Monday, June 30, 2014

The labour market will be key to helping the Fed navigate the noise

It’s been very “noisy” in America lately.  The recent move higher in US inflation has largely been dismissed as “noise”.  Likewise the March quarter GDP contraction can be attributed to a confluence of one-off negative factors that belies the underlying trend improvement in the economy.  How’s the Fed to navigate its way through the noise?  Why, by focussing on the labour market of course.

Market participants are currently trying to ascertain the messages, particularly for monetary policy, of recent data showing that in the March quarter the US economy contracted at its fastest quarterly pace since the GFC recession, while at the same time most measures of inflation have nudged higher.

We buy the story that the March quarter growth number was an aberration (see post below).  That said annual average growth now seems likely to come in under 2% this year.  That lower growth has direct implication for the size of the output gap and the length of time it will take for pressure to emerge on resources and for generalised inflationary pressures to emerge.

At the same time data shows the annual rate of headline CPI inflation reached 2.1% in May.  The core index (excluding food and energy) rose 0.3% in the month to take the annual rate to 1.9%.  Sharply higher airfares was quoted by most analysts as the reason for the higher-than-expected increase in core inflation over the month and hence the comment that the number could be attributed to “one-offs” and “noise”.  That sentiment was given “Fed-cred” with Janet Yellen commenting in the post-FOMC press conference that “the data we are seeing is noisy” followed by “broadly speaking, inflation is evolving in line with the Committee’s expectations”.

It seems risky to dismiss the move higher completely, especially with a broad range of inflation measures now pointing higher.  Along with the core CPI the core Personal Consumption Expenditure (PCE) deflator, the Feds preferred inflation measure, is also heading higher, albeit from a lower base.  More telling is that key trend measures such as the annual rates of median and trimmed mean inflation are also heading higher.

The FOMCs comments about noise indicate they are not seeing anything in recent data to suggest a rise in generalised inflationary pressures.  I’ve long pointed to the labour market and, more precisely, unit labour costs as the key indicator to watch in that regard.

Future wage growth will be determined by the degree of excess capacity in the labour market. The conventional wisdom is there is plenty of it.  While the official measure of unemployment (U3) has fallen more rapidly than expected, at 6.3% it remains elevated by historical standards.

A broader measure of underemployment in the economy (U6) which includes people “marginally attached” to the labour market and those who work part-time “for economic reasons” also remains elevated at 12.2%.  Furthermore, the gap between the two (U6-U3) which averages 4.6 percentage points over the last 20 years, currently stands at 5.9 percentage points.

But you could also point to the recent drop in the unemployment rate of those who have been unemployed for just a short period of time (less than 27 weeks) to 4.1% as indicative of a declining pool of people whose skills are (arguably) the most relevant in the new post-GFC US economy and thus a labour market that is tighter than the other indicators suggest.

It seems to me there is certainly slack in the labour market, but the amount of slack is moot.  While there is uncertainty, the Fed will rely on labour market price signals (wages) to determine the spare capacity in the labour market.  While some measures of wage growth are heading higher, it’s the interaction with productivity and the resultant impact on unit labour costs (ULCs) that will determine the inflationary consequences. 

ULCs are highly volatile, but once (heavily!) smoothed display a nice fit with core inflation.  However, the Fed will not want to wait for ULCs to be heading higher before starting to remove the extraordinary levels of monetary accommodation.  Judgement will still play a critical role.

On balance it seems to me the Fed will still be pretty relaxed about both the growth and inflation outlook for a little while yet.  Risks arouind the consensus view that the Fed will be able to hold off until mid-next year still appear to me to be evenly balanced.

But we are still of the view that the next problem for the US economy and for markets to navigate is inflation. As it inevitably heads higher clear and unambiguous communications from the Fed will become even more critical.  That’s especially if they are prepared to wear higher inflation while the other part of their dual mandate, full employment, needs more time.

Thursday, June 26, 2014

Disappointing US GDP revision

March quarter US GDP was revised down to an annualised -2.9%, significantly lower than the market expectation of -1.8%.  While the factors behind the downward revision were well known (healthcare spending, net exports) and most of the growth-detracting factors in the quarter can be attributed to one-offs (weather, lower inventory investment) the scale of the revision was nevertheless disappointing.

Markets took the news in its stride as most partial activity data has rebounded since.  Indeed the Leading Economic Index has resumed its upward trend following a brief wobble.  That’s indicative of a strengthening in underlying growth.

