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GDP grew 2.4% in Q1 2015, up from a revised 1.6% in Q4 2014 but well below the 3.5% in 2014 overall. Within this, stronger oil output saw oil GDP up 1.8% in Q1, compared with a 0.7% fall in Q4, while non-oil GDP growth slowed further to just 3.3% in Q1 from 3.5% in Q4. While public non-oil sector growth was fairly resilient at 3.1%, private non-oil sector growth eased to just 3.3%, its slowest in many years reflecting the impact of lower oil prices. We have lowered our forecast of GDP growth in 2015 to 3.2%, with a further slowdown to 2.6% in 2016 as oil output growth slows to 1% and the impact of government spending cuts mounts. Yet despite lower oil prices and warnings that the budget will move into sustained deficit unless there is substantial austerity, it is unlikely that there will be a big cut in spending this year because of the need to support growth and living standards. We expect spending to be cut by just 2.5%, implying a spending overshoot of nearly 25%. However, the budget will post a substantially larger deficit of 12.3% of GDP in 2015 compared with 2.3% last year.
Last night the leaders of France and Germany called on Greece to deliver “serious and credible proposals” to allow a deal to be struck that would keep Greece within the euro area. Early press reports suggest that Greece has tabled a revised version of last week’s European Commission proposals with a view to submitting new proposals to the monitoring institutions tomorrow. There would therefore appear to be no new proposals for euro area leaders to discuss at tonight’s emergency summit. The lack of urgency is surprising. Last night the ECB tightened its collateral requirements for Greek banks while keeping the overall ceiling for ELA unchanged at €89bn. Expectations that capital controls will be lifted soon continue to be misplaced and we still believe the banks will remain closed until a new agreement is in place. Conversely, there must be a limit to the time the ECB is prepared to extend ELA and we think the 20 July, when Greece has to repay €3.5bn owed to the ECB, will prove the final denouement.
Trade deficit widens as global headwinds weigh on US exports. Export
activity has slowed due to sluggish global growth and a strong dollar. Imports fell in May, but solid domestic
activity continues to pull in more goods from abroad. Net trade will represent
a smaller drag in Q2 than Q1, but a lingering drag on growth through 2015.
Despite an expected slowdown, May’s industrial production numbers corroborates the notion that the German economy continues to grow at a fairly solid pace despite the increasing turmoil taking place in the Eurozone. Trade data showed a widening of France’s trade deficit in May, as growth in exports to the rest of the European Union seem to be hitting a wall.
Implications and analysis
German industrial production was flat compared to the previous month in May (April: +0.6% m/m), a result that came broadly in line with consensus expectations. We had anticipated a significant weakening in industrial output owing to May having more “bridge days” than normal, which are not accounted for by the seasonal adjustment process. Against this backdrop, May’s outturn thus appears to be a pretty solid reading.
The figure was driven by a strong decline in the volatile energy industry, which was enough to completely offset gains in consumer and investment goods production, as well as in manufacturing. Therefore, we remain optimistic about the evolution of the industrial sector and currently expect industrial production to have accelerated a touch in the second quarter. This, in turn supports our view of an acceleration in GDP figures in Q2. According to our GDP model, the German economy may have increased 0.6% in the second quarter, therefore doubling the 0.3% growth rate recorded in Q1.
On the external sector, today we saw the release of French trade data. According to the figures released by the customs office, the trade deficit reached €4 billion in May, thus widening from the €3.3 billion gap registered in April.
The deficit figures were the result of a monthly 0.6% decline in exports and a 1.2% increase in imports, thus suggesting that, after a steady acceleration in the first months of the year, the French external sector may now be starting to lose some steam, as exports to the rest of the European Union – which account for more than half of total exports of goods – are now stagnating.
May’s industrial production data provide further reason to believe that GDP growth in Q2 saw a decent acceleration on the first quarter’s weakish expansion. But the ‘makers’ face a challenging environment, not least from a surge in the value of sterling and the crisis in the euro-zone.
