Invesco: Monetary divergence triggers volatility

The key feature of 2016 Q1 was the abrupt sell-off between the start of the year and mid-February in financial markets – equities, lower-rated corporate bonds and commodities. The sell-off was based on misplaced fears of recession in the US, added to concerns about the continuing slowdown in China and its impact on commodity markets. These anxieties proved to be misplaced principally because the key drivers of the US economic recovery remained intact.

Influenced by the weakness in financial markets and indicators such as “financial conditions”, the Federal Reserve’s Open Market Committee (FOMC) postponed a widely anticipated interest rate hike in March. Instead they published FOMC members’ Fed funds rate expectations showing only two rate hikes during 2016 compared with four rate hikes implied by the December “dot plot”.

However, as I explained in December, the key indicator to watch was the rate of growth of bank credit. The US is the only major economy where bank credit growth has returned to normal. Even since the December rate hike total bank loans have continued to grow at over 8% p.a. to mid-March. This, together with balance sheet repair in the private sector, has enabled US equity markets to shrug off the early phase of interest rate hikes and return to end-December levels.

By contrast, the Eurozone and Japan are still in the midst of extended programmes of quantitative easing (QE) intended mainly to keep interest rates low along the length of the yield curve (rather than directly to boost the rates of growth of money and purchasing power), and hence to stimulate the two economies.

However, the QE programmes of the European Central Bank (ECB) and the Bank of Japan (BoJ) both suffer critical design flaws. Hence both are failing to gain traction, and it is no coincidence that both the Eurozone and Japan are experiencing sub-par growth, near-deflation and negative interest rates.

In the UK the Bank of England (BoE) is in an intermediate position, having implemented a textbook example of QE, but then it leant too harshly on the banks preventing any growth of their balance sheets. It did this by virtually outlawing interbank funding, tightening capital requirements, and imposing multiple misconduct penalties, all of which have drastically limited credit growth.

These divergences in monetary policy between the Fed and the BoE on the one hand and the ECB and BoJ on the other imply probable further volatility in the currency, fixed income and equity markets.

The overall picture is one in which both growth and inflation will remain subdued against the backdrop of very low money and credit growth during the past few years.

In the emerging economies the slowdown in China, together with on-going recessions in Brazil and Russia are impacting commodity markets. Despite the recent upturn in oil and iron ore prices, numerous basic industries have massive excess capacity which will likely weigh on global trade volumes for at least the next year – possibly longer.

Beyond that, emerging market (EM) commodity producers are likely to suffer further currency depreciation, while EM manufacturers should start to benefit from the steady recovery in the US.

As I argued in December, the recessions or growth weakness in the EM economies are unlikely to derail the modest-paced recovery in the developed economies. While some companies or sectors cannot avoid being affected by the problems of the EM, the transmission of key fundamental forces – like monetary policy and balance sheet repair – still runs primarily from developed markets to EM, not vice versa.

In addition, the recovery in the US, already nearly seven years old, will not die of old age. Unless credit is tightened unexpectedly and the yield curve becomes inverted, business investment and consumer spending will continue to regain momentum.

United States
With the gradual healing of private sector balance sheets, and the normalization of bank credit growth, domestic demand continued to grow moderately in the first part of 2016 Q1. However, the recovery in core CPI inflation to 2.3% in February eroded personal incomes and outlays in the latter half of the quarter. This caused real personal outlays (a proxy for personal consumption in the GDP) to slow from 2.4% annualised in the October – December period to 1.6% in DecemberFebruary. Business equipment investment appears to have stabilised, as shown by the +3.9% rebound in core capital goods orders in January.

These shifts, together with the deterioration of the trade balance by -0.26 percentage points, combined to lower the Atlanta Fed’s “GDPNow” estimate for the first quarter from 1.4% to 0.6% at 31 March. Even so, as inflation stabilises at a low rate of increase I expect real GDP growth to resume a moderate upward path. For the year as a whole average I forecast real GDP growth to be 2.2%.

Meanwhile the solid growth in manufacturing output continued with +0.5% monthly increase in January and +0.2% in February. The rise in the forward-looking new orders component of the ISM index to 51.5 in February implies that the manufacturing sector is weathering the strong US dollar and the global slowdown better than expected.

Another area of continuing strength is the US labour market. In March payroll employment grew by a solid 215,000, following an upwardly revised 245,000 in February. Even more significant, the strong expansion of the labour force and employment as shown by the (separate) household survey in February and March (averaging 388,000 per month) kept the unemployment rate at 5.0% in March. These improvements were reflected in the rise in the participation rate to 63%, up 0.6% since September, confirming there is greater slack in the labour force than conveyed by the headline unemployment rate, and suggesting that longer term unemployed or discouraged workers who have hitherto remained on the sidelines are being pulled back into the labour market by the growth in employment opportunities.

