Global growth momentum was roughly flat over the past month, while remaining in expansionary territory. Global business confidence deteriorated slightly as some improvement in developed markets (DM) was offset by further China-driven contraction in emerging markets (EM), while global new orders less inventories edged up. Commodity-related components weighed on momentum again and Korean exports (a leading indicator for global trade) continued contracting on a year-on-year basis but improved sequentially. Consumer confidence declined but remained at high levels. DM recovery remained intact and some EMs showed signs of stabilising.
View: Global growth improvement in Q2 should continue during the remainder of 2015. The renewed slide in commodity prices of late, if sustained, could prolong the tailwind that has been benefitting consumers globally, but would also continue driving differentiation between net commodity producers and consumers. DMs will remain the primary driver of global growth for now, but some EMs are also likely to finally show signs of a turnaround, helped by potential stabilisation in China in the coming months (conditional on further policy action).
Even though the pace of global growth is expected to continue picking up through the year, the rebound is likely to be relatively subdued as the generally low-growth/low-inflation environment is set to prevail for a while. With inflation unlikely to pick up meaningfully until at least later in the year, central banks will maintain liquidity support for now (and, in case of the Bank of Japan and the European Central Bank in particular, might be forced to ease more if inflation does not materialise). Risks to the outlook all revolve around tightening financial conditions (charts 5 and 6) which could come from different sources.
Risks to the outlook: With the Fed’s first rate hike looming, it will be important to watch the pace of growth improvement in the US over the next few months. I believe acceleration will be gradual, allowing the Fed to stay on hold until at least the end of the year and to then tighten very gradually. But stronger-than-expected signs of growth and/or inflation could accelerate the pace of hikes. This tightening in global financial conditions after years of accommodative monetary policy could prove disruptive to global growth and markets, particularly where vulnerabilities are high.
Given the delicate balance between the Chinese government’s wish to both stimulate and reform China’s economy, China seems to be particularly vulnerable to a policy mistake. Insufficient/inappropriate policy stimulus that leads to a sharper slowdown would deliver another blow to global trade and rattle global financial markets, exacerbating the transmission (Charts 7 and 8 illustrate vulnerabilities across the main economies). In addition, this would put further downward pressure on commodity prices.
Further downward adjustment in commodity prices could continue to weigh on EM growth (particularly for commodity exporters) while potentially providing little additional stimulus to global consumption due to high leverage. However, a sharp rise in commodity prices could fuel global inflation, forcing central banks to tighten earlier and faster which could put an end to the post crisis expansion.
Data: Data was a bit mixed over the past month. July;s ISM manufacturing fell, although the underlying components were moderately encouraging. The non-manufacturing index rose sharply, reaching its highest levels since 2005 (Chart 9). July’s employment report delivered another decent non-farm payroll number (215,000), while the unemployment rate stayed at 5.3%. Personal income continued growing but consumer spending was flat in real terms in June.
Inflation and wage growth remained subdued as the Q2 Economic Confidence Index was much weaker than expected, at 2.0% year-on-year. down from 2.6% year-on-year., and average hourly earnings growth at 2.1%. Q2 GDP came in below expectations at 2.3%, driven mostly by consumption, and revisions to prior years showed lower growth on average.
The Q3 Fed’s Senior Loan Officer Survey showed easier lending standards and better demand for loans, with substantial improvement in the residential mortgage segment.
View: The US economy remains in a good shape and should continue accelerating at a moderate pace through to year end. Labour market progress (although at a slower rate), strength of the services sector and improving activity in housing-related sectors should support growth for the rest of 2015. The consumption rebound from the weak first quarter should also accelerate.
In terms of the negatives, the manufacturing sector continues to face headwinds (Chart 9) from US dollar strength and weak external demand. The new low in oil prices (if sustained) will continue weighing on the energy-related sectors. Meaningful wage and price inflation pressures are still unlikely to resurface in the next few months. Broader measures of unemployment (such as U6) point to some slack remaining in the economy which should prevent wages from picking up in the immediate future. In conjunction with wages, lower commodity prices and US dollar strength will keep inflation in check for now (both headline and core).
Over the past few months, the Fed seems to have lowered the bar in terms of conditions for the first rate hike. However, there is a risk of hiking before wage growth and inflation indicators turn more positive and undershooting the inflation target. With uncertainty surrounding Greece’s bailout still an issue, China concerns must add to the Fed officials’ outlook.
All in all, I believe the current backdrop does not warrant an immediate rate hike and December still remains my baseline scenario.
