Fidelity Macro update: September 2015

Global growth momentum slowed over the past month, though still remained in positive territory.The deterioration was led by manufacturing-related components – particularly in emerging markets. Consumer confidence rebounded after a drop last month. The developed market recovery remained intact, while emerging market economies were generally weaker.

View: As DM fundamentals remain relatively solid for now, the growth improvement seen in Q2 should continue through the remainder of this year. At the same time, EMs are likely to continue struggling for now, unless further policy action in China brings about the long-awaited stabilisation in Chinese activity and commodity markets.

RISKS FOR 2015

• The Fed starts to hike at a faster-than-expected pace, due to e.g. 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 spill 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 sovereign or corporate credit event as EM currency weakness vs USD puts further pressure on EM corporates whose liabilities are USD-denominated
• A Russian crisis following further declines in oil prices spills over to Europe and leads to further geopolitical tensions
• Policy stimulus in Europe and/or Japan proves insufficient to escape the low-growth/low-inflation equilibrium (e.g. the Bank of Japan steps back from pursuing the 2% inflation target)
• EU/Greece negotiations break down leading to a Grexit/Grexident

ECB decides to taper earlier as a result of much stronger growth and inflation (positive) or a big inflationary shock (for example, following a spike in oil prices) choking off recovery (negative)

Looking into 2016, the global growth outlook turns somewhat weaker. I expect DM growth to slow as the boost to consumption from lower energy prices slowly diminishes, as stronger currencies and weak external demand continue to weigh on trade and manufacturing. The slowdown in China will remain a drag, directly and via other EMs Tighter financial conditions as of late (Charts 3 and 4, next page) cap the recovery (note the long lags involved). Inflation should start picking up on base effects in early 2016 but will remain subdued.

Given this backdrop, some central banks will have to ease policy further to support their economies – the European Central Bank and Bank of Japan are prime candidates for ramping up quantitative easing this year or in early 2016. At the same time, the US Federal Reserve is still likely to hike rates in 2015 (December) and the Bank of England is still likely to follow in 2016, but the pace of hikes thereafter will be very slow (possibly less than is currently anticipated).

The outlook for EMs is set to remain tricky as headwinds from a slowing China, low commodity prices and tightening financial conditions globally will continue weighing on them. Within the EM universe, debt-related vulnerabilities are likely to resurface, although there will be some bright spots too.

Risks to the outlook: Given the tight balance between stimulus and reform faced by the government, China seems to be particularly vulnerable to a policy mistake. Insufficient/incorrect policy stimulus that leads to a sharper slowdown, would deliver another blow to the global trade channel and rattle global financial markets, exacerbating the transmission.

Further downward adjustment in commodity prices would continue weighing on EM growth (particularly exporters) while potentially providing little additional stimulus to global consumption due to high leverage. 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.

With the Fed’s first rate hike still to occur, the pace of growth improvement in the US is key to watch over the next few months. I believe acceleration will be steady, with growth slowing next year, allowing the Fed to tighten very gradually. But stronger-than-expected signs of growth and/or inflation could accelerate the pace of hikes. This sharp tightening in global financial conditions after years of accommodation could be disruptive to global growth and markets, particularly in those places where vulnerabilities are high.

A combination of some or all of the above risks would put further pressure on EMs, potentially resulting in an EM crisis. While at this point in time the EM market rout is probably more of a symptom than a cause, it could turn into a powerful transmission mechanism as EM vulnerabilities spill over to DMs via financial links.

In addition, this would put further downward pressure on commodity prices.

US

Data: Data was robust, if somewhat mixed, over the past month. Q2 GDP was revised up strongly, from 2.3% to 3.7% (annual), driven by increases in consumption, investment, government spending and net exports. The manufacturing ISM fell to 51.5 in August, the lowest reading since May 2013. The non-manufacturing ISM also declined but remained robust at 59.0. A large part of the headline declines in both surveys was driven by deteriorating employment subcomponents.

The August jobs report was mixed, with the non-farm payrolls at a lower-than-expected 173k, weighed down by manufacturing and mining (Chart 7). Average hourly earnings growth edged up 0.3%mom and 2.2%yoy. The U3 unemployment rate fell to 5.1% and the broader U6 underemployment rate fell to 10.3%. Housing and construction data continued to improve. Inflation remained subdued, with core PCE now at 1.2%yoy, its lowest level since March 2012.

