Strategy & economics
Mind the gap
Divergence in monetary policy between the US and the eurozone
The theme of monetary policy divergence between the US Federal Reserve (Fed) and the European Central Bank (ECB) came to the fore in October. In its September meeting, the Fed referred to China and emerging markets (EM) as key reasons for leaving monetary policy on hold. In October, the Fed adopted a surprisingly hawkish tone as it removed the sentence on external risks from its statement. The Fed also downplayed weaker industrial data and focused instead on solid growth in consumer spending. Explicitly, it will be assessing whether to hike or not “at the next meeting”, firmly putting December on the table. The shift in tone led financial markets to refocus on the very real possibility of a rate increase in December and, more significantly, the start of a tightening cycle.
Conversely, the ECB sent a very dovish signal following its October meeting, thereby raising expectations for further easing measures in December. The ECB signalled that it is considering amendments to the current quantitative easing (QE) program and a cut to deposit rates. The “shadow”1 policy rates suggest that monetary policies in the US and the eurozone have been diverging since the start of 2014. This is due to the conclusion of QE in the US and the start of QE in the eurozone. December will be an interesting month as we are likely to see the first interest rate rise in the US since 2006 and, possibly, the first negative refinancing rate in the eurozone.
US – stronger services versus weaker manufacturing activity
It is now almost 18 months since oil prices began to slide and the US dollar embarked on a now very substantial appreciation. Consequently, the US energy and manufacturing sectors, especially multinational exporters, have encountered strong headwinds. The negative narrative in financial markets in August and September was a reflection of the fact that energy and multinational companies make up a significant portion of the S&P 500 Index. According to Deutsche Bank’s estimates, the share of earnings in the S&P 500 coming from manufacturing industries is a whopping 68%. However, the composition of the index is very different from that of the US economy. While capital expenditure in the energy sector has plunged and manufacturing activity has slowed, the two sectors only account for 15% of the US economy. But these hard-hit sectors are dwarfed by the service sector, which represents 85% of the US economy, as well as 86% of employment creation.
While growth in US manufacturing output has slowed to just +0.4% year-on-year (YoY), household spending growth strengthened to +3.2% YoY in September. There is no evidence that either financial market volatility or a Chinese slowdown has negatively impacted US consumer demand. In terms of outlook, leading indicators, such as the Institute of Supply Management (ISM) Non-Manufacturing New Orders Index and the National Federation of Independent Business’ (NFIB) Small Business Optimism Index, continue to suggest robust activity in the services sector.
It is worth noting that the divergence in the performance of services and manufacturing is not confined to the US. Services, which comprise the lion’s share of activity in most developed-market economies, are less heavily traded and less subject to the vagaries of the international economic cycle. Hence, they have benefited more from the stimulus to domestic demand in those economies provided by lower energy prices, higher disposable income and better employment prospects.
Europe – manufacturing activity stabilises
In the eurozone, the Purchasing Managers’ Index (PMI), a survey-based measure of business activity, suggested that manufacturing sector regained some momentum in October. Against the backdrop of continuing weakness in manufacturing activity in Asia, industrial output in the eurozone appears to have stabilised. As we have commented previously, the marked deceleration in the Chinese economy is unlikely to derail the eurozone’s ongoing recovery, as China accounts for a mere 3% of eurozone exports. Within this, Germany is one of the more exposed economies, as it exports more to China (5.4% of total exports) and partly reflecting this, factory orders dropped throughout the third quarter. Even so, business surveys have held up well and the German manufacturing PMI showed good growth in orders in October. In addition, despite the Volkswagen scandal, the IFO business confidence index2 was more resilient than expected in October, with the expectations index strengthening for the second month.
Closer to home, the UK manufacturing PMI has bounced to the highest level since mid-2014. Output, new orders (including exports) and employment all recorded robust rates of growth in October. Given the reliability of PMI surveys and strong historical correlation with actual GDP growth, it is reasonable to anticipate an improvement in industrial and trade data in coming months.
Japan – Diverging headline and core inflation kept the Bank of Japan on hold
In Japan, continuing weak domestic activity has resulted in growing pressure on the central bank to step up its QE programme. Nonetheless, with tentative signs of a pick up in inflation, the Bank of Japan seems content to leave monetary policy on hold for the moment. Although the annual rate of increase in the headline Consumer Price Index fell to zero in September, a measure of prices that excludes fresh food and energy, showed inflation of 1.2% - the highest rate since 1998. As a result, further monetary easing seems unlikely unless economic data deteriorate substantially.
1Model-based measure of the stance of monetary policy when policy interest rates reach the zero lower bound. Source: Fathom Consulting.
2The German IFO (Institute for Economic Research) Business Climate Index - an index that rates the current German business climate and measures expectations for the next six months.
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