Strategy & economics
US vs eurozone - a shift in pole position
US economy took a pit-stop
As a keen spectator, I can assure you that economics and markets – the pace, timing, strategy, outcome and reaction – are as exciting as Formula One. Economic divergence between the US and the eurozone has been a key theme since the second half of 2014. However, there was a marked shift in fortune in the first quarter of 2015, as US economic data came in substantially below expectations while those for the eurozone ran ahead. Is the US economic engine running out of steam, or just taking a pit-stop? We believe the latter to be the case.
Inclement weather being a drag on US first-quarter growth creates a sense of déjà vu. According to the National Weather Service, the first quarters of 2015 and 2014 were by far the coldest since 1997. It is self-evident that, as snowstorms hit, households do not dine out or shop as often (or at all), and homebuilders have to abandon outdoor construction activity. It is worth noting that despite weaker manufacturing and services output, employment indicators have held up well, suggesting employers believe that the fall in demand will prove temporary. If the first quarter of 2014 is a reference, we are likely to see a strong rebound from the second quarter onward. However, other headwinds were at play in the narrowing of the US’s lead over Europe in the first quarter of this year.
Oil & gas capex blistered
The halving in oil prices since mid-2014 has had a very negative impact on the US oil & gas sector. It has been reflected in job cuts at energy companies and the sharp fall in the number of active oil rigs. US GDP barely expanded in the first quarter of 2015, and within this fixed investment in mining exploration, shafts and wells plunged 6.6% year-on-year. Although capex in the oil & gas sector accounts for only 5% of total fixed investment and 0.8% of GDP, its negative impact will have rippled through to other sectors. This is because although a slump in the oil price is good news for manufacturers, the shock creates sudden uncertainty in the price of a key input variable – and businesses do not like uncertainty.
Dollar strength puts on the brakes
US economic leadership and the expectation of monetary tightening have led to a sharp appreciation of the US dollar. While a strong dollar is damaging to external competitiveness, it is consistent with a robust domestic economy, one that can support more imports and fewer exports. In fact, exports account for only around 13% of US GDP and multinationals are not the major job creators domestically.
Nonetheless, there is evidence that the negative impact of a stronger dollar is feeding through faster than expected. Under normal circumstances, the sensitivity of trade flows to currency movements is about 12 to 24 months, but on this occasion, it would seem that the negative influence of dollar strength is coming through more rapidly. Some of this effect may be the result of the harsh weather conditions and also disruption caused by labour disputes in the West Coast ports. However, it may prove that a more difficult export environment continues to act as a drag on growth.
To gauge the impact of the stronger dollar on businesses, a special question was included in the Philadelphia Fed business outlook survey in April. Results indicated that while the dollar is affecting domestic business activity to a lesser extent than foreign business activity, the net effect on overall activity is negative.
The US economy to be back on track
On the basis that the various factors contributing to weaker growth are likely to prove largely temporary, we expect the US economy to regain momentum over the rest of the year. Having said that, expectations at the start of the year that the economy could grow by 3% or more in 2015 are likely to prove over-optimistic. Further ahead, with the labour market tightening, faster growth will require the emergence of a more robust trend in productivity – a situation similar to that in the UK.
Eurozone’s recovery track greased by liquidity
In terms of economic momentum, the eurozone overtook the US during the first quarter, with the strongest economic surprises coming through in the area’s major economies. Recent industrial, retail and confidence data, in particular from Germany and Spain, suggest that activity has accelerated. In particular, bank lending to the eurozone private sector rose by +0.1% year-on-year in March; albeit a fractional gain, this was the first increase since early 2012. It underpins the view that the eurozone credit cycle is now beginning to turn around. Given the compression in yields caused by quantitative easing (QE), bank recapitalisation and an easing in lending standards, the credit engine is likely to provide further impetus through 2015. With additional support coming from the lower oil price, a weaker euro and a confidence boost from QE, we believe eurozone growth forecasts are likely to be revised upwards.
A modest deceleration in the UK
While activity trends continue to be positive in the UK, there has been a small loss of momentum since the second half of 2014. The preliminary estimate of UK first quarter GDP growth was much weaker than expected, with a broad-based moderation in activity, particularly in the construction sector. Although details are not available yet, fixed investment is likely to have contracted for a second quarter. Uncertainty prior to the General Election may be one factor resulting in a duller first quarter. However, it is also evident that the boost to housing construction and consumption from Help-to-Buy and the Payment Protection Insurance (PPI) compensation is beginning to diminish. As in the US, recent business surveys and the continual strength of the labour market suggest that we will see a rebound in UK activity later in the year. However, the robust pace of economic growth in 2014 may prove hard to repeat in 2015.
How will the rest of the seasons unfold?
In the US, the Federal Open Market Committee (FOMC) acknowledged recent data weakness, attributing part of that to weather effects. While the latest FOMC statement leaves the door open for a rate increase, the tone does not sound strong enough to indicate action is likely in June. In view of this and recent developments, the scope for further near-term US dollar strength looks more limited, and is likely to remain so until stretched technical conditions are unwound and supportive economic fundamentals catch up. As we expect activity to rebound later in the year, we see upside risks to wages and inflation, and hence policy rates are expected to start rising in the third quarter of 2015. Over the medium-term, the US dollar is likely to continue to appreciate, supported by both higher interest rates and a structurally superior domestic economy.
We have moderated our positive view on US equities. Valuations continue to be expensive and it is evident that earnings expectations are being trimmed as a result of the wider impact of a stronger dollar and, more specifically, the weaker oil & gas sector. Reflecting improved eurozone growth prospects, and against the backdrop of quantitative easing, we have upgraded our assessment of continental European equities. Despite QE, the further tightening in peripheral European sovereign and credit spreads represents significant overvaluation. The recent sharp sell-off in German Bunds, after stronger-than expected inflation data and a weak five-year German Bund auction, is a reminder that risks in bond markets far outweigh potential rewards.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
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All data contained within this document is sourced from Cazenove Capital unless otherwise stated.