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RBI left repo rate unchanged at 7.25%, but kept the door open for further rate cuts unlike June.
We continue to look for another 25bp rate cut as we are less upbeat than the RBI on India’s growth prospects and expect inflation to stay within the central bank’s target this year.
The July manufacturing PMI data for the three biggest CEE economies suggest growth momentum remains generally strong in the region, in line with a reasonably robust recovery in the rest of the EU. Hungary, however, surprised with a sharp drop in its July PMI, signalling a slowdown after a recent surge in activity.
Weak gain for construction spending. Despite only a slight monthly gain, spending rose for a seventh consecutive month on a gain in residential spending. Private single-family spending declined for the first time in three months, but should recover in the latter half of the year as housing activity accelerates. We expect that residential investment will strengthen in the coming quarters.
We believe China’s growth has slowed to well below the official 7% pace. The rash of policy measures undertaken this year are indirect evidence of that – if everything is fine, why has policy easing accelerated, with further steps being contemplated? Our baseline forecast expects policy easing to continue along similar lines to that seen so far this year. But, if the economy fails to respond a number of other policy options may be considered including currency depreciation, deficit spending and ultimately a return to ‘direct’ measures such as targeted lending.
In our view, policy measures to date have had only a limited impact, reducing some of the downside risks to growth but not lifting growth itself appreciably. The extent to which the authorities will shift away from the current policy course depends on the trajectory of growth in the months ahead and also on whether the growth slowdown starts to generate other undesirable effects such as significant unemployment or social discontent. There have been some signs recently that a change of course may be being considered, including official talk of ‘effective measures’ to combat weaker growth and the announcement of a planned further widening of the fluctuation band of the currency.
Manufacturing activity unsurprisingly cools in the face of global headwinds. Domestic fundamentals remain solid but sluggish global growth, a strong US dollar and depressed oil and gas activity are weighing on activity. We expect these drags to gradually dissipate, but they will not fade overnight.
Spending cools modestly but maintains solid pace. With income rising steadily and expected to firm in the coming months, we see personal outlays strengthening in coming months. Spending on durables may be slowing after months of strong expansion, but outlays on services seem to be taking the baton.
Saudi crude oil production hit another record level of 10.6m b/d in July. Some of the increase is attributable to higher seasonal demand at domestic power plants and increases in domestic refining capacity. But it is also because of the Kingdom’s determination to maintain market share – abandoning its swing producer role – which has been reinforced by the possible normalisation of relations between Iran and western powers. We now see hydrocarbon sector growth of 4.8% this year. Meanwhile, despite further slippage in the oil price over the past month and signs that it is affecting the economy more broadly – the non-oil private sector PMI stood at a survey low in June and the fiscal position will now record a larger than previously expected deficit – we have left our already bearish non-oil growth forecast for 2015 unchanged at 3.1%. Overall GDP growth is seen slowing from 3.7% this year to 2.6% in 2016 on a smaller contribution from the oil sector.
Today's PMI data indicate that most of the region's manufacturing sector started Q3 on a weak note, with China, Korea, Taiwan, Malaysia and Indonesia all posting below the neutral level of 50.
Not only did production slow in July, but new orders also weakened across most Asian economies. This suggests that manufacturing conditions are likely to remain sluggish in the short term. And if this pattern persists then there is clearly a risk that our forecast of a modest improvement in regional trade during H2 does not materialise.
Exports have rebounded from the acute weakness of May but are still fairly weak. Industry has been depressed by a subdued China, whose latest PMI actually weakened further in July.
The greatest pressures in regional trade are likely to have been in Q2 but the recovery is set to be modest. Against this background, exports are likely to remain weak despite the recent fall in the won.
With even dovish members of the MPC entertaining the prospect of a near-term rate rise, August may see unanimity break down, with two or three members voting for a hike. But ‘noflation’ and the strong pound are set to keep a majority supporting no change in rates.
Today we saw the release of manufacturing PMI figures for July across the Eurozone. While the aggregate number for the Eurozone as a whole came in slightly better than the flash estimate, individual data at a country level offered a mixed bag: on the positive side, Germany’s data confirmed steady growth, while Italy’s PMI defied expectations and reached the highest level in over four years. On the other hand, manufacturing activity in Greece collapsed, as the country suffers the effects of capital controls and an extremely uncertain economic and political environment.
The final Eurozone manufacturing PMI decreased slightly from 52.5 in June to 52.4 in July, better than the 52.2 initially reported in the flash estimate. Thus, the index remains well above the 50 mark that separates expansion from contraction and is still close to its highest level in four years, suggesting that manufacturing activity in the Eurozone has so far remained relatively insulated by the ongoing crisis in Greece. The number for July sits slightly above the average seen in the second quarter and therefore corroborates our view of steady growth in the Eurozone in the second half of the year.