In the arena of monetary policy the FOMC decided not to raise the target range for the Fed funds rate at its meeting in mid-March, stating that “global economic and financial developments continue to pose risks.” In keeping with this added cautiousness, members of the FOMC revised down their median projections for the Fed funds rate to 0.875% by end-2016 and 1.875% by end-2017, roughly equivalent to two hikes in 2016 (from four projected in December) and four in 2017, while keeping their economic forecast broadly unchanged. The Fed’s official view remains more hawkish than the market’s expectations as reflected in, for example, the Fed funds futures contract which is still pricing in only two rate hikes by end-2017. This implies scope for further interest rate surprises in the months ahead.

On the inflation front there has been excessive concern at the possibility of a return of inflation, often naively based on the threat of wage increases. For some perspective on this, recall that the main measures (headline CPI, core CPI and core PCE) have all been below the Fed’s target of 2% for some time. To appreciate what is really going on, two propositions must be understood. First, overall price changes are ultimately driven by money and credit growth, and the outcome for (say) the headline CPI is determined by the weighted average of the services CPI and the goods CPI. Second, if commodity prices fall – as they have over the past year and a half – then consumers will have more money to spend on services, and the result will be lower goods price inflation but higher service price inflation. The recent brief recovery in oil prices has pushed up the goods component of the CPI, but service price inflation, which tends to lag somewhat, has not yet come down. Many commentators are wrongly adding higher goods price inflation to (temporarily) higher service price inflation and predicting a significant rise in inflation. The reality is that with no acceleration in money and credit growth it is unlikely that inflation can increase significantly. For 2016 I forecast a 1.1% increase in headline CPI inflation, rising to 1.4% in 2017, still well below the Fed’s 2% target.

The Eurozone
In Europe the second estimate of real GDP confirmed the slowdown in the Euro-area in 2015 Q4 to 0.3% quarter-on-quarter, following on from 0.6% in Q1, 0.4% in Q2 and 0.3% in Q3. The net result was an overall growth rate for 2015 as a whole of just 1.5%. This disappointing outcome together with a downward revision of the inflation outlook by the ECB staff in February/March prompted the ECB’s Governing Council (GC) to expand their QE asset purchases from EUR 60 billion per month to EUR 80 billion per month, to run until March 2017, “or beyond, if necessary and in any case until the GC sees a sustained adjustment in the path of inflation consistent with its aim of achieving inflation rates below, but close to, 2% over the medium term.” The issuer and issue share limits were also expanded. A novel feature was the decision to include investment-grade eurodenominated bonds issued by non-bank corporations in the asset purchases from Q2. Finally the GC decided to launch a new series of four targeted longer-term refinancing operations (TLTRO II), starting on June 2016 providing financing to banks that could be as low as the negative 0.4% deposit facility rate.

As explained in past issues of this publication, the ECB’s QE programme continues to be less stimulating to markets and the broader Euro-area economy than it should be due to basic design flaws. It is no coincidence that the two main areas which are experiencing negative interest rates, sub-par growth and near-deflation – i.e. Japan and the Eurozone (plus the three euro-linked economies of Sweden, Denmark and Switzerland) – are also the economies where the major central banks have implemented flawed versions of QE.

The fundamental problem is that the ECB and the BoJ are trying to implement QE through the normal credit creation channels of the banking system (which aren’t working) and relying on interest rate cuts, instead of creating new money in the hands of firms and households outside of the banking system by asset purchases directly from these non-bank entities. The latter is in effect what the Fed and the BoE did. In other words it would be better for the ECB to circumvent the banks, not to rely on them to create loans and hence deposits at a time when they are suffering impaired balance sheets. In any case, QE is (or should be) about expanding M3, not lowering rates and hoping the banks will expand lending.

The rebound in industrial production by 2.1% in January (after declines of 0.5% in December and 0.2% in November) seems unlikely to be sustained, as suggested by the fall in the Purchasing Managers’ Index (PMI) to a 12-month low of 51.2 in February and 51.6 in March. Also, the labour market in Europe continues to make only very slow progress with unemployment falling from a peak of 12.1% in April 2013 to 10.3% in January 2016, contrasting sharply with the steeper declines seen in the US and the UK over the past five years.

