Friday, July 31, 2015

US GDP - revisions imply lower productivity growth

US real GDP bounced back to a solid +2.3% annual pace in the second quarter of the year, proving that March quarter weakness was largely temporary.    The best part of the result was the +2.9% increase in consumer spending but private sector investment was less exuberant at +0.8%.

This release was also interesting in that it incorporated annual benchmark revisions back to 2012.  Of particular note was the upward revision in March quarter growth from an annualised -0.2% to +0.6%.  However on average the revisions knocked 0.2% off annual growth over the period of the revisions.

With respect to the comments I made yesterday about underwhelming productivity, these GDP revisions make the mystery a bit deeper by lowering implied productivity growth.  Any immediate concerns about that for the Fed will be ameliorated by the still subdued annual 1.3% increase in the core personal consumption expenditure deflator, but it does reinforce that the time for the Fed to start the interest rate normalisation process is nigh.

Thursday, July 30, 2015

The Fed: How much is "some"?

There were only minor tweaks to the FOMC statement this morning when compared to the June statement.  In short the Fed expects to be starting to raise interest rates after it has seen “some further improvement in the labor market”.  Anything less than that would have been inconsistent with Fed Chair Janet Yellen's recent Humphrey-Hawkins testimony to Congress and any number of recent comments from other FOMC members.

The only question now is exactly what “some further improvement” looks like.  Comments earlier in the statement about “recent solid job gains and declining unemployment” and “underutilization of labor resources has diminished since early this year” provide helpful guidance.  It seems a continuation of monthly payrolls gains of over 200k per month and a continued drift lower in the unemployment rate may well be sufficient for interest rate normalisation to begin.  Of course upcoming prints on employment costs and GDP will also add colour to future deliberations.

It might seem a tad trivial that after having prognosticated on interest rate normalisation for so long that all that matters now is the next couple of payroll numbers – but that would belie the significant improvement in the US labour market over the last seven years. 

It’s important not to forget the ongoing uncertainties.  Why has labour productivity growth underwhelmed since the great recession?  How much of the decline in the participation rate is structural and how much is cyclical?  What are the levels of potential growth, the natural unemployment rate and the neutral interest rate? 

We (including the FOMC) won’t know the answers to those questions for some time.  Even Janet Yellen in a recent speech admitted she didn’t know why recent productivity growth was so low.  But not knowing the answers to these questions shouldn’t delay the start of the normalisation process, indeed we will soon be at the point where the risk of tightening too early is being overtaken by the risk of going too late.  

So barring a significant downward data surprise, we expect “lift-off” in September and a very gradual pace of rate hikes thereafter.

Thursday, July 23, 2015

RBNZ reduces the OCR to 3.0%, further cuts likely

As was widely expected the RBNZ cut the Official Cash Rate 25 basis points to 3.0% this morning, its second consecutive cut.  In a well-balanced statement, the RBNZ signaled that some further easing was likely.

The RBNZ acknowledged the recent softening in the economic outlook.   At this point that seems consistent with our view of growth dropping down to a 2.5% pace rather than the earlier expectation of 3.0%.  It’s important to note however that they won’t do a full forecasting round until the lead-up to the September Monetary Policy Statement.

On inflation they expect the CPI to be close to the midpoint of the target band by early 2016 – again consistent with our own forecasts.  We have headline CPI inflation at 1.9% in the year to June 2016.  Much depends though on the speed of the pass-through of the recent decline in the exchange rate into the CPI which will be dependent on the strength of underlying demand, competitive pricing pressures, margins and profitability.

On the exchange rate they acknowledged the significant decline since April and the contribution this has made to the recent easing in monetary conditions.  The RBNZ has dropped the recently oft-used line about the level of the exchange rate being unjustified and unsustainable, although they state that further depreciation is necessary given the weakness in export commodity prices.