View: The fundamental growth story for the second half of 2015remains unchanged as the economy should continue rebounding from the weak Q1. Labour market progress (although at a slower rate), a consumption rebound helped by lower energy prices, the strength of the services sector and improving activity in housing and construction should support growth for the remainder of the year. Meaningful wage pressures are still unlikely to resurface in the next few months as broader measures of unemployment (such as U6) point to some slack remaining in the economy.

Together with wages, lower commodity prices and USD strength will keep inflation in check for now (both headline and core). As the economy is now approaching the end of the cycle, growth is set to slow as we move into 2016 (thus H2 2015 will be the peak for now). A combination of old and new headwinds will contribute to the slowdown: (1) the consumption boost from lower energy prices will moderate (but remain positive); (2) USD strength and weak external demand should continue weighing on manufacturing and exports, though it might be less negative than in 2015; (3) the recent tightening in financial conditions (partly China-related) represents a significant drag on growth, if sustained; (4) direct effects related to China developments (trade, CNY) are likely to be modest but still negative; (5) some tightening from the Fed will also weigh, even though it is likely to be modest, with a December hike in 2015 followed by at most two hikes in 2016 being a reasonable expectation.

I expect the growth consensus for 2016 to be revised significantly, as at 2.7% it remains too optimistic and could potentially drop to below 2%.

EUROZONE

Data: Data remained relatively solid.Q2 GDP came in at 0.4%qoq (non-annual) and 1.5%yoy, with net exports and private consumption making positive contributions. French growth was flat (partly on inventory reversal), Italian GDP edged down (0.3%qoq), German growth accelerated slightly (0.4%qoq) while Spain was the strongest performer (1.0%qoq). The Euro area composite PMI ticked up in August, with both manufacturing and services relatively stable.

Only Germany posted an increase in its manufacturing PMI, with significant declines seen in other countries – with France still in contraction. Services PMIs in Germany, Spain and Italy all rose. Retail sales rebounded in July, driven by Germany and Spain, while France posted a contraction. The area-wide unemployment rate fell for the first time since March, from 11.1% to 10.9%, driven by improvement in peripheral countries (Chart 8). Both flash headline and core CPIs were unchanged in August, at 0.2%yoy and 1.0%yoy, respectively.

View: The eurozone-wide recovery remains intact for now, supported by the forces discussed throughout the year. But looking ahead, some of these tailwinds are likely to start fading. The consumption boost from lower energy prices, while still positive, should start diminishing over the next few quarters. Some strengthening in the euro as of late, combined with continued weakness in external demand, could start reducing the positive contribution of net exports to growth.

EM-related developments also represent an additional growth headwind, particularly given European companies’ relatively high exposure to EM revenues. A somewhat stronger euro combined with low commodity prices should keep inflation around zero for longer. Given the labour market improvement, only Germany’s recovery has the potential to become self-sustaining, with consumption benefitting from stronger income growth, but it is vulnerable to external shocks.

Overall, moving into 2016, without further monetary policy support, area-wide growth will start slowing. In other words, the growth trajectory over the next few quarters is conditional on policy support – further easing could prolong acceleration. I remain convinced the ECB will stick to full implementation of QE as promised, at least until September 2016. In fact, it is now more likely that QE will be increased in size (as soon as this year or in early 2016) and extended beyond September 2016.

UK

Data: Data was softer over the past month. Q2 GDP came in as expected at 2.7% (annual), driven to a large extent by net exports and modest contributions from consumption and investment. Manufacturing PMI fell in August, to 51.5, on weaker employment and prices, though the new orders less inventories component was slightly better. Services PMIs also weakened, with business expectations falling for the third consecutive month. July headline retail sales stayed roughly flat in July, in line with the recent trend.

The housing market continued accelerating, as the number of mortgages approved for new house purchase rose, although price growth eased somewhat in August. Labour market data was weaker again as the unemployment rate stayed at 5.6% while employment fell in the three months to June (this is of course very lagged). Average earnings growth eased to 2.4% yoy in June (Chart 9, next page). Both headline and core CPI rose in July, with core rebounding to 1.2%yoy from 0.7%yoy, largely driven by clothing.

View:While the pace of growth remains decent at this point, the recovery remains quite uneven and tentative signs of a slowdown are appearing in the data. Given the limited slack left in the labour market and the upcoming introduction of the national living wage, the employment outlook is likely to deteriorate from here, with some surveys already pointing to weaker hiring prospects.

