From Complacency To Crisis Around The World
We have discussed the CRIC cycle a number of times - especially with regards Europe - but it seems the never-ending story of Crisis-Response-Improvement-Complacency has struck once again as Morgan Stanley notes when complacency becomes pervasive, it usually gives way to a renewed crisis. Complacent financial markets appear to be looking through the fact that the global economy remains stuck in a 'twilight zone' between expansion and recession. Dismissing weak PMIs in China and EU, markets have feasted in QEternity and OMT and this has, as expected, affected European policy-makers (e.g. ongoing disagreements over the details of the much-anticipated negative-feedback-loop-breaking banking union; and Spain/Italy's 'belief' they can avoid an ESM 'austerity' program).
The Einhorn Cycle...
Via Brevan Howard:
The recovery in the US continues to be subdued, with the latest jobs report looking especially bleak. Payroll employment rose by only 96,000 and prior months’ gains were revised down. Smoothing through the monthly volatility, job creation has slumped below 100,000 over the last four months. Although the unemployment rate declined to 8.1%, this was only because many workers have given up looking for jobs. In fact, the labor force participation rate has fallen to a multi-decade low. Perhaps most alarmingly, hints of deflation are creeping into wages as average hourly earnings have declined outright since last month.
Hopes that activity would pick up meaningfully in the second half of the year have obviously been dashed. The labor market is stuck in low gear and GDP growth is tracking below 2%. The sectors of the economy that had been leading the expansion now appear to be vulnerable. Orders for core capital goods have fallen below shipments which usually means that business investment is on the verge of falling into recession. Forward-looking indicators for manufacturing are also sobering. In the most recent survey of manufacturing supply managers, orders contracted for the third consecutive month. Clearly, businesses are concerned about global growth as well as home-grown worries about the fiscal cliff looming at the start of 2013. Housing remains a bright spot, with new construction, sales and prices all trending upward. Unfortunately, the housing sector is too insignificant as a share of the overall economy to offset the sluggishness in other sectors.
With both growth and the labor market disappointing and measures of core price inflation falling, the Federal Reserve ("Fed") confirmed additional quantitative easing on 14 September. At its last meeting, the Federal Open Market Committee pointed to action by saying that they would “closely monitor” developments and provide additional monetary accommodation “as needed". The minutes stated that additional easing would likely be “fairly soon” if there is not a “substantial and sustainable” improvement in growth. The preferred options are Treasury and MBS purchases as well as extending and perhaps enhancing the policy commitment to keep rates low into 2015 as the recovery further progresses. These measures may provide a safety net for the economy but are not expected to add more than one-quarter to one-half of a percentage point to GDP growth. Even after Fed action, the economy is anticipated to face serious downside risks.
In the second quarter, EMU GDP contracted by -0.2% quarter-on-quarter, marking the beginning of a renewed recession period. In August, the Composite EMU PMI declined further, but only slightly. Noticeably, the German PMI continued to fall, to as low as 47.0, a value almost in line with the EMU average. Orders were lower than the EMU average. The unemployment rate continues to be the key worry, reaching previously unseen peaks in Spain and Greece, and new highs in Italy also. Owing to increases in VAT in some member states, as well as the hikes in energy and food prices, inflation rates in the euro area are creeping upwards despite the economic slowdown.
In the September policy meeting, the ECB decided to keep all its policy rates unchanged, as the staff revised the GDP projections downwards and HICP projections upwards. In the questions and answers session, President Draghi was not encouraging of an imminent rate cut decision, although the Introductory Statement highlighted that the Council envisages downside risks around the new GDP projections. Crucially, the ECB disclosed details of the new bond market program (Outright Monetary Transactions, or OMT):
(i) the program will target bonds with 1-3 years maturity;
(ii) no quantities are set ex-ante;
(iii) the purchases will be sterilized;
(iv) in terms of seniority purchases will be treated pari-passu to the private sector;
(v) neither the intervention targets for bond yield levels nor the indicators that would guide the ECB purchases were specified;
(vi) conditionality will be strict, and;
(vii) the IMF will participate in the surveillance of the programs.
The ECB also modified its collateral requirements so that countries in the OMT would see their minimum credit rating thresholds for sovereign bonds removed. The initial market reaction to the ECB announcement was positive, as investors seemingly considered it an important step in supporting the peripheral economies in their adjustment effort. The attention is now turning to Spain, which is considered likely to be the first country to apply for the program, and to what will be the additional conditionality required for them to qualify.
Some unusual holiday patterns related to this year’s Jubilee celebrations caused distortions in the monthly and quarterly data (temporarily pulling down second quarter growth and pushing up third quarter growth) of around 0.0-0.5%, which highlights the weak underlying growth trend. This has created some confusion as it led to some excessive pessimism in the second quarter, and might cause some unjustified optimism during the third quarter.
