Market Update Late August 2013 Market Update: Global Economic Themes So far this summer, we have produced two Market Update papers covering capital market themes and geopolitical risks. In this final paper for the summer, we take a closer look at the economic issues that markets are likely to focus on over the next three to six months. Robert Parker Head, Strategic Advisory Group Overview US growth likely to be 2.5%+ in H2 2013 and then close to 3% in H1 2014 Fed tapering is likely to start in September/October but, at least initially, the pace of it will be slow After six quarters, Germany has led the Eurozone out of recession Given the lack of progress in improving French competitiveness, GDP growth is likely to lag that of Germany Risks to Japan in 2014, but H2 2013 growth likely to be maintained at 3% annualized Weaker currencies should lead to a recovery in emerging economies United States In the US, one of the key economic indicators, consumption, remains robust, even though there was a slight reversal in the consumer confidence index to 80.3 in July. Retail sales rose by 4.9% annualized over the last three months. Excluding the auto sector, the corresponding rise in retail sales over the last three months has been 3.3%. The fastest growing area of consumption has been the auto sector with spending up 4.3% outright in Q2 while, significantly, the weakest areas have been spending at gas stations and food and on beverages (typically recessionary indicators). Positive factors for consumption have been the continued slow improvement in the labor market (July unemployment was at 7.4% and nonfarm payrolls were up 1,347k y-t-d), the wealth effect from the S&P (up around 16% y-t-d) and from the housing market (CS 20 city composite +12.2% y-o-y), improved borrowing conditions with consumer credit outstanding up 5.8% y-o-y, the savings ratio at a moderate 4.4%, and personal incomes up 3.1% y-o-y. The pace of consumption, up 2% y-o-y in real terms in the Q2 real GDP data, should extend to 2.5% over the next six to nine months. Investment spending has also been strong, rising by 5.5% y-o-y in real terms in Q2. Positive factors have been the improvement in final demand, the upturn in the M&A cycle (albeit slowly), tight credit spreads and low absolute borrowing costs, the slow reduction in surplus corporate cash, and improved bank lending. Commercial and industrial loans rose by 9.8% y-o-y in May and should continue to grow at an annual rate of close to 10%. At the same time, surveys are generally positive. The July manufacturing ISM was 55.4, up 4.9% y-o-y and up from a May low of 49, while the service sector ISM jumped to 60.4, compared to 51.7 in June. The new orders subcomponent of the ISM manufacturing index was 58.3, up 19.5% compared with the May figure. The Philadelphia Fed outlook survey for manufacturing was 44.9 in July, up 21% y-o-y, while the New York Fed equivalent was 32 compared with a May low point of 25.5. Consequently, the recent weak production numbers should improve in H2 2013. Industrial production was flat m-o-m in July and has also been flat since March. Capacity utilization slipped to 77.6 in July compared with 77.9 in April. Neither historical nor future performance indications and financial market scenarios are guarantee for current or future performance. 1/5
However, durable goods orders rose by 10.8% y-o-y in July and, significantly, nondefence capital goods orders increased by 24.2% outright in Q2. It is assumed that during H2 2013 the y-o-y increases in industrial production will improve back to around 3%. Looking at the trade deficit, this narrowed to USD 34.2 bn in June from USD 45 bn in May. The trend is for the monthly trade deficits now to be close to USD 30 bn, supported by the improvement in the energy deficit due to the development of shale and the pickup in demand in Europe and Japan. In the Q2 real GDP data, real exports rose by 1.9% y-o-y and this growth rate should improve to 3 5% annualized over the next six months. Elsewhere, government spending continues to contract, down by 1.2% in real terms in Q2. In H2 2013, given the sequestration process and improved fiscal revenues, the budget deficit should decrease to 4.5% of GDP. In addition, monetary conditions remain exceptionally easy with the y-o-y increase in the monetary base up 19.2%. The corresponding increases in M1, M2, and MZM are 12%, 6.9%, and 7.6% respectively. Turning to inflation, it continues to undershoot with the core PPI at 1.2% y-o-y and the CPI at 1.7%. The headline CPI is at 2% y-o-y. At least in 2013 and early 2014, the headline CPI is unlikely to move beyond 2.5% y-o-y. The debate on when the Fed starts to taper misses the key question about how quickly/slowly the tapering will take place. Assuming that growth accelerates to 2.5%+ in H2 2013 and then close to 3% in H1 2014, tapering is likely to start in September/October but, at least initially, the pace of tapering will be slow, and during Q4 2013 quantitative easing (QE) could