Friday, May 31, 2013

Has the shine come off emerging markets?

We continue to expect a cyclical recovery in emerging markets, but it is proving to be hard work.  Softer than expected domestic demand and still weak demand for emerging market exports from the key developed economies is hampering a more robust recovery.  That is in turn highlighting some key structural constraints to continued high and sustainable growth. 

However, we still expect emerging markets to post average growth of 5.4% in 2013, well in excess of the 1.3% we expect from developed economies.  Furthermore, it is still our expectation that looking further ahead, emerging markets can still be relied on to account for around two thirds of global growth over the next decade.  But necessary structural reform remains an essential part of that equation.  In short, the shine hasn’t come off emerging markets, but a bit of structural polishing wouldn’t go amiss.

For the full report, including country specific commentary on China, India, Brazil and Russia, click here.

Thursday, May 30, 2013

A bit of breathing space in Europe

The pace of austerity in the Euro zone is being allowed to slow in return for a stepping up of structural reform.  That’s a good thing.  Regular readers will know we have long been of the opinion that the recipe for repair of the euro zone was too unbalanced, favouring austerity over more fundamental structural reform.  The reality is that both are required, but when a country is in deep austerity-induced recession structural reform becomes academic with no political, let alone public, appetite for implementation. 

To be fair, considerable progress has been made on deficit reduction.  For the euro zone as a whole, the budget deficit reduced from 3.6% of GDP in 2011 to 2.0% in 2012.  But the cost of that adjustment has been high in terms of lost output and high unemployment, especially youth unemployment.

The more recent calm in financial markets, driven off the back of ECB commitments to do whatever it takes to save the Euro and the establishment of the Outright Monetary Transactions (OMT) program, which is still yet to be activated, have created a window of opportunity for some rebalancing.  To that end the European Commission has granted Spain and France an extra two years to meet the 3% deficit target while the Netherlands and Belgium were both granted another year.  The extra time for Belgium is despite the fact that they were ruled to be in violation of EU rules by missing its deficit target last year.

The extra time is a quid pro quo for a stepping up of structural reform.  The Commission has made a number of recommendations for structural across member states in areas of taxation, pensions, public administration, services and the labour market.   All of these are essential if Europe is to return to sustained economic growth. 

The next step is in the hands of politicians.  Whenever I say that, it’s with a sense of trepidation!  But there is reason to be optimistic.    Both President Hollande in France and Prime Minister Rajoy in Spain have been vocal about the need for a relaxation of austerity to create room for growth enhancing reform.  Now is their opportunity.

Thursday, May 23, 2013

The Fed will not end QE prematurely

A thorough read of the minutes of the April 30 / May1st meeting of the Federal Open Market Committee (FOMC) shows a Committee not in any mood to risk an early or premature end to the asset purchase program.  Markets have focussed on Ben Bernanke’s comments during his Congressional testimony that suggested the FOMC could potentially reduce the quantum of asset purchases “in the next few meetings”.  The important qualification was that this would only happen if the outlook for the economy continues to improve along with the level of confidence in the sustainability of that improvement.

The assessment of the current state of, and outlook for, the economy in the Minutes bore no surprises.  The meeting participants recognised the costs of fiscal drag in constraining aggregate demand, the improvement in the housing market (though off a low base) and that progress was being made in the labour market.  However, the Committee also noted that the recent decline in the unemployment rate is overestimating the reduction in slack in the labour market given the decline in the participation rate.

I have made the point before that it is unlikely a reduction in the unemployment rate that has been in large part due to people opting out of the labour market meets the FOMCs conditions for a substantial improvement in labour market conditions.  While there are structural reasons why the participation rate should be trending lower, I think at least some part of the recent decline is cyclical.  If that were to be reversed continued modest jobs growth could be accompanied by a stabilisation or even increase in the unemployment rate.  Time will tell.  The Committee also noted the recent soft inflation readings.  Core Personal Consumption Expenditure (PCE) was 1.1% in the year to March.

Much has been made in the media that “one participant” preferred to begin decreasing the rate of asset purchases immediately, but has missed the point that “another participant” wanted to add more stimulus at that meeting.  The important point is: “Most participants emphasized that it was important for the Committee to be prepared to adjust the pace of its purchases up or down as needed to align the degree of policy accommodation with changes in the outlook for the labor market and inflation as well as the extent of progress toward the Committee’s economic objectives.”  While that was in response to the weaker data at that point, especially the initial read of March payrolls data, it also seems to me the Committee didn’t want markets to get too far ahead of themselves in anticipating an end to the asset purchase program.

