Quarterly Economic Outlook for Third Quarter 2014
July 17, 2014 | By John Greenwood
After the unexpectedly sharp downturn of the US economy in the first quarter of 2014 due to severe winter weather, US growth has resumed a more normal trajectory, with the economy growing at a pace closer to its potential than we have seen for several years. The Federal Reserve (Fed) is on course to end its asset purchases by year end, but rate hikes will probably not occur until mid-2015.
In the euro area, growth is still anemic, and although the European Central Bank (ECB) announced a series of stimulatory initiatives in early June, the prospects for a strong upturn in the single-currency zone are still remote. Meantime, consumer prices are approaching deflation.
The UK recovery has continued to be strong, although there have been signs of cooling in the housing market, and, as yet, real wage increases remain elusive.
Japan's economic upswing has paused following the imposition of the consumption tax hike in April. Ahead of the tax increase, spending was very buoyant in the fourth quarter of 2013 and the first quarter of 2014, but since then spending has slowed abruptly. Thanks to the tax hike and previous yen depreciation, inflation is temporarily elevated.
The outlook for China depends heavily on the prospects for global trade, which remains stalled, and domestic spending, which is constrained by the understandable reluctance of the authorities to ease monetary policy. Elsewhere in the emerging market arena, growth has been generally weak, notably in the largest emerging economies of Brazil, India and Russia.
|Table 1 - Inflation and Growth Forecasts|
|2013 Actual||2014 Consensus Forecast |
|Real GDP||CPI Inflation||Real GDP||CPI Inflation|
|US||1.9%||1.5%||2.2% (2.0%)||1.8% (1.5%)|
|EU-17||-0.4%||1.3%||1.1% (1.0%)||0.7% (0.6%)|
|UK||1.7%||2.6%||3.0% (2.7%)||1.8% (1.8%)|
|Japan||1.5%||0.4%||1.5% (1.8%)||2.6% (2.7%)|
|Australia||2.4%||2.4%||3.1% (3.0%)||2.7% (2.8%)|
|Canada||2.0%||1.0%||2.2% (2.2%)||1.8% (1.9%)|
|China||7.7%||2.6%||7.3% (7.2%)||2.5% (2.5%)|
|India||4.7%||9.5%||5.4% (5.2%)||7.8% (7.5%)|
Source: Consensus Economics, survey date June 9, 2014. Eurozone countries now number 18 with the addition of Latvia at the beginning of 2014. Actual 2013 eurozone data is for 17 countries, while forecast data is for 18 countries.
As I have previously predicted, there are two important bright spots ahead: sustained low inflation (especially in the developed world) and a longer-than-normal business cycle upswing. The common reasons for both these developments are that balance-sheet repair implies lower-than normal rates of growth of money and credit, and that subpar growth will ensure excess capacity persists for several more years.
Following the disruptions due to severe winter weather, lower-than-expected health care spending and disappointing export performance, US economic growth in the first quarter of 2014 was revised sharply downward to -2.9% annualized. However, growth appears to have rebounded across a broad front since then, resuming a much more normal trajectory of close to 3%. A revival in business capital spending, combined with moderate growth of housing activity and continued steady growth of consumption, has buoyed domestic demand. For example, core capital goods shipments increased by 0.4% in May, and manufacturing output increased by 0.7%, while survey indicators of consumer confidence, as well as regional and Institute for Supply Management surveys of manufacturing and services continue to register healthy expansions, all suggesting solid underlying momentum. Unemployment has fallen to 6.1%, and nonfarm payroll growth has averaged 231,000 per month since December.
Source: Thomson Reuters Datastream. Data as of June 15, 2014
Thus, although overall gross domestic product (GDP) forecasts for the calendar year have been revised down due to the very weak first quarter (e.g., the consensus for the year is now 2.2%), the performance of the three subsequent quarters looks likely to approach a vigorous average of 3.5% annualized.
In response to this buoyant backdrop, the Fed has continued to reduce its asset purchases at the measured rate of $10 billion per Federal Open Market Committee meeting, implying an end to its quantitative easing operations by year end. Fortunately for Chair Janet Yellen and her colleagues, the commercial banks have been taking up the baton of credit creation from the Fed by increasing their lending at a rate of 8.7% annualized so far this year, or 5% year-on-year. As yet, this pace of credit growth is modest, giving support to the economy but not so much as to threaten inflation. On the contrary, even though the amount of slack in the economy will steadily be reduced, inflation is likely to remain subdued through 2014 and 2015.