We have become even more cautious about Korea recently. The external backdrop remains weak, hit by softening Chinese activity, while the outbreak of the MERS virus is now dampening private spending. But further policy stimulus should provide some support to activity; in June, the Bank of Korea cut interest rates for the second time this year, and the fourth time in the last 12 months, due to growing worries about the economy, and this month the government has said it will boost spending by almost US$20bn (more than 5% of last year’s spending bill). However, these measures will take time to feed through, so we have lowered our GDP growth forecast for 2015 to 2.7% (from 3% last month), before a pick-up to 3.4% in 2016.
A look back at Japan’s dramatic economic slowdown in the 1990s suggests several lessons for China. Forecasters were extremely slow to recognise how much Japan’s growth potential had dropped and the collapse of asset prices had profound and long-lasting effects. Global growth was not very badly affected in the following decade, with advanced economies performing quite well, but there were negative regional spillovers that contributed to the Asian crisis in 1997-98.
Trade exposures of the major advanced economies to China today are mostly quite moderate and similar to exposures to Japan in 1990, with the exception of Germany. Asian countries have intense trade links with China, greater than they had with Japan 25 years ago. The direct impact of a sharp Chinese slowdown would be centred in Asia, as was the case following Japan’s crash in the 1990s.
Japan’s financial linkages with the world looked quite large on paper in 1990 but in reality foreign exposures to the frothiest Japanese assets in the early 1990s were limited – explaining the lack of widespread financial distress in advanced economies after Japan’s crash. However, financial linkages with Asia through Japanese overseas lending were significant and reduced Japanese overseas investment contributed to the balance of payments pressures that built up in Asia in the mid-1990s. China has not played the same role in international financing but a sharp slowdown there could still impact global financial conditions and capital flows through other channels.
Non-manufacturing activity still bubbling. The headline index rebounded in June, with business activity and new orders both expanding at a faster pace. Employment is still growing but at a slower pace. Backlogs rebounded as we expected and signal a rise in future activity. We expect expanding non-manufacturing activity to underpin solid real GDP growth in the coming quarters.
It is far from obvious where Sunday’s resounding victory for the “no” vote leaves Greece this morning. The gambit that a win for the “yes” camp would force Greek Prime Minister Alexis Tsipras to step down has comprehensively failed and Europe must now negotiate with an emboldened Mr Tsipras.
We doubt an agreement can be reached quickly, although the departure of the flamboyant Greek Finance Minister this morning is clearly an attempt to reset relations. Greece is likely to seize on Thursday’s IMF debt sustainability analysis as a template for a solution that includes an element of debt restructuring.
This is going to make life very challenging for Greece’s European partners who have resisted making outright transfers to Greece and are likely to baulk at the sheer size of Greece’s financing needs over the next three years. Greece too may be underestimating the degree of fiscal tightening that will now be needed to balance the books and will be demanded as a condition for any renewed assistance.
What Greece needs from here is a comprehensive programme of reform to get the economy back on its feet, that is sufficiently generously financed to avoid another self-defeating spiral of recession and missed fiscal targets. There is a narrow trajectory from here that sees an emboldened Greek parliament accepting the need for reform in return for a debt write-down. The next 48 hours will therefore be crucial.
The Chancellor will present his ‘Summer Budget’ to parliament at 12.30pm on Wednesday 8th July. Here we present our checklist of things to look out for.
May’s first clutch of Eurozone industrial production and orders readings from Germany and Spain made pretty encouraging reading. Not only do they suggest that the positive effects of the weak euro may be starting to feed through but that Q1’s global trade figures may have overstated the underlying weakness of demand abroad.
While the latest developments in Greece cast a shadow over the strength of the recovery in H2, the region still looks well positioned to have at least matched Q1’s 0.4% quarterly rise in GDP in Q2.
The Modi government has set an April 2016 deadline for rolling out the dual goods and services tax (GST) that is intended to replace the country's plethora of indirect taxes. We think this is too optimistic; at best we expect a partial introduction next year. The new tax system is not expected to have an immediate positive impact on tax collection (the GST is not a short-term fiscal remedy but a structural reform expected to improve economic efficiency through better allocation of resources). Over time, the GST should help India’s fiscal performance, as low flat tax rates increase economic activity and encourage compliance. According to the study commissioned by the thirteenth Finance Commission from the NCAER, the GST could shift the level of India’s GDP higher by 0.9-1.7%
The GST bill is currently pending in the Rajya Sabha but is broadly expected to be cleared in the next parliamentary session (starting 21 July). Nevertheless, several steps remain before the new tax system can be rolled out. Most importantly, the bill has to be ratified by the legislatures of at least half of the states.
