Uncertain outlook: Standard Life Investments

Throughout the uncertainties, the United States Federal Reserve has been able to keep interest rates low, helping underpin the housing market recovery, an essential ingredient for a more broad-based revival. Low and stable mortgage rates and a steady uptick in prices have sustained demand, with existing home sales up over 9% on the year, writes Douglas Roberts, Senior International Economist, Standard Life Investments.

Standard Life Investments – Macro Digest – Report Summary – 2013

United Kingdom K – No more Mr Boring

Whatever happened to the ‘boring’ Governor of the Bank of England? Sir Mervyn King has long opined that monetary policy should be ‘predictable’ and clearly established. The Governor has resolutely adhered to this principle – until last week’s revelation that he had voted for an increase in QE at the last monetary policy committee meeting.


That was a complete surprise. Economic recovery, albeit bumpy, was supposedly in sight. Previous minutes spoke of encouraging developments in the global economy, and of the committee’s ongoing faith in the Funding for Lending Scheme. As for super-loose monetary policy, the Governor had voiced concern about possible asset price distortions and the probability of diminishing returns from further QE. So what prompted the volte face?

Given the expectation that inflation will continue to disappoint, the change in emphasis can only be to shore up the growth outlook. Perhaps more QE would smooth the recovery path? Perhaps a weaker currency is worth the inflation risk if it promotes stronger export growth? Or perhaps it was a gesture to the incoming Governor that the committee was not bereft of constructive ideas? Apparently, though, there was considerable discussion about how to get more credit flowing.

The UK is not the only economy challenged by a weak recovery in lending growth. However, it seems most unlikely that an extra £25 billion in QE would have a significant impact. The ‘inadequate” flow of credit is not just a problem of supply. The Bank of England’s own Agents’ report in February noted there was little sign of an increase in banking borrowing, which they  largely attributed to weak demand for credit’. While the overall demand outlook remains unpromising, there is unlikely to be an eagerness to take on more debt.

While the demand profile at home may be languid, in many parts of the global economy demand is reasonably brisk – UK companies have been looking to tap into that demand. The Agents’ report noted more robust growth among exporters, and the ongoing efforts of UK businesses to increase their involvement. It takes time to build the necessary trade networks. Even so, for some there were signs that those efforts were starting to be repaid.

The Office for National Statistics (ONS) provided tangible proof of progress, countering complaints that UK business was dragging its feet in re-orienting its activity. Exports to the BRICS jumped from £12.7 billion in 2007 to £27.1 billion in 2012, with their share of UK exports rising from 3.3% to 5.5%. So, headway is being made, although it is difficult to wean industry off its dependence on Europe, which still accounts for over 40% of UK exports.

Just how weak is the UK economy? Labour market data continue to surprise positively, with the numbers in employment up another 154,000 in Q4, to a record 29.73 million. And that gain was driven by an increase of 167,000 full-time employees, and a fall in the inactivity rate to around 22%, the lowest since 1991. Why has British business recruited over half a million extra employees over the past year if the economy is not growing – and vacancies too are at a healthy level. It seems increasingly likely that 2012’s GDP numbers will be revised up over time to show that the economy did indeed expand last year.

Perhaps the UK would not have lost its top credit rating had the true state of the economy been known. Moody’s cited (as reasons for the downgrade) ‘weakness in the nation’s growth outlook, challenges to the government’s fiscal consolidation program and its high and rising debt burden’. The UK is not alone in facing these challenges, so it is unclear just what the consequences of the downgrade will be – certainly, others that have been downgraded have not seen a dramatic rise in their funding costs.

A recent OECD report advised that, should growth continue to disappoint, the government  should not impose more tax increases or spending cuts, but rather should pare back its deficit reduction plan. The report also opined that economic policy had gained credibility, despite weak growth hampering the planned deficit reduction.


United States – Kick or treat

The release of January’s FOMC meeting minutes caused at least momentary turmoil in financial markets. Why that reaction? The main issue was the commitment to open-ended asset purchases, until certain objectives had been accomplished. Significantly, few were concerned about possible inflationary consequences. The main concerns involved the potential costs and risks from the present policy thrust, the additional exit complications and the possible undermining of financial stability by continued purchases. While it is difficult to gauge the extent of opposition to the current policy stance, it is clear that there are major splits within the Committee.


Be clear what is at issue, though. The minutes indicated that almost all members expected a highly accommodative monetary policy stance to be maintained, and economic conditions would likely warrant exceptionally low levels for the federal funds rate through late 2014. In other words, the issue is not about policy stance, but about policy content.

