Originally published by IFM Investors
As the second half of 2018 begins it appears that peak investor and participant bullishness towards the much vaunted synchronous global economic cycle has now passed. It is early days, but there are already signs that this cycle is becoming distinctly less synchronous as variations in economic growth become more prevalent. This is true in both developed and emerging markets, and across regions and individual countries. As forecasters factor this into expectations, the prospect of a distinct deceleration of growth is apparent.
Global: Investor sentiment
Investor’s current bullish attitude is fading as future concerns build
Added to this narrative, externalities are also threatening further downside risks. These include: political risks, particularly in the Eurozone and emerging markets; geopolitical tensions; the impact of tighter monetary conditions emanating out of the US; and, arguably the most concerning risk amongst them, “trade wars” between the US, China and others (either willingly or unwillingly). In a desynchronising environment, these factors will present economic risks to both stronger and weaker economies, especially those that remain economically and fiscally fragile, have internal and external imbalances, and have central banks still looking to extricate themselves from long periods of extreme monetary policy accommodation.
Indeed, the apparent shift in the global economic environment that we appear to be in the early stages of may pose monetary policy makers with a challenge they have not collectively faced in the inflation targeting period since the mid to late 1990s. That is, growth that appears to have peaked at an above trend rate and may decelerate, while inflation is still below mandated targets. Usually, at this point in the growth cycle central banks would have had collectively tighter policy and would be defending economies from excessive inflation. Whereas they currently still find themselves still with accommodative policy in the hope of fostering a further acceleration of inflation to sustainably fulfil their mandates.
This divergence in growth and inflation, which presents a conundrum for central banks, is more pronounced in advanced economies. However, the US and the Fed remain the outlier, with this economy having been spurred on by aggressive fiscal policy pushing growth above trend; and forward indicators suggesting this trajectory will continue. This growth has produced enough inflation and wages growth to allow the Fed to remove policy accommodation. By contrast, other advanced economies, most notably across the Eurozone and in Japan, have experienced interruptions to growth in the early part of 2018. While they may yet rebound, the mid-year forward indicators are suggesting a sustained economic acceleration over, and above, recent performance should not be expected. This may be of concern given inflation in these economies is tracking in a less than convincing manner towards respective central bank targets.
The suggestion that we may be passed the peak of growth in many economies can be evidenced in individual country and global composite PMI data. Collectively, the global composite PMI index has declined from a peak reached earlier this year, suggesting any material upside to global growth may be limited. This is not to say they point to economic weakness, indeed the vast majority of these PMI indicators remain in expansionary territory. They are simply less positive than they have been.
Looking more closely at the major economies within the collective PMI data, all but the US and Germany, among major advanced economies have experienced declines.
The former is benefitting from fiscal policy largesse in the form of tax cuts. And the latter, ultra-loose monetary policy and a weak exchange rate that, while appropriate for the Eurozone, is arguably not appropriate for its own economic environment. Across emerging markets, the Chinese PMI is down modesty from its peak as it grapples with internal deleveraging, however, the Indian PMI is significantly above where it was one year ago. Nonetheless, the overall emerging market PMI is slightly off its peak, which was reached in January this year due to volatility created by domestic risks and imbalances exacerbated by tighter financial conditions emanating out of the US.
This emerging trend of gradually declining activity indicators across economies is likely being driven by both domestic and external factors. On the external side, growth in trade volumes is coming off recent peaks and, at the margin, will be weighing on activity – particularly in export-intensive economies. This deceleration comes at a precarious time in the global free trade narrative, with the
escalation of trade tensions seemingly having increasing potential to have a material negative impact on trade volumes and subsequently economic activity. Indeed, IMF modelling in 2017 suggested that a 10% effective increase in import tariffs between the US and the rest of the world would lead to a 1ppt fall in world trade and 0.5ppt fall in world GDP.
