovered somewhat into the end of 2012.

The biggest news was the part-resolution of the “fiscal cliff” in America.  Politicians belatedly reached agreement on the tax aspects of the problem but as we suspected, expenditure (sequestration) was too hot to handle and that can got kicked down the road.  But not too far; expenditure will be discussed again shortly as part of the raising of the debt ceiling debate which needs to take place by end of February/early March.  More importantly, in the absence of a “Grand Bargain”, fiscal policy in America will continue to be a make-it-up-as-you-go process.  For more on the “fiscal cliff”, see the post below.

Recent activity data supports the view of the US economy finishing the year with modest growth, but improving fundamentals more generally.  December PMI data was good, though not spectacular, and housing data has continued to support the view of a recovery emerging in that market.   The labour market held up well into the end of the year with a 155k increase in non-farm payrolls in December.  If anecdotal evidence is correct, firms have been delaying hiring and investment decisions.   That could see some stronger employment gains in the months ahead and some recovery in capital spending.

Our working assumption has been that US fiscal drag in 2013 would be around twice that of 2012.  GDP growth looks set to come in around 2.3% (annual average) for calendar 2012.  With fiscal drag of around 0.7% over the year, growth would have been around 3.0% without the contractionary influence of fiscal policy.  In 2013, we think fiscal drag will be around 1.5%.  Our forecast for GDP growth for the year is 2.1% or around 3.5% without the fiscal drag.  That feels about right, especially given the modestly improving housing market.

The US bond market took fright with the release of the minutes of the December Federal Open Market Committee meeting, with concern that QE3 might end as early as the middle of this year.  These supposedly “hawkish” comments saw bond yields up sharply.  Isn’t it amazing what’s considered hawkish these days?  It’s too early to tell how long QE3 runs for, but given our view that US GDP growth will most likely demonstrate an accelerating profile over the course of 2013, I think it’s likely we will at least see a reduction in the quantum of QE (currently $85 billion per month) later in the year.  Anything beyond that will depend on the labour market and the path of inflation, particularly the personal consumption expenditure (PCE) deflator.

Economic activity remains weak in Europe.  Business sentiment remains soft and the labour market continues to weaken: Europe’s unemployment rate reached 11.8% in November.  Latest PMI data suggests that while the recession isn’t getting any deeper, but neither does there appear to be any chance of imminent recovery.  We think the earliest we will see a return to growth in Europe is late this year.  The ECB left interest rate unchanged last week.  I’m ok with that; any cut to interest rates now would be largely symbolic, rather than having any meaningful impact on economic activity.  Perhaps the biggest news of the last few weeks in Europe was, once again, politics with an election likely in Italy In February.  Mario Monti, the caretaker Prime Minister, will stand again.  That’s encouraging.

In Japan activity data remains weak and prices continue to fall.  That supports Prime Minister Abe’s call for more aggressive monetary policy action.  While in the past I have questioned the merits of quantitative easing for the purposes of influencing real activity in the economy, it is more effective with respect to combating deflation.   QE could and should have been used more aggressively in Japan.  Raising the Bank of Japan’s (recently introduced) inflation target from 1% to 2% would also help lift inflation expectations, but needs to be followed up with aggressive monetary policy action.  Last week the new Government announced a new fiscal stimulus package which should help see Japan out of the current recession later this year.

In China recent data has supported our view that GDP growth recovered into the end of 2012 but also that the recovery will likely remain modest overall.  Export growth was strong in December, although the data can be volatile.  Money supply and loans data is trending gradually higher.  We continue to expect a stronger recovery in industrial production as the inventory cycle turns.

Inflation in China nudged higher in December on the back of a weather-induced increase in food prices, but underlying inflation pressures appear well-contained.  Nevertheless, as inflation edges higher over the period ahead, authorities will remain constrained to monetary policy fine-tuning rather than anything more aggressive.  I will have more to say on China on Friday after the release of Q4 2012 GDP data.  We expect annual growth of 7.8%.