That said it’s not all good news all the time.  Trade remains an underperformer and the high frequency monthly data still throws up the accessional disappointment:  May durable goods orders were also released overnight and were weaker than expected falling -1.0% m/m, although core non-defence capital goods orders rose +0.7%.

I’ve got an annualised +3.8% pencilled in for June quarter GDP growth.  That will now combine with the March quarter to produce only 1% growth for the first half of the year.  And with expected growth of around 3.2% in the second half of the year, my annual average growth forecast for calendar 2014 is now 1.8%.  That’s about the same as last year although the flat profile for the numbers belies the improvement in the underlying growth trend. 

Tuesday, June 24, 2014

June "flash" PMIs

“Flash” estimates of manufacturing PMIs for June paint a picture of stabilization in China and Japan, a strong second quarter recovery in growth in the US following the weak first quarter and a Eurozone economy that appears to be losing momentum.

The US index climbed to 57.5 in June, up from the 56.4 recorded in May.  This is consistent with other activity data suggesting the economy is bouncing back strong from the growth contraction in the first quarter (which appears likely to be revised down again later this week to an annualised -2.0% on the back of weaker trade and services data).  Of the major economies, the US continues to have the strongest growth momentum.

Then China index rose to 50.8, a seven-month high.  Improvement in the sub-indices was broad-based.  In particular the new-orders sub-index rose to 51.8 (from 50.0) with the new export orders index rising a smaller amount.  That tells us the improvement is coming through on the domestic side of the economy reflecting increased infrastructure spending and other policy tweaks to support domestic demand.  I still think Q2 GDP slips further to around 7.2% but fears of a dip below 7.0% appear increasingly overdone.

In Japan the index continued the recovery from the post-tax hike decline.  The index rose from 49.9 in May to 51.1 in June.  The critical question here is how the economy tracks in the second half of the year after the widely expected contraction in the second quarter.  While this latest index tells us to expect a return to growth, at this point I think that growth will be modest at best.

The concern is again the Eurozone.  The manufacturing index dipped lower from 52.2 in May to 51.9 in June while the more widely watched composite index (manufacturing and services) fell from 53.5 to 52.8.  That suggests caution is required before expecting any meaningful pickup in growth from the current low trajectory.  That said there remain strong divergences in performance across the region.  The strongest growth momentum is coming from the periphery while France continues to cause most concern.

Friday, June 20, 2014

Economic growth in New Zealand

This week’s GDP release confirmed the New Zealand economy entered 2014 growing strongly largely thanks to the three C’s of confidence, construction and commodity prices.  March GDP growth came in at 1.0%, a touch under our forecast of 1.1%.  Thanks to positive revisions to prior quarters, year-on-year and annual growth came in stronger than expected at 3.8% and 3.3% respectively. That’s the fastest annual average growth since late 2007.
There were no real surprises in the result – construction was the start performer rising 12.5%.  But this followed a couple of flat quarters so much of this was due to timing/catch-up.  Growth elsewhere was more modest but generally broad-based.  A couple of sectors went backwards over the quarter.   The decline in wholesale trade followed a strong prior quarter so we put that down to data volatility.  The decline in business services was more meaningful and consistent with recent softer housing (real estate) data.

We are now well into the June quarter and the pace of growth appears to be moderating somewhat.  While business and consumer confidence remain at healthy levels they are off their recent highs.  Recent housing market data has been a touch softer than expected, although we put at least some of that down to the way Easter and ANZAC fell in April with many folk taking an extended break over the two long weekends.  Retail spending growth has also lost some momentum recently.

Dairy commodity prices have fallen faster than we thought they would and Fonterra’s opening milk price forecast for 2014/15 is commensurately lower.  The May BNZ-BusinessNZ manufacturing PMI for May showed another decline although the index remains in expansion territory.  And of course the Reserve Bank of New Zealand has begun the process of withdrawing the significant monetary stimulus in the economy and is expected to continue to do so.

There are a couple of recent developments that are positive for the growth story.  Despite the Reserve Bank raising interest rates, fixed rate mortgages have actually fallen recently on the back of lower global interest rates.  And of course net inward migration has continued to climb.  The construction sector will continue to underpin growth in the period ahead, although not at the pace seen in the March quarter.

While the pace of growth is expected to moderate from the June quarter of this year it will remain solid and, importantly, in excess of our potential to grow without generating inflation.  That means pressure on resources, upward pressure on inflation and further tightening in monetary conditions.