Global: Trade volumes and manufacturing
A weaker global trade pulse will likely lower manufacturing growth
While this modelling is only indicative of the potential negative impact, as we do not know high nor how broad tariff measures will go, it is clear that a material impact on exports and economic activity should be anticipated. Initially, it is likely to be centred in the US and Chinese economies before emanating outwards. As I previously noted in the IFM Investors’ Economic Update (April 2018), for Australia, at this stage there seems more indirect risk to the domestic economic via our exposure to the Chinese economy and via financial and commodity markets.
US: data strength
June brought a much anticipated 25bp increase in the US Federal Reserve (Fed) Funds rate from the Federal Open Market Committee (FOMC), taking it to a 1.75 – 2.00% range. Much of the focus of the meeting outcome was on the future path of rates as outlined in the well-known ‘dot plot’. Here, the FOMC recognised short-term economic upside, balancing this with medium-term caution as the Funds rate approaches its estimate of neutral (the latter also saw ‘forward guidance’ in the communication removed). As such, the dot plot pulled forward expectations for rate hikes (as a result of one member revising their projection), seeing the median forecast for 2018 shift to 4 hikes from 3; 2019 remained at 3; while 2020 dropped to 1 from 2. This would yield a 2.5%, 3.25% and 3.5% Funds rate by year’s end 2018, 2019 and 2020 respectively. Importantly, there was no foreshadowing of a higher endpoint in this policy path and, therefore, it was not interpreted as significantly more aggressive.
Accompanying this shift was the FOMC’s communication, which was slightly more upbeat, noting economic activity was “solid” and that the improvement in average hourly earnings and wages increases was “moderate” and that business investment was continuing to “grow strongly”. The FOMC’s forecasts were largely unchanged, with 0.1pp added to 2018 real GDP growth at 2.8%, and
2019 and 2020 left at 2.4% and 2.0% respectively. The unemployment rate was also shaved 0.1pp to bottom at 3.5% in 2019. Importantly, core PCE inflation was only revised up in the near term, with 2018 moving up 0.1pp to 2.0% and the out years being left at 2.1%. Nonetheless, subsequent to this upbeat assessment, real GDP growth was revised lower by 0.2pp to 2.0%saar in the March
quarter, on the back of marginally weaker consumer spending, net export and inventories. This was largely dismissed by markets as the majority of data flow continued to support a strong Q2 rebound.
The prevailing expectation was underpinned in the data flow by particularly solid retail sales growth that, excluding autos, was a solid 0.9%mom in May and is running at just under 5%yoy. This spending is being underpinned by solid labour market growth, with non-farm payrolls adding another 213,000 jobs in June. The unemployment rate rose to 4.0% as participation moved higher, and the added capacity saw wages growth track sideways at 2.7%yoy. Improved spending and higher trending wages growth has been supportive of the inflationary pulse, with the headline measure accelerating to 2.8%yoy in May and the core measure to 2.2%yoy. Both measures were in line with expectations.
Eurozone: ECB hesitates
The focus in the Eurozone was also on monetary policy in June. But while the Fed was becoming slightly more hawkish, the European Central Bank (ECB) gave markets a somewhat dovish surprise. This was especially true given the upbeat intra-meeting comments made by ECB council members and its Chief Economist. On its asset purchasing program, the ECB will continue to buy €30 billion until the end of September this year, reducing this pace to €15 billion until the end of December 2018, after which net purchases will then end. However, this downsizing remains contingent on “incoming” data confirming the ECB’s inflation outlook. While the ECB left rates on hold in June, as expected, it also provided the indication that rates would remain at “present levels at least through the summer of 2019” and “as long as necessary” to ensure its inflation target is reached.