There is broad consensus among political parties on the need for GST. However, state governments are worried about the potential loss of revenue in its initial years. Consequently, agreeing a tax base and a revenue-neutral rate (RNR) acceptable to both the central and state governments has become a contentious task. In the study sponsored by the Empowered Committee of State Finance Ministers, the National Institute of Public Finance and Policy (NIPFP) has recommended a composite RNR of 27%, which is significantly higher than the average GST rate in other Asia Pacific countries.
The implications of closing Greece’s banks are even more horrible than running up arrears to the IMF; partly because bank closures are more difficult to reverse. The equation can be written “Demand for withdrawals minus ECB willingness to increase ELA equals extended bank closures”. Whatever the referendum outcome, the ECB is unlikely to significantly increase ELA limits any time soon. Cyprus was able to gradually loosen capital controls because of a decisive and credible commitment to reform. This is not possible in Greece. Our latest scenario analysis suggests an exit probability of around 67%.
Quarterly GDP growth of 0.3% in Q1 2015 was driven by a 0.7% rise in consumer spending. Export volumes rose by 2%, but values were dampened by low commodity prices. We expect GDP growth to rise to 2.1% for 2015 as a whole, up from 1.5% last year. The medium-term outlook remains downbeat, as structural issues go unresolved and the external picture continues to be fairly bleak. CPI inflation has averaged 4.3% so far this year, compared to 6.1% for 2014 as a whole. Eskom’s application to raise electricity tariffs by an extra 12% in 2015/16, over and above a similarly large increase already accepted, would have further raised headline inflation, but the additional rise was denied this week. We now expect inflation to average 5% in 2015, then 6.4% in 2016. The South African Reserve Bank’s Monetary Policy Committee kept interest rates unchanged at 5.75% in May, but again made it very clear that the central bank remains in an interest rate tightening cycle and that there is very little leeway left to keep rates unchanged, despite the fact that the economy is struggling to gain momentum. A hike in rates seems likely late this year after the US Fed starts to tighten.
The last month has seen some hawkish rhetoric from MPC members. But with July’s meeting coinciding with a likely fiscally tight Budget and the risk of ‘Grexit’ rising, a unanimous vote to keep rates on hold on 9 July seems a certainty.
As expected, June’s CIPS services survey suggested that May’s hefty fall in the survey’s main business activity index was only a temporary hiatus. But evidence of robust growth in the services sector provides further contrast with a much more subdued performance from industry.
Payrolls rose solidly in June, retaining strong momentum with broad-based gains. Overall wage growth slowed, after a pick up in the prior two months. However, as labor market slack continues to dissipate, we anticipate a broadening in wage growth. The employment figures support a September Fed rate lift-off.
In our view, markets and Eurozone policymakers are being too sanguine about the risk of contagion if Greece eventually leaves the currency bloc. Contagion will take many forms, some of which have been given little attention in the wider debate, but could be very powerful.
Speculation is rising that a possible Greek exit from the Eurozone would delay the Fed's rate lift-off beyond September and possibly into next year. We believe it is premature to determine at this point. For now we maintain our call for a September lift-off, but the Fed will be closely monitoring possible contagion effects that would include wider corporate bond spreads, weaker equity prices and a stronger US dollar.
The first consideration would be whether a possible GRexit is orderly, which would represent a negotiated exit. Or alternatively, if it is disorderly and disruptive to global financial markets and economies. An orderly exit could keep the Fed on track for a September lift-off, while a disorderly exit would certainly stay the Fed's hand.
A further rise in construction spending. Spending was up for a sixth consecutive month in May on gains in both residential and nonresidential spending. Private single-family spending was flat, but we expect it to accelerate. Residential investment growth should strengthen as housing activity appears to finally be breaking out of its shell.
