Contraction may prompt Budget rethink

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1 Produced by the Economic Research Unit July 2013 A monthly analysis of international and Irish markets Contraction may prompt Budget rethink Group Chief Economist: Dr. Dan McLaughlin GDP now likely to contract this year Proposed fiscal adjustment may be scaled back The Irish economy is again in recession; real GDP contracted by 0.6% in the first quarter which followed a 1.2% decline in the second half of last year. The downturn owes something to the Patent Cliff but exports in general have weakened (merchandise exports ex chemicals fell by over 6% in Q1) while domestic demand also fell sharply in the first quarter, with consumer spending sliding by 3%. Consequently, the consensus growth forecast for the year as a whole, at 1.2%, now looks challenging and real GDP will probably contract in 2013, which runs counter to the widely held expectation that the economy would pick up momentum on the back of a stablisation in domestic demand alongside a robust export performance. Nominal GDP is also likely to emerge well below the Government s forecast this year, and could well be unchanged at best from 2012 which would imply a debt ratio in excess of 126% of GDP instead of the 123% projected by the Department of Finance. On current plans the Irish Government is set to reduce demand in the economy in 2014 with another round of fiscal adjustments, this time by 3.1bn (1.9% of GDP) or 2.5bn excluding revenue measures carried forward from this year. That would reduce the fiscal deficit in 2014 to 4.3% of GDP, on current projections, on the additional assumption that the annual saving from the Promissory Note deal (about 1bn) is used for deficit reduction. That assumption may well be challenged however given the recessionary environment at home and elsewhere in Europe, particularly as the EU s Excessive Deficit Procedure calls for an Irish deficit of 5.1% of GDP, so giving the government some leeway. An additional complication is the timing of the 2014 Budget, which will now be presented in mid-october, even though the level of uncertainty about the economy s performance in 2013 will still be high so adding to the risks of a major forecast error with regard to next year. In any case it may well be that the outturns for the fiscal and debt ratios could be very different from that planned at the beginning of the year but regardless, the performance of the economy of late, as revealed in the national accounts, is likely to prompt calls for some easing of austerity. United Kingdom Page 2 Growth looks to have accelerated in Q2 Europe Page 3 Euro area economy still contracting United States Page 4 Taper talk Economic Diary - July Page 6 Forecasts Page 7 Bank of Ireland estimates Exchange rates Official interest rates Five-year swap rates GDP and inflation Contact Us Page 8

2 United Kingdom Growth looks to have accelerated in Q2 Growth picking up The economy recovered in the first quarter of 2013 with GDP increasing by 0.3% after a fall of 0.3% in the final quarter of Real consumer spending rose for a sixth consecutive quarter, increasing by 0.3% after a 0.5% gain in Q4, while investment posted a small gain (0.2%) after falling sharply (-4.9%) in the previous quarter. Exports fell slightly in the quarter (-0.1%) after a large decline in Q4 (-1.9%) but imports fell by more (-2.0%), so net exports made a positive contribution to GDP growth. The latest available hard and soft data, meanwhile, point to an acceleration in the pace of growth in the second quarter, with GDP rising by possibly 0.6% or more and thus posting the first back to back increase since sharp rise in market interest rates Having fallen to year-to-date lows towards the end of April, market interest rates have backed up sharply over the past couple of months, with swap rates from 2- out to 10- years rising by between 25bps and 75bps. The 5-year swap rate rose to almost 1.80% in late June before falling back to around 1.55%, though the latter is still 60bps higher than at the start of May. There are a couple of reasons for the back up in rates. Firstly, the Federal Reserve in the US has indicated that it is preparing to slow the pace of asset purchases under its latest quantitative easing program (QE3), which has led to a marked rise in market interest rates generally from which the UK has not been immune. Secondly, the signs of gathering momentum in the UK economy have also put upward pressure on interest rates. The market is now attaching a much higher probability to a hike in the Bank of England s Bank Rate by the end of 2014 than was the case a couple of months ago (the implied 3-month interest rate at end 2014 is now 90bps, up from 54bps), and is pricing in a full 50bps increase (at least) from current levels by end unlikely to be sustained Even with the recent back up, swap rates are still historically low, and so at some point they will return to more normal levels. However, we don t think we are seeing the start of a sustained rise in rates. The Bank of England has become a little more optimistic about the economy s prospects, but the recovery is still fragile and growth is forecast to remain below normal rates for some time. Hence one still cannot rule out the possibility of some further easing of policy by the Bank of England, be it additional asset purchases (QE) or some form of forward guidance to influence market expectations regarding official interest rates, which everything else equal would put downward pressure on market interest rates. Overall, we think swap rates will ease back further over the coming months though the lows of earlier this year are unlikely to be revisited. sterling range bound. The UK economy has picked up some momentum relative to its Euro area counterpart. There is, however, still the possibility that monetary policy will be eased further in both economies. In any event, it is very hard at this juncture to make any case for a decisive move in the sterling exchange rate in either direction that would take it out of the 80p to 90p range that has mostly prevailed since the beginning of 2010 (absent, perhaps, a renewed flare-up in the euro debt crisis) and we see just a very modest appreciation of sterling over the remainder of this year. 2 Bank of Ireland Global Markets