On the ECB’s own forecasts, this may be some way off. While inflation was upgraded by 0.3pp to 1.7% in both 2018 and 2019, this was largely due to oil price revisions and there was no change to the 2020 forecast, which remained unchanged at 1.7%. Notably, this remains below the ECB’s target. Further, core inflation measures were not revised in 2018 at 1.1%, and there was only a modest movement of 0.1pp in 2019 and 2020 to 1.6% and 1.9% respectively. Further, real GDP forecasts were revised lower. This was the result of recent softer data and “uncertainties related to global factors” becoming more “prominent”. Growth across the Eurozone in 2018 is expected to be 0.3pp lower at 2.1%, with 2019 and 2020 unchanged at 1.9% and 1.7%, with only gradual progress in bringing unemployment down going from the current 8.4% to 7.3% by 2020.
Eurozone: Inflation contributions by key sector
Durable goods inflation remains weak
The measured progress on inflation in particular was underscored by June’s advanced read. Headline inflation accelerated 0.1pp to 2.0%yoy from May, however the ‘core’ measure decelerated a tenth to just 1.0% as the 8.0%yoy rise in energy prices was stripped out of the calculation. The split that has characterised many advanced economies between goods inflation and that in services is
as stark in the Eurozone as anywhere. Services inflation is running at 1.3%yoy, whereas the measure for non-energy industrial goods (i.e. goods excluding energy and food, alcohol & tobacco) inflation is running at 0.4%yoy.
UK: BoE preparing to hike
In the UK, the Bank of England (BoE) voted six to three to keep the benchmark interest rate on hold at 0.5% at its June meeting. This was shift from the seven to two vote in May. The switch to supporting a hike came from BoE Chief Economist Andrew Haldane, and it is notable that the Monetary Policy Committee has not voted unanimously to keep rates on hold since its February meeting.
There were two notable conclusions to take from the accompanying communications. The first was that the BoE expects that the “dip in output growth in the first quarter would prove temporary” (as was judged at the time of the May Inflation Report). Secondly, that despite some softness in wages growth over coming months that it would also “strengthen again”.
UK: Bank of England monetary policy & market pricing
Markets favours a near term policy rate hike from the BoE
On the former point, the BoE asserts that “the incoming data” is supportive of a rebound. Indeed, retail sales expanded a strong 1.3%mom in May and are now 4.4%yoy higher through the year, and this should be supported by the ongoing run of good labour market outcomes. The economy adding 146,000 jobs in the three months to April, keeping the unemployment rate low at 4.2% and average weekly earnings growth solid, despite decelerating 0.1pp in April to 2.5%yoy. But there is cause for some caution. Industrial production was weaker in April, now having expanded only 1.8%yoy. The National Institute of Economic & Social Research GDP estimate underscores this, with growth over the three months to May estimated at just 0.2%qoq, whereas the implied forecast from the BoE is a 0.4% June quarter rebound. Nonetheless, markets continue to price a very solid chance that the BoE will raise rates to 0.75% at its August meeting.
Japan: Q2 rebound but little inflation
Japan’s weak first quarter of economic growth was confirmed at -0.6%saar, and there were revisions within these data. Business and public investment were deemed slightly stronger, and residential investment was less weak. However, this was offset by a downward revision in consumer spending. The nominal GDP deflator was unchanged and is running at just 0.5%yoy, which underscores the weak inflationary impulse throughout the broader economy.
Nonetheless, forward indicators remain positive. The manufacturing PMI rose to 53.1 in June and the Tankan business conditions surveys has edged off recent cyclical highs. So it is reasonable to expect a rebound in economic growth in the June quarter. That said, the Bank of Japan’s growth outlook may need to be revised, as fiscal 2017’s expectation of 1.9%yoy has been undershot at 1.1%yoy (a March quarter of 0.6%qoq was required). That said, fiscal 2018 growth is a relatively modest 1.6%yoy, which should be achievable if the economy were to rebound solidly in Q2.