All things considered this was a well-balanced statement acknowledging the recent deterioration in the growth outlook and the appropriate need for easier monetary conditions.  We expect the RBNZ will lower the OCR further with 25bp cuts in September and October, but the need for more aggressive action is reduced by the recent meaningful adjustment in the exchange rate.

Thursday, July 16, 2015

Quarterly Strategic Outlook - July 2015

Today we released the July issue of Quarterly Strategic Outlook.  The commentary below is the Executive Summary.  To view the full publication click here.

Investors were rewarded for diversity in the June quarter. Among the more defensive assets, domestic cash and bonds produced positive returns for the quarter.  In contrast, global bond returns were negative as Eurozone deflation risk was priced out of the market and the US Federal Reserve (the Fed) reaffirmed it is still on course to raise rates this year. An earlier than expected rate cut from the Reserve Bank of New Zealand (RBNZ) meant domestic bond yields didn’t follow offshore yields higher.

Returns were also negative in the main equity asset classes with Greece concerns and higher bond yields playing a key role in a number of markets. New Zealand shares have come under pressure on various fronts recently. GDP growth has slowed and earnings growth has hit the pause button. It also appears the weak New Zealand dollar (NZD) is leading some foreign investors to sell local shares to limit currency losses.

A shift to a neutral stance from the Reserve Bank of Australia (RBA) and a surge in long term bond yields, weighed heavily on the Australian share market over the quarter, particularly the high dividend paying financial sector.  In contrast, solid returns from China, Brazil and Russia held up emerging market shares over the quarter.

Among real assets, property and infrastructure returns were also under pressure from rising bond yields.  However, commodity prices recovered some of their recent losses as oil and global agriculture prices rallied on declining inventories. The rate cut from the RBNZ together with further weakness in dairy prices and softer GDP growth contributed to a 10% decline in the NZD over the quarter, lifting returns on unhedged offshore assets. 

Growth in economic activity has underwhelmed in the first half of the year, a theme we have become well used to since the Great Recession.  The weakness was all the more relevant because it centred on the world’s two largest economies: the United States and China.  But it hasn’t all been bad news with the Eurozone looking stronger as the year has progressed, despite the ongoing debt saga in Greece.

We are expecting a stronger second half of the year, led predominantly by the US as it recovers from the disruptions from the start of the year, along with further improvement in Europe.  At the same time, we are seeing early signs of macroeconomic stabilisation in China with the recent decline in its share market representing a necessary correction rather than signalling any new signs of weakness in the economy. 

We have lowered our New Zealand GDP forecasts on the back of further declines in dairy prices and a softening in business confidence.  This will allow further reductions in the Official Cash Rate.
As we move into the second half of the year, the key focus will be on the Fed and the next steps towards monetary policy normalisation, the broader global ramifications of higher US interest rates, economic and financial stability in China, and Greece.

With the situation with Greece changing on a daily basis, it is easy to get caught up in the ongoing drama and lose sight of the fundamentals. Valuations are the key determinant of asset returns over the medium term and our view is bonds are still expensive, developed market and New Zealand shares are fully valued, whereas commodities and emerging markets remain inexpensive relative to longer term trends. We also think the NZD is close to fair value at current levels.

Over a shorter term horizon, asset returns are more influenced by macro fundamentals such as global growth. Given our central view that growth will pick up over the coming year, we expect bond yields and equities to also rise but there will likely be some setbacks along the way. Finally, we think the NZD/USD ‘correction’ is over, and any further falls against the US dollar (USD) would take it into currency ‘overshoot’ territory.

Tuesday, July 7, 2015

Revising the outlook for NZ growth and monetary policy

Recent weak data on dairy prices, business investment and business confidence has seen us shave a bit move off our GDP forecasts for New Zealand. 

March quarter GDP growth disappointed as the summer drought and lower oil exploration took a greater toll on the economy than we expected.  On the expenditure side of the accounts investment spending disappointed most of all.  Investment data can be volatile but the decline appears consistent with the recent decline in business confidence, as signaled by today’s release of the NZIER’s Quarterly Survey of Business Opinion (QSBO), so it’s hard to dismiss as just volatility.  Lower business investment clearly also has implications for future growth.