3 Europe Euro area economy still contracting Euro area economy still struggling The Euro area economy contracted again in the first quarter of this year, with GDP falling by a further 0.2% after a 0.6% decline in the final quarter of Consumer spending was the only component of GDP to post an increase in the quarter, rising by 0.1%, with government spending, investment and exports all falling from Q4. The available hard data paint a mixed picture of the second quarter. Industrial output rose for a third consecutive month in April, helped by a recovery in exports, and was some 1% above Q1 levels, but retail spending fell for a third consecutive month in April and was almost 1% below Q1. The Purchasing Mangers survey data have shown steady improvement through the course of the second quarter, with both the manufacturing and services measures of activity rising from the lows of March/April. However, they both still remain below the 50 expansion/contraction threshold and so, on the face of it, point to a further decline in GDP in Q2. Euro area Purchasing Managers Indices (50 = expansion-contraction threshold) Jun-07 Feb-08 Oct-08 Jun-09 Feb-10 Oct-10 Jun-11 Feb-12 Oct-12 Jun-13 Manufactur ing Services and ECB has an open mind about cutting interest rates Despite the still depressed state of the economy, market interest rates have backed up sharply over the past couple of months, with the 5-year swap rate, at around 1.20%, some 45bps higher than at end April albeit it has eased back by about 15bps since late June. The rise in rates triggered largely by developments in the US where the Federal Reserve is preparing to scale back QE has prompted ECB members to embark on something of a charm offensive to remind investors that monetary policy in the zone will remain accommodative for as long as necessary and that an exit from the current very low official interest rate environment is very distant. Indeed, the ECB President, Mario Draghi, has reiterated that the central bank still has an open mind about all the available standard and non-standard policy measures it could deploy to provide further stimulus to the Euro area economy - the former includes cutting the refi rate from the current 0.5%, the latter includes cutting the deposit rate from the current 0%. For now, though, the ECB seems likely to keep policy on hold, given the improvement in some of the recent data. while euro is on the back foot again. The euro strengthened against the dollar over the first half of June, rising to around $1.34 against the US currency. It has since fallen back to around $1.30, however, following the Fed meeting in the middle of the month which confirmed that a slowing of asset purchases is likely to commence this autumn. The single currency has now fallen by around 6% from February s high of around $1.38, consistent with the continuing relative outperformance of the US economy. The latter is set to continue for a good bit longer, and so the euro is likely to lose further ground to the dollar. 3 Bank of Ireland Global Markets

