Vive la Revolution
2017 is a critical year for European politics not to mention the triggering of Article 50 and Trump.
The UK economy looks set to have recorded only a marginal strengthening in the pace of GDP growth in Q2; figures are due 26 July. Looking forward one question is over the extent and duration of the squeeze on consumer spending, given inflation continues to outstrip pay growth; we see this continuing to weigh on the growth pace. On monetary policy, some of the heat has come out of recent rate hike momentum with enough key players on the MPC seemingly not ready to vote for a tightening. Political uncertainty has remained a key theme, with talk of an autumn leadership challenge to Theresa May resurfacing. Despite the air of entrenched political chaos, sterling has traded up at $1.31 against the USD recently. Our targets remain the same - $1.30 end-2017 and $1.32 end-2018.
Two key forces on risk assets of late have been the strengthening global growth backdrop and monetary policy normalisation. The renewed focus on policy tightening followed the ECB’s 26-28 June Sintra conference at which central bankers from across the globe, debated stimulus removal. In the days after Sintra, sovereign bond yields moved up markedly and sentiment in stock markets soured. Lately though, with the S&P500 and the MSCI World index not far off recent record highs, it would appear that the resilient growth backdrop, with diminishing downside risks, is currently the dominant factor. However we still expect normalisation to remain a key theme through the rest of 2017 as market participants gain greater sight of central banks edging towards the policy exit. We continue to look for higher sovereign yields virtually across the board. And we suspect that equities generally will become more wary of central bank actions.
We expect US Q2 GDP figures (28 July) to show the economy expanding more robustly than in Q1, with consumer spending rebounding. Over the remainder of the year, a softer spending picture is likely, but we do not expect a sharp drop-off. Indeed, counter to the situation in the UK, we are not witnessing a hit to household real spending power, with US inflation running below pay growth. We see the Fed announcing when it will commence unwinding its QE holdings in September, with October as the most likely start point. White House political capital continues to be absorbed by the Russia election interference investigation whilst the administration faces continuing blockages in advancing health care legislation. Both further dampen hopes the administration will succeed with the likes of corporate tax cuts.
Our baseline case is that the ECB will taper its pace of QE purchases over H1 2018, announcing its intention to do so this autumn, although any further signs of weakness in ‘core’ inflation could see plans delayed. Getting the communications for this right has been challenging however. Despite President Draghi’s best efforts to emit dovish tones in his 20-July press conference, the Euro had a mini ‘taper tantrum’, with €:$ rising to a near two year high in recent days. Bond markets have shown less concern, with peripheral Eurozone yields actually falling. Other Euro supportive factors lately include market participants taking increasing note of decent Euro area growth momentum, whilst a USD on the back foot has also helped. Our end year goal for €:$ remains at $1.14; whilst this been overshot lately, we expect the USD to find its feet before end-year. We look for $1.18 for end-2018.
Figures relating to growth in Q2 have so far been lacklustre. Industrial production fell back by 0.2% in May, while construction contracted by 1.1% and although we may see some improvement from Q1’s slow pace of quarterly GDP growth of 0.2%, any strengthening is likely to be marginal. Our estimate of monthly GDP growth (Chart 19) illustrates the slowdown recorded so far. Earlier in the month the ONS announced that it also plans to publish a monthly GDP series early next year, as part of an exercise where preliminary quarterly GDP data are no longer published, but where later stage estimates are brought forward by around a fortnight.
A key question over the outlook concerns the extent and duration of the squeeze on consumer spending, given that inflation (2.6% in June) continues to outstrip pay growth (1.8% in May). Much attention is paid to the Markit PMI indices, in particular, that for services. This was recorded at 53.4 in June, down from a high of 56.2 in December last year, but close to the average for the past 12 months as a whole. We maintain that this gives a false steer as it excludes retailing activity, an area which is autonomously soft. Plotting a chart of the PMI and services output does suggest that the PMI is currently oversignalling, just as it undersignalled when high street activity strengthened during H2 last year.
Kristin Forbes, one of three rate setters who voted for a hike in June, has now left the MPC, taking some heat out of rate hike momentum. Moreover Deputy Governor Ben Broadbent effectively put an end to speculation over a summer move, when he declared that he was not yet ready to vote for a tightening due to a number of ‘imponderables’, such as corporate nerves over Brexit uncertainty. Our view is that we may be close to the peak in the short-term inflation cycle. Note that PPI output price inflation, often a decent proxy for goods price inflation, is easing back (Chart 21). We still expect the targeted rate to exceed 3% over the next few months, but only just and not for long.
