Economic Outlook March 2015 Philippe WAECHTER Head of Economic Research My twitter account @phil_waechter or http://twitter.com/phil_waechter My blog http://philippewaechter.en.nam.natixis.com
The Scenario The oil price will stay low for the coming months Excess supply (production and inventories) creates pressures on price => transfer of purchasing power from oil exporters' countries to oil consumers' countries. Demand oriented policy from the ECB to be maintained at least until December 2016 Refi rate at 0.05% with the commitment to stay low for an extended period => low euro TLTRO to transfer risks from commercial banks to the ECB (lender of last resort) QE operation to keep euro low and to maintain the yield curve as low as possible This will lead to a stronger business cycle until at least 2017 Solid growth is expected in the USA Moderate growth pace during the first quarter Still no pressures from wages and inflation No change in the Fed's monetary policy in 2015 A higher dollar is doing the job No upside expected on Chinese growth It's still a story of growth rebalancing with constraints from the past (real estate, debt overhang, overcapacities, shadow banking) This slow rebalancing is limiting Chinese's impulse on the rest of the world, mainly on emerging countries. But that creates conditions for low commodity prices Inflation rates will stay low Negative during the first half of the year and then will move to positive territory as the negative energy contribution will vanish Monetary policies will remain accommodative In the Euro Area it is relied to the ECB strategy, in the UK and the US they have to wait until inflation will become higher No expected change in Japan as the economic momentum remains low Potential risks: Greece and Grexit, UK referendum, the absence of inflation, geopolitical tensions in the middle East, 2
Global Dynamics The increase in overall economic activity remains limited as suggested by the evolution of industrial production indices and the reduced growth of trade. The dynamics of the activity is robust in Asia but follows a slow momentum in all other regions including emerging area. One would have imagined that industrialized countries are penalized by structural issues while emerging countries had leeway to rebound. This was not really the case. Regional discrimination is not really significant. In the near future, China's slowdown will weigh on Asia ex-japan index. This area will nevertheless follow a strong dynamics. World trade momentum has changed little since the end of summer 2011. Trade is no longer a source of impulse for growth. The decline in energy prices has not boosted the world trade dynamics. The fall in recent weeks of the Baltic freight index is not encouraging for a trend reversal. 3
Interest rates and Commodities Interest rates remain low, but the divergence between the euro zone and the US is increasing. This can be clearly seen on the short end of the curve, the rate 2 years. On the long end, the divergent trajectories reflect very different expectations about future monetary policy. Expectations on a Fed lift-off of its interest rates are sooner that expectations on an ECB move. However, interest rates should remain low even if the Fed intervenes in the second half of the year as inflation remains clearly below central banks' target One reason for this lack of inflation is the deep and lasting decline in commodity prices. The demand for commodities is less robust than in the past but supply remains abundant, especially in a market like oil. 4
The oil market in two charts Since the beginning of 2014, oil supply is growing more rapidly than demand At the end of 2015, expected demand momentum, according to IEA, is still low, comparable to current supply. This mirrors the low global economic momentum. But supply continues to increase and inventories are at an historical high specifically in the US where production is at its highest at least until 1983 and inventories at its 80 years high. We are in a situation where no one wants to reduce its production. Small producers would lose revenues without having a real impact and the big three producers continue to test their balance of power and to produce. If there is not a strong change in world growth dynamics, demand will not increase rapidly and the oil price could go lower. In the short run, geopolitical constraints create uncertainty limiting the downward orientation. 5
Euro Area: Reasons to change the ECB monetary policy From the first quarter of 2011 to the fourth quarter of 2014, the GDP level was unchanged but with a deep and long recession between the two dates The private demand momentum is too low to expect a endogenous recovery. That's the type of cycle that was seen in the past but this is not what's happening currently. At the same time, there is a strong divergence in growth momentum in the Euro Area. Germany is leading with a GDP which is well above its pre-crisis level. This is not the case for Italy at the bottom of the spectrum if we exclude Greece. This heterogeneity is not what was seen in the past. Usually as countries trade a lot one with each other, business cycles follow the same common trend. This is not the case since 2011 and the austerity policy. There is a need for a shock that could change countries' behaviors and economic agents' behavior. That's what the ECB has in mind 6