For the year as a whole, I expect 2% real GDP growth and 1.5% consumer price inflation.
Real GDP growth for the euro area slowed to 0.2% quarter-on-quarter in the first quarter of 2014, down from 0.3% in the fourth quarter of 2013, registering only 0.9% year-on-year. The recovery is at best bumping along the bottom and remains acutely vulnerable to a rise in global oil prices or even a mild financial shock. Markit's Purchasing Managers' Index (PMI) for manufacturing across the eurozone slowed to 51.8 in June, the lowest level so far this year, with Greece (49.4) and France (48.2) both showing contractions. Consensus expectations for real GDP growth this year amount to just 1.1% — well below the 2.5% rate experienced between 2004 and mid-2008 before the crisis erupted in 2008 and 2009.
There are three broad reasons for the failure of the eurozone to resume normal economic growth in the aftermath of the financial crisis of 2008 and 2009:
- First, the fiscal and monetary authorities have not provided sufficient stimulus to promote economic recovery. Austerity programs on the fiscal side and the ECB's reluctance to engage in pre-emptive balance sheet expansion on the monetary side have held back any possible growth of spending.
- Second, the failure to repair private sector balance sheets — especially among those households, companies and financial institutions that became over-leveraged going into the crisis — has meant that even with low interest rates it is proving very difficult for private sector entities to repay loans and clear up balance sheets.
- Finally, the strength of the euro has inhibited any possibility of an export-led recovery.
The composite PMI for June was 52.8, suggesting a slightly better rate of real GDP growth in the second quarter of perhaps 0.4%. However, the signals continue to be very mixed. While costs have been falling and competitiveness has been improving in the periphery, bank lending in the core area has been declining. Also, the risks of longer-term disruption to oil and gas supplies from Russia through Ukraine remain significant unless some kind of geopolitical settlement can be reached in the coming months. The weakness of the upswing is reflected in the data for unemployment, which remained at 11.6% in May, only slightly down from 12% over the past year, in contrast with steeply declining unemployment rates in the US and the UK.
Source: Thomson Reuters Datastream. Data as of May 30, 2014
Against this background of weak GDP growth and inflation falling well below the ECB's 2% target, the ECB finally acted at its June meeting to implement a broad-ranging program of expansion. The package of measures included:
- A 0.1% charge (or negative deposit rate) on commercial banks' funds held at the ECB above required reserves.
- A 400 billion euro targeted lending plan to be implemented in stages over the next four years.
- The de-sterilization of prior bond purchases under the Securities Markets Program.
- An announcement that the ECB will explore purchases of asset-backed securities.
- Forward guidance implying the anchoring of interest rates until 2016.
- And, perhaps most importantly, a promise (dependent on macro developments and, critically, inflation) that the ECB is not yet finished. ECB President Mario Draghi signaled that this could even include the purchase of sovereign government debt if inflation fails to pick up.
Because the ECB's plan was well discounted in financial markets ahead of the actual announcement, it did not have any dramatic impact on bonds, equities or the currency. Moreover, as we saw with the previous long-term refinancing operation program in 2011 and 2012 (which coincided with a decline in bank lending), lending to banks is far less effective in increasing money and credit growth than purchases of government securities from nonbanks — as conducted by the Bank of England. It will therefore be surprising if this plan is enough to revitalize the stumbling eurozone economy.
I forecast eurozone real GDP growth for the year as a whole to reach just 1%, while the inflation rate will undershoot the ECB's target again, falling to 0.6% at best. I maintain my long-standing forecast for deflation in the eurozone.
The recovery of the UK economy continued during the first half of 2014 with numerous indicators suggesting that the UK's recovery is stronger than any other leading developed economy. For example, the PMI for manufacturing in June recorded 57.5, well ahead of any euro area economies, Japan, and even slightly ahead of the US.
