Wednesday, August 26, 2015

Is it really that bad in the emerging economies?

A significant correction is underway in global equity markets with concerns about emerging market growth, in particular China, at its epicentre.  We think emerging economy growth fears are overdone and that this correction will eventually sow the seeds of a recovery, but the correction may have further to run in the near term.

The prevailing wisdom in emerging economies has been dominated by positive demographics, absorption of new technologies, fast rising productivity growth and the burgeoning growth of the middle classes would lead to transformational growth.  Today concerns reflect a confluence of cyclical headwinds, renewed concern about structural impediments to growth and higher leverage given impending US Federal Reserve rate hikes.  All are taking their toll on emerging market sentiment and asset prices.

The latest bout of weakness can be sheeted home to the recent devaluation in the Chinese Yuan (CNY).  We see this as a pragmatic move that was not about competitiveness and gaining export market share – China has been hugely successful at building market share even with a rising exchange rate.  The CNY devaluation was mostly about the desire for a more market determined exchange rate given aspirations of inclusion in the IMF’s basket of foreign reserve currencies.

We are not in the China hard-landing camp.  China is going through a challenging transformation as growth slows from unsustainably high levels, the economy rebalances from investment to consumption and its financial markets are liberalised.  This will inevitably lead to the occasional wobble, but long term we remain of the view that a slower China is a more sustainable China.

With respect to the emerging economies more generally, the once optimistic outlook has now seemingly been replaced with the overly pessimistic.  The headlines are now screaming about the need for structural reform in the emerging world.  This is not a new story, Regular readers know that since the GFC we have written about the need for transformational structural change in emerging economies to realise the opportunity presented by such positive factors as fast growing working-age populations. 

Neither is structural reform a story that is exclusive to the emerging economies.  Structural reform is needed everywhere.  You say Brazil and Russia, we say Italy and Japan.   In reality it is some of the emerging economies that are embracing reform better than many developed economies.  We put India, Mexico and even China into that bucket.

Overall we remain optimistic on emerging market growth and in particular their ability, on average, to outpace the growth of developed economies.  The reasons are the same as they were before – positive demographics, technology enhancing productivity growth and growing middle classes.  But structural reform is needed if those opportunities are to be realised.



Right now comparisons are again being made to the 1997/98 fallout in emerging markets.  As we said at the time of the taper tantrums in 2013 – this is not a repeat of that period.  Notwithstanding their own idiosyncrasies, we believe most emerging economies are generally in better shape now than they have been during previous episodes of rising US interest rates. 

It’s the reform agenda embraced by many emerging economies following the Asian Financial Crisis that we expect will see many of them come through the next round of higher US interest rates better than they have before.  Those reforms include more flexible exchange rate regimes, lower levels of external debt, higher levels of foreign reserves and better capitalized banking sectors.

In the immediate term US dollar sensitivity is being cited as the major negative for emerging markets.   EM currencies have been falling, most notably against a rising USD, but also on a real effective exchange rate basis. Ultimately a weaker currency will improve competitiveness and profitability of the tradeables sector.

What may be needed to end the negative feedback feeding through global currency and share markets at the moment though is a policy easing. This came in 1998 with the US Federal Reserve easing monetary policy. We can’t rely on that this time.  But it will take a decisive easing of liquidity/financial conditions for the risk premium to be priced back out and as we have seen over the past few years, when the flows come back they come fast.


The circuit breaker policy easing this time around ideally needs to come from China and it started last night with cuts to interest rates and the required reserve ratio.  Keep an eye out for more. 

Monday, August 17, 2015

GDP growth underwhelms in Japan and the Euro zone

I’ve warned all year about not getting too carried away with heightened expectation of growth in the Euro zone and Japan.  That caution has been rewarded with underwhelming June quarter growth for both.  Sure Japan beat expectations (-1.6% qoq annualised vs -1.9% expected) but only because the economy contracted less than expected.  And while the Euro zone posted modest growth in the quarter (+0.3% qoq), it and its three largest constituent parts (Germany, France and Italy) all fell short of expectations.

At this stage we don’t have a breakdown of Euro zone-wide growth but prior releases of retail sales suggests consumption was a likely solid contributor to growth over the quarter and we expect exports would have been OK for some, especially Germany.  However indications from the respective national statistical agencies are that business investment was weak in at least France and Germany.

To be fair, annual growth of 1.2% for the year to June is the strongest since September 2011, but it’s hardly shooting the lights out.  Easy monetary conditions should continue to support a further cyclical upswing via the low exchange rate, low interest rates while the TLTRO will continue to support stronger credit growth.


The question for the ECB is whether growth becomes strong enough to lift inflation from its current “unusually low” level, let alone maintain it at close to their 2% target.  Until they are of that view expect the central bank to continue its program of sovereign bond purchases.

A contraction in Japan Q2 growth was widely expected.  Consumption was weak over the quarter, despite better labour market data, and exports were weaker still.  Capital expenditure also posted a small negative (although this could yet be revised up and came after a solid Q1).  The only positive surprise was inventories which posted a small positive contribution where a negative had been expected following the significant inventory build in the first quarter – but that will simply serve to suppress future production.