Manufacturing activity expands at faster pace in June. Domestic fundamentals remain solid though still-present growth constraints continue to restrain activity in Q2. However, we expect the recent drags on manufacturing will dissipate in the coming months and allow for stronger activity in H2.
Improvements to the methodology for calculating construction output have caused some sizeable upward revisions to the recent history for GDP growth. Each of the four quarters to Q1 2015 were upgraded and the economy is now estimated to have grown by 3% in 2014 and 0.4% in Q1 2015. The Q2 data have shown a re-emergence of the traditional ‘two-speed’ economy, with manufacturers struggling but firms in the services sector, particularly those closely-related to the consumer, reporting strong activity. Meanwhile, the Chancellor is set to introduce a new fiscal rule when he presents the ‘summer Budget’ on 8 July. The new framework will commit the government to running a budget surplus in “normal times”. While the practical impact is uncertain, the move could cause the government to tighten fiscal policy even further than currently envisaged, which could be a risk given the lack of scope to loosen monetary policy and the mounting downside risks to growth including the escalating Greece crisis. For now, we expect growth of a solid 2.6% this year and 2.7% in 2016.
Greece moved into uncharted waters last night, becoming the first advanced economy to default on the IMF. Yesterday also marked the end of Greece’s second adjustment programme and with it the end of the existing bailout proposals. This leaves Greece needing to agree a fully-fledged third bailout programme, which will be much more politically challenging as it will need to be ratified by European parliaments.
Meanwhile, early opinion polls suggest that Syriza may actually win Sunday’s referendum, at least on the basis of it being a vote on “no to austerity” and not a “no to euro membership”. But the spectacle of watching a Greek government campaign against the conditions of the now expired second bailout will not help negotiations for a third.
Hence the last minute offer by Greece to accept a deal in return for €30bn of financing under a third bailout programme appears to be too little, too late. It appears to vastly underestimate the significance of last night’s deadline and the political obstacles to agreeing a third bailout. At the very least, this will prove a protracted and complicated process that will most likely take months to complete. In the interim, it is impossible to see capital controls being lifted without a significant increase in Emergency Liquidity Assistance – which the ECB cannot do while Greece remains outside an official adjustment programme.
The Q2 Tankan survey was more upbeat than expected with manufacturers and non-manufacturers showing resilient optimism. There was also a large increase in investment intentions suggesting optimism about future demand prospects. Steady GDP growth is likely through the rest of the year. Japanese equities were boosted as the Tankan survey reported better than expected business confidence. This was especially true for manufacturing where it was feared that the China slowdown would undermined optimism. Other Tankan data showed a strong rise in investment intentions and unchanged employment intentions. Along with other surveys the Tankan points to steady growth consistent with our overall 1% GDP growth call for 2015. beat Tankan points to continued momentum
Key data elements
The latest quarterly Tankan survey showed greater optimism than consensus expectations. The widely watched large enterprises outlook improved for both manufacturers and non-manufacturers. Other balances were broadly unchanged with steady employment and pricing intentions. But investment intentions improved considerably with large enterprises upping their capex intentions for this fiscal year to 9.3% from -1.2% in March. There is a tendency for these forecasts to be revised upwards through the year but the scale of this revision is unusual.
Impact and outlook
The latest Tankan survey provides further support to the view that the Japanese economy will continue to expand steadily through the rest of the year. The resilience of manufacturing is especially encouraging as it had been feared that the China slowdown would hurt the sector. But this does not appear to have been the case and non-manufacturing optimism also improved.
Other Tankan survey data showed little change in employment and pricing intentions. Prospects for overseas demand among large manufacturers are also the same as in the March survey (-4), but this is above the level of both one and two years ago when the balances were -7 and -10 respectively. The depreciation of the yen is still helping the outlook for exports.
Along with other measures of business and consumer confidence the latest Tankan survey points to steady growth through the rest of the year. The 1% q/q growth in Q1 may not be repeated, but underlying growth of 0.4% to 0.5% a quarter is likely. For the year as a whole GDP growth of 1% is likely.