That being said, those numbers mask enormous difference between countries. The German manufacturing PMI was revised up (51.8 points versus 51.5 points initially reported), leaving it virtually unchanged from the 51.9 points recorded in June. While the manufacturing PMI is below the Eurozone average, we expect the wider economy to have outperformed the region as a whole in Q2 thanks to buoyant growth in the more domestically focussed sectors of the economy. Manufacturing numbers for France were in line with the flash estimate (49.6), below the 50-mark that is consistent with declining activity.
Meanwhile, Italy and Spain – where there are not flash PMI numbers available – showed divergent trajectories in July. Manufacturing PMI in Spain continued to show strong growth (53.6 points versus 54.7 points in June) but data suggest a gradual moderation in economic activity going into the third quarter, in line with our view. Italy, on the other hand, posted a positive surprise, with its manufacturing PMI number hitting 55.3 points, the highest level in over four years. Moreover, the largest contribution came in from the investment subcomponent, a very encouraging for the Italian economy, which has been struggling to gain momentum for quite some time.
Finally, Greece saw manufacturing activity collapse in July, with its PMI plunging from 46.9 in June to 30.2 in July, a new record low. The country continues to suffer the effects from capital controls and an extremely uncertain economic environment, which in turn, is hampering economic activity. While the manufacturing sector in Greece is relatively small, the sheer size of the drop sends a clear signal about the dire state of the Greek economy, which is expected to contract again this year.
The July CIPS survey saw the manufacturing PMI edge up from June’s 26-month low, but this did little to alter the story of a struggling sector which is lagging behind the rest of the economy. Poor export performance remains the key constraint, with the strength of sterling being particularly damaging. The impact of a strong pound provides a powerful argument for the MPC to keep its powder dry this week and, while we may see votes for a hike, we think the chances of an imminent rate rise remain very low.
Sentiment falls but consumers still confident. Both the current and expectations declined in July but nonetheless consumers overall remain optimistic about the economy. Confident consumers will support consumer spending growth of around 3.0% in H2 2015.
Employee compensation slows sharply in Q2 with smallest advance since 1982. Part of the slowdown represents a pull-back from the strong Q1 results that were boosted by strong bonus payouts. Nonetheless, the crucial private industry wages and salaries index slowed sharply. Slower-than-forecast wage gains are disappointing and provide less urgency and support for a September rate liftoff.
Oil prices have dropped from over US$70 per barrel in May to around US$54 per barrel now, the lowest level since March. The available evidence suggests supply factors are important in the latest move which would be positive for world growth. But there is some evidence of demand effects being present too – at least concerns about future demand – so it is not all good news.
The recent oil price slump has coincided with a further strong rise in global supply, especially from OPEC countries. If oil prices were to remain at around US$54/barrel until end-2016 our modelling suggests this might add 0.2-0.4% to advanced countries’ GDP in 2016. But oil exporters like Russia and Malaysia would be losers, and there are some signs that the oil price fall signals concerns about global growth: other commodities have also seen big price declines and there has been a recent correlation between oil prices and the slumping Chinese stock market.
Real GDP contracted in May on broad-based weakness, with energy, manufacturing, and wholesale trade leading the way lower. We remain optimistic that non-energy sector activity will rebound in the latter half of the year but average real GDP growth for 2015 will be weak overall.
Taiwan’s economy contracted by 2% on the quarter, the largest drop since Q4 2008, leading to the slowest year-on-year expansion since 2012. A major deterioration in external trade was responsible for the plunge in GDP, with the fall in exports primarily driven by the weakness of Chinese import demand this year.
More positively, consumer spending continued to grow steadily. However, the breakdown of the demand components also suggested that inventories rose sharply in Q2. These will need to be run down in the coming quarters given the likelihood that the external background will only gradually improve. As a result, the rebound in Q3 GDP may be constrained. It now seems likely that average GDP growth this year will fall far short of previous expectations, probably in the 1-2% range.
The initiatives put forward by the Abe government to strengthen corporate governance and capital efficiency will tend to lift the profitability of Japanese companies. These measures are expected to boost the return on equity (ROE) via higher dividends and share buybacks. We measure the upside potential for the Topix ROE from a catch up of Japan’s dividend payout ratio (proportion of earnings paid out as dividends to shareholders) to international standards.