The Committee’s view on short-term economic conditions improved slightly, following the avoidance of the full ‘fiscal cliff’. However, the concerns have merely been adjourned, given the present lack of a resolution to the sequester issue and a medium-term Budget plan. Meanwhile, the Committee expects the US economy to remain on a moderate growth path. It does though see major headwinds: at home concerning the economic outlook and government policies, both restraining hiring and investing decisions, and abroad with European imbalances a major worry. These uncertainties seem likely to keep the authorities on alert, even if they themselves are unsure as to the most appropriate monetary support.

Kicking the can down the road postpones but does not resolve the issue. During the debt ceiling debate in mid-2011, spending cuts of over $1 trillion over the subsequent decade were agreed. A ‘super-committee’ was created to agree the details but, if it failed, automatic cuts would kick in, split equally between defence and non-defence spending. The first tranche of cuts was scheduled for fiscal cliff January 2013, but the two parties agreed to kick the can a little further – this Friday 1 March is the next decision day.

At stake is but the first tranche, just $85 billion, equating to about half of January’s tax increases. Alone, it is unlikely to impede growth. It should instead focus politicians’ attention on the need to cut spending – the country’s debt cannot be reined in by tax increases alone. Continued political point-scoring can only damage economic prospects and keep the Fed on alert.

Throughout the uncertainties, the Fed has been able to keep interest rates low, helping underpin the housing market recovery, an essential ingredient for a more broad-based revival. Low and stable mortgage rates and a steady uptick in prices have sustained demand, with existing home sales up over 9% on the year. Significantly, sales of ‘distressed’ properties are now less than 25% of monthly sales, compared to 35% at the beginning of 2012. The inventory overhang is much reduced, down to 4.2 months, which is around normal historic levels. This is driving a steady improvement in housing activity. Starts fell in January, but only after an upward revision to December, when milder-than-usual weather boosted starts. Indeed, single-family starts rose, the downside being confined to the multi-family sector. Even in that sector, the Architectural Billings Index is supportive in 2013. And there has been a steady rise in permits, which are less affected by the weather, suggesting the recovery still has legs. However, it should be stressed that present activity levels are around the same levels as previous housing market troughs.

Overall, residential investment was up strongly in Q4, by over 15%. However, construction spending growth is more broad-based, with non-residential spending up over 9%, at an annualised rate, in Q4. The one negative is that public sector construction spending appears to be tailing off again. The Fed needs to ensure the housing market recovery persists.


Europe – No blue sky

Despite the more stable financial environment and less pessimistic survey evidence, the European Commission (EC) lowered its GDP growth forecast to -0.3% from -0.1%. At the same time, the EC expects unemployment to rise to a new high of over 19 million. While that makes grim reading, GDP is expected to expand by 0.7% in the final quarter of 2013, and by 1.4% in 2014. This may prove a tad optimistic, as the forecast is derived from unchanged policy assumptions.


It is easy to understand why the EC is so downbeat. The big four (Germany, France, Italy and Spain) account for over 75% of the region’s GDP, and the respective forecasts for this year are +0.5%, to +0.1%, -1.0% and -1.4%. Even taking a more optimistic view, it is difficult to build in more than a modest uptick. And given bank lending standards are still being tightened and unemployment will likely continue to rise, a more favourable outcome appears improbable.

The recent improvement in PMI readings halted abruptly in February, the composite index falling from 48.6 to 47.3. Broken down, the data were more encouraging, with the more forward-looking components – new orders and new export orders – at their highest levels since mid-2011

Discouragingly, though, new car registrations sank to an all-time low in January, the 16th month of decline. This trend reflects not just a cyclical downturn, but structural imbalances. There is chronic over-capacity in the region, with an ageing population and a lengthening average car life. Demand will remain weak even after the economy starts to recover.

Despite the gloomy prognostications for the Euro-zone as a whole, most forecasters see an immediate bounce-back in the German economy, following a one-quarter contraction. Last week, more details were released of the Q4 GDP contraction of 0.6%, with net exports accounting for 0.8 percentage points (p.p.) and investment 0.1 p.p. Specifically, exports to the US declined an estimated 7% in Q4 compared to Q3, much of that being fiscal cliff related.

Looking forward, German new orders have been picking up. Last week’s IFO report highlighted that manufacturing firms were increasingly optimistic about export opportunities, with the expectations index reaching its highest level since mid-2011. The PMI findings corroborated the positive export expectations with the strongest reading in 22 months, driven largely by improved demand from Asia. Consequently, there do seem to be sound grounds for expecting a return to expansion for the German economy in Q1.