A Three step strategy The first step is to drive down interest rates and interest rates' expectations in order to push down the euro. On September the 4 th, the refi rate was reduced at 0.05% and Mario Draghi was able to convince investors that this low level was here to stay. The euro/us dollar exchange rate dropped to 1.15 at the beginning of 2015. The point is to create a shock of competitiveness The second step for the ECB was to be perceived as the lender of last resort. TLTRO operations are targeting weak banks to transfer credit to the ECB. Banks must be able to amplify the impulse on activity due to stronger competitiveness. The third step is the Quantitative Easing. It must keep the Euro at a very low level and flatten yield curves throughout the Euro Area. The QE announcement pushed the euro to 1.05. 7
Lower Yield curves The ECB wants to limit the incentive to transfer wealth through time. That's why one of its target is to flatten the yield curve. If the transfer is limited, households will spend more now and it could push companies to invest if they perceive that the environment is changing. If they have to transfer wealth, return will be low on sovereign bonds. Investors will have to take more risks on financial markets and/or on real assets (real estate and capex) The other target is to reduce the financial fragmentation within the euro area. Financial conditions are too heterogeneous, so companies have very different incentives depending on their location. On the second chart this can be seen with a large spread between Germany and France on one side and Italy and Spain on the other The three step strategy will help to reducing this fragmentation 8
Weak expectations on change on monetary policy The ECB has been successful in convincing investors that its low rate strategy is here to stay. On the first chart, the 3 month Euribor is expected at 0.7% at the end of 2020. It is well below what is expected on Fed's side (1.6% in September 2017 according to the Fed Funds futures) Competitiveness has deeply improved as the euro real effective exchange rate dropped dramatically since the beginning of the year. In other words, there is no defiance on the ECB strategy Restoring competitiveness by creating an impulse on exports through a lower Euro value The impulse will drive up economic activity and will densify trade between euro countries. It will create synergies leading to a strong improvement in growth prospects. People have incentives to spend now Growth will accelerate in 2015, 2016 and 2017 9
But the recovery has started This demand oriented monetary policy is helped by a low oil price. This latter has improved households' purchasing power and companies' margin On the first chart we see more optimism on companies' side. The PMI Markit index is improving since the beginning of the year; By countries in surveys we see a acceleration in Germany, in Italy and in Spain. France's profile is more confused. On households side, there is rapid improvement on confidence, at its highest level since 2008, and in retail sales. This is positive on activity The other positive point is that it is Germany that has triggered this improvement with Spain. This latter is just out of a long recession so its impact is limited but German's improvement leads to a stronger internal demand in the Euro Area. That's what was expected in order to accelerate the rebalancing between countries that were penalized by austerity policies (Spain, Italy, Portugal, France) and Germany which has taken advantage of its comparative advantage on the world market. 10
And it will improved in the coming months The momentum has changed in the Euro Area. This can be seen on the labor market. Employment has increased by 0.6% on average in 2014 and the Markit employment index points to further improvements Unemployment rates are falling everywhere except in Italy, in France and in Greece. For the first two it reflects the inertia of the recovery. For Greece, it shows that the crisis is not over. This global improvement can perceived also on new orders flows. The ratio of New orders to Inventories in the Markit survey is increasing rapidly. Usually this is consistent with a expansion of the industrial production index. This improvement in demand will be a trigger for capex. Companies will expect a stronger demand and with easy financial conditions, investment will increase and be the support for a long lasting business cycle. With a stronger momentum on consumption and an impulse on exports, economic activity will increase and then will accelerate with investment. 11
The recovery will limit the risk of deflation One reason for Mario Draghi to change the ECB monetary policy is the risk of deflation. The inflation rate was negative in January (-0.6%) and February (-0.3%) for the Euro Area. It is clearly linked to the drop in energy price. But in many countries the inflation rate is negative and reflects the depth of the structural adjustment. Liquidity will not create higher inflation rates spontaneously but change in economic activity will have a positive impact on expectations. Moreover with the recovery some companies will be able to fix their prices. So the story can change and exit from a situation where wages on new labor contracts are trending downward. 12
The US economy is growing more slowly The dynamics of the US economy remains robust but it is slowing. The recovery, that took place after June 2009,was carried by domestic demand. This latter has lost momentum recently. Households spending grew much more slowly in the first two months of the year and the real estate dynamics is low. At the same time industrial production contracted in the first two months of 2015. Capital goods orders are weaker, which should result in less productive investment There are explanations for this, including the cold wave from the northeast but it is not enough because the slower dynamics was general and not located only in the North-East. There were more specific explanations for investments: a lower oil price has reduced incentives to invest in the However, the economy has not grown as fast as it could and the perception is that, may-be, the peak of the cycle was hit in the fall. 13