For more information on the outlook for the New Zealand economy, equities, fixed interest and the NZD, have a look at our latest issue of New Zealand Insights which you can find here.

Monday, June 16, 2014

Further signs of stabilisation in China – but keep an eye on property

May activity data continued the story evident in the April data of the beginnings of stabilisation in growth.  Exports, industrial production, infrastructure investment, lending and money supply growth are all supportive of that story.  However, property activity continues to slow and remains a real risk to the outlook.

Export growth accelerated to 7.0% in May, or about where we thought underlying growth has been recently absent the invoicing issues from last year.  Import growth slowed to -1.6% but we are not reading too much into that at this point.  Growth in industrial production moved a touch higher from 8.7% in April to 8.8% in May. 

Retail sales data was mixed with nominal sales growth ticking higher while real sales softened a touch from 10.9% yoy in April to 10.7% in May.  Year-to-date fixed asset investment inched lower from 17.3% in April to 17.2% in May.  That reflects strength in infrastructure spending offset by continued declines in growth of manufacturing and property investment.

Our China forecasts for this year incorporated expectations of rising export growth on the back of the improving growth outlook in America and Europe, declining fixed asset investment predominantly due to manufacturing overcapacity and a flat profile for retail spending. 

Two things have changed – the overall weaker than expected growth at the start of the year, which we expect will result in a further decline in growth in the year to June, and the weakness in the property market.  While we are generally happy with how the data is panning out now, the soft property market represents a clear risk to the downside.

The Government has introduced small and targeted easing measures over the last few months, the latest of which was a cut to the required reserve ratio for financial institutions with significant exposures to agricultures and SMEs.  These moves are best described as “fine tuning”.  We expect the Government will continue with that approach unless Q2 GDP looks like it might breach 7.0% (our forecast is 7.2%).  Although inflation ticked higher in May, the inflation outlook is no barrier to further easing.

We cannot be fully confident of stabilisation in the overall growth outlook until we see some stabilisation in the property market.  The Government has some options at its disposal that will help including speeding up the hukou (household registration) reforms and removing home purchase restrictions.  The key risk is a policy mistake – that is the Government doesn’t move fast enough to prevent a more entrenched and damaging downward trend.  Right here right now we give that a low (but higher than zero) probability.

Thursday, June 12, 2014

RBNZ hikes a third time - more to come

The Reserve Bank of New Zealand (RBNZ) raised the Official Cash Rate 0.25% to 3.25% today, the third consecutive hike.  Most of the interest prior to this statement was the extent to which the RBNZ would lower its projected interest rate track in light of recent falls in dairy prices and the continued higher-than-desirable level of the currency.  In the end the interest rate track was largely unchanged – which is in our view the correct course of action.

That means today’s Monetary Policy Statement (MPS) was more hawkish than market expectations.  Market reaction therefore has been to take interest rates and the New Zealand dollar higher.

The reality is there have been both positive and negative developments in the economy since the March MPS.  Dairy prices are lower, the New Zealand dollar has been a touch lower but remains unsustainably high, recent housing market data has been softer-than-expected (which we put down to the way Easter and Anzac day fell this year), fixed mortgage rates have declined, and net inward migration has continued to rise.  On balance that still leads to a picture of an economy that is still growing considerably faster than potential and in which spare capacity is being absorbed.  That means “Inflationary pressures are expected to increase”.

The RBNZ’s real economy forecasts are broadly similar to our own.  That means they have revised up their growth forecast for the year to March 2014 (reflecting a higher March quarter forecast of 1.1% q/q), but lowered their year to March 2015 forecast.   Inflation is expected to gradually head higher towards 2%.

The RBNZ appears to be forecasting another two rate hikes this year, in line with our forecast of 25bp hikes in both September and December.  At this point, especially given the tone of today’s MPS, I won’t completely dismiss the possibility of a further hike in July (or possibly instead of the September hike).  But at the moment we are happy with our forecast of an OCR of 3.75% by the end of this year and an eventual peak of 5.25%.

The only interesting change of wording in the Statement was the sentence “The speed and extent to which the OCR will need to rise will depend on future economic and financial data, and its implications for inflationary pressures.”  Rather than “financial data” the RBNZ had previously referred to the exchange rate.  That does not signal any diminution of the importance of the exchange rate going forward.  That, and whole range of other known unknowns, and no doubt along with a few unknown unknowns, will ultimately determine the phasing and extent of the hiking cycle.