My read of the minutes, Bernanke’s testimony to Congress and other recent speeches from FOMC members (Bullard, Dudley) is that the Committee is not going to be in any rush to do anything other than continuing to ease.  In his testimony Bernanke made the important point that a premature tightening of monetary policy could lead interest rates to rise temporarily but could also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.

Given our outlook for the economy we believe the next move in US monetary policy is a tapering in the pace of asset purchases.  However, they will need to be conscious of not starting to taper too early.  As soon as they start the process markets will anticipate the eventual cessation of the program and eventual tightening, even though the Fed will still be easing at that point.  We continue to expect the earliest we will see a reduction in the pace of asset purchase will be the end of this year, although recent inflation data is probably more indicative of a 2014 start to that process.  The good news is that when the tapering begins, it will be because the FOMC sees a fundamental improvement in the outlook for the US economy.

Tuesday, May 21, 2013

Japan: A new dawn?

Japanese GDP growth for the first quarter of 2013 surprised on the upside, posting an annualised increase of 3.5% (0.9% q/q).  The result was ahead of market expectations of an annualised increase of +2.7%.  It was all the more impressive for the fact that the higher than expected growth came off a higher base following an upward revision to growth in the fourth quarter of 2012 to an annualised +1.0%. 

The growth was reasonably broad-based over the quarter.  Consumption was the star performer, but exports contributed with their first quarterly increase in a year.  Housing investment also remained strong.  The only laggard was business investment which is to be expected given the lags between a boost to confidence and the implementation of investment plans.

The question is where to from here?  There are a number of reasons to believe the recent strength will be maintained, at least in the near term.  Consumer confidence is strong on the back of recent equity market gains which will support consumption growth and underpin further gains in the housing market.  A significant public works program following the supplementary budget announced in February will also support activity in the period ahead.  And of course the recent depreciation in the Yen combined with higher global growth in the latter part of the year (particularly in America) will provide further support for exports.  Business investment is likely to show some strength as profitability improves on the back of stronger demand and the depreciation in the Yen.

Remember there are three components of Abenomics: an increase in fiscal stimulus focussing on public works, an aggressive monetary easing by the Bank of Japan and structural reforms to boost productivity.  So far we have seen action on the first two which is delivering gains.  However, from my perspective, it’s progress on the third leg of the trifecta that’s necessary to make higher growth sustainable.

I think it’s a bit like Europe where the ECB has created a window of opportunity for politicians to get on with the job of fiscal consolidation and structural economic reform; in Japan fiscal and monetary stimulus is creating a window of opportunity for the Government to get on with the hardest part of the reform agenda.  We need to see policy reform in goods markets, the regulatory environment (particularly the regulation of network industries) and the labour market also needs some work to address rigidities.

An important part of the necessary structural reform is dealing with the related issues of tax reform and unsustainable fiscal settings.  Japan needs a long-term fiscal plan (where have we heard that before?).  Here’s where a better economic environment is creating room to move.   An increase in consumption tax is scheduled to take effect in two steps from April 2014.  At that point the tax increases from 5% to 8% and then again to 10% in April 2015.

When the tax increase was announced it was qualified with the implementation being conditional on the state of the economy at the time.  This recent economic strength and its likely continuation this year means the consumption tax increases are more likely.  They will take an economic toll and inevitably add volatility to the growth profile over the next couple of years as people pre-spend prior to the tax increases, followed by a soft patch.  But they are a step in the right tax-reform direction.

We see annual average growth of 1.6% (2.9% q4/q4) in calendar 2013 followed by 1.4% (0.5% q4/q4) in 2014.  After that we see growth slipping back to trend growth of around 1.0-1.5% per annum.  I need to see a more ambitious reform agenda getting too excited about the medium term outlook.

Thursday, May 16, 2013

New Zealand Budget 2013

Budget 2013 marks another milestone of the pathway back to fiscal sustainability.  Solid economic growth continues to underpin a return to surplus in the 2014/15 fiscal year.  This is one year earlier than Australia (not that we’re at all competitive). Net debt is projected to peak at 28.7% of GDP in fiscal 2014/15, confirming New Zealand as having one of the strongest fiscal positions in the developed world.

Fiscal projections in the 2013 Budget are underpinned by average growth of 2.5% over the forecast period.  Growth is forecast at 2.4% in the year to March 2014, lower than the 2.9% expected in the Half-Year Economic and Fiscal Update (HYEFU).  The drought is the primary reason for the downward revision, taking an estimated 0.7% off growth this year.  Growth is then expected to rebound to 3.0% in 2015.  These forecasts are slightly lower than ours (2.8% and 3.2% respectively) and are therefore on the moderately conservative side in our view. Growth is expected to drift lower in the years following.