Data: The July manufacturing PMI came in a bit lower, as declines in Germany, France and Spain offset an increase in Italy. The French PMI fell back into the contractionary territory. While the Euro Area-wide services PMI edged down, it remained well above 50. Retail sales fell in June, but consumption is still likely to have been the main growth driver in Q2. Industrial production fell on the month in Germany and France. Spain Q2 GDP rose to 1.0% quarter-on-quarter – the strongest pace since Q2 2006. Lending to non-financial corporations and households continued rising in June. The headline inflation rate was unchanged at 0.2% in July but core inflation rose to 1.0% year-on-year. Unemployment remained stable at 11.1% in June.
View: The eurozone-wide recovery continues, with the periphery generally improving at a faster pace than the core. With a resolution in sight for the Greek crisis, growth should continue to rebound at a moderate pace to year end. But some tailwinds that have been supporting the recovery over the past year are starting to fade. This includes the euro, which has strengthened by around 5% on a trade-weighted basis since its lows in April. This, combined with continued weakness in external demand, might start bringing to an end the ongoing recovery in exports over the next few months.
At the same time, upside inflation pressures related to a weaker currency should also slowly diminish. Additionally, the recent falls in commodity prices, if sustained, could keep inflation at these low levels for longer and, depending on the magnitude of adjustment in commodities, could push prices back into deflation. In the meantime, there are some tentative signs that the associated boost to household spending might already be fading (as the main oil price adjustment from $100 a barrel to $50 a barrel took place in H2 2014). The recent declines in consumer confidence might be pointing to a peak in consumption around Q3/Q4 this year (Chart 10).
Overall, there are no signs of a slowdown just yet, though without further policy support this recovery might come to an end at the start of 2016. I remain convinced the ECB will stick to full implementation of QE as promised, at least until September 2016. In fact, there is a chance QE might need to be increased in size and/or extended beyond that date (particularly because Greece-related risk is likely to resurface next year).
Data: July’s Tankan manufacturing index was unchanged, while non-manufacturing deteriorated significantly after a record high in June. July consumer confidence also fell considerably, while the Economy Watchers Survey improved slightly. June industrial production recovered somewhat but inventories continued building (Chart 12 next page), particularly in capital goods/export-oriented sectors.
Retail sales decelerated further in June, to a similar level last seen right after the consumption tax hike in June 2014, which was largely driven by fuel retailers. June nominal and real cash wages declined in a sharp downturn, driven by a fall in special wages. The June core national CPI was 0.1% year-on-year, unchanged from May, while headline slowed to 0.4% year-on-year. July’s Tokyo core CPI turned negative for the first time since April 2013, when the BoJ started QE.
View: The economy seems to have lost some momentum in Q2, and Q3 started on a soft note. Despite Japanese yen weakness, exports have not managed to stage a decisive recovery – this is partly due to long-standing structural factors affecting the Japanese economy, and partly due to sluggish external demand, which will remain a headwind for the external sector and related manufacturing activity. Consumption is likely to remain constrained by the subdued nominal and real wage dynamic, partly on the back of the disappointing result of wage negotiations. The recent falls in oil prices, combined with lower electricity prices, are likely to sustain the downward pressure on headline and core inflation in the coming months.
Having set the bar for further action relatively high (at least from the inflation perspective), the BoJ should remain on hold for now, waiting to assess the benefits from somewhat higher wage growth and lower energy prices. But further stalling in growth momentum, inflation and inflation expectations would necessitate more easing later this year or next year. It is still hard to see how this recovery can become self-sustained without more policy action (the three policy arrows of Abenomics comprise fiscal stimulus, monetary easing and structural reforms), as support from external cyclical factors fades over the next few months.
Data: The official PMI edged down to 50.0 in July, mainly driven by declines in production and new orders. The non-manufacturing PMI increased slightly on the back of the better services PMI while the construction PMI fell (Chart 13 next page). July export growth fell sharply, mainly on lower exports to Japan and the eurozone. Imports also declined, largely reflecting falling commodity prices. Industrial production, retail sales and fixed-asset investment all moderated in July. Headline CPI inflation ticked up to 1.6% on higher food prices, core remained unchanged, while PPI contracted further. Soufun’s 100-city property price index pointed to a further rebound in prices, while inventories continued to moderate, indicating further stabilisation in the property sector.
View: Despite some signs of stabilisation brought about by the June data, Q3 started on a softer note. Among the positives, service sector activity is expanding strongly, offsetting the ongoing contraction in manufacturing and exports. Additionally, with property prices recovering slowly, related construction activities should start gaining pace, supporting the economy. But with no sign of substantial easing in broader financial conditions (in fact, they have tightened somewhat lately, mainly driven by gains in the RMB prior to the August 11 devaluation, and partly by the equity market sell-off), a growth rebound is unlikely without further policy action.