What that wording does signal is a new concern for the RBNZ: the recent decline in fixed mortgage rates which risks (re)stoking the housing market.   That reflects the current and likely ongoing challenge for the RBNZ in desiring higher interest rates and lower exchange rate.


Monday, June 9, 2014

Broad-based gains in US jobs - keep watching wages

The 217k broad-based increase in US jobs growth in May supports the story of solid GDP growth in the period ahead.  The three-month average jobs gain is running at +234k while the unemployment rate remained stable at 6.3%, suggesting the sharp fall in April wasn’t an aberration.

The combination of strong growth in hours worked (three-month annualised growth of +4.2%) and wage growth (private sector average hourly earnings +2.4% in the year to May) indicates strong income growth which in turn supports our contention of strong growth in personal consumption of around an annualised 3% over the next few quarters.  Recall personal consumption growth was the star in the generally disappointing March quarter GDP data, supported in part by higher spending on utilities as a result of the poor weather.   Underlying growth was probably closer to 2.5%, but based on this data we expect momentum to pick up as the year progresses.

We continue to believe that wage growth, productivity and ultimately unit labour costs hold the key to the timing of interest rate increases in the US.  Wage growth is still low but is clearly trending higher.   Productivity and unit labour costs have been volatile lately; in the March quarter productivity slumped and unit labour costs surged as poor weather saw a decline in output while firms held onto labour reflecting the likely short-term nature of the disruption.  That will likely reverse in the June quarter.
We expect the labour market will continue to tighten and wage growth to continue to trend higher.  That will ultimately lead to higher unit labour costs and higher inflation – it’s just a question of when.  At this point we remain of the view that the Fed will be able to get to mid next year before contemplating raising interest rates.

Friday, June 6, 2014

The ECB delivers

The only surprise in the decision by the European Central Bank (ECB) to ease monetary conditions further today was they did everything they could (at least at this point in time).  That included interest rate cuts, a 400 billion injection of liquidity via a targeted long-term refinancing operation (TLTRO) and ending the sterilisation of the central bank’s earlier purchase of government debt.

The interest rate reductions have taken the ECB into uncharted territory.  Along with a cut to the in the refinance rate to 0.15% the Governing Council also lowered the deposit rate to -0.1%.  A negative deposit rate means banks will now pay the ECB to hold deposits at the central bank rather than receive interest.  ECB President Mario Draghi intimated this is probably it for interest rate reduction by stating “For all practical purposes, we have reached the lower bound”.

As you know we have been less than optimistic about the ability of lower interest rates to make much difference in the Euro zone.  That makes the other measures more interesting.  Of those the TLTRO seems to have the best chance of making a difference.  We know from earlier comments that Draghi found the Bank of England’s Funding for Lending program  somewhat compelling, so it is no big surprise to see a similar program from the ECB to encourage banks to increase lending to the private sector.  There is a difference between the two however: the ECB program excludes household mortgages.

Of course higher credit growth requires both a lender and a borrower.  While credit availability will now be improved, there needs to be sufficient willingness from the private sector to borrow and invest.  That remains to be seen and will ultimately determine the success or otherwise of the program.

It is also not altogether clear whether banks will be able to invest in sovereign debt although Draghi stated in his Q&A session that the ECB was “determined that the TLTRO money is not spent on sovereigns”.

The ECB has also decided to end the sterilisation of their earlier purchases of government debt under the Securities Markets Program which began in 2010.  The decision to end sterilisation makes it a "delayed” quantitative easing program.

More important than the small size of the program is the fact that all of today's measures were endorsed unanimously by the Governing Council, which includes the Bundesbank.  That seems to open the door a little wider to full scale quantitative easing should it be required further down the track.  It always seemed to me the support (or lack thereof) from the Bundesbank would be a major hurdle for QE.

Finally, the Governing Council has undertaken to progress the work required in preparation for outright purchases of asset backed securities.  This is a clear signal to the market the ECB is prepped to do more should it be required.

So will any of this make a difference?  The fundamental problem in the euro zone is economic growth is insufficiently robust to make any serious dent in the significant degree of spare capacity that exists across the euro area.  Today's measures are a step in the right direction in avoiding outright deflation, but seem unlikely to change the outlook from one of subpar growth and below target inflation into the foreseeable future.  A more comprehensive quantitative esaing program remains more than likely.  But there is, after all, only so much monetary policy can do.