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20th May 2013
Standard Life Investments’ Global Strategy team provide regular analysis of the key economic data that has been influencing financial markets.
Available on a weekly basis, the Macro Digest takes a detailed look at the global economic issues that have been impacting our investment strategy. The regional approach aims to provide an easy-to-navigate guide to the most recent developments in the global economy.
If you prefer, you can access a text-only version of macro digest.
UK - A note of optimism
Mervyn King's last Inflation Report before the handover to Mark Carney sounded a cautiously optimistic tone, in keeping with the recent modest improvement in the data flow. According to the monetary policy committee, the growth of both demand and effective supply are likely to pick up gradually over the next year or so. Inflation meanwhile is expected to fall back to around 2% in the latter part of the forecast period, as external price pressures fade and a gradual revival in productivity growth curbs increases in domestic costs. The upshot is that the recovery will remain weak by historic standards but it is a recovery nonetheless.
The Bank of England's (BoE) central forecast is that GDP growth will reach 1.5% over the four quarters of 2013 and increase to 2.1% in 2014. Their modelling also suggests that there is a 33% chance that four-quarter growth will be less than 1% by the end of 2013 and only a 14% chance that growth will be negative. Meanwhile, inflation is expected to still be 2.9% at the end of 2013 before falling back to 2% by the end of 2014.
The BoE's confidence that inflation will finally return to target appears reasonably well placed. Rises in administered prices have put significant upward pressure on headline inflation in recent years but these forces should gradually fade over the forecast horizon. Moreover, most indicators of underlying inflation pressures are well contained. Inflation expectations have remained close to 2% despite headline inflation being well above this target level for the past three years and labour costs are trending down. In April, annual wage growth (excluding bonuses) fell to just 0.8%, only fractionally above the post-crisis low, while the figures including bonuses fell to a new low. The only way that underlying inflation will pick up from here is if the UK's already poor productivity performance deteriorates further.
Achieving a growth rate of 1.5% this year will require the pace of activity to pick up in each successive quarter. How likely is this? It is certainly possible. Household and business confidence has improved in recent months and household balance sheets are in better shape. There are nascent signs that easy monetary policy is gaining traction and the housing market is becoming more supportive of growth. We remain confident that the global growth backdrop will become more supportive by the end of the year.
However, the risks are firmly tilted to the downside for three key reasons. Firstly, without an about-face by the government, which is unlikely, fiscal consolidation is actually set to be larger in 2013 than in 2012. This is likely to take around a percentage point off growth. Secondly, the global economy has weakened through the first part of 2013, which will make the recent upturn in UK manufacturing sentiment and trade difficult to sustain until the global recovery kicks in (hopefully) later in the year. Thirdly, with employment growth levelling off in recent months, real wages falling and the temporary support from payment protection insurance payouts fading, the outlook for household incomes over the next 12 months is poor. Lifting consumption growth against this backdrop will be difficult unless households begin running down their savings. So, although we share the view that the future looks brighter than the recent past, the journey back to trend may be longer than the BoE expects.
US – The Disappearing Deficit
Since the beginning of the year it has been clear that the federal deficit was coming down much faster than anyone anticipated. In February, the Congressional Budget Office was forecasting a 2013 fiscal year deficit of 5.2% of GDP, down from 7% in 2012. Now, only three months later, the agency expects this year's deficit to come in at just 4% of GDP, and then fall to 2.1% of GDP in 2015. If realised, these projections imply that the public debt-to-GDP ratio will peak at 76.2% in 2014, before falling to 71.5% by the end of the decade.
The rapid near-term improvement in the budget outlook has been two parts austerity, one part revenue surprises and one part slower-than-expected health care spending. Fears that the US might face a public debt crisis in the short-term were always overblown. The country's fiscal problems are primarily long-term in nature – namely, unless the tax burden is raised significantly and entitlement spending is reformed, the structural budget deficit will rise over the coming decades as the population ages. Fortunately, there is time to make the necessary adjustments.
Last week's economic data was mixed and continues to point to weaker GDP growth in Q2 than in Q1. Manufacturing production slumped for the second month in a row in April and the first regional manufacturing sentiment surveys for May provided little reason to believe that a turnaround in the sector is imminent. This lends support to our thesis that inventories are set to subtract significantly from growth this quarter. Small business sentiment did improve in April, but remains well below historic norms.
The news on the consumer front was more positive with solid core retail spending in April starting off the quarter on a good footing and the Michigan consumer confidence index rising to its highest level in nearly six years. Initial jobless claims did spike last week but really this was just a return to their average over the first four months of the year and does not point to a deterioration in labour market conditions.
The housing data was bearish for near-term growth but bullish for the longer term. On the positive side of the ledger, home builder sentiment improved in March after three consecutive declines. Meanwhile, housing permits, which are the best leading indicator of residential investment, surged in April to reach their highest level in the current cycle. However, housing starts, which correlate more closely with investment in the current quarter, dropped significantly in the month after a strong March. Both moves were led by the volatile multi-family sector. Looking through the noise, residential investment remains on a solid upward trend.
As expected, the consumer price index fell in April, by 0.4%, led down by the steep drop in oil and other energy prices. Core consumer prices rose only modestly in the month and the annual rate of core inflation fell to 1.7% from 1.9%. This was the slowest pace since June 2011 and is consistent with other indicators showing that underlying inflation is running below the Federal Reserve's 2% target. The weakness in headline inflation will boost consumers' purchasing power and may have contributed to the upside surprise to retail sales in the month.