One factor which perhaps should have made a greater contribution to Euro-area growth was the depreciation of the euro from over USD1.30 in 2014 to a range of 1.06-1.14 through most of 2015 and so far in 2016. Exports from the Euro-area only picked up modestly in mid-2015, and have subsequently slowed again. The main explanation is that without volume growth abroad, price changes alone will do little to boost demand from Europe. Consequently, Eurozone exports, in line with the sluggish performance of global trade in recent years, were essentially static between 2012 and mid-2015. Meantime the current account has moved to a surplus of 3.0% of GDP in 2015 Q4, reflecting weak imports (resulting from sub-par domestic demand) as much as any upturn in exports.

United Kingdom
The recovery of the UK economy continued in 2015 but slowed from 0.7% real GDP growth per quarter in 2014 to just over 0.5% per quarter in 2015. As in previous years of this recovery it has been services that have been leading the way, with manufacturing and construction lagging behind. Viewed from the expenditure side, the main reason for the slower growth was a moderation in the pace of gross fixed capital formation, especially business investment which had been accelerating in 2103-14, but slowed in 2015. Personal consumption has been firm, helped by the decline in the inflation rate which has temporarily boosted real wages. Overall, however, the real growth rate of the UK economy remains subdued, with the Office for Budget Responsibility (OBR) forecasting 2.0% for 2016 (compared with my forecast of 2.2%) and 2.2% for 2017.

One aspect of the slower growth in the UK has been the contrast between the weakness of certain basic industries (such as oil and gas, steel, and other manufacturing) and the strength of services. The problems of basic industries generally reflect global overcapacity in these sectors and the strength of sterling last year. Thus while the GDP figures were held back by the impact of a strong pound on manufacturing and exports (with mining and quarrying declining by 1.4% over the year and production output increasing by 1.2%), services expanded by 2.8% in real terms between January 2015 and January 2016, led most recently by distribution, hotels and restaurants. Other components of services which expanded strongly over the past year included transport, storage and communications, as well as business services and finance. With the service sector accounting for 78.6% of UK output but production just 14.9% (in 2012), the UK economy is overwhelmingly a service economy.

In this steady but unglamorous growth environment, two politically-driven events dominated the quarter in the UK: the decision by the Conservative government to call a referendum on 23 June to determine whether the UK will remain in the European Union (EU) or leave, and the Budget on 16 March. The outcome of the referendum on British membership of the EU – which has come to be known as the Brexit debate – looks very evenly balanced. From an economic and market viewpoint voting to leave will doubtless generate huge uncertainty compared with voting to remain. Large amounts of foreign direct investment in the UK in both manufacturing and services are tied to foreign companies being able to use the UK as a convenient platform for selling into the rest of the EU, whereas exiting the EU would greatly reduce that advantage, and also place considerable doubt over the UK’s future trading status. These uncertainties have already weakened sterling and could undermine equities and gilts. On the other hand, there can be little doubt that the bureaucracy in Brussels has become a significant financial burden for UK industry, and the UK economy might well be able to grow more vigorously outside the EU than within it. These arguments will no doubt continue until the last hours or even minutes before referendum day, implying that investors must expect further turbulence in the pre-referendum period.

The government’s budget had less short-term impact on financial markets, but there is starting to be a clear pattern whereby the closing of the budget deficit (and the stabilisation of government debt) which were supposed to be achieved by 2015 are continuously being pushed further into the future. Revenues continue to fall short of targets, while the government appears to need to grant hand-outs or tax concessions to various categories of voters every year. The verdict of the OBR, an independent watchdog, was that despite a weaker outlook for the economy and tax revenues, the Chancellor had announced net tax cuts and new spending commitments. The government, it said, remained on course for a £10 billion surplus in 2019-20, but only by delaying capital investment, promising further cuts in spending on public services, and bringing forward a one-off boost to corporation tax receipts into 2019-20.

The recent brief recovery in energy prices has pushed up the goods component of the CPI (from -2.3% in September 2015 to -1.6% in February 2016), but service price inflation (at +2.4% in February 2016), which tends to lag somewhat, has not yet come down. With low money and credit growth persisting, inflation below target and growth slower than in previous years I now expect the BoE’s Monetary Policy Committee to keep interest rates unchanged during this year. I forecast CPI inflation to be 1.0% in 2016 – similar to the OBR which expects CPI inflation to remain below target at 0.7% in 2016 and 1.6% in 2017.

Growth in Japan slumped in 2015 Q4, falling by 0.3%, leaving overall growth for the calendar year at just 0.5% – a disappointing outcome after three years of Abenomics since the election of December 2012. Consumer spending in particular exerted a -0.5% drag on GDP growth, and appears to have continued into the new year with a -0.2% fall of consumer spending in January despite better employment growth (+1.4% yoy) and lower unemployment (3.2% in January).