Looking ahead we think consumption will look a bit stronger next quarter while there are pluses (US) and minuses (China) for exports.  And stronger capex remains a pre-condition for any sustained pick-up in growth.  I’ve got a rebound to 2% growth penciled in for Q3.  The Bank of Japan lowered their growth and inflation forecasts recently but they are likely still too optimistic on both fronts making further monetary easing likely.

Wednesday, August 12, 2015

China devalues

The decision by the People’s Bank of China to devalue the Chinese Yuan (CNY) 1.9% against the USD has surprised markets and led to allegations of China joining the currency war.  Those allegations are wide of the mark.

This was, nevertheless a significant move.  This is by far the biggest change in the daily reference rate, the previous biggest move was around 0.4%.  Furthermore  during the last period of managed devaluation in early 2014, the entire adjustment over 4 months amounted to around 1%.

We see this as a timely move on the exchange rate in an economy that needs easier financial conditions for cyclical reasons.  China’s growth challenges are well understood: excess capacity, high real interest rates and an overvalued exchange rate. 

To allege this move as China joining the “currency war” is unfair and wrong.  Yes China is a surplus country, but so too are Japan and the Euro zone and both are pursuing monetary policies that have resulted in significantly weaker exchange rates.  So at least include them in the allegation.

The more relevant point is that in June China’s real effective exchange rate was 14% higher than year ago levels.  That is unsustainable in an economy where the export sector is struggling and the high exchange rate has been a significant contributor to disinflationary forces.

So from our perspective, while this move was a surprise, a lower exchange rate is a timely and welcome addition to the raft of easing measures already in train including lower interest rates, fiscal stimulus and lower reserve ratios for the banking sector.

The authorities have portrayed this move as a one-off move as part of a more market-determined approach to setting the level of the CNY.  That is a firm nod in the direction of the IMF who are considering the CNY’s inclusion in their reserve currency basket.  That requires China to undertake further interest rate liberalisation and allow greater “free-usability” of the CNY.  In that respect this is a step in the right direction.


Markets took this news negatively, however we think it’s a necessary and pragmatic step to ease overall financial conditions to the benefit of the outlook for the Chinese and global economies.

Monday, August 10, 2015

Labour markets and monetary policy

The past week has seen important labour market releases out of New Zealand, Australia and the United States – at a critical juncture for monetary policy considerations in each of these countries.

In New Zealand June data showed employment growth slightly below expectations over the quarter but still coming in at a healthy +3.0% annual clip (+68,000 jobs).  That's down from 3.2% in March and expect a further slowdown in growth as growth in the economy more generally slows over the period ahead.

The unemployment rate ticked higher again to 5.9%, up from 5.8% in March, with strong migration continuing to fuel strong growth in the working age population.  That has combined with high rates of labour force paricipation to generate strong growth in the labour force.

It’s this significant increase in labour supply that has kept wages and domestic inflationary pressures subdued recently despite strong growth in both economic output and jobs.  Indeed the Labour Cost Index came in at +1.8% for the year – only just short of being consistent with 2% inflation – but going nowhere fast.

The monetary policy question in New Zealand right now is how much room there is for the RBNZ to cut interest rates.  While we expect employment growth to slow in the period ahead, the outlook for the unemployment rate is somewhat ambiguous as we expect growth in labour supply to slow also. 

At this point we’re still happy with our call of another two 25bp cuts to the Official Cash Rate in September and October, taking the OCR back down to the historical low of 2.5%.  We believe the significant fall in the (trade weighted) exchange rate will negate the need for more aggressive action on interest rates.

In Australia the question is whether the Reserve Bank of Australia is done with rate cuts or if there's more work to do.

In that respect recent labour market data there didn’t provide much guidance with mixed messages.  July data showed a stronger than expected increases in jobs over the month with annual growth now at a 4-year high of 2.1%.  But that came with a rise in the unemployment rate back to January’s level of 6.3%, up from 6.1% in June.  A rise in the participation rate was the catalyst for the rise in the unemployment rate - itself a sign of a healthy well-functioning labour market.

This result seems broadly in line with the comments from the RBA following their August meeting where the statement acknowledged somewhat stronger employment growth and a steady rate of unemployment over the past year.   This result therefore seems to suggest the RBA is on hold, at least for now. Our economics team in Sydney still think there is a “50/50” chance of a rate cut later this year.

In the United States the question is what “some further improvement in the labor market” the FOMC needs to see  to push the lift-off button looks like and whether July’s data fits the bill. 

July saw payrolls growth of 215k jobs, an increase in hours worked of +0.5%, a +0.2% increase in average hourly earnings (annual rate +2.1%) and a steady unemployment rate at 5.3% (although the broader U6 measures nudged lower to 10.4%). 

September rate hike chances took a bit of a hit following the recent lower-than-expected increase in the June Employment Cost Index (ECI), but we don’t think that will deter the Fed from hiking soon.  The June ECI data was probably compensation for stronger-than-expected wage growth in March data which the Committee was right to "look through".     

Wages are an important part of the inflation story and will inevitably be critical in determining the pace and extent of the interest rate cycle,  However its data on employment growth and more importantly measures of spare capacity such as the unemployment rate that will determine the extent of the Committee's confidence that inflation will return to 2% in time.

I think the July employment data was good enough to keep odds of September lift-off at still a touch over 50%.