The monthly real economy indicators in April and May suggest that the contraction deepened in Q2, with the monthly measure of GDP reporting annual falls of 4.2% in April and 4.9% in May, led by large declines in both consumer spending and investment. These developments are in line with our expectations. As a result, we maintain our GDP forecasts for -3.5% in 2015 followed by a mild recovery in 2016 of 0.8%, as the downward pressures on demand gradually ease. Our baseline forecast assumes that Brent oil prices will average US$62 in 2015 and US$68 in 2016, while lower inflation and a relatively stable RUB will allow the CBR to reduce interest rates further, thereby easing the tight financial conditions faced by households and firms, especially those affected by sanctions.
With the manufacturing PMI dropping to a 26-month low, the UK economy appears to have fallen back into its traditional ‘two-speed’ state, with the production sectors lagging well behind services. Poor export performance remains a key constraint and, with the Greek crisis escalating, there appears to be little chance of this situation improving in the short-term.
The Eurozone has been a laggard in terms of productivity in recent years. Furthermore, after the financial crisis, productivity growth has decelerated even further, at only 0.5% per year. This is possibly related to labour hoarding and in line with other developed economies where productivity growth has slowed.
Divergences across its members remain one of the main features of the Eurozone. Spain and Ireland, and to a lesser extent Portugal, are the only main Eurozone countries, which maintained reasonable productivity growth after the financial crisis. However, part of this gain came from a fall in employment rather than a surge in output; these economies were adjusting to the business cycle rather than permanently increasing productivity.
We expect productivity in the Eurozone as a whole to bounce back in the next couple of years, increasing by around 1% per year, mainly as a consequence of the relatively low employment growth. However divergences will remain across countries, mainly as a factor of the tightness of the different labour markets.
Hopes the economic slump would be limited to Q1 were dashed as real GDP contracted in April. Economic activity should regain its footing in H2 as the impact of lower oil prices fades, but the recovery will likely be tepid.
Further declines in Chinese stock prices have taken the key indices into bear market territory. Given strong evidence that prices had entered ‘bubble’ territory, the sell-off could have considerably further to go: additional declines of 30-40% would be needed to restore valuations to their long-term averages. The macroeconomic fallout will be limited by low levels of stock ownership, but is unlikely to be negligible.
Ownership of shares among households in China is relatively low but has expanded rapidly, fuelled by credit. Margin loans outstanding are very high at around 9% of the estimated free float of the combined exchanges risking inducing forced sales. A further steep sell-off could damage consumer and business confidence.
Having encouraged the bubble to form, Chinese policymakers are now in a tough spot – monetary policy was loosened further last weekend but this may not be enough to stabilise the market. Interest rates may have to rapidly follow equity prices lower.
Consumer Confidence Index exceeded expectations in June. Consumer confidence rose on a more optimistic view of both current and expected economic conditions. Consumers' improved view of the labor market bodes well for Thursday's June employment report. Rebounding economic activity alongside accelerating wage growth and rising employment will underpin household spending growth in 2015.
The rebound in India’s headline growth over the last two years is impressive. However, this partly results from major statistical changes to the calculations of GDP. Indeed, the mixed trends in the monthly indicators raise concerns about both the pace and sustainability of the recovery. Credit growth and indicators of rural consumption remain weak, while the underlying health of the manufacturing sector is unclear. In our view, macro policy will need to stay supportive if the economy is to grow by 7.5% in 2015 as a whole. In response to the patchy economic performance, the RBI has lowered the repo rate to 7.25% from 8% at the start of the year. We expect another 25bp cut in the next couple of months, provided that CPI inflation looks set to stay below 6%. However, the downside risks to our forecasts have increased. Worries about a rebound in inflation due to temporary weather or exchange rate shocks have picked up in recent months, thereby clouding the monetary policy outlook.
In 2010, sectoral financial imbalances in the US reached what is most likely an all-time high. By 2015, they had reverted to below their long-term average.
Although households are still deleveraging, this is now done through income and wealth growing faster than borrowing. Non-financial corporates have also deleveraged, but their debt was never as excessive as that of the household sector. The private sector deleveraging process is broadly speaking complete.
This supports the view that what we have seen is a balance-sheet recession and its aftermath, rather than the beginning of secular stagnation. Current interest rates are not the ‘new normal’.