More disappointing have been the divergent trends between the German and French economies. Yes, Germany contracted twice as much as France in Q4, but while the survey evidence for Germany points towards an imminent pick-up, that for France has plumbed ever deeper. That trend was halted by the February manufacturing PMI, although the composite index is still at an extremely low 42.3 – inconsistent with thoughts of economic expansion.

France saw a similar bounce in the manufacturing sector index of the INSEE report, driven by foreign order books and demand. However, the overall INSEE index remained on 87 for a third straight month in February. There is a strong suspicion that sentiment is being held down due to doubts about likely government policy. As economic growth has fallen short of government expectations, so has the prospect of meeting the deficit reduction goal. The concern is whether the government might introduce additional austerity measures in order to meet the target.

The French government has stated ‘we won’t take responsibility for further weakening the weak economic growth’. The government had previously assumed 0.8% GDP growth this year, but now expects no growth whatever. The EC has accepted that deficit targets may be missed because of sluggish growth, and is prepared to acquiesce, provided countries are carrying out the necessary structural reforms. The problem is that such reforms are more readily adopted during a crisis – for France, unless the economy is contracting, the pressure for reform will likely be resisted.


Asia-Pacific – Chinese policy rollercoaster

The region’s various countries are at different stages in the monetary policy cycle, with China  close to easing back on policy accommodation, while Japan is stepping up on its stimulus initiatives. Somewhere in between, the Australian authorities believe they have done enough, but are ready to ease further if necessary.


Chinese policy has been on a rollercoaster since 2008, when the global economic recession struck. Policy was eased and spending projects approved, allowing the economy to avoid the excesses felt in many parts of the world. The policy response was possibly too effective, forcing a subsequent policy about-turn to confront incipient inflationary pressures.

Again, so effective was the policy, it evoked fears last year that the Chinese economy might be heading for a hard landing – a cue for another change in policy direction, which resulted in quarterly growth settling at a comfortable 2.0%. Unfortunately, the stabilisation of the economy involved removing some heat from the housing market and re-engaging with the Local Authorities. Both come with baggage, the former due to over-building and the latter due to uneconomic developments.

The authorities are now acting to contain the policy impulse. The finance minister has called for a crackdown on irregular funding by local authorities, which have been frozen out of the regular banking system. As for housing developments, after turning a blind eye for many months, the authorities are now re-emphasising the importance of keeping a lid on the market and curbing house price increases.

Significantly, the authorities have also been draining liquidity from the system, and by the most in any week on record. That followed the record growth in Total Social Financing. Some have reasoned that this was merely a removal of excess New Year liquidity, but that would not have required the repo operations by which the authorities drained the liquidity. It was more likely a sign of the punchbowl being removed – job done.

For the Japanese, the job is just starting. It is true that ‘talking down’ the yen began in November, and that some details of a proposed further supplementary budget have been revealed. But now the appointment of a new Bank of Japan-friendly governor has been brought forward, which is expected to herald the next phase of the ‘grand scheme’ to end deflation and resuscitate the economy. The question remains whether the proposed policy assault will be any more successful than the umpteen attempts of the past 20 years.

Last week’s report that real exports rose for a second straight month gave some credence to the weak yen route for reviving the economy. However, it is not just the weaker yen that is behind the export pick-up – Japanese exporters are successfully targeting other, more rapidly growing emerging markets, such as Mexico and Chile, and making good progress. The more successful the export renaissance, the more likely the yen’s depreciation will be halted. Without greater structural reform and a tighter fiscal policy, the Japanese economy will struggle to break clear of slow growth and deflation.

The Australian authorities are rather more persuaded that their policy stance is appropriate. In its semi-annual statement, the Reserve Bank of Australia (RBA) judged  that there was a good deal of interest rate stimulus in the pipeline, and that it was sensible to allow it time to do its work (the RBA has reduced interest rates by 175 basis points since November 2011).

By way of evidence that policy was taking effect, consumer confidence jumped sharply in February to its highest level since December 2010. Not only were consumers more optimistic about economic prospects in the year ahead, but also judged it a better time to make a major purchase. This should underpin the housing and retail sectors going forward.

The labour market, though, is not sharing the improved sentiment. Unemployment was unchanged at 5.4% in January, but only due to a decline in those looking for work and an increase in part-time jobs. Perhaps the RBA’s job is not yet over.