We show that in the absence of a catch up, the ROE will remain flat at 8.2% by Q4 2015 and 8.4% by Q4 2016. By contrast, if the payout ratio increases gradually to 45% or 60% by 2018, the ROE could respectively reach 8.5% or 8.7% by the end of 2015 and 9.5% or 9.9% a year later. The improvement in profitability should sustain equity valuations for the next couple of years.
We estimate a model that highlights the short and long-term macro drivers of the Topix ROE as well as corporate governance drivers such as dividends and share buybacks. The short-term drivers are earnings growth, the real effective exchange rate, share buybacks and dividends per share, while the long-term drivers are unit labour costs and the capacity utilisation rate.
Eurozone CPI inflation was 0.2% in July, broadly in line with the outturns of the preceding few months. While energy inflation decreased, core inflation rose to 1%, its highest level in over a year. With renewed rises in energy inflation over the coming months likely and the weak euro perhaps starting to increase pipeline price pressures, we still expect headline inflation to rise to about 1% by the end of 2015.
Today’s other releases were more or less in line with expectations: the Eurozone unemployment rate, at 11.1%, was stable in June, while consumption in France ended last quarter on a positive note. The main disappointment came from the Italian unemployment rate which rose from 12.4% to 12.7%. But the underlying employment numbers painted a more positive picture.
June’s consumer price data showed the target measure steady at 0.1%. Consumer spending recorded a large monthly contraction which translates into a quarterly fall of around 3% The unemployment rate ticked up to 3.4% as both the labour force and employment increased in the month. Target inflation was steady at 0.1% in June, although core inflation (excluding food and energy) increased to an annual rate of 0.6% from 0.4% last month. Target inflation will stay close to zero in coming months. Elsewhere the monthly consumer spending data showed a 3% monthly drop in June, pointing to a contraction in household spending in the Q2 GDP release. But the labour market is buoyant and employment increased by over 1% in the quarter. Nevertheless, real activity data point to an overall contraction in GDP in Q2.
Key data elements
The slew of latest data recorded the target measure of inflation (CPI excluding fresh food) steady at a 12-monthly rate of 0.1% in June. Excluding volatile food and energy prices, core inflation rose to 0.6% from 0.4% last month. Elsewhere the unemployment rate edged higher to 3.4% from 3,3% in May. But this was because the labour force increased by more than employment ie the participation rate increased. The job-to-applicant ratio stayed at a 23-year high of 1.19 in June (see chart). The bad news is that the monthly consumer spending data reported another large monthly fall in June (3%). Over Q2 as a whole this measure reported a fall of just over 3% compared with Q1.
Impact and outlook
After a strong Q1 the economy looks as though it has contracted in Q2. Over Q2 as a whole industrial production fell by 1.5% and goods exports by 3%. Monthly consumer spending data also point to a contraction in the quarterly household consumption component in the Q2 GDP print (due 17th August). Meanwhile inflation continues to hover close to zero, well below the Bank of Japan’s 2% inflation target. But there are grounds for optimism on the outlook, Confidence measures are holding up, investment intentions are buoyant and the labour market especially strong. Indeed it is worth noting that the level of employment increased by 1.1% in Q2 over Q1 – not consistent with a weak economy. A forthcoming Research Briefing will discuss in detail our view on the outlook for the Japanese economy
The recent leg of the Greek crisis has once again exposed the problems of monetary union without closer fiscal and political ties. But although the troubles have prompted a wave of visions, demands and pledges of closer integration, major divisions remain on the size, form and ordering of such measures. Unless significant concessions are made, the risk of Eurozone fragmentation will build.
The exchange rate's pass-through, coupled with the likely policy normalization in the US, continue to be the main source of concern on the inflation front.
Lower than expected investment, subdued confidence indices, rising unemployment and slower growth in wages pose the main threat for GDP growth in the remainder of the year.
The current and future path for wage growth is a key focus for market investors and monetary policy officials. Policy officials have long been concerned that wage growth was too sluggish, a sign that an abundance of slack remained in the labor market. However, some equity investors have cheered the anemic wage gains since it has tempered companies' labor costs. These investors now fear that an acceleration of wage increases could put an end to the six-year bull market.
Consistent with the empirical and anecdotal evidence of labor market tightening, the fixed-weighted Employment Cost Index wage and salary component and the Atlanta Fed's new wage growth tracker best reflect the upward trend in wage growth. In a series of Research Briefings we evaluate what the rising wage trend means for monetary policy, the bond market and the equity market.