Other economic forecasts are broadly in line with our view.  Inflation is expected to be lower than previously forecast in the near term on the back of the high exchange rate.  Treasury is also forecasting a gradual decline in the unemployment rate (which will now be from a lower starting point following the release of March quarter HLFS data).  They are also forecasting deterioration in the current account deficit which is also in line with our own view.

Crown revenues are forecast to rise over the projection period on the back of solid economic growth.  And after two “zero” new spending budgets the improved fiscal outlook has allowed the Government a bit more latitude on spending.  They have allowed themselves $900m in new spending in Budget 2013, which along with continued reprioritisation of existing spending and higher revenue has enabled new initiatives in health, education and social services. 

A further boost to investment in innovation is welcome via increased funding to Callaghan Innovation for R&D grants.  That’s important support for the innovation system and I continue to favour the use of targeted grants to support our aspiring innovators.

Other significant initiatives include a reduction in ACC levies and a further commitment of $2.1 billion to the Canterbury rebuild.

Operating balance (excluding gains and losses or OBEGAL) is estimated at -2.9% of GDP in the current fiscal year (-3.4% of GDP in the HYEFU), a deficit of -0.9% in 2013/14 (-0.9%) and a surplus of 0.0% ($75 million) in 2014/15 (0.0%, $66 million).  Net core crown debt continues to rise to a peak of 28.7% of GDP in 2014/15, and then begins to decline.  Gross debt peaks at 38.5% of GDP in 2013/14.

Historical efforts to reduce New Zealand’s debt levels have stood us in good stead.  Our low level of debt combined with a credible plan to get back to fiscal sustainability after the Global Financial Crisis (and in our unique case the Canterbury earthquakes) is the key difference between us and much of the rest of the developed world.  By comparison gross debt as a percentage of GDP is 95% in Europe, 108% in America and 245% in Japan.  In the Australian Budget yesterday we saw the benefit of low and prudent debt levels when the market took the deterioration in the Australian crown accounts in their stride.

The fiscal impulse is expected to be somewhat less of a headwind than estimated in the last Budget.  Fiscal drag is now expected to be at its worst in 2015 at -1.2% of GDP.  That compares with a previous “peak” of -2.0% in 2014.  Further out fiscal drag is now forecast to be slightly greater than previously forecast.  That being the case it remains a critical reason why we expect only a moderate increase in interest rates over the next tightening cycle.

Concerns about fiscal drag also need to be tempered by the fact the government is also running a significant investment program.  Following the partial sale of Mighty River Power the Government has boosted the Future Investment Fund by $1.5 billion, taking the Fund to $2.1 billion.  This will be used to fund investment in schools, hospital, rail and irrigation.  The Government announced today that Meridian Energy will be the next asset up for partial sale, market conditions permitting.

The housing market was a key focus in the Budget.  Housing represents one of the biggest risks to New Zealand’s financial stability.  Improvements in household debt levels since 2006 have already started to turn for the worse again.  The most significant issues facing the housing market in New Zealand are supply-side in nature.  The Government announced today they will be introducing legislation to enable a streamlining of new housing developments in areas where housing is least affordable.  That’s a positive and helpful step in the right direction.

However it’s inevitable that demand management will also have to play a role.  The Minister of Finance announced today that he and the Reserve Bank Governor have signed a Memorandum of Understanding defining the operating guidelines for the use of macro-prudential tools to assist in the management of the credit cycle.  The tools are as proposed in the Reserve Banks’ recent consultation process and will be a welcome addition to their tool box.  However, it remains to be seen what impact they will have, especially given the housing cycle upturn is well advanced.  International evidence on the efficacy of such tools is, at best, mixed.  We continue to see them as complementary to the traditional demand management tool of interest rates and therefore continue to see the Reserve Bank embarking on a tightening cycle from later this year.

New Zealand is in good fiscal shape.  To be fair there are things I’d like to see the Government do differently, but they are mostly at the margin.  In general, the Government is managing a credible pathway to fiscal sustainability that looks increasingly robust.  At the same time they are managing to invest in growth enhancing infrastructure, public services and the rebuild of Canterbury. Rating agencies should be well pleased.