be reduced to an average of USD 60 bn per month. Exports also recovered in June, with a 0.6% m-o-m increase, while the volume of new overseas orders rose by 6.3% y-o-y, suggesting that export growth will strengthen further. Although retail sales reversed in June by 1.5% m-o-m, consumer spending should strengthen in H2 2013 given low unemployment of 6.8%, recent wage increases approaching 4% annualized, and the wealth effects from the rise in the DAX (up around 11% y-t-d), and upward pressure on real estate prices. Bank lending is improving, with private commercial bank loans rising by 3.9% y-o-y. After a q-o-q increase in real GDP for Q2 of 0.7%, annualized German growth during H2 2013 and early 2014 has now been revised upwards to 2%. Although the French July manufacturing PMI was 49.7 and the services PMI 48.6, Q2 French real GDP growth was 0.5% q-oq. Two positive factors have been the improved demand for exports with the June current account deficit narrowing to EUR 1.4 bn and the improvement in consumer confidence, with the index at 82 in July compared with 79 in June. However, industrial production was down by 0.2% y-o-y in June and consumer spending declined by 0.5%. The budget deficit is likely to remain above 3.5% relative to GDP for the foreseeable future. Given that fiscal policy will remain tight, unemployment will be constant at close to 11% and, given the lack of progress in improving French competitiveness, French growth is likely to lag Germany with annualized GDP growth struggling to exceed 0.7% in H2 2013. The debate on when the Fed starts to taper misses the key question about how quickly/slowly the tapering will take place. Europe Finally, after six quarters of recession, the Eurozone has turned the corner. Led by Germany, the region has exited recession and structural adjustments in the stressed countries are also making good progress. In Germany, economic data has shown a sharp improvement in the last two months. The manufacturing PMI rose to 50.7 for July, while the services PMI was 51.3. The July IFO survey showed a further improvement at 106.2 compared with a recent low of 104.4 in April, while the future expectations IFO index is now up 6.9% y-o-y. By sector, the manufacturing index is up 4.9% y-o-y, and since April the retail trade index has risen from 116.7 to 119. German industrial production rose by 2% y-o-y in June and the recovery in production has been led by the capital goods sector. In Italy, GDP declined by 0.2% q-o-q in Q2 after a q-o-q fall of 0.6% in Q1. However, the manufacturing PMI has improved to 50.4 with the services PMI rebounding to 48.7 from June s 45.8. The y-o-y decline in industrial production has moderated to 2.1% in June after a decrease of 4.2% in May. For the last two months combined, the budget has been in surplus, while in June a trade surplus of EUR 3.6 bn was reported. The current account surplus as a percentage of GDP should exceed 1% for at least the next 12 months. The unemployment rate has improved slightly to 12.1%, while retail sales improved modestly in May with a m-o-m increase of 0.1% and with the y-o-y decline moderating to 1.1%. Italy should exit recession in late Q3, with annualized growth in Q4 2013 of approximately 0.5%. The July Spanish manufacturing PMI remained close to 50 at 49.8 with the services PMI at 48.5. The current account moved into a strong surplus of EUR 2.4 bn in May. By year end, the Neither historical nor future performance indications and financial market scenarios are guarantee for current or future performance. 2/5
current account surplus could be close to 2% of GDP. However, consumption remains exceptionally weak with retail sales down by 7% y-o-y in June. It is also premature to forecast a turnaround in industrial production, which decreased by 1.9% y-o-y in June. However, the Q2 decline in Spanish GDP was only 0.1% and the y-o-y GDP figure for Q4 2013 should be close to zero. After the decline in Irish GDP in Q1, GDP growth should recover in H2 2013 with y-o-y growth approaching 1.5%. The current account surplus is now well established above 5% of GDP, while the trade surplus in May was EUR 3.1 bn. The budget deficit should be less than 5% of GDP by mid-2014. The July manufacturing PMI was reported at 51 while the services PMI was a strong 57.6. Industrial production in June was also strong, up 3.1% y-o-y. Additionally, the real estate market is forming a base and June property prices were up 1.2% y-o-y. Consumer spending is likewise forming a base and although retail sales by volume in June declined by 1.5% y-o-y, the consumer confidence index rebounded to a strong 70.6. Portuguese data is starting to show an improvement. Industrial production in June rose by 2.1% y-o-y and the m-o-m increase in retail sales was 1.1%, reducing the y-o-y decline to 2.6%. The May current account balance was a slight deficit of EUR 72 m. The q-o-q Q2 real GDP number rose by 1.1% with the y-o-y decline falling to less than 2%. Portugal has probably already exited