Tuesday, November 17, 2015

Growth and monetary policy in Japan and the Eurozone

Third quarter growth was weaker than expected in both Japan and the Eurozone.  Further monetary easing appears inevitable in both cases.  This will, in turn, have implications for the extent to which the Fed can take its foot of the monetary policy accelerator.

Eurozone GDP expanded 0.3% in the third quarter of 2015, below the consensus expectation of +0.4%.  Annual growth came in at +1.6%, up from +1.5% in the second quarter.  France and Germany both posted growth of +0.3% over the quarter with Italy disappointing at +0.2%.  Spain continues to expand more rapidly with a +0.8% increase over the quarter, though off a lower base.

Breakdowns of growth into its core demand components are not yet available but partial data for the quarter suggest the detail will show reasonably solid consumption growth offset by weakness in capital spending and net exports.

We see little scope for growth to accelerate from the current 1.6% annual pace in the near-term.  As we’ve said all year, the likely pace of growth is unlikely to prove sufficiently fast to put any sustained upward pressure on inflation.  While core Eurozone inflation is off its lows, it remains stuck at around 1.0%, well shy of the ECB’s 2.0% target.

ECB President Mario Draghi recently stated that “signs of a sustained turnaround in core inflation have somewhat weakened” and that the bank’s monetary policy stance will be re-evaluated at its December meeting.  That along with the downside risks to growth in the Eurozone key trading partners seems to make further easing a done deal.

Turning to Japan, the economy entered its second (technical) recession in 18 months.  The first came in the aftermath of the consumption tax increase last year, making this more recent downturn more worrying in that it highlights the fundamental weakness of the economy. 

GDP contracted at an annualised rate of -0.8% in the September quarter, well below the market consensus of -0.2%.  The biggest disappointment was the drop in capital spending which contracted at an annual rate of 5.0% over the quarter.  Strong capital spending growth observed in the in the first quarter of the year has now been completely unwound.  That’s inconsistent with recently upbeat capital spending intentions from various business surveys with concerns about the domestic economy and more recently China resulting in those intentions being delayed.

Consumer spending was solid at an annualised pace of +2.1% and net exports were positive, the first positive contribution in three quarters.  Weaker inventories was the major downside surprise, although that provides some scope for a recovery in production further down the track.

Looking ahead we think capital spending will remain soft and exports appear likely to slow.  Furthermore the positive impact from the last supplementary budget is now beginning to fade.  That leaves consumer spending as the determining factor of the pace of growth from here.  So it seems inevitable here too that the central bank will be forced to step up its monetary easing.

One of our “Themes for 2015” was the emergence of divergent monetary policy settings amongst the G4, with the US and the UK the first to tighten with more easing likely in the Euro zone and Japan.  While expectations of UK tightening are now pushed out well into 2016, our base case is the Fed hikes in December.  That means we can stop fretting about the timing of lift-off and start worrying about what really matters – the pace and extent of the tightening – which we expect to be gradual.  One of the key limiting factors on US interest rate increases will be the strong likelihood of further easing in Europe and Japan and upside implications for the USD.