Macro digest

The economic backdrop continues to improve – slowly. The most high-profile report was industrial production for March, which showed output rising 0.7% in the month, exceeding market expectations for a 0.2% gain. This series has been volatile recently, partly related to North Sea oil and gas extraction and partly to adverse spring weather. March was no exception to this pattern, with oil and gas output falling 1.8% and utilities output rising 2.4% as households kept their heating on more than usual for this time of year.

More importantly, manufacturing output, which accounts for about two-thirds of total industrial production, jumped 1.1% in March, well ahead of expectations, while growth in February was revised up by 0.7 p.p. to 0.9%. For Q1 as a whole, manufacturing output dropped 0.3% due to the large 1.9% production decline in January, while production is still down 1.4% over the year. Nevertheless, the improvement over the past two months points to a reversal in momentum and, unless there is a sharp reversal in April, manufacturing production will contribute positively to GDP growth in Q2. Stepping back from the month-to-month volatility, UK manufacturing output has risen some 3% since the trough in Q2 2009 but industrial production has fallen about 3%, primarily due to declining output in the North Sea fields.

The optimists had some other data to consider too. The latest REC/KPMG report on jobs painted a moderately positive report on the labour market. Recruitment for permanent jobs increased for the seventh successive month, with recruitment growing at a faster pace in April than March, alongside a discernible increase in business confidence. This report, plus the expansion in manufacturing, and the slow recovery in the CIPS/PMI and CBI business surveys into April, all suggest that the UK may be suffering less from the travails in Europe and is beginning to benefit more from the solid, albeit not stellar, growth in the Americas and Asia. It may also be indicative that historically easy monetary policy settings are starting to gain some traction.

Given the recent improvement in the data flow, the monetary policy committee’s (MPC) decision to leave policy unchanged at its meeting last week came as very little surprise. Policy is currently on hold as the Bank of England (BoE) waits for some firmer signs of whether the recent data uptick turns out to be a blip or the start of a longer trend. The markets now await the next edition of the Inflation Report, due later this week, for guidance about how the BoE sees the economy performing and inflation evolving over the next two years. This will be the last major report (and press conference as well) for Sir Mervyn King before he is replaced by Mark Carney in July. Therefore, it may be an opportune moment for him to place some markers about the direction of future policy.

At least one US labour market indicator continues to go from strength to strength. Initial jobless claims declined again in the week ending 4 May, taking the 4-week moving average down to 336,000, which is the lowest since the recession began at the end of 2007. Historically, jobless claims were one of the better indicators of employment momentum but the relationship has weakened in the post-crisis period.

To understand why, we should recall that changes in employment from month to month are the net result of flows into employment (the hiring rate) and flows out of employment (the separation rate). Separations themselves can be either voluntary (quits) or involuntary (firing). Moreover, not all workers who lose their jobs are eligible for unemployment insurance. So, jobless claims are only one part of one of the flows that affect overall employment growth.

During the current recovery, separations have fallen to a historically low level, both because there is little firing activity and the quit rate has remained very low. Nevertheless, aggregate employment growth has not been strong enough to lift the employment-to-population ratio because the hiring rate has failed to improve, despite a solid upward trend in job openings. Although the weakness in hiring relative to job openings could be signalling that structural unemployment has increased, the dominant view inside the Fed is that demand is simply too weak to generate a stronger dynamic in the labour market.

March’s consumer credit report showed that, although lending conditions are continuing to thaw, households are still in no mood to lever up to boost spending. Total consumer credit rose $8 billion in the month but, as has been the case for much of the past two years, almost all the growth came from student loans rather than lending categories like credit cards. The enormous growth in student loans since the start of the recession in part reflects an increase in the proportion of young people staying on in education, as well as older people returning to study to improve their employability. With returns to a college education still, on average, reasonably high relative to a high school education, on balance this trend is positive for longer-term loan growth.

However, the growth of student debt also has a more sinister side. The rise in such debt not only reflects an increase in the number of students with loans, but a greater amount of debt per student. Only around 40% of college students complete their degrees and, among those that do, unemployment is high, with many working in lower paying jobs that don’t properly use their qualifications. As a result, almost 12% of student loans are delinquent, while around half of all loans are in deferral.

Wholesale inventories increased 0.4% in March, suggesting that the 1 percentage point (p.p.) contribution of inventory accumulation to GDP growth in Q1 is unlikely to be revised down in the second estimate. However, the outlook for inventories in the second quarter is less rosy. Wholesale sales fell 1.5% in March, leaving the inventory-to-sales ratio at an elevated level. Depending on how quickly the overhang unwinds, inventory accumulation is likely to subtract 0.5-1 p.p. off Q2 growth. Currently, the market consensus for growth in the second quarter is just 1.6%, which would leave quarter-on-quarter (qoq) growth at 1.9%, a little below its average over the past three years.

The growth picture remains very mixed across the region, with strength in Germany and to a lesser extent Spain offset by continued weakness in Italy and France. The preliminary estimate for Euro-zone GDP in Q1 will be released on Wednesday with market economists expecting a quarter-on-quarter fall of between 0.1% and 0.2%. Although this would be a smaller contraction than in Q4 2012, it would mark the sixth consecutive quarter of declining output.