recession with the budget deficit expected to fall to less than 5% of GDP by year end. The Greek economic collapse is moderating. The y-o-y decline in Q2 real GDP was only 4.6% after a 5.6% fall in Q1. The July manufacturing PMI rose to 47 from 45.3 in June. Industrial production rose by 0.4% y-o-y in June. During Q3, the budget deficit should be less than 5% of GDP, decreasing to less than 4% in H1 2014. The current account deficit is now less than 1% of GDP and should move into surplus in Q2 2014. Looking at Eurozone inflation, it remains low with the y-o-y CPI at 1.4% in Q2. Given the high level of unemployment and spare capacity with the euro stable, the headline CPI should remain close to 1.5% for the foreseeable future. So, in summary, the Eurozone themes are: The German economy is recovering strongly, led by improving exports and consumption. Consensus forecasts of 1 1.5% growth in H2 2013 are likely to be exceeded. Although French growth recovered in Q2, France will lag Germany significantly due to competitiveness issues. Italy and Spain are showing early signs of recovery, although the exit from recession will be moderate. Amongst the bailout countries, the recession in Portugal is now probably over and even Greece is starting to form a base, while Ireland should experience growth in H2 2013 of at least 1.5% annualized. Eurozone current account deficits have largely been removed and in all countries budget deficit adjustments are continuing to make progress. Japan Japanese monetary policy has remained expansionary, and in June, the y-o-y increases in M1 and M2+CDs were 5.1% and 3.8% respectively. Since March, broad liquidity has risen at an annual rate of 8.9%. Bank lending (ex Trusts) has increased by 2.3% y-o-y, while the corresponding rise in new housing loans has been 8.5%. The impact of the Bank of Japan (BoJ) QE policy and the objective of obtaining 2% inflation by 2015 have led to an improvement in business confidence, and the Q3 Tankan survey rose to -2, up from -20 in Q1 and -10 in Q2. The business conditions index has risen by 22.2% y-o-y. Although the Japanese yen s weakness has reversed slightly with a current range of 95 100 against the US dollar, export growth has been robust with a y-o-y gain in July of 12.8%. Positive factors for exports are the recovery in demand in the US and Europe, the stabilization of the Chinese economy, the competitiveness of the Japanese yen, and the scope for improved market share in the tech and healthcare markets. Export growth should be maintained at 10%. Although real consumer spending rose by 0.8% outright in Q2, recent consumer spending figures have been erratic. Department store sales (nsa) fell by 2.5% y-o-y in July while expenditure in real terms by workers households rose only by 0.6%. The recent setback in consumer sentiment could be due to concerns over sales tax being increased, the impact on consumption from higher import costs (with the import price index up 13.8% y o y), and the recent negative trend in real disposable incomes. However, the question of sales tax being increased is still uncertain and in any event would be delayed until 2014/15, while the change in inflationary expectations should boost consumption. With the Tokyo CPI rising by 0.8% outright since February, there is a reasonable probability that headline inflation will exceed 1% y-o-y by early 2014 and real consumption should increase by 1 2% annualized over the next year. Private sector machinery orders have risen by 15.8% y-o-y and the manufacturing operating ratio has improved to 98.1. Therefore, the recent setback in industrial production, with a y-o-y decline in June of 4.6%, should prove temporary and after a Q2 real decline in business spending of 0.1%, production and investment should pick up. Positive factors for the business sector are the trend improvement in final demand, the weakness of the Japanese yen, low borrowing costs, and high levels of corporate liquidity. While there are a number of risks to Japanese growth later in 2014 notably the impact on consumption from the proposed increases in sales taxes and the effect on the budget deficit from rising JGB yields, at least for H2 2013 and early 2014 growth should be maintained at an annualized rate above 3%. Neither historical nor future performance indications and financial market scenarios are guarantee for current or future performance. 3/5