Tuesday, May 14, 2013

Better China data but areas of weakness remain

After being disappointed with March quarter GDP growth in China we have been anxiously waiting for April data for a read on the start to the second quarter of the year.  On balance the data makes me more comfortable with the story of a modest cyclical upturn, but there are still areas of weakness.

The release of April activity data began last week with trade and money and credit aggregates.  Credit increased Rmb 793 billion over the month with total social financing rising by Rmb 1.75 trillion.  The data shows continued healthy demand for credit with non-bank lending particularly strong.  M2 money supply is running strongly at an annual pace of 16.1% over the year, well ahead of the target growth of 13% for the year and supporting the story of an improvement in the nominal economy.

April exports and imports both exceeded expectations over the month, rising 14.7% and 16.8% respectively.  Some China-watchers are questioning the validity of the export data given other export indicators such as port put-through and PMI export orders suggest somewhat weaker growth.  Import data suggests some strength in domestic demand.  Implied commodity volume growth supports further growth in infrastructure investment.

Annual growth in industrial production rose from 8.9% in March to 9.3% in April, although the monthly change was negative.  The annual rate rose by virtue of a larger monthly negative number dropping out of the annual calculation from last year.  Nominal retail sales growth nudged higher from 12.6% in March to 12.8% in April.

The disappointment came in the growth in Fixed Asset Investment which fell to 20.1% in April, down from 20.7% in March.  The weakness was largely due to a decline in the annual rate of infrastructure investment, although the import story above supports some degree of pick-up is likely in the period ahead.

I’m still hanging onto my 8.2% GDP forecast for the year.  While the activity data is undeniably soft in some areas, the credit data in particular gives me confidence there is still some upward momentum in the economy.    However, we may now have to wait until later in the year for the improvement to show through in the GDP numbers.  A stronger US economy later this year will also assist export growth.

I don't think there is enough in this data to spur a policy response from the authorities.  Although non-food inflation printed at a benign 1.6% in April, we continue to expect inflation to trend up to around 3% this year.  That’s significant in light of the lower 3.5% inflation target for this year.  That, along with clear attempts already by the authorities to contain the recovery in the housing market seems to preclude interest rate reductions.  But neither do we expect a tightening in monetary conditions until next year.


Thursday, May 9, 2013

Closing the employment gap

This week saw the release of the broad range of quarterly New Zealand labour market indicators for the March quarter.  The good news is the recent gap between the two employment growth series closed up somewhat.  Furthermore, it closed for the right reason: we saw a solid bounce back in employment growth in the Household Labour Force Survey (HLFS), the series that we believe has been understating the health of the labour market recently.  The not so good news was that wage data came in a tad softer than expected.

The gap between employment growth in the HLFS (as the name suggests, a survey of households) and the Quarterly Employment Survey (or QES, a survey of businesses) has roughly halved this quarter.   Employment growth in the QES stands at 1.8% for the year to March whereas the annual rate in the HLFS is now +0.4%, so the HLFS still has some work to do before I’m completely happy.

On the back of the growth in HLFS employment of +1.7% over the quarter the seasonally adjusted unemployment rate fell from a revised 6.8% in December (and 7.3% in September!!) to 6.2% in March.  In a further sign of improving labour market conditions, the participation rate rose 0.6 percentage points to 67.8%.

It has been our contention that while both employment series are based on surveys, and are therefore both wrong to some extent, it was the HLFS that was probably “more wrong” than the QES recently.  That contention was supported by a range of other indicators such as wage growth, growth in unit labour costs, consumer confidence and retail spending, business confidence and hiring intentions – none of which seemed to us to be indicative of a labour market that was going backwards.

However, wage growth did disappoint somewhat over the quarter.  The Labour Cost Index for private sector salary and wage rates rose +0.3% over the quarter for an annual increase of +1.8%.  This was below market expectations of a +0.5% increase and a Reserve Bank forecast of the annual rate of +2.1%.  This series adjusts for the quality of work done which makes it more akin to a measure of unit labour costs.  So while recent wage growth has told us the labour market is probably not as weak as the HLFS has been recently painting it, neither is it hugely robust.

The unadjusted LCI (a better measure of nominal wage growth) for the private sector came in at +0.7% for the quarter and +3.3% for the year.  That’s not bad, especially when you consider the annual rate of CPI inflation over the same period was +0.9%, indicating pretty solid real wage growth which is helping underpin consumer confidence and retail spending.

