Economic Update - August 2014
Renewed volatility materialised during August, probably the least welcome time of the year to test our investment nerves, considering quite a number of readers are probably sipping cocktails by a beach somewhere. The escalation of geopolitical risks has been the biggest contributory factor to the recent pull back in risk assets, especially in continental Europe, where economic sanctions on Russia and the associated retaliation threatened to undermine an already stuttering recovery. Although the trade links between Russia and the rest of continental Europe are not significant, one cannot rule out the possibility of further escalation, particularly on the energy side, which could put further strain on fragile economies.
2014 started with more optimistic consensus growth expectations. However, there is growing uncertainty about whether momentum can be sustained during the second half. While economic surprises remained negative in the US, UK and much of the Eurozone in the second quarter, Italy slipped back to recession and Germany risks seeing its first GDP contraction in six quarters. For Japan, data releases after the consumption tax hike in April have been mixed but mostly skewed to the downside, and there are lingering doubts over the efficacy of President Abe’s ‘third arrow’ which focuses on structural reform. In China, while there has been a reasonable pickup in economic data, which has helped boost market sentiment, it is uncertain whether the rebound in activity is sustainable. China faces structural challenges that demand more than the quick fix of a mini-stimulus package, and the benefits from the announced reforms are likely to be visible only in the longer term.
Growing uncertainty in key economic regions, escalated geopolitical risks and tighter market liquidity during the summer have combined to trigger a mild set-back across risks assets, most notably equities and high-yield credit.
In the US, recent economic developments offer some reassurance that things are heading in the right direction. GDP growth rebounded more than expected in the second quarter, expanding at an annualised rate of +4.0%, following a contraction of -2.1% (upwardly revised from -2.9%) in the first quarter. Household consumption and investment recovered strongly, indicative of robust, domestically driven, private sector growth. We think that the US GDP figures are encouraging and that consensus growth forecasts will likely be revised up from the current +1.7%. Significantly, economic data (aside from those relating to the housing sector) sustained solid momentum at the start of the third quarter. To cite a few notable releases, business surveys conducted by the Institute of Supply Management (ISM) have strengthened to multi-year highs, with strong order pipelines. Non-farm employment gains have been maintained above 200,000 for the sixth consecutive month, a development that would have historically triggered rate increases.
Accordingly, we think that after the negative impact of weather disruption during the first half, growth momentum in the US and the UK economies is now quite similar. At a micro level, corporate mergers and acquisitions activity in the US has increased, reflecting rising business confidence as well as perceived value in the current level of the equity market. A positive second quarter reporting season has led to modest upward revisions to S&P 500 earnings forecasts, which has helped explain the relative resilience of the US equity market.
The Eurozone stumbled through a problematic second quarter, causing the European Central Bank (ECB) to adopt a more cautious view at its latest policy meeting. Disappointingly, Italy slipped into a recession in the second quarter and real GDP remains 9.1% below its pre-crisis peak. As ECB President, Mario Draghi, pointed out, the lack of structural reform is holding back growth in certain economies, a pointed reference to Italy. Germany also found itself under a negative spotlight, as industrial data disappointed throughout the second quarter, putting downside risks to growth during the period. We remain cautiously optimistic on Eurozone growth and we believe the jitters in the second quarter were fluctuations around a gently improving trend.
On the positive side, 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. Furthermore, the ECB’s Bank Lending Survey for the second quarter showed that credit standards eased for corporate lending, mortgages and consumer credit, while net loan demand was positive for all loan categories. Notably, these trends seem strongest in the peripheral countries, where progress is most needed. The survey also suggested that banks expect to continue to modestly ease lending standards over the next quarter. Hence there is evidence that credit conditions are genuinely improving, possibly helped by the introduction of Targeted Longer Term Refinancing Operations (TLTROs).
In stark contrast to the lacklustre growth on the other side of the Channel, the UK achieved a milestone in the second quarter as GDP finally surpassed its pre-recession peak. The services sector expanded at the strongest pace in seven quarters. At the same time, the trend in employment remained strong and conditions in the housing market continued to improve. In its July World Economic Outlook (WEO), the International Monetary Fund (IMF) revised up its UK growth forecast for 2014 for the fifth successive time, most recently from 2.8% to 3.2%, which is the highest predicted growth amongst G7 countries. While topping the growth league is something UK politicians are keen to highlight, especially ahead of the general election next year, it comes at the cost of excess demand, as evidenced by a recent deterioration in trade accounts.
The widening growth differential between the UK and the Eurozone (UK’s largest trading partner) means imports are outpacing exports, causing a structural deterioration in trade deficit. While UK activity is undeniably expanding at a solid pace, we believe that there will be a small loss of momentum during the second half of the year. Rather than something to worry about, this would represent a return to a more sustainable rate of expansion. On monetary policy, we continue to think it is likely that interest rates will go up either later this year or early in 2015. This is likely to be preceded by one or two Monetary Policy Committee (MPC) members starting to vote in favour of rate hike, which will kick off a more intense policy debate and prepare financial markets for the inevitable. How much of a threat financial markets perceive this to be will be determined by how an initial policy tightening is presented by the MPC. The risk is that the economy continues to grow at 3%+, and that investors judge the initial tightening as being only the first step in a longer sequence. It is evident at the moment, however, that the Governor of the Bank of England is keen to reassure markets that any tightening will not be overly aggressive.
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