A "sweet and sour" GDP release. Sweet upward revisions to residential activity and solid Q2 consumer spending momentum, but a sour taste from reduced household outlays on services and lower equipment spending. Although economic output and productivity have trended lower than previously estimated since 2011, we see the economy rebounding firmly in the second half of the year and into 2016.
Today’s raft of data releases from the Eurozone showed an overall positive picture: GDP figures showed that Spain continued to grow at very strong pace in the second quarter, while unemployment remained stable in Germany in July. Finally, despite the recent exacerbation of the Greek crisis, the Eurozone Economic Sentiment Indicator surprised to the upside in July.
Implications and analysis
Preliminary data showed that Spanish GDP expanded by a strong 1.0% over the previous quarter in Q2. The figure represented the fastest growth rate since 2007 and was broadly expected by the market. In annual terms, GDP increased by 3.1%, which confirms Spain as of the fastest growing economies in the Eurozone. We expect Q2 to have marked the peak in terms of quarterly growth and to ease gradually in the coming quarters, however, this will be enough to maintain annual growth rates above 3% so we are sticking to our 3.2% GDP growth forecast for 2015.
A breakdown by components will not be available until next month, but we expect consumer spending, once again, to have been the main driver behind the strong expansion in the second quarter. We will be paying close attention to fixed investment in particular, in an attempt to gauge if the growth is broadening from a consumer-led expansion towards a more sustainable recovery.
Meanwhile, confidence in the Eurozone surprisingly rose to its highest level in four years in July, showing that the events taking place in Greece do not seem to be having a lasting impact on sentiment so far.
The Economic Sentiment Index climbed to 104 points in July (June: 103.5 points) defying expectations that the ongoing crisis in Greece would be reflected in a decline in confidence figures. It is unclear if this positive number already reflects the very latest developments that saw a U-turn from a likely exit from the Eurozone to the current situation where (slow) progress towards a deal seems be underway. In any case, solid, relatively unaffected confidence in the face of the latest Greek drama is an encouraging sign for the Eurozone that reinforces our view of a gradual pick-up in economic activity.
Finally, we saw the release of unemployment numbers in Germany. July figures showed the jobless rate remaining stable at 6.4%, in line with our expectations. The German labour market continues to show remarkable resilience but the pace of job creation seems to be slowing. Over the coming months, we expect employment growth to be moderate at best, although the effect on income growth should be offset to some degree by a further pick-up in wage growth.
China’s trade weighted exchange rate has appreciated by 14% over the past twelve months as the authorities have kept the Yuan stable against the US$ while most other Asian currencies have weakened noticeably. This will have a significant impact on export volumes: China’s exports are particularly sensitive to price effects and strong wage growth in recent years has already been steadily eroding competitiveness.
We estimate that the exchange rate appreciation of the last year could lower exports by as much as 11%. Some of this drag will be offset by a modest rise in global demand. However, we now think that goods exports volumes will fall by more than 1% on average this year.
This analysis strengthens our view that monetary policy will have to act on the exchange rate as well. Otherwise the Yuan will follow the US$ into even stronger territory when the Fed starts raising interest rates. To avoid this, the Chinese may have to cut rates sharply.
The economy faces challenges from all directions. Consumer confidence fell in Q2, amid rising petrol and electricity prices, higher personal income tax rates, new labour laws (which deter job growth), and high levels of social and political tension. Meanwhile, a weak exchange rate, low commodity prices and electricity blackouts are dampening growth in investment and the external sector. Despite the lacklustre prospects for GDP growth, which we see at just 2.1% this year, the MPC increased interest rates to 6% in July to support the weak rand and dampen rising inflationary pressures.
In a unanimous decision, the COPOM decided to raise its benchmark rate by 50bps, to 14.25%.
A change in the communique language suggests that the tightening cycle may have come to an end.
The convergence to the bank's inflation target in 2016 still seems too ambitious.
Though we had correctly predicted that wage growth would pick up in 2015, the extent of the acceleration has surprised. A tighter labour market, October’s increase in the minimum wage and the introduction of the national living wage next April should ensure that pay growth remains above 3% into 2016.
The flip side is likely to be weaker growth in employment as, facing costlier labour, firms have a greater incentive to drive productivity improvements. If they are successful in achieving stronger productivity then the pickup in pay growth should not cause undue alarm to the MPC.
In line with our expectations, the FOMC continues to prepare markets for a September rate lift-off.
In the FOMC statement, policy makers upgraded their assessment of the US economy. The FOMC dropped the reference to the weak Q1 GDP and characterized employment gains as "solid" and labor market slack as diminishing.
Policy makers now only need to see "some" further improvement in the labor market before raising rates, indicating significant progress has been made towards fulfilling the FOMC's mandate to engineer full-employment.