The bigger picture is that UK growth is somewhere between the US (growth slightly below trend) and the eurozone (recession). What UK policymakers were hoping for is that the three major headwinds - household deleveraging, bank deleveraging and fiscal austerity - would be partly offset by an investment and export recovery, assisted by a weak currency. However, with 50% of the UK’s exports going to the eurozone, an export-led recovery is not viable. While exports to the rest of the world have risen 10% over the past year, this has been entirely offset by eurozone exports which are down 10%.
Meanwhile, domestic headwinds show no sign of abating. Credit growth to households and firms has been zero for four years now and the housing market remains stagnant in both activity and prices. On the inflation front, there have been some upward revisions in near-term forecasts due to energy and food prices however the medium-term picture remains benign. Inflation expectation surveys are close to long-run averages and wage growth remains subdued. Recent currency strength is also anticipated to put downward pressure on inflation and is a further unwelcome impediment to the rebalancing of the economy towards exports.
Currently, the BoE’s QE target of GBP 375bn is expected to be reached in November. In recent months, the BoE has also launched a Funding for Lending Scheme, intended to lower bank funding costs and generate loans for the real economy. There has been progress towards lowering bank funding costs, but it is too early in the program to assess progress against the second goal. Fiscal policy has not yet wavered from the mantra of “sticking with the austerity plan”. Disappointing growth figures have led to a higher deficit path via automatic stabilizers, but have been accompanied by promises of further austerity in years to come. With tight fiscal policy, ongoing domestic deleveraging headwinds, and an EMU recession continuing to hinder UK recovery prospects, weak growth and monetary stimulus look set to continue.
Activity in Japan continues to slow in the third quarter, following a disappointing second quarter. Indeed, second quarter GDP was revised downward, now showing a growth rate of only 0.7% quarter-on-quarter annualized, half of the growth shown by the initial release. Furthermore, at the beginning of the third quarter, actual data indicated further deceleration both in domestic and external demand. In July, private consumption fell by 0.5% month-on-month ("m/m"), to a level 0.9% lower than the second quarter average; export volumes contracted by 3.1% m/m, and were about 4.5% lower than in the second quarter; and, to complete the dismal picture, industrial production also dropped by 1.2% m/m, disappointing market expectations of an expansion, to a level 2% lower than that recorded in the second quarter.
Conditions are in place for another fall in GDP during the third quarter. However, in August, indications provided by surveys were more mixed. While the weakness in manufacturing seems to be continuing, due especially to an on-going deterioration in global demand – the manufacturing PMI fell further – some indicators more geared on domestic demand like the services PMI or consumer confidence indicators improved. The deteriorating business cycle has not yet reached the labor market, which remains stable, as indicated by both the unemployment rate, at a low 4.3%, and the job-to-applicant ratio. The rate of deflation also remains constant, with the CPI index excluding both food and energy contracting in July at a pace of 0.6% year-on-year ("y/y"), like in June.
The Chinese economy continues to experience a soft patch. In August, the official manufacturing PMI fell to 49.2, the lowest level since December 2011, while the HSBC PMI dropped to 47.6, the lowest level since April 2009. This weak PMI data shows a renewed slowdown in manufacturing activity as de-stocking continues and new orders are yet to catch up. Indeed, actual industrial production continued to slow, from 9.2% y/y in July to 8.9% y/y in August. The rest of the economy is somewhat more robust, as both the official Chinese non-manufacturing PMI and the HSBC Services PMI are fluctuating around higher levels. Overall, China's growth rate is likely to slow further in y/y terms in the third quarter.
There are some signs that inflation has bottomed out, as the y/y CPI growth rate rebounded to 2% in August. Both input and output price indices of the non-manufacturing PMI jumped sharply to over 50, while input prices in the manufacturing PMI rebounded although remaining below the 50 threshold. Perhaps more importantly, property prices continued rising in August for the third consecutive month. Policy-wise, the People's Bank of China continues to use reverse repo to inject liquidity rather than reducing the reserve requirement ratio or cutting rates as expected by the market, in response to concerns about the renewed rise in property prices. With no aggressive easing in the pipeline despite weakening growth, China’s activity is anticipated to remain subdued for a prolonged period.
But apart from all that concern: World Wealth (according to Credit Suisse's indicator) has just reached all-time highs...
This feels eerily like the March/April period when post-LTRO improvements induced euphoria in traders and governments/ECB to relax prematurely and as Brevan Howard explains above - every major developed economy is facing significant downside risks - no matter how enthusiastic markets appear to be.