There are still slacks on the labor market Employment has accelerated significantly since April 2014. But when we compare the current job profile and that of past periods since 1960, we see that the current cycle does not cause significant job creation. That is why there still significant imbalances in the labor market. They are also regularly discussed by the Fed to justify a postponement of its action on interest rates. The labor market is marked by a sharp decline in the participation rate and this is what explains the rapid decline in the unemployment rate, despite the lack of job creation. There are, among the people leaving the labor market, a lot of baby boomers. However, if one removes over 55 years the participation rate is lower and the employment rate is smaller than in the previous cycle. No surprise then that wage pressures are reduced as shown in the graph on wages profile. 14
Trade off between interest rates and the dollar Investors expect a rise in the Fed's interest rate before the end of 2015. The question is whether the decrease of the unemployment rate will inevitably imply higher inflation. If it is the case it is necessary to tighten monetary policy preemptively in order to reduce inflation risks in the future as there are delays between the change in monetary policy and its effect on inflation. This is the position taken by Janet Yellen at her conference in San Francisco on March 27. The other position is to wait until the moment where the inflation rate an inflation rate will be above the Fed's target. In the first case if inflation remains low, the tightening of monetary policy may have a negative impact on the business. This is a case which has been repeatedly observed. In fact, this policy will require to have an idea about when or inflation will accelerate.? Acting is too late to take the risk of having a little inflation. Is it worse than a possible slowdown in activity? For sure it is not The rising dollar already constrains the US economy and this will be enough in 2015. A liftoff in interest rates could have to wait until 2016 15
China on a slower trend Chinese question is a transition under constraint. The government's goal since 2011 is to rebalance the growth process towards domestic demand, particularly consumption. Growth is now expected to depend more on internal demand than on external stimulus. This reflects the fact that there is a rapid development of the middle class that want to spend more on consumption goods and services. But the transition is not an easy task. It takes time and is not linear. Currently the adjustment bears on investment and is not clearly on the consumption side. There are no price pressures. The main reason for this slow adjustment comes from the previous growth framework. Since 2009 it was relying on the accumulation of situations that stress the economy today: real estate currently adjusts downward penalizing investors; public companies and local government indebtedness figures are too high to give them some leeway, overcapacity is still significant and the shadow banking has grown rapidly since 2009. These factors limit the ability to reallocate resources easily to the domestic market. The government wants to improve the current momentum by limiting the impact of high indebtedness. The central bank is becoming more accommodative by lowering interest rates. 16
Weak momentum in Japan In Japan, the economic activity declined in 2014 after the VAT increase at the beginning of the fiscal year on April 1. This can be seen on the two graphs on the right. There is the peak of household spending in the first quarter of 2014(March in the 2 nd graph) and its sharp decline after. When comparing the shock of 2014 and the equivalent in 1997 we find that the impact of the VAT increase was significantly higher last year. The recession in 1997 was very long and took place in a period where the world economy and the world trade were growing rapidly. This is not the case today, the internal shock was very strong and the measures taken to counteract have been limited. At the same time, the overall dynamics and global trade are not progressing quickly (see chart page 3). The recent increase in exports was only temporary since February they have inflected, erasing rapid increases seen in December and January. Under these conditions a rebound in Japanese growth doesn't seem likely in 2015. Keep in mind that after April 1, the tax effect will fade and the inflation rate will be close to zero and may be negative. The BoJ target was 2% in 2015. All these efforts for that? 17
More robust situation in the United Kingdom The situation of the British economy strengthens. The rapid development had been done and is still on precarious work contracts have helped to change the perception by households of their environment. As the same time the government has not had a very restrictive fiscal policy. In 2014 the budget balance showed a deficit of -5.5% of GDP. Private demand could gradually improve and business investment grow without being forced excessively Growth is strong and this is reflected in the increase in retail sales. Consumers are reassured about their environment However, inflation has fallen to 0% in February. This is the lowest figure since the middle of 1960. Since wages are not rising rapidly, the Bank of England will keep its benchmark rate at 0.5% throughout 2015 18
Forecasts Source Economic Research Natixis Asset Management 19
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