In light of the continued weakness in dairy prices and lower confidence levels we have shaved a bit more off our GDP forecasts for this year and next.  We had already assumed a moderation in quarterly growth rates from the middle of this year as both the Canterbury rebuild and net migration peak – we have simply accelerated the pace of slowdown. 
Our previous forecasts had annual average growth at around 3.0% in 2015 and 2016, but this now looks like being closer to 2.5% in both years before a further dip down to 2.0% in 2017. 

These forecasts are not as pessimistic as some in the market as we put some weight on some positive offsetting factors.  As residential construction activity slows in Christchurch, we expect it will be picking up in Auckland and while dairy prices continue to slide, prices of some other commodities are doing well.  The exchange rate is also significantly lower with the Trade Weighted Exchange Rate Index (TWI) now 15% below the recent peak in April.

So what does this mean for monetary policy?  While we had acknowledged the chance of lower interest rates this year we didn’t expect the Reserve Bank of New Zealand to cut the OCR in June.  Developments since that time have vindicated the Bank’s move.  When they cut in June they signaled a further cut was likely which we know expect to be delivered at the July OCR review.  A further cut in September is now likely.

From there it gets a bit harder.  While the outlook for growth is deteriorating we expect inflation to be rising over the remainder of this year and into next. That’s a function of rising petrol prices (which the Bank will look through) the decline in the exchange rate (which the Bank may look through), but also whether pricing intentions and prices will remain low in the face of higher capacity utilisation and the lower currency.  Margins can only be squeezed so much.  We think capacity pressures will remain elevated even as growth slows as we believe potential growth will be slowing also.  Finally, we believe global inflation will be rising next year.

So the key message for today is the RBNZ was right to cut in June, more is coming (we think two more 25bp cuts), but caution is warranted about expecting too much.  

Monday, July 6, 2015

Another Greece update....

The “No” vote in the Greek referendum this morning has moved Greece a step closer to exiting the Euro zone.  The immediate issue now is the willingness of the various parties to resume talks. 

The Greek Prime Minister has, not surprisingly, already announced his willingness to resume negotiations.  But he will need willingness to resume discussions on the part of the institutions and Europe’s political leaders for any progress to be made.  In that regard the upcoming meeting between German Chancellor Angela Merkel and French President Francois Hollande will be critical as will the EU summit that has been scheduled for Tuesday. 

The next critical date is July 20 when Greece is scheduled to make a €3.5 billion payment to the European Central Bank.   In the meantime expect more Greece-related market volatility and no rush on the part of European leaders to find a resolution too far ahead of that date.  As I said last week Greece is already getting a taste of life outside the Euro zone which will put public pressure on its own Government to find a way-forward while remaining in the common currency.

Predicting the outcome from here is challenging because it’s largely about politics.  Politics made the early part of the crisis easy to predict: bail Greece (and others) out or precipitate the failure of the Euro project.  But politics has also meant the elephant in the room - Greece’s elephant-sized public debt - hasn’t been able to be dealt with.  No European leader has yet been prepared to tell their tax-payers they are going to wear the cost of a Greek debt write-off, let alone deal with the moral hazard implications for Portugal, Ireland, Spain and Italy.

Debt relief, at least without significant concessions from Athens, is still a step too far.  However, post-referendum, Mr Tsipras thinks debt restructuring is on the table and his negotiating power is enhanced.  I think that's optimistic.

So the odds of a Greek exit from the Euro-zone just went up.  But, while the strength of my conviction has diminished over the last couple of weeks, I still think exit will be avoided.  But that view continues to rely on the point that no-one wins if Greece does exit – and the biggest loser will be Greece itself.

Last week we published an Insight Paper “Greek Turmoil and the Potential Implications for Investors”.  The section on implications for investors remains valid.  You can find that paper here.