Looking ahead we expect further modest gains in employment, in line with modest economic growth.  Employment gains will likely remain strongest in the construction sector (at least in the QES survey) with higher than average wage gains in that sector as well, spilling over into other sectors as momentum continues to build.   We expect wage and unit labour cost  growth to move higher as we get closed to the end of the year.  Despite the lower than expected wage increase, I’m still happy with my forecast of a first tightening in monetary conditions at the end of this year.

Monday, May 6, 2013

Solid US jobs report in April

The recent improvement in the housing market has had us thinking that economic growth in America was finally starting to find some firmer foundations (the pun was unintentional).  We’ve been a bit more cautious about the labour market, especially in light of the fiscal drag headwind to growth and jobs this year.  However, the April employment data was decidedly “solid”.    That keeps us confident of more sustainable, though still modest, growth in America this year.

April payrolls beat market expectations rising 165k in the month.  On top of that we saw a continuation of the trend of significant upward revisions to prior month results with a total of 114k jobs added to the February (from +268k to +332k) and March from +88k to +138k) results.  The participation rate was steady at a 34 year low of 63.3% and the unemployment rate dropped to 7.5% in April from 7.6% in March.

The private sector remains the key driver of jobs growth.  That’s to be expected in an environment of fiscal consolidation.  But while the Government sector lost 11k jobs over the month, that’s really no better or worse than the trend of recent months.  Private sector payrolls have expanded an average 212k per month over the last three months.  Not spectacular, but definitely solid and in line with our expectations of around 2% GDP growth in America this year.  The only real disappointment recently has been the flat performance in manufacturing jobs over the last two months.

Growth in hourly earnings blipped up to 1.9% in April; again not spectacular but definitely solid.  That will underpin further modest gains in consumption expenditure in the period ahead and offset concerns about a consumer slowdown on the back of higher taxes.

Last week the Federal Reserve alluded to the fact that they had the option of both increasing and reducing their asset purchase program.  That’s a nod to recent weak activity data, especially the weaker than expected first print of +88k jobs growth in March (which is now +138k).  From our perspective the June quarter was always going to the weakest part of 2013.  However, the April jobs report, along with the improvement in the housing market, gives us confidence the underlying fundamentals are continuing to improve.

Friday, May 3, 2013

The ECB and the Fed

This morning the European Central Bank acted on the recent run of weaker data and lower inflation by cutting the main refinancing rate by 25bps to 0.5%.  ECB President Mario Draghi said the bank remained “ready to act if needed”, which he suggested could mean negative interest rates whereby banks would be charged for depositing money at the ECB.
Economic conditions remain dire in the euro zone.  Unemployment reached 12.1% in March and the inflation rate has recently fallen to 1.2%.  I’m not convinced however that today’s action from the ECB will do much to help, other than send a message that they are worried. 
At risk of sounding like a worn record the best course of action right now is to take advantage of relative financial calm to relax deficit reduction targets.  I agree with the ECB’s comments today that Governments should not “unravel” progress on deficit reduction, but I think they should take a more pragmatic approach to further deficit reduction.  I’d also like to see the ECB target still difficult financing conditions, especially in the SME sector, by implementing a UK style funding for lending program.  If the Bank is going to do something, they might as well do something that’s going to make a difference.
Such measures would allow scope for further structural reforms in individual countries aimed at improving competitiveness.  At the same time authorities should continue reverse engineering the gaps in the original construction of the Euro by establishing a banking union, at least as the first step.  As it stands monetary policy is being required to do too much of the work and compensate for lack of structural reform and harsh front-loaded austerity.  That’s still not the first-best plan. 
In a similar vein the US Federal Reserve is working hard to try to offset the growth-dampening effect of fiscal drag that will be around 2 percentage points this year.  A comprehensive and credible medium-term plan would have spread that out a bit. Yep, it’s that same worn record.
I’m not overly concerned about the recent run of softer data in America.  The end of 2012 and first half of 2013 was always going to be a difficult period in which to read too much into the data.  The end of 2012 was weak as firms and households delayed activity on the back of fiscal cliff concerns. We saw the catch-up activity in early 2013 and now further into the year we are seeing the toll that fiscal drag is taking on the economy.  We always expected the June quarter to be the weakest patch of the year. 
The bright bit of news is recent labour market data such as initial jobless claims which is holding onto recent gains.  We will see if that translates into jobs growth with April payrolls data scheduled for release tonight.
The Fed is obviously watching closely as in this week’s statement they signalled that they are ready to reduce or increase their asset purchase program.  I think growth picks up in America later this year as the housing market continues to improve and as the impact of fiscal drag wanes.  That means the next likely move by the Fed is a reduction in asset purchases, but that’s a late 2013 story at the earliest.