Looking forward, minimal wage growth (+0.4% year-on-year) in January combined with weakness in consumer confidence (which fell to 40.1 in February from 42.5 in January), implies spending could continue to be weak. This would be exacerbated if Prime Minister Abe decides to go ahead with a second increase in the consumption tax in April, even after the dismal results of raising the tax in April 2014 from 5% to 8%. On the industrial side of the economy production surged 3.7% in January after falling in November and December, but firms foresee a renewed decline of -5.2% in February. In sum, the economy appears marooned in the doldrums.

Against this weak growth background, inflation has also remained quiescent, falling well short of BOJ Governor Kuroda’s target of 2% yoy growth in core CPI inflation. In February the national headline CPI was +0.3% yoy and core inflation (excluding food and energy) was +0.9%. Following the strengthening of the yen from a range of JPY 118-124 per USD for most of 2015 to 111- 114 in February and March the inflation data are likely to fall further in the months ahead. The stronger yen has been threatening weaker profits for exporters, leading to downward pressure on wage negotiations typically conducted in spring ahead of the new fiscal year starting in April. As a result wage increases are expected to below 2% in 2016, suggesting another year of lacklustre consumption spending.

On the monetary policy front the big event of the quarter was the adoption of negative rates by the BOJ Policy Board on 29 January on a narrow majority of five to four. The negative rate of -0.1% will only apply on new (incremental) reserves of banks at the BoJ, so it will not apply to customer deposits at commercial banks. Nevertheless, this is a drastic move, prompted by the failure of all the QE previously to move the dial on growth or inflation. The decision led to a sharp fall in the value of the yen, a momentary upward movement in the stock market, but a sharp weakening of bank shares and the overall market in early February.

As with the ECB’s shift to negative rates, this latest move by the BoJ is the the sad consequence of an ill-designed QE program. If the BoJ had concentrated on buying long-term securities only from non-banks instead of from banks, the results would have been very different, directly creating new deposits and hence M2 in the hands of the non-bank public. M2 growth rates of 5-6% or more in turn would have triggered the portfolio re-balancing plus the increased investment and consumption spending effects that were achieved by the US and the UK QE programmes. Instead, Japan’s M2 continues to grow at just 3.1% in February, just half the optimal rate of M2 growth which I calculate at 6% p.a.

China and non-Japan Asia
Economic activity in China continued to slow in January and February. However, there were signs of stabilization in March. The official PMI for manufacturing increased to 50.2 in March (the first increase above the 50 level since July) compared to 49.0 in February (which in turn had been the lowest level since 2011), while the services PMI increased to 53.8 in March compared with 52.7 in February. The unofficial Caixin PMIs, which focus on medium and smaller size companies, showed similar trends. These figures implying lower growth are consistent with the announcement by Premier Li in the 2016 Government Work Report setting the growth target for 2016 at 6.5-7.0% — a lower growth rate than the target of “around 7%” set for 2015.

To alleviate the slowdown and offset the liquidity drain due to continuing capital outflows the People’s Bank of China, the central bank, undertook further easing measures, cutting the reserve requirement ratio by a further 50 basis points to 17% and 15% for large and small banks respectively at the beginning of March. Further measures are likely during the year as the authorities grapple with slowing growth, adverse balance of payments flows, and the desire to maintain a stable currency against a basket. In addition the planned fiscal deficit was widened from 2.3% to 3% this year, but it is unlikely that such minor steps can do much to counter the de-leveraging that is needed across the state-owned sectors that dominate China’s heavy industries where excess capacity and accumulating losses are most concentrated.

Given the need to deleverage the economy after seven years of very rapid credit growth and given the slow growth of China’s more developed trading partners, it seems inconceivable that there could be any significant upturn in the growth rate anytime soon. For 2016, I expect real GDP growth to slow to 6.6%, and inflation to remain broadly unchanged at 1.5%.