In this respect, the devaluation may help. However, the impact of the currency move depends on its magnitude – it would have to be much bigger (possibly in the region of 20%) to have a meaningful effect on exports. Besides, sluggishness in exports has been mostly due to subdued external demand which devaluation cannot fix. In terms of further policy measures, a further rise in CPI inflation (on higher pork prices and potentially on weaker FX) amid the activity growth slowdown may limit the extent of further policy easing, especially in terms of conventional monetary policy measures.
On the fiscal side, further support to the economy will likely continue to be channelled through policy banks China Development Bank and Agricultural Development Bank of China, a funding mechanism which helps to limit the leverage build-up in commercial banks and non-bank financial institutions. Overall, the different nature of stimulus relative to the past (especially versus 2009) seems to be a reflection of the government’s intention to reform and make growth more sustainable, which is good news for China. But this also makes the growth story more vulnerable to a policy mistake.
The ongoing RMB devaluation may well turn out to be that policy mistake but it remains to be seen – this is conditional on what happens over the next few days and weeks. Risks to the outlook remain skewed to the downside as the headwinds from overcapacity, capital outflows, falling competitiveness, the government’s anti-corruption campaign and other reforms efforts continue weighing on growth.
Data: The aggregate EM manufacturing PMI fell again in July, remaining below 50 for the fourth consecutive month. This was driven by the Chinese data sinking to its lowest level for over a year, with Russia and Indonesia also sliding further into contraction. The picture was brighter elsewhere, however, with Brazil, Mexico, India, Turkey, Poland, Korea and Taiwan all improving month-on-month. The forward-looking New Orders to Inventories ratios improved almost everywhere, with the notable exception of China. Services PMIs also picked up for the most part, except for Brazil where the domestic picture continues to deteriorate significantly. Korean exports declined again in year-on-year terms but edged up sequentially. Q2 GDP for Korea and Taiwan was weak, with Taiwan contracting at an annualised rate of -7.9%.
View: The EM recovery is struggling to gain momentum, with the headwinds of lower commodity prices, high real rates (and rising in places, as shown in Chart 14 on the next page) and the slowdown in China intensifying. Brazil and Russia are moving into deeper recessions. Some improvement in July PMIs in a few countries is encouraging, but it remains to be seen whether it will be sustained. Some stabilisation in China and commodities, as well as moderately faster growth in DM should help the broad EM complex to finally start recovering.
However, the first two factors do not seem to be imminent, while the third one might not be sufficient to radically change the EM growth story, particularly given the structural slowdown in global trade. The theme of differentiation between commodity producers/exporters and consumers/importers will continue, defining winners and losers. The lack of structural reform and vulnerability to the Fed’s rate normalisation means that many countries are unlikely to stage a strong rebound in any scenario.
The crucial question is whether EM recovery can become well-entrenched before the Fed is ready to hike – if it does, the fallout could be limited. It is unclear though if the most vulnerable countries (such as Turkey, South Africa, and Brazil) can do enough to prepare for higher global rates in the coming months and come out unscathed after the Fed hike.
RISKS FOR 2015
- The Fed hikes at a faster-than-expected pace (due to a sharp acceleration in inflation), undermining the global recovery via tighter financial conditions globally
- A policy mistake in China, leading to a faster-than-expected growth slowdown and/or financial stress which spills over via trade and financial channels
- Commodity-related moves: (1) further downward adjustment in commodity prices weighing on EM growth while providing little stimulus to global consumption due to high leverage; (2) a sharp rise in commodity prices fuelling global inflation and forcing central banks to tighten, ending the extended period of policy accommodation much earlier
- A Russian crisis following continued declines in oil prices spills over to Europe and leads to further geopolitical tensions
- EU/Greece negotiations break down leading to a Grexit/Grexident
- Policy stimulus in Europe and/or Japan proves insufficient to escape the low growth/low inflation equilibrium (e.g. the Bank of Japan ends pursuing its 2% inflation target)
- The European Central Bank decides to taper earlier as a result of much stronger growth and inflation (a positive event); or a big inflationary shock, for example, following a spike in oil prices, choking off recovery (a negative)
- EM currency weakness versus the US dollar puts pressure on EM corporates whose liabilities are US dollar-denominated
- A sovereign or corporate credit event in a country like Venezuela or Russia, or in the banking sector)
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