Emerging Markets Recent Chinese data has shown a clear improvement after the weakness of Q2. Consumption has remained strong with retail sales increasing by 13.2% y-o-y in July. Investment spending has likewise held up, with fixed asset investment increasing by 20.1% y-o-y. Industrial production has also improved, up 9.7% y-o-y. And, after the poor export data in Q2, exports in July rose by 5.1% y-o-y. PMI data has generally shown an improvement with the official manufacturing PMI at 50.3 and the nonmanufacturing figure at 54.1. The HSBC/Markit figures, having weakened in July, have improved in August with a manufacturing figure of 50.1, after 47.7 in July. This increase was primarily due to domestic demand and partly reflects the impact of tax breaks for smaller firms and increased infrastructure investment, notably in the railway system. The services figure for July was 51.3. Growth should be maintained at close to 7.5% annualized in H2 2013 and at least in H1 2014. Positive factors are continued robust domestic consumption, a high level of infrastructure investment spending, an upturn in real estate development, inventory restocking, and improved export data based on stronger demand in Europe and the US. The squeeze in the interbank market in June has now subsided, and although default rates will inevitably rise in the medium term in the shadow banking market, it is assumed that this problem will not derail the economy over the next year. Note that the current account surplus remains above 2.5% of GDP, while the minor budget deficit in H2 2013 should move back to a surplus in early 2014. In contrast, Indian data has weakened except for the export sector. Industrial production in June fell by 2.2% y-o-y after a 2.8% y-o-y decline in May. The July HSBC/Market manufacturing PMI declined to 50.1, while the services PMI reversed from 51.7 to 47.9. The CPI has remained elevated at 9.6% and, given the devaluation of the Indian rupee, will probably exceed 10% over the next three months. The budget deficit remains above 5% of GDP with a current account deficit close to 5%. The only positive factor has been the recovery in exports, up 11.6% y-o-y in July and, given the new competitiveness of the currency, export growth should be maintained above 10%. Given the slowdown in investment spending and the impact of the Indian rupee s decline on foreign currency borrowings by Indian corporates and rising default rates at the banks, growth could remain stalled under 5% for the foreseeable future. Brazilian data is showing signs of slow improvement. Industrial production in June rose by 3.1% y-o-y after a mediocre gain of only 1.4% in May. However, the upturn in production is likely to be slow given the PMI manufacturing data for July of only 48.5 and a services number of only 50.3, down from 51. The rise in Brazilian yields with the 10 year BRL yield now at 12.2% will constrain investment at least in the near term. The devaluation Data Source: Credit Suisse of the Brazilian real will boost the export sector but import input costs will inevitably increase. Retail spending has picked up, and the Serasa retail index improved to +0.2% in July compared with -1.5% in June, while the June headline increase in retail sales was reported at 1.7%. After an increase in y-o-y growth of only 1.9% in Q1, growth in H2 2013 will probably pick up slightly to 2.5% led by the export sector, some stabilization of commodity prices, and improved demand in China and the US. However, the budget deficit is likely to remain close to 3% of GDP, while the current account deficit could increase to 3.5%. Russian growth has slowed significantly with Q2 real GDP only Positive factors for China include robust consumption and improved export data based on stronger demand in Europe and the US. increasing by 1.2% y-o-y. However, more recent data shows an improvement in consumption with real retail sales rising by 4.3% y-o-y in July, real disposable incomes accelerating by 4.2%, and unemployment down to 5.3%. Although the recent production data has been weak with the manufacturing PMI at 49.2 and with industrial production down by 0.7% y-o-y in July, the recent increase in oil prices should lead to production turning positive in late Q3 2013 with Q3 real GDP growth returning to 3%. The current account surplus remains close to 2% of GDP with a small budget surplus. Conclusions Despite the impact of a tighter fiscal policy, US growth should progressively improve to 2.5%+ with no pickup in inflation. Eurozone growth is now improving and German growth should accelerate to 2% annualized over the next six to nine months. Spain and Italy will exit recession in the near term and Portugal and Ireland are already out of recession. Inflation will continue to undershoot. Japanese growth should hold at around 3% at least for the rest of 2013 and early 2014, with inflation picking up to 1%. The Chinese economy is stabilizing and growth of 7.5% should be achieved this year and early next year. Brazilian growth is picking up slowly and, as in India, the exports sector should benefit from the devaluation of the currency. Likewise, Russia should benefit from the current high level of oil prices. After the slowdown in emerging economies in 2012 and H1 2013, improved growth in the developed economies, stable commodity prices, and, in many cases, weaker currencies should lead to a recovery in the emerging economies. Neither historical nor future performance indications and financial market scenarios are guarantee for current or future performance. 4/5
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