The Chancellor took advantage of the Conservatives’ surprise election victory by presenting a radical ‘Summer Budget’ on 8 July. The headline measure was the introduction of a compulsory ‘living wage’, which is expected to reach £9 per hour in 2020. The preliminary estimate for Q2 reported quarterly GDP growth of 0.7%, although the expansion was unbalanced towards the service sector Our forecast for 2015 GDP growth is unchanged at 2.6%, down a little on the 3% achieved in 2014. Further out we have revised down our forecasts a little, reflecting the impact of the measures announced in the ‘Summer Budget. Our call is that the first rise will come in Q1 2016, by which time inflation should have moved back above 1%. Thereafter rates will increase very gradually by around 50bps a year.
India’s monthly indicators continue to be at variance with the pace of growth suggested by headline GDP. In fact, latest trends suggest growth slowed noticeably in Q2 2015. However, we expect supportive macro policy to engineer a revival in Q4, although potential downside risks (such as from inflation and capital flows) warrant attention.
June’s household borrowing numbers offered further evidence that activity in the housing market is reviving, with both mortgage approvals and lending for house purchases rising by more than expected. Nevertheless, the rate of growth in lending remains a long way from the debt-fuelled ‘noughties’.
Emerging currencies have been in a bear market since 2013 and prospects for a sustained recovery look poor. With emerging market growth slipping to its weakest level since 2009, foreign capital inflows have been dwindling. Meanwhile, China’s slowdown is contributing to slow world trade growth and continued downward pressure on commodity prices, hitting emerging markets’ terms of trade. Low yields in many emerging countries are a further negative factor.
Our index of key emerging currencies has now fallen by 19% since mid-2013, with a 12% drop over the last year. This decline is comparable to that seen in the global financial crisis, albeit more long drawn-out. Weaker currencies may boost activity in some countries but can have negative feedback effects on growth and capital inflows, risking a ‘downward spiral’ for some emerging countries. In terms of relative value, the countries most at risk of further FX weakness are those with weak external positions, low growth and offering modest yields.
Our updated risk-reward assessment suggests the riskiest currencies are the Turkish lira, South African rand, Brazilian real and Russian rouble with the rand offering especially poor value in terms of carry for its riskiness. The Mexican and Malaysian currencies also show a relatively poor risk/reward trade-off while the Indian rupee looks better value.
We expect the RBA to leave the cash policy rate unchanged at 2% until 2017 when the recovery in non-mining investment and household spending is expected to be on a more solid footing and the drag on growth from the end of the mining investment boom will be close to having run its course. Nonetheless, the pace of normalizing interest rates will be gradual and by end-2017 interest rates are forecast to still be stimulatory at 3.25%. A depreciation of the A$, both against the US$ and on a trade weighted basis will also boost growth. The A$ is expected to reach a cyclical low of 72 cents against the US$ this year and range between 72 and 85 US cents during the next couple of years. We expect GDP growth of 2.6% this year and 2.8% in 2016. However, a slowing China represents a significant risk to the outlook, as would another market tantrum following the Federal Reserve’s first interest rate hike.
Surprisingly weak consumer confidence at a ten-month low. The decline was led by a plunge in the expectations sub-index, with consumers more pessimistic about labor market prospects. Despite the decline, confidence still points to generally optimistic consumers. Faster wage growth and rising employment should support household spending growth in the second half of 2015.
Ukraine’s public debt faces a long and winding path towards sustainability, and so do its bond prices. Last week we tackled the issue of Ukraine’s restructuring negotiations game, and concluded that tortuous negotiations were likely to deliver an agreement that was favourable to bondholders and lead to prices trading for a while above long-run fundamentals. We think long run fundamentals justify a price of 46 for exchanged bonds, derived as a probability-weighted average price across three scenarios.
We think restructuring negotiations will almost inevitably lead to an inadequately low haircut because it will turn out to be impractical to factor in negative risks. Creditors have a strong incentive towards brinksmanship as the expected value of future bond returns may be higher if negotiations go over the wire and there is a default prior to restructuring; than if they agree to large haircuts. Meanwhile the IMF position appears to be governed by its DSA under the baseline, which is likely to imply moderate (if any) reduction in principal.
Current account balances and their changes are a zero-sum game. This makes them a powerful short-term forecasting tool.
2014 saw a further rebalancing away from the global imbalances that were one of the causes of the Great Recession.
But rebalancing so far relies primarily on the OPEC current account being the swing factor. The volatility and cyclicality of the OPEC current account makes this a less than ideal solution.
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