In the first quarter of 2014, real GDP grew at 0.8% quarter-on-quarter and 3.0% year-on-year, and expectations remain firm for the remainder of the year. Private consumption spending also expanded by 0.8% over the quarter, and this has been echoed in continuing strong growth of retail sales (up 5.0% year-on-year in volume terms in the three months to May). Meanwhile, fixed capital formation expanded by 2.4% in the first quarter, showing that the recovery is by no means limited to consumer spending only. In effect, the economy is firing on all cylinders with manufacturing, services and construction all growing strongly. If the current pace of activity continues, the UK will exceed its precrisis peak level of GDP in real terms during the second or third quarter.
Source: Thomson Reuters Datastream/Fathom Consulting. Data as of June 15, 2014
Progress in the labor market has been particularly encouraging, with employment rising strongly from 28.8 million at the trough in 2009 and 2010 to almost 30.5 million in the three months ending in April, an increase of 1.7 million jobs. At the same time, unemployment has fallen rapidly to 6.6%, below the level at which the Bank of England's Monetary Policy Committee (MPC) had previously said they would start to consider raising interest rates. The housing market has also shown strong buoyancy with the Nationwide index of house prices increasing 11.8% in the year to June, although most of the price increases have been concentrated in London and the southeast. In addition, housing starts in England increased to 36,450 in both the first quarter of 2014 (up from lows of 17,000 in the first quarter of 2009), but still below the precrisis peak of almost 49,000 in the first quarter of 2007.
To cool the housing market, the Bank of England's Financial Policy Committee introduced in June macro-prudential restraints on mortgage loan-to-income ratios — setting a maximum of 4.5 times income for 85% of new residential mortgages — and required banks to conduct stress-testing of householders' ability to repay in the event of a 3% rise in mortgage rates. Mortgage approvals had already fallen from 76,000 in January to 62,000 in May, and there have been signs that prices in London are softening.
Reflecting strong economic activity, rising property prices and the expectation that UK interest rates would be raised before year end, the pound has appreciated to the highest levels since 2008, retracing about one-half of its depreciation during the crisis.
Looking ahead, the pace of economic growth is unlikely to accelerate much from here, but various indicators suggest that the growth will be maintained at somewhere between 2.5% and 3%. The available spare capacity in the economy and in the labor market, combined with the appreciation of sterling and moderate rates of money and credit growth, should ensure that inflation risks remain minimal through 2014 and 2015.
Turning to monetary policy, the Bank of England's once-clear forward guidance has been overtaken by a series of mixed messages not only from MPC members, but also from Governor Mark Carney himself. After he abandoned the 7% unemployment threshold in February in favor of a set of 18 indicators, while promising that rates would stay low for an extended period, the strength of the economy has forced a recent volte-face. In June, the governor advised that rates could rise by year end. Inevitably, this chopping and changing has undermined the bank's credibility in the eyes of market participants. Forward guidance now means little more than that the bank will rely on its own discretion in assessing the timing of rate hikes.
For this calendar year, I now expect 2.7% real GDP growth and 1.8% Consumer Price Index (CPI) inflation.
In Japan, consumer spending picked up strongly ahead of the 3% increase in the consumption tax on April 1. This spending surge drove up real GDP by 1.6% quarter-on-quarter, or 6.7% at an annualized rate in the first quarter of 2014. Since then, spending has slowed abruptly, and the critical question is: When will Japan return to a more normal growth rate? Given that the initial impetus from President Shinzo Abe's "Abenomics" had already been starting to fade, the real test of the policy will be how quickly the economy returns to a sustainable trajectory over the coming months.
Retail sales dropped an astonishing 13.6% in April as consumers stayed away from department stores and supermarkets, and the declines continued into May. Vehicle sales plunged in April, May and June, while industrial production fell 2.8% in April but recovered by a respectable 0.5% in May. However, it is widely expected that in the aftermath of the tax hike, real GDP growth will fall by 3.2% quarter-on-quarter in the second quarter and 0.8% in third quarter, pulling down the year-on-year growth rates to 0.7% and 1.1%, respectively. For the year 2014 as a whole, I expect 1.8% real GDP growth.