Europe - Grinding Down
The Euro-zone's drawn out slide continued in the first quarter of the year, with GDP contracting 0.2% according to the flash estimate, to be down 1% over the year. The decline in activity was more muted than the 0.6% fall recorded in Q4, but it was around the same pace as the average of the first three quarters of 2012. As yet, we have very little hard data for Q2, but if the survey data are to be believed, the economy's performance is unlikely to improve.
At the area-wide level we receive no formal breakdown of the different expenditure components' contributions to growth with the first release. Nevertheless, we can make some educated guesses, on the basis of the partial indicators released by Eurostat and the national authorities. For example, with nominal extra-European exports up 2.1% in Q1 and nominal imports down 0.8%, net exports likely made a positive contribution to growth in the quarter. Unfortunately, there were few other bright spots. Construction output declined 3.2% in the first quarter and is now 30% below its pre-crisis peak. Bad weather accounted for some of that weakness but by no means all of it. Industrial production was fractionally higher in Q1 than in Q4, but once the cold weather-induced spike in energy production is stripped out, output declined. Household consumption growth was probably neutral, with a modest increase in retail sales offset by a decline in auto sales. Meanwhile, non-residential business investment is also likely to have weighed on growth.
At the national level, the regional divergences in growth that have been evident since the end of the global financial crisis continued in Q1, although none of the Euro-zone members is performing particularly well. The best performers were Germany (up 0.1% in the quarter), Belgium (also up 0.1%) and Austria (flat), though German growth was below the consensus expectation of 0.3%. Among the other large economies, France contracted 0.2% for the second quarter in a row, confirming that the country is mired in recession. Nor was the composition of French growth particularly encouraging, as only public consumption and inventories made positive contributions, neither of which looks sustainable. Meanwhile, both Spanish and Italian GDP fell 0.5% in the quarter as their painful internal adjustments continue.
It is easy to be pessimistic about the outlook for Europe, but if one is looking for grounds to be optimistic, German wage developments are one place to begin. IG Metall, Germany's largest union, struck a deal with Bavarian employers last week to raise wages by 3.4% in the current year and by another 2.2% in May 2014. The ramifications of this agreement go beyond the benefits they will have for the roughly 800,000 affected employees. To begin with, increases of a similar magnitude are likely for another 3 million or so metal workers in other states. In addition, because IG Metall acts as a benchmark for negotiations in other sectors, the prospects for economy-wide wage growth in 2013 now look more positive. With both headline and core inflation on a downward trend, this will translate into stronger real wage growth, which will provide solid support for consumption spending this year. Most importantly perhaps, to the extent that domestic demand is boosted and relative unit labour costs are raised, stronger wage growth in Germany will promote rebalancing within Europe.
Asia-Pacific - The power of policy
The news out of Japan could hardly have been better in recent months. Since October, the yen has depreciated 30%, the Nikkei Index has leapt more than 75%, and consumer, business and investor confidence has improved accordingly. Partial indicators had implied that Q1 would be a solid quarter for GDP growth, but the preliminary numbers were even better than expected. Not only was output estimated to have risen 0.9% in the quarter, but growth in the last quarter of 2012 was revised up to 0.3% from the initial flat reading.
The surge in first quarter growth was a case study of policy in action. Household consumption increased 0.9% despite the ongoing weakness in income growth, as rising wealth and confidence in the future encouraged consumers to empty their wallets. Net exports also made a solid contribution to growth as yen weakness fed through into healthy export growth and only modest growth in imports. Meanwhile, both residential investment and government spending grew at a healthy clip. The only real negative aspect of the release was that fixed business investment declined, albeit less significantly than in Q4.
Japan 's economy should do well again in the second quarter as the easing in financial conditions continues to flow through to activity and the initial effects of the recent fiscal stimulus are felt. The prospects for business investment also seem to be improving, as firms' cashflows are boosted by stronger demand and the weaker currency. Machine orders, which are a good leading indicator of capital spending, surged in March by the most since 2003.
Elsewhere in Asia, activity data continue to disappoint. Malaysian GDP was much weaker than anticipated in Q1, dragged down by weak external demand. Year-on-year (yoy), growth fell to 4.1%, from 6.5% in Q4, leaving the run rate for growth at its slowest pace since mid-2011. For now, policy is on hold as the central bank seems confident that global growth will improve in the second half of the year and that domestic demand will accelerate to offset any slack that might develop. However, if the recent string of weak data points were to continue, the central bank will quickly come under pressure to do more. GDP growth also surprised to the downside in Thailand, with the 2.2% contraction dragging yoy growth down to 5.3%. An easing in policy is looking increasingly likely there too.
From this side of the world, the furore in Australia over last week's Commonwealth budget is hard to understand. After the underlying cash balance declined from 2.9% of GDP in 2011-12 to 1.3% in 2012-13, the federal government announced that it would be targeting a deficit of 1.1% in 2013-14. The key reason for the consternation is that in last year's budget the government was promising a return to surplus for the current fiscal year. That always looked unrealistic, however, and given that commodity prices have subsequently fallen and the economy grew more slowly than projected, more aggressive tightening would have been counterproductive anyway. Pro-cyclical fiscal austerity may be necessary in countries like Italy and Spain where markets are concerned about public debt sustainability, but in Australia, where the public debt ratio is only a little more than 10% of GDP, it is hard to see the rationale.