4 United States Taper talk Fed taper talk heats up As Bernanke signals the end of Q3 is coming The word of 2013 for financial markets will surely be taper. It first entered the lexicon when it was included in the March FOMC minutes when a number of participants said they believed that the tapering of asset purchases should begin before or around mid-year. These participants were most likely the usual hawks but the momentum around tapering picked up speed during Fed Chairman Bernanke s May 22 nd testimony to Congress. In a reply to a question, he said the Fed could step down the pace of asset purchases in the next few meetings if the labour market continued to improve. This caused quite a stir in the markets and when other Fed members confirmed they too were leaning towards the stepping down or tapering purchases then markets roiled with the news. 10-year Treasury yields were already on the way up from a 2013 low of 1.6% due to a stronger than expected payrolls outturn for April but the tapering talk was the catalyst to send then through 2% and by mid June were some 60bps higher than early May. That set up the June meeting of the FOMC as key for more information on tapering. In the event, the Fed did not disappoint with Chairman Bernanke laying out a more or less complete timeline (in his post meeting press conference) which could see purchases ended by the middle of next year. The writing was on the wall for the securities purchase program in the FOMC s statement issued before Bernanke spoke. In the statement, the FOMC kept the current pace of purchases at $85bn a month but said that downside risks to the outlook for the economy and labour market diminished since the fall. The Fed s latest forecasts also issued at the June FOMC meeting raised the 2014 forecasts for growth while lowering the unemployment and inflation forecasts. In the press conference, the key message from Bernanke was that if the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year and if the data continues to perform to expectations then we would continue to reduce the pace of purchase in measured steps through the first half of next year, ending purchases around mid-year. That was more detail at this point than the market was expecting and was, perhaps, at the more hawkish end of expectations with tapering possibly beginning towards the end of Q3 and purchases halted within 3 quarters. Bernanke was at pains, however, to stress that the Fed had no deterministic or fixed plan to end purchases and any action remains data dependant. Even since the meeting we have had two Fed members Lacker and Stein voice the opinion that tapering should start at the September meeting baring a dramatic downturn in the employment data (which is unlikely to occur). This outlook sent Treasury yields even higher with 10-year yields hitting 2.6% for a time. So it looks like the September Fed meeting is going to T-Day for the markets. US 10-year yield since the start of the year Jan-13 2-Feb-13 2-Mar-13 2-Apr-13 2-May-13 2-Jun-13 2-Jul-13 4 Bank of Ireland Global Markets