From a longer-term perspective, the success of Abenomics is still in doubt. Although there has been a temporary growth spurt, much of this was due to the depreciation of the yen in 2012 and 2013 and the spending surge ahead of the April tax hike. A stronger yen and a continuation of the spending slump after April and May would raise doubts about the sustainability of the program. During the annual spring negotiations between unions and larger companies, wage increases were moderate, with the result that wages at smaller firms did not increase much. Consequently, the May index of wage earnings in all industries increased by just 0.6% year-on-year, implying a continuing decline in real terms.
Moreover, the deterioration of the external trade and current accounts is continuing to act as a drag on growth. This is due mainly to increased imports of oil and gas to replace the power lost from Japan's nuclear energy providers whose plants were closed down following the tsunami damage to the plant at Fukushima. Despite the yen's 30% depreciation against the US dollar, the current account has switched from a surplus of 4% of GDP in 2010 to deficits since 2012, and is now running at about 1% of GDP. Meanwhile, the trade balance has also switched to large and persistent deficits.
So far, most of the inflation can be attributed to the weaker yen and higher imported commodity prices — especially energy products and food items — not stronger domestic demand. While the weaker yen may help to achieve Prime Minister Abe's goal of 2% inflation in the short run, unless wages and personal incomes rise more than 2% on a continuing basis, the result could simply be an episode of temporary imported inflation, followed by a resumption of weak domestic spending and growth as inflation subsides again.
On the monetary policy front, the Bank of Japan has refrained from any significant action since it announced two enhanced lending schemes on Feb. 18 — the Growth-Supporting Funding Facility and Stimulating Bank Lending Facility — both designed to encourage more bank lending. Since then, there have been few signs that commercial bank lending has picked up much, but the whole period has been disrupted by the surge in spending followed by the slump in spending in reaction to the consumption tax. In this atmosphere of uncertainty, the authorities have understandably announced that if growth were to weaken persistently, they would be prepared to adopt further easing measures.
Source: Thomson Reuters Datastream. Data as of June 30, 2014
For the year as a whole, I expect Japan's national consumer prices to rise by 2.7% (including the effects of the consumption tax hike).
China and non-Japan Asia
The momentum of the Chinese economy remained subdued in the first half of 2014 as policymakers tried to support the economy with modest fine-tuning measures on the one hand, while taking care not to engage in large-scale stimulus measures on the other. Among the easing moves, the deliberate depreciation of the Chinese yuan from around 6.05 per US dollar in January to 6.25 in April and May was probably the most important. Although the depreciation was widely considered to be an attempt by the authorities to inject some two-way uncertainty into the yuan/dollar exchange rate, it came at a time when Chinese exports were continuing to struggle, growing at low single-digit rates in an environment of weak world trade growth and rising wage costs in China. Since May, the currency has resumed a mild recovery, strengthening to China yuan renminbi 6.20, but the prospects for a sustained recovery of exports depend more on the revival of overseas demand than anything the Chinese government can do in the short term.
At home, the housing market has weakened from its recent peak in 2013, and excess capacity problems in various parts of the manufacturing industry have persisted, adding to the pressure on banks' asset quality. The overall official nonperforming loan (NPL) ratio of the banks as published by the China Banking Regulatory Commission is just 1%, but sectoral data suggest a more worrying picture, with NPLs rising to 2% to 5% in key manufacturing sectors such as steel.
Source: Thomson Reuters Datastream. Data as of July 9, 2014
The practice of evergreening NPLs — lending more to enable borrowers to pay interest due — especially to state-owned enterprises (SOE) is widespread, and the growing involvement of cash-rich SOEs in shadow-bank lending to financially vulnerable small and medium enterprises have also contributed to the general perception that Chinese corporate and financial balance sheets are less healthy than the official ratings suggest.
Against this background, economic activity in China showed further signs of moderation. After real GDP growth of 7.4% in the first quarter of 2014, the official manufacturing PMI, which focuses on larger, state-owned firms, remained barely above the 50% threshold between expansion and contraction in April and May, though it did improve to 51.1 in June. Hong Kong and Shanghai Banking Corporation's (HSBC) PMI, which focuses on smaller, private companies, fell below 50 from January to May and as low as 48 in March, returning to 50.7 in June. At the same time, aggregate house prices in 70 cities declined in May (month-on-month) for the first time since mid-2012, while property transaction volumes remained sluggish. These indicators suggest China continues to work through a growth adjustment phase.