Negotiations on finding a last minute solution to the Greek crisis are apparently ongoing, with the European Commission President Jean Claude Juncker suggesting the Eurogroup could be convened at any time up to midnight tonight to agree a new programme and avert a default.
Yesterday however saw both sides retreating behind their respective barricades with Greece insisting a no vote in Sunday’s referendum would give them a renewed mandate in the negotiations, while the Europeans insisted that a “no” vote would be tantamount to voting for a euro exit.
Either way, we continue to stress that the character of the negotiations will materially change by the end of today when the current bailout expires. This will leave Greece needing to negotiate a fully-fledged third bailout programme in an environment made more acrimonious if Greece also choses to default on the IMF this evening.
Japan’s budget deficit and public sector debt are the highest in the developed world. But JGB yields are low and domestic investors have readily funded the government. The Bank of Japan will soon be the main holder of JGBs. This will diminish financial stability risks, but not alter the need to restore fiscal credibility. Trends in public spending and taxation mean that faster GDP growth is the best way to achieve this.
Divergent trends in spending and receipts make a graph of Japan’s public finances look like a crocodile mouth. But the Japanese government still pays very low interest rates – in large part due to persistent deflation or very low inflation. Passive domestic investors have helped insulate Japan from the need to sell bonds to overseas investors.
But Japan needs to establish fiscal credibility, despite the large proportion of JGBs now held by the BoJ. In theory the BoJ could simply write off its JGB holdings reducing debt to GDP ratios by 70 to 80 percentage points of GDP. But markets may well take fright at this: the public finances are a (slow-ticking) time bomb and not a free lunch.
The fall in Eurozone CPI inflation to 0.2% in June confirmed that May’s increase overstated the rise in underlying inflationary pressures. But with energy prices set to rise further and the weak euro appearing to push up prices, we still expect headline inflation to rise to about 1% by the end of the year.
German’s retail and labour data confirm that the household spending driven recovery remains on track, but there are growing signs that capacity constraints in the labour market will prevent further significant rises in employment over the coming quarters.
With GDP growth revised upwards for each of the past four quarters, the official data have moved closer to the other activity data, although we wouldn’t rule out further upward revisions. The domestic economy has been reasonably balanced, with investment strong. Consumers are clearly enjoying the fruits of ‘noflation’ and today’s data reinforces our confidence in our above-consensus forecast for GDP growth.
It is hard to describe the scale of disaster that has this weekend befallen Greece with the imposition of capital controls. The suppressed demand for deposit flight will mean capital controls will be hard to lift without a significant injection of new financing from the ECB. This is only likely to be forthcoming if Greece is inside a new bailout programme. But this is likely to take months to negotiate and means capitals controls will remain in place most likely for months to come.
But even if Greece votes “yes” next Sunday, negotiating a whole new third bailout package for Greece is going to be politically challenging. The IMF is likely to insist that a debt write-down forms a central part of any third bailout which may make it very difficult to get any new agreement through the various European parliaments. The imposition of capital controls is likely to inflict significant damage on the economy and the government’s tax revenues, significantly raising the price tag and the amount of austerity that will be need to be imposed in any third bailout package.
While some commentators have suggested that a referendum would be a wake-up call for the Greek people, we are concerned that the practical hurdles to an eventual solution have been made significantly larger by the imposition of capital controls. Our initial estimate would be that Greece needs a new three year programme worth at least €50bn with a debt write down of a similar size. This is unlikely to appeal to either the Greeks or their European partners, raising the risk that no new programme can be agreed and increasing the risk of an eventual exit to 70% in our view. This suggests Greece may be heading out of Europe, prompting a huge geopolitical reconfiguration of the Balkans.
The PBoC cut both the lending rate and the seven-day reverse repo rate to new lows of 4.85% and 2.7%, respectively. In addition, it selectively lowered banks’ reserve requirement ratios.
This is the most decisive easing by the PBoC since the global financial crisis. In our view, the latest easing is likely to have been triggered by the sharp sell-off in the stock market. But the market may already have entered a downward spiral that cannot be halted by interest rate cuts.
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