Wage growth should continue accelerating at a moderate pace, helping consumption, although for now consumer spending remains muted. Exports and manufacturing should continue to face the headwinds of strong sterling and subdued external demand exacerbated by a slowing China. While these headwinds are similar to those seen in the US, the UK is a much more open economy (exports account for 28% of GDP vs 13% in the US) with high commodity exposure, making it more sensitive to changes in currency, commodities and external demand. Headline inflation is likely to turn negative again in the coming months, and start picking up slowly around the start of 2016 on base effects.

A referendum in the UK on EU membership, to be held within the next two years, will also become an increasing source of uncertainty, potentially leading to lower investment and capital outflows, raising UK vulnerabilities in light of the wide current account deficit. All in all, there seems to be no reason at all for the Bank of England to hike this year. And while it is likely that more Monetary Policy Committee members will be voting for higher rates in the upcoming meetings this year, the actual hike is still a 2016 story – probably Q2 or even the second half of 2016, depending on the Fed.

CHINA

Data: China’s official manufacturing PMI dipped into contraction in August, while the Caixin headline slumped to 47.3, with the new orders to inventories ratio falling to an 18-month low. The non-manufacturing PMIs also declined but remained in expansionary territory. Employment components in all PMIs are now either in contraction or flat lining and deteriorating (Chart 11). July exports and imports contracted, although exports were less negative than in the previous month, as the trade surplus skyrocketed. Industrial profits fell in July, consistent with the sharp slowdown in activity. The 100-city average house price increased for the fourth consecutive month, yielding a positive year-on-year reading for the first time following 10 months of contraction. The People’s Bank of China’s (PBOC) FX reserves declined by $94bn in August, to $3.56trn

View: Despite weakness in some key indicators and negative headlines, China should experience steady growth rather than a hard landing for Q3. The services and property sectors remain in expansionary territory, but weakness in industrial activity and slowing trade continue to weigh on growth. Weak activity in August is likely to have been partly driven by some short-term factors, such as production/construction shutdowns around events in Beijing. But with no sign of substantial easing in broader financial conditions, a growth rebound is unlikely without further policy action. The PBOC’s move to cut interest rates and the reserve requirement ratio in August is a step in the right direction. But while this might help sentiment, it’s not enough to reverse the ongoing China slowdown.

EMERGING MARKETS

Data: The aggregate EM manufacturing PMI contracted for the fourth consecutive month in August, touching a post-crisis low; Poland and South Africa saw particularly large falls in the headline. Only Indonesia’s and Korea’s readings improved, but both remained below 50. Mexico, India, Vietnam, the Czech Republic and Poland remain in expansionary territory (above 50) for now. Brazil’s July industrial production contracted at the fastest yearly rate since 2009 as the economy slipped further into recession.

Korean exports slumped in August, recording the sharpest decline since August 2009, with particularly deep contractions in exports to Japan and Europe. The Korean inventory/shipments ratio eclipsed its crisis-time peak in August (Chart 12). India remains a bright spot with Q2 GDP running at 7.0%, as government spending ramps up. Russian inflation accelerated while real wages and retail sales continued contracting.

View: The EM slowdown continues, with headwinds from lower commodity prices, high real rates and slowing Chinese demand intensifying. Brazil and Russia are moving into deeper recessions while India remains one of the few EMs with decent prospects.

Some stabilisation in (1) China and (2) commodities as well as (3) 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 or long enough to radically change the EM growth story, particularly given the structural slowdown in global trade.

The lack of structural reform, vulnerability to China’s developments, and the Fed’s rate normalisation mean that many countries are unlikely to stage a strong rebound for now. As EM currencies have weakened over the past few years, the hard currency debt burden has increased further as a share of GDP, particularly in commodity exporters and/or countries with large external imbalances, such as Russia, Chile, South Africa, Brazil, Mexico and Turkey.

While overall resilience seems to be higher than in the 1990s, there are fragile pockets across EMs. It’s probably too early to worry about this and certainly some respite for EM FX would reduce pressure on highly indebted corporates for now. But while at this point in time the EM market rout is probably more of a symptom than a cause, it could turn into a powerful transmission mechanism as EM vulnerabilities spill over to DM via financial links.

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