The Bank of Japan (BoJ) believe improved economic growth is possible, stating at its June policy meeting that, despite recent negative growth caused by “temporary factors such as irregular weather”, private consumption and export figures had improved. Thus, it forecast overall growth should return to “positive territory”. Where the BoJ is more circumspect, however, is on inflation, noting that there is “still a long way to go” to achieve its target. This is despite improvements in June, where headline CPI inflation accelerated to 0.6%yoy and core ex-food and energy to 0.4%yoy.
Somewhat concerning has been that wages growth has been “weak” and therefore not supportive of an inflationary pulse. This is particularly relevant as spare capacity in Japan’s labour market has been materially eroded, with the unemployment rate hitting 2.2% in June, the lowest level since 1992. This comes despite recent strong increases in labour force participation, primarily from older workers and marked increases in female participation. Wages have to some extent been held back by a compositional shift between regular and non-regular (largely part-time) workers. Consequently, labour market tightness may be somewhat overstated by the headline unemployment rate.
Japan: Unemployment & participation rates
Labour market remains tight despite higher participation
Australia: Tracking sideways
In Australia, the economic data continues to paint a picture in which there are few convincing signs of any further improvement in the domestic economy. While some indicators are showing tentative signs of improvement, others are easing in terms of growth or are in outright decline.
Positive developments over recent weeks have been a pickup in retail sales, which expanded at 0.4% in May, coupled with April’s solid result which was revised up 0.1pp to 0.5%mom. This has seen economic growth through the year bottom out at 2.5%yoy, stemming the rate of recent deceleration, but still well below the average since 2002 of 4.7%. And in light of strong population and employment growth, which implies more people being able to spend, it remains a particularly soft outcome. Also notable is that food sales (including prepared & unprepared food) are running at 3.1%yoy, whereas durable retail sales are at a more modest 1.7%yoy. Here, the latter is facing pressure not only on soft volumes but with challenges for margins that exhibit little scope for price pass through.
Australian international trade data was again good in May, with the fifth consecutive surplus being recorded in the month of $847m. This built on the $427m surplus recorded in April, as a 4.0% increase in exports more than offset a 3.0% rise in imports. Recent strength in iron ore and LNG exports have been largely responsible for the consistency of these trade surpluses. This has occurred whilst a concurrent pick up in import growth has occurred, indeed the growth in imports at 12.6%yoy has outpaced that in exports at 8.1%yoy. Within this, consumption and capital goods imports have expanded at 8.1%yoy and 10.5%yoy respectively, which suggests consumer demand is picking up as is business investment – a positive sign for overall growth.
Australia: Retail sales
Better monthly sales but tepid growth through the year
The labour market continues to provide solid employment growth. However, this growth has slowed materially from the pace that was recorded in 2017. This may become concerning if labour supply, buoyed by strong population growth and high participation, continues to expand apace and results in spare capacity in the labour market being eroded at a slower rate, if at all. May’s labour force report showed a 12,000 person rise in employment, a less than breakeven outcome and a concern, given employment growth has run at just 6,500 in the previous four months (since February). This rate is materially slower than the 35,600 per month recorded on average over twelve months prior to that period. Nonetheless, the unemployment rate dipped to 5.4% due to a 0.1pp decline in the
participation rate. This points to a potential turning point in participation, which may alleviate some concerns of labour supply overwhelming demand.
Despite the unemployment rate declining in seasonally adjusted data, we also note that, in trends terms, it has remained virtually stagnant since September 2017 at 5.5%, fluctuating in just a 4bp range over that time. Consequently, the unemployment rate remains uncomfortably high, in terms of the degree of spare capacity that currently exists.
Ultimately, this matters because a significantly tighter labour market is likely to be required to generate sustainable wages growth.As a result, the Reserve Bank of Australia (RBA) is expected to remain on hold in terms of its policy settings, as it did again in July, in an effort to erode this capacity. Efforts to erode this capacity more quickly by loosening policy are unpalatable to the RBA at this stage, as it seeks to balance the benefit of doing so with the future risks of exacerbating what is already a high and rising household debt burden.