Longer-term the MPC is looking closely at (and fretting over) pay. Its forecasts in May’s Inflation Report (IR) see earnings growth climbing to 3.75% in Q4 2019 from 1.8% now (ex-bonuses 2.0%). With unemployment now at 4.5%, this conclusion is understandable, but other central banks (e.g. the ECB) are trying to figure out why low joblessness is not driving pay growth more forcefully in their jurisdictions. Indeed IR forecasts have consistently overpredicted pay growth. Of course the BoE could be correct this time, but we are struck by how much faith the MPC seems to place in its forecasts. Our baseline case is still that wage growth will remain modest and that the Bank rate will stay at 0.25% until H2 2019.
Perhaps the summer ‘silly season’ is to blame, but open warfare appears to have broken out in the UK Cabinet. Talk of an autumn leadership challenge to Theresa May has resurfaced and Chancellor Philip Hammond is facing political pressure to lift the 1% cap on public sector salaries, as well as facing accusations that he stated that public sector workers are overpaid. ONS data suggest that average public sector pay levels are 2% above those in the private sector, although this does not take into account factors such as job type or number of hours worked. In terms of pay increases, the starting point matters. Private sector workers have won out in the past four years, but the picture is more mixed the further back you go.
Despite the air of entrenched political chaos, sterling has traded up as high as $1.31 recently. This owes partly to the strength of the EUR (which has reached $1.1684), but also due to the USD being on the back foot. Our end-year targets remain the same - $1.30 and $1.32 for this year and next and 88p and 90p against the EUR. We see a case for the pound to move up further – certainly on valuation grounds a considerable degree of tail risks seem to be priced in. But we judge that markets will be aware that sterling is vulnerable if the political drama unfolds badly, and at risk of a sell-off should events go badly. And this is why we downgraded our sterling forecasts modestly in June and have left them there.
It is difficult to determine which of two forces is the greater on risk assets – the strengthening of global growth or the process of policy normalisation. With the S&P500 and the MSCI World index both still not far off record highs, it would appear that the former is the dominant factor. A decent supporting argument is that it is not just about raw numbers, but also that downside risks are diminishing. This is certainly true of the Euro area, but also of prospects for some larger EMs. But if one takes the view that the additional liquidity (and scarcity of assets) brought about by QE has helped to fuel the broad based rally in assets, then the opposite, when QE is reversed, surely holds as well.
As mentioned last month, the Fed has published broad proposals to slim its balance sheet and the ECB is probably close to announcing a steady winding down (and probably the eventual reversal) of its asset purchase plan. In recent weeks, markets have shown some signs that they are adopting this mindset - seven sessions in the US since the start of June have witnessed a simultaneous sell-off in equities and bonds (Chart 2). But broadly, the overall trend has been one of stockmarket resilience. We continue to look for higher sovereign yields virtually across the board. And we suspect that equities generally will become more wary of central bank actions.
It was the ECB conference in Sintra in late June that threw the market spotlight onto normalisation. There central bankers from across the globe, debated stimulus removal. Market nerves over normalisation have settled since, as have interest rate expectations, which firmed after Sintra (see Chart 3). But we still expect normalisation to remain a key market theme through the rest of 2017. The US is already four hikes into rate normalisation. Recently questions have been asked over whether the Bank of Canada is at the start of a hiking cycle, having enacted the first rate increase in seven years on 12 July. It should also not escape readers that the PBoC has quietly raised liquidity rates several times this year.
Of course it is not just interest rate policy which has been the focus of normalisation discussions, but QE too. Outstanding QE stands at $11trn globally - the Fed accounts for the largest share, 38% of the total, although this looks set to begin to fall as the Fed allows some roll-off soon. Those assets held by the ECB however will continue to rise, with it still likely to be adding to its QE stock through H1 next year, albeit by smaller amounts as the year goes on. Aside from the Fed, the process of unwinding holdings still looks a way off. When other central banks get to this stage, we expect a cautious approach (similar to the Fed), given that the removal of this level of liquidity may have unknown consequences for markets.
Firmer world growth has been the reason why central bankers globally have been content to debate normalisation more openly. Within this the Chinese economy has been particularly resilient in the face of macro-prudential reforms. Growth in Q2 was recorded at 6.9% y/y, keeping the Chinese economy on track to meet and even exceed the government’s 2017 target of 6.5% (we forecast 6.7%). In turn, a robust Chinese economy looks to be helping China’s neighbours and major exporters to the region; the Bank of Korea recently upgraded its economic assessment, while the RBA also acknowledged improving conditions. We continue to see global growth increasing to 3.6% this year from 3.2% in 2016.
Amidst a resilient global growth backdrop, the threat of a rise in global protectionism remains in the background. Despite the US having pulled out of the Trans-Pacific Partnership and with renegotiation of NAFTA and the US-Korea Free Trade Agreement underway, the US has been one of the recent complainants of countries persistently running large trade and/or current account deficits or surpluses. China has been a focus of criticism, but most recently Germany has taken some flack