5 but no Fed Funds increase for some time yet as data points to economy picking up in H2. To ease the pain of the tapering plan, Bernanke also stressed at his press conference that accommodative policy would be needed for some time yet and that the Fed may lower the unemployment threshold (currently 6.5%) before raising interest rates. The Fed s forecast currently has unemployment touching off 6.5% at the end of 2014 but the Fed may now lower that threshold to push any talk of interest rate increases into In the economic projections, 15 of 19 Fed members expect no increase in the federal funds rate before 2015, up from 14 members in March. It appears that Bernanke and the Fed are trying to create a clear dichotomy in their current policy trying to be hawkish on quantitative easing but dovish on interest rate policy. The US economy, whilst growing moderately, is in no condition for monetary policy to be tightened. However, the Fed does want to wean markets off QE but at the same time wants it to be perfectly clear that any tightening of the Fed funds rate is still some way off in the distance. For the most part, the markets believe them with the first increase in the Fed funds rate not priced in until late 2014/early 2015 but we think the Fed would not like to see the market price in an increase any earlier than that. Hence why they may lower the future guidance thresholds in combination with tapering in order to convince the markets that a first interest rate increase is still a long way off even after all securities purchases have been halted. The data over the past month has, for the most part, increased the argument for tapering to begin in September rather than later in the year. PMI surveys have shown increases in their latest readings with the ISM manufacturing increasing to 50.9 in June from 49.0 in May now above the key 50 level that separates contraction from expansion while the ISM non-manufacturing index strengthened further in May rising to The housing market recovery is roaring ahead with indicators of price and activity continuing to rise. Spending data was more modest. Consumer spending rose by 0.2% in May after a fall of 0.1% in April. For April-May, spending is running just 1.2% (annualised) above Q1. So that indicates that Q2 spending is going to be somewhat slower than Q1 when spending increased at an annualised rate of 2.6% - even with another 0.2% monthly increase in June it would still leave Q2 spending at just 1.6%. More encouraging is the capital goods orders, which are a good indicator of business investment. Core capital goods orders rose for the third straight month (+1.1% in May) with the three month rate of increase at an annualised 7.6% now up from 5.1% in the three months to April. This illustrates that businesses have a good deal of confidence that economic activity is going to continue to expand and strengthen. Finally, confidence data shows that consumers are more optimistic about the economy now than at any time in the past five years; US consumer confidence rose to 81.4 in June from 74.3 in May and is now at its highest level since January 08. The conference board said that consumers are more positive about current business and labour market conditions than they were at the beginning of the year. Expectations have also improved considerably over the past several months, suggesting that the pace of growth is unlikely to slow in the short-term, and may even moderately pick up. The more positive trend in the data points to a strengthening recovery in the second half of the year. Of course, the key data for the Fed is the labour market. Employment gains have been modest but steady year to date with 175k new jobs created in May and an average of 190k new jobs a month since January. In the same period the unemployment rate has fallen to 7.6% in May from 7.9% in January. Those numbers represent solid, if not spectacular, employment growth and an unemployment rate that is slowly declining. If that performance continues through the summer there does not appear there is anything that can stop the start of tapering in September. 5 Bank of Ireland Global Markets

6 Economic Diary - July Date Europe United Kingdom United States 1 PMI Manufacturing, Flash HICP, PMI Manufacturing, Mortgage Approvals ISM Manufacturing Unemployment 2 PPI's PMI Construction ISM New York, Factory Orders 3 PMI Services, Retail Sales PMI Services DP Employment Change, Initial Jobless Claims, ISM Non-Manufacturing 4 ECB Meeting BoE Meeting 5 German Factory Orders Nonfarm Payrolls, Unemployment Rate 8 German Industrial Production 9 RICS House Price Balance, Industrial Production NFIB Small Business Optimism 10 Fed Minutes 11 Initial Jobless Claims 12 Industrial Production PPI's, University of Michigan Confidence 15 Rightmove House Prices Empire Manufacturing, Retail Sales, Business Inventories 16 Inflation Data, ZEW Surveys PPI's, Inflation Data Inflation Data, Industrial Production 17 Bank of England Minutes, Unemployment, Earnings Housing Starts, Building Permits, Beige Book 18 Retail Sales Initial Jobless Claims, Philly Fed, Leading Indicators 22 Existing Home Sales 23 Consumer Confidence House Price Index 24 Flash PMI's New Home Sales 25 IFO Surveys Q2 GDP, Index of Services Initial Jobless Claims, Durable Goods Orders 26 U. of Michigan Confidence 27 German Retail Sales 29 Mortgage Approvals, Nationwide House Prices Pending Home Sales 30 Confidence Indicators CaseShiller Home Price, Consumer Confidence 31 Flash HICP, Unemployment FOMC Meeting, Q2 GDP, ADP Employment Change,Chicago PMI 6 Bank of Ireland Global Markets

7 Forecasts Bank of Ireland estimates Exchange Rates Current End Sep End Dec End Mar EUR/USD EUR/GBP USD/JPY GBP/USD Source: Bank of Ireland Global Markets Official interest rates Current End Sep End Dec End Mar USD EUR GBP Source: Bank of Ireland Global Markets Swap rates: 5 year Current End Sep End Dec End Mar US Eurozone UK Source: Bank of Ireland Global Markets GDP and inflation (annual average) GDP Inflation GDP Inflation US Eurozone UK Source: Bank of Ireland Global Markets 7 Bank of Ireland Global Markets

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