Economic Update - September 2014
August proved to be a fairly positive month in terms of financial markets performance, and turned more vibrant as trading floors are now full houses again after the summer. Developed Market (DM) equities were generally higher but the highlight goes to the S&P 500 Index which surpassed the 2,000 mark. Performance was relatively mixed in Europe but overall moderately positive, whereas the MSCI Emerging Markets (EM) Index posted its 7th consecutive month of positive return in August. In terms of economics, there is rising prominence of ‘decoupling’ as a key theme. Previously, the decoupling story was notably between DM and EM, but there is increasing evidence of decoupling within DM. We hereby analyse such developments in DM with respect to growth, inflation and monetary policy and assess their implications on financial markets.
On growth, second quarter GDP and more recent releases in the UK, US and Eurozone provided more evidence of a decoupling in activity within DM. US GDP growth in the second quarter rebounded by +4.2% on an annualised basis, and the absolute level of GDP is now 6.7% above its 2007 peak. Strong factory orders, alongside strong manufacturing surveys, suggest a continual upward trend in industrial activity. On the consumer side, Conference Board Consumer Confidence surged to the highest level in nearly 7 years in August, likely driven by the upbeat momentum in the labour market. The broad-based strengthening of recent data points to solid trajectory in US activity. While headline wage growth remains relatively steady and subdued, it is likely to face further upside pressure as slack is used up faster, from the robust data we have seen recently, and structurally lower labour force participation.
For the UK, GDP was up +0.8% quarter-on-quarter (QoQ) and +3.2% year-on-year (YoY) in the second quarter of 2014 and finally surpassed its 2008 peak by +0.2%. It is worth noting that the latest Office of National Statistics (ONS) Blue Book revisions to UK GDP growth suggest the 2008-09 recession was less deep, while recovery was notably stronger than previously estimated. The methodological changes to GDP estimates are providing us with, we assume, a more accurate picture of growth now and historically. For the recent period we believed growth to have been underestimated, given other data emanating from the economy. The fact is that the UK economy has grown more strongly over the past few years than previously thought, and it is highly likely that the spare capacity that exists is being used up very rapidly. While the robustness of UK data has somewhat cooled compared to the start of the year, activity remains firmly in expansion across various sectors. In particular, industry surveys suggest that demand for labour remains very strong, with worsening staff availability and continued upward pressure on pay. We believe there is a disconnect between weak official wage data and survey data, meaning underlying wage pressure has probably been understated, and hence think inflationary pressure will rise further down the road as wages adjust.
In stark contrast to the positive growth momentum in the US and the UK, Eurozone activity has faltered in the second and third quarter. As Italy slipped into recession, Germany contracted and France stagnated, Eurozone GDP growth disappointingly slowed from +0.2% to flat in the second quarter. Latest readings of the Eurozone Purchasing Manager Indices, which capture direction of manufacturing and services sector activity, remained on the disappointing side and confirmed the loss of positive momentum in the area. Against the backdrop of weak wage growth and lower commodity prices, inflation is subject to more downside pressure. Eurozone headline Consumer Price Index (CPI) slowed from +0.4% YoY to +0.3% YoY in August. Italy’s CPI has dipped into negative territory (from 0% to -0.2%) while Spain’s CPI contracted deeper (from -0.3% to -0.5%) in August. France and Germany’s readings are flirting with sub-1% and hence price levels of the area’s biggest economies look vulnerable. Given the heightened uncertainty on growth, the recent broad-based fall in confidence and the sustained disinflationary pressure, medium-term inflation expectations have deteriorated.
On the back of decoupling in growth and inflation, there is an increasing divergence with respect to the path of monetary policy in the US/UK and the Eurozone. The most significant event to highlight this development is the latest easing measures announced by the European Central Bank (ECB) at its September meeting, triggered by the ‘dis-anchoring’ of medium-term inflation expectations. The ECB unexpectedly cut interest rates across the board by 10 basis points and confirmed it will start buying a broad portfolio of asset backed securities (ABS) in October. The ECB hopes that both the ABS program and the upcoming targeted longer-term refinancing operations (TLTROs) will lead to a ‘sizeable’ impact on banks’ balance sheets.While the ECB is still devising how to ease monetary policy further, there is more heated debate in the Federal Reserve (Fed) and the Bank of England (BOE) on the timing of the first tightening move. In the UK, the BOE meeting minutes in August delivered surprises, as there was a first split in unanimity, in more than 3 years, with respect to the vote on the rate hike. The dissents from two out of nine Monetary Policy Committee (MPC) members are consistent with our view that there will be more heated debate and disparity amongst the MPC members as it became increasingly apparent that current and expected economic conditions justify a rate hike. Similarly, the latest Federal Open Market Committee (FOMC) minutes reflected a bit more disparity in opinion amongst members, with more acknowledgement
of a better than expected improvement in the labour market. It was cited that many participants expect an earlier hiking cycle should the labour market continue to improve.
So finally, what are the market implications of the growth and policy decoupling? While we think the ECB easing announcements are going to have negligible impact on real economic growth given the potential program size and structural challenges in the area, it is no doubt a boost of confidence to markets and shows the ECB’s commitment to “whatever it takes”. Given there was a discussion of QE at the meeting and the ECB’s strong easing bias, there is heightened expectation of full-blown QE at some point. The potential prolonged policy decoupling between the US/UK and the Eurozone is likely to weaken the euro, thereby boosting exports, inflation and potentially, asset prices. We remain sceptical of how much lower bond yields can go given expensive valuations. Given that policy normalisation in the US and the UK is fundamentally driven by improved economic conditions, equities are likely to be favoured in a scenario of better growth and a low interest rate environment.
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