Looking at the details, there was a raft of stronger-than-expected German data released last week. These kicked off with a 2.2% jump in factory orders in March, led by a 4.1% increase in orders from other Euro-zone countries. This was followed by the third consecutive month of above 1% growth in manufacturing production and an improvement in exports. Meanwhile, the current account surplus continues to widen.

We think there are two main takeaways from the upside surprises in the German data. The first, and most positive, is that there is now a good chance that the German economy expanded in Q1, contrary to initial fears of another contraction. The second, however, is that the improvement looks unlikely to be sustained. The deterioration in German and broader European business sentiment in March and April will not show up in the hard data until the April and May reports are released. In addition, the fact that so much of the strength in March orders was driven by demand from other European countries looks odd, given the ongoing recessions across most of the zone. We therefore expect a correction in the coming months.

Looking at Spain, industrial output was up 0.6% per annum in March, a 19-month high and well above market expectations. The largest improvement was seen in capital goods. If the data are not revised, it may mean that Spanish GDP performed better than the initial estimate of -0.3% between Q4 and Q1. The laggards though this week were Italy and France. Italian industrial production declined 0.8% in March, the fifth month out of the past six in which output has fallen. Manufacturing production was even weaker in the month, dropping 1.4%, with only vehicle production providing any support. Meanwhile, French industrial production also disappointed in March, falling back 0.9%, down both for the quarter as a whole and over the year.

If the Euro-zone economy fails to recover as expected, the ECB can alter monetary policy in several ways. Not only might it cut interest rates, as it did at the most recent meeting, but it also might provide verbal guidance to the marketplace about potential future changes. For example, ECB executive board member Jorg Asmussen last week remarked that the ECB has an open mind to look at all things it can do within its mandate to revive lending, and that it had therefore discussed buying Asset Backed Securities to support small and medium-sized businesses. Fellow member Yves Mersch, on the other hand, argued that inflation expectations were stable as far as the eye could see and that the risk of deflation was no bigger than 10-15%. The bottom line is that, for now, the ECB has boxed itself into only taking actions around the margin to support activity and inflation, rather than the QE bazookas being deployed by the US Federal Reserve and the Bank of Japan.

The quality of Chinese data is suspect at the best of times. This is even more so when the authorities warn about problems with the statistics. At face value, the Chinese trade data for April were very supportive of an upturn in regional and global activity. In year-on-year (yoy) terms, export growth accelerated to 14.7% from 10% in March, while the pace of import growth also picked up. However, the underlying picture is much weaker. While exports to the US and Europe remain sluggish, there has been a dramatic ramp-up in reported exports to Hong Kong that has not been reflected in the island’s corresponding import data. Chinese specialists looking more closely at the anomaly have concluded that trade receipts are probably being inflated to mask capital flows and that the true rate of China’s export growth is probably closer to 6%.

Growth in industrial production (9.3% yoy from 8.9%) and retail sales (12.8% yoy from 12.6%) improved modestly in April compared with March, suggesting that although the growth picture doesn’t appear to be deteriorating, activity isn’t improving much either. Because real economic activity has been slow to respond to the startling growth in total social financing in recent months, speculation has grown that the Chinese authorities might ease policy into the summer or autumn. However, if the People’s Bank of China were to reduce the policy rate or reserve requirements, offsetting measures to rein in financial excesses would also have to be implemented.

The Reserve Bank of Australia (RBA) eased policy at its May meeting, reducing the overnight cash rate by 0.25% to 2.75%. We had thought that the RBA might have waited at least another month to see whether the 125 basis points-worth of cuts in 2012 were gaining more traction. However, the Board ultimately decided that the combination of underlying inflation likely to persist at the lower end of the 2-3% target band, the stubbornly high exchange rate, the recent stuttering in the global recovery and a domestic economy growing a bit below trend together necessitated looser monetary policy.

Australia is in the fortunate position that the monetary transmission mechanism is functioning well. In the wake of the RBA announcement, all the major banks announced that the official rate reduction would be passed through to borrowers, which will further boost a housing market that was already showing renewed signs of life in the early months of the year. If April’s strong employment growth marks an end to the year-long upward trend in unemployment, May’s rate cut will probably be the last.

The negative impact of the yen’s depreciation has been most marked in countries such as Korea that have a similar export profile and are also suffering from weakness in the key export markets of Europe and China. The related slowdown in the Korean economy has led policymakers to take action. After a stimulatory budget a few weeks ago, the Korean central bank unexpectedly cut interest rates by 0.25% last week and rates have now been lowered by 0.75% in total since June. The fact that inflation has been running well below the Bank of Korea’s target made the decision even easier.

Other countries are in a similar position. Malaysian industrial production fell 1.3% in March, after a decline of 1.1% in February, leaving it 0.2% lower than a year earlier. Malaysia’s exports continue to underperform those of its neighbours, and there are signs that the support the economy has been receiving from domestic demand may be fading. Nevertheless, the Malaysian central bank decided not to lower interest rates at its May meeting as it remains confident that the domestic economy will stay on track.