April bliss – a taste of spring for macro and markets
April bliss – a taste of spring for macro and markets
Although still a bit chilly, spring has officially arrived. It feels good to enjoy the (occasional) sunshine and longer daylight. Markets enjoyed the kiss of spring too after a tough opening to the year. By the end of April, Western developed markets equities had recouped most of the ground lost during that period (with the S&P 500 Index and FTSE 100 Index both now up year-to-date), thanks to better news on the economic front.
The improvement in Chinese data has been important in reassuring investors. Although GDP growth slowed in the first quarter, high-frequency data, including industrial production, retail sales and fixed investment, have pointed to a recovery in activity. The better economic momentum was mainly driven by real estate and infrastructure investment. Home sales, home prices and residential construction all jumped in the first quarter, thanks to supportive fiscal and monetary policy (as well as limited alternative investment options). Improving liquidity is evident in the surge in new social financing in March. In addition, foreign reserves have risen for the first time since last November, indicating a turnaround from months of significant capital flight. Most importantly, sentiment toward the Chinese yuan has stabilised.
The question now is whether the positive momentum can be sustained. As the recent recovery has been largely liquidity driven, it may not last. The pace of industrial production may not be sustained due to significant overcapacity and muted external demand. The recovery in home prices had been largely driven by top-tier cities while there remain significant housing inventories in lower-tier cities. Also, the measures introduced in March controlling property purchases in tier-one cities may now begin to dampen investment sentiment.
We remain concerned by the lack of appetite to rein in credit and steer away from the traditional growth drivers – in particular, infrastructure and real estate investment. However, to prevent further over-heating in certain parts of the economy, the authorities are likely to
hold off further easing until later this year. Nevertheless, despite concern over longer-term growth and debt sustainability, the risk of a near-term Chinese hard-landing has diminished.
Fears over an impending US recession have evaporated as apparently weaker areas of the economy have stabilised. In 2015, US industrial activity suffered from the slump in capital spending in the oil and gas industry, as well as from the strong dollar, but there are signs of a Spring recovery in manufacturing activity. For instance, the Institute of Supply Management (ISM) Manufacturing Index returned to a positive growth reading in March after five months of contraction. Within this, leading indicators such as new orders bounced strongly. We expect to see a gradual recovery in external demand as the dollar headwind fades. In addition, the previous downturn in capital spending in the oil industry has probably ended.
Looking at the labour market, the latest employment report showed continuing strength. Non-farm employment continued to increase above a 200,000 monthly pace and wage growth picked up to +2.3% year-on-year. Initial jobless claims dropped to a 42-year low and job openings remained at robust levels, which will likely lead to more upside wage pressure later in the year.
With the labour market remaining very tight and the ISM Manufacturing Index returning to expansion, we expect the US economy to accelerate in the second half of 2016. In conjunction with an improvement in domestic financial conditions and rising inflation expectations, as well as the stabilisation in international developments, we believe a federal funds rate hike in June remains a “live” possibility and we continue to look for up to two 0.25% increases in rates during 2016 as a whole.
However, it has become increasingly difficult to determine the future pace of monetary tightening in the US as the Federal Open Market Committee (FOMC) has been giving confusing signals. Most recently, the FOMC moderated the previously outlined pace tightening, following the market weakness in the opening weeks of the year. Markets are currently pricing in a very low probability of a federal funds rate hike over the next few meetings, and less than one full hike by the end of the year. We believe expectations are too conservative, and that the Federal Reserve will have to start preparing markets for a possible rate hike at one of the meetings over the summer. While it is evident that the pace of tightening will remain highly data dependent, with little being priced in by the financial markets there could be a negative surprise.
The European Central Bank (ECB) is certainly no novice in delivering positive messages to financial markets. Recently, it has cut the deposit rate deeper into negative territory, increased the amount of quantitative easing (QE) and extended asset purchases to include non-financial corporate bonds. The ECB has also disclosed details of its corporate bond purchase scheme which is wider ranging than expected.
We believe there is scope for upside surprise in eurozone growth thanks to accommodative policy and favourable credit conditions. The eurozone bank lending survey for the first quarter was solid, especially taking into account the volatile market conditions and a decline in confidence over the period. On the credit supply side, conditions continued to improve for the corporate sector. The net easing of credit standards was greater than the historical average since 2003 and more pronounced than expected.
The improvement has been most obvious in ‘peripheral’ countries such as Italy, despite the fact that banks there remain under severe pressure due to profitability and non-performing loans concerns. Meanwhile, credit demand remained resilient across the board, with particular strength again in Italy.
Encouragingly, eurozone banks have used the additional liquidity from the asset purchase programme to grant loans, and credit expectations for the next quarter remain robust. While it was reported that the negative deposit rate had a positive impact on lending volumes, it had a detrimental impact on banks’ net interest income and loan margins. Given the overwhelmingly negative response to the ECB’s latest measures, in relation to their impact on banks’ profitability, we believe the ECB will be very reluctant to cut interest rates further.
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