The slowdown in world trade has hit China and other Asian economies especially hard. Asian EM are heavily reliant on exports. Entrepôt economies such as Hong Kong and Singapore naturally have exports levels that are multiples of their national incomes. Hong Kong’s exports are over 160% of GDP and the comparable figure for Singapore is 138%. But even in Malaysia and Taiwan exports account for 72.4% and 61% of GDP respectively. Therefore declines in exports are having a dramatic effect on East Asian economies’ reported GDP growth rates. The exports of Asian countries have seen a noticeable dip. For example, Figure 7 shows Chinese exports were down -7.2% in February (on a 12-month moving total basis in dollar terms). Similarly, the ASEAN group of countries – excluding Singapore – has seen exports fall by -11.8% compared to the same time last year. The newly industrialised countries (NICs – Korea, Taiwan, Hong Kong and Singapore) have also seen dramatic declines: their exports fell by -12.0%. Of course these declines are in USD terms and some of these countries’ currencies have fallen considerably against the USD in 2015. The Malaysian Ringgit was down 8.5% against the dollar at the end of March compared to a year ago and the Korean won had fallen 6.1% in the same period. Looking at the overall export levels on a 12 month moving average basis it can be seen that the fall in exports began in early 2015 and has persisted since, affecting all Asian country groupings.

There are three main explanations of this collapse in trade. Firstly, the QE programmes in the US, the EU and Japan have boosted asset prices but have had little effect on consumer demand; this can be seen by the weak growth in US median wages. Secondly, there has been a collapse of demand in the commodity producing countries such as Russia and Brazil, due to their weakening terms of trade (the fall in their export prices relative to their import prices). Thirdly, even the import of components to China has declined, as more of the Asian supply chain has been relocated to China itself.

So far in 2016 the commodity markets have seen a bounce. The key question is whether this small recovery is a result of a change in the fundamentals, or is it simply a dead cat bounce? Brent crude is up 41% from its low of US$26 per barrel on 1st January 2016, to US$36.7 currently (29/03/2016). Iron ore has also seen an uptick since the start of the year and is now trading at 41% above its low point for the year on 14 January. Gold has seen an 11.3% rise since January to US$1214 per ounce. However the fundamentals that led to the dramatic falls in the commodity markets since mid-2014 still persist. These include: the slowdown in China, the recessions in Brazil and Russia, the emergence of new supplies of energy such as US shale oil, Iran and Iraq ramping up production, and commodity investment projects in Chile and elsewhere coming on stream.

One reason for the price bounce is short-covering by speculators. Another, as in the case of iron ore which rose 20% on 7 January alone, is the influence of purely local Chinese factors. For example, an upcoming horticultural show in Tangshan caused the authorities in the northern city to order a six-month partial closure of local steel mills to control air pollution during the show. This decision led steel producers to rush to buy increased quantities of raw materials in order to boost production before the restriction comes into force. Another factor is the re-opening ahead of the peak construction period in spring and early summer of steel mills in China that were shut down last year.

In the case of oil, news of a production freeze agreement between Russia and Saudi Arabia in February has been supportive of the price, but subsequently we have learned that Iran will not participate in the production controls. Although there has also been a very slight fall in US crude oil production since the start of the year (-1.6%), with more Iranian and Iraq crude coming online and the demand fundamentals not improving, a significant price rise by the end of the year is unlikely. Gold prices are also unlikely to rise further if US inflation remains low, if fears of a recession wane (as I expect they will), or if the US dollar strengthens. On the contrary, the gold price is more likely to fall under these circumstances.

Given that the fundamentals have not improved, the recent recovery in commodity prices seems destined to be a false dawn for them. From a broader economic standpoint low prices are a requirement to cut supply and reduce excess capacity across a range of commodities. In turn both lower prices and reduced capacity are required to raise prices in the medium to long term.

The two key problems facing the developed economies over the past seven years since the crisis of 2008-09 have been the inter-related issues of balance sheet repair in the private sector and the lack of money and credit growth from the banking system. These are the primary explanations for sub-par growth, near-deflationary conditions, and, most recently, negative interest rates in Japan and the Eurozone (together with the euro-linked economies of Denmark, Sweden and Switzerland).

While the US and the UK are generally emerging from these problems – both on account of their more thorough-going balance sheet repair and because of their more successful conduct of QE operations by their central banks – they nevertheless must attempt to recover and grow in an environment that is adversely affected by the policy missteps in the Euro-area and Japan. These problems will continue to act as a drag on global growth in 2016 and into 2017.

Added to the problems of the developed economies are the more recent recessions and slowdowns in the EM arena. Their problems follow directly from the huge stimulus policies enacted in these countries in the aftermath of the global financial crisis. Too much money and credit has built up a vulnerability to debt which must now be unwound. Many of the EM economies were also very dependent on commodity exports, and the collapse of commodity prices will depress incomes in these economies. Since it will take several years for the leading EM economies to repair their balance sheets and restore internal and external balance, it must be expected that commodity prices, global economic activity and global inflation will all remain subdued for at least the next year or two.

John Greenwood, chief economist Invesco 

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