I expect China's real GDP to continue to soften toward 7% by year end (averaging 7.2% for 2014), while CPI inflation will remain calm at 2.5% for the year as a whole.
The remainder of non-Japan Asia is suffering from the same weakness in world trade that has been holding back China. However, with only a few exceptions (such as India, Indonesia and possibly Korea) the regional economies do not have large enough domestic markets to provide a locomotive effect. Consequently, the entire region is watching and waiting for progress in the developed economies, and especially the eurozone, to begin a more vigorous upturn.
Readers of this report will know that I have been somewhat bearish on the outlook for commodity prices for the past year. The second quarter of 2014 has been notable for further falls in iron ore prices (from $113 to $90 per metric ton), Australian coking coal and the copper price. All three commodities basically reflect weak economic activity in China, other emerging economies and the developed world. This weakness of prices has been echoed by the flatness of the Reuters-CRB Index and the range trading in the S&P Goldman Sachs Commodity Price index.
Another event in the quarter from April through June that temporarily drove energy prices higher was the ISIS (or jihadist-led) attack on numerous towns and cities in Iraq, prompting a brief spike in Brent from $108 per barrel to $115 in June, as well as in other internationally traded crude oil prices. The failure of this and earlier food price surges to be sustained is further evidence of the weakness of global demand, specifically the subpar growth rate witnessed until recently in the US, the eurozone and the UK, together with the slowing trend of growth in the leading emerging market economies of China, India and Brazil.
Source: Thomson Reuters Datastream. Data as of July 9, 2014
Although central banks have been promoting faster credit and money growth with near-zero interest rates, my view has been that as long as balance-sheet repair remains the order of the day among commercial banks and their customers then rapid growth of mass purchasing power will not happen. As central bankers often say, inflation expectations are well-anchored. The fundamental driver behind this trend is that balance sheet repair is inherently disinflationary, or even deflationary. Consequently, as long as the major economies remain in balance sheet repair mode, commodity price surges can result only from local or temporary supply disruptions, such as occurred with oil prices in June. This broad diagnosis remains intact. A broad surge in commodity prices is neither imminent nor likely.
In the financial markets, there is a recurrent debate about the apparent disconnect between high bond and equity prices and the contrast with weak global economic activity. In my view, this reflects two broad misunderstandings.
- First, asset prices are driven primarily by the business cycle, with monetary conditions at the forefront. Currently near-zero central bank interest rates have been effective in promoting equity and other risk asset prices, but not yet effective in ensuring repair of private sector balance sheets or restoring normal growth. On this basis, it will be a long time — perhaps several years — before the business cycle and asset prices peak.
- Second, financial markets are principally reflecting the favorable effect on long duration assets of abnormally low short-term interest rates. As normality returns to household and bank balance sheets enabling growth to resume, higher short-term interest rates will be counter-balanced by stronger economic activity underpinned by recovering wage and profit growth. In other words, a PE- or multiple-driven equity market will give way to an earnings-driven environment.
Naturally there are risks in such an outlook, but low money and credit growth provide some assurance that we are not in the same environment as in 2005 to 2007, when rapid credit growth and high leverage made balance sheets acutely vulnerable to any adverse shocks. In short, this is not a financial bubble of the kind that occurred before the financial crisis. On the contrary, a key feature of the current environment is the gradual healing of household and financial sector balance sheets, to be followed later by the healing of public sector balance sheets.
Thanks to the slow growth of money and credit, inflation will also stay lower for a longer period of time than in previous business cycle upswings. In addition, a more gradual profile for rate hikes will at least partially insulate longer duration risk assets from downward shocks. In short, continued moderate GDP growth implies that larger exposures to risk assets are warranted for several years ahead.
All data provided by Invesco unless otherwise noted. Data as of July 10, 2014 unless otherwise noted. Unless otherwise specified, data was supplied by Mr. Greenwood.
All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments. This does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Where John Greenwood has expressed opinions, they are based on current market conditions as of July 10, 2014 and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Past performance is not a guarantee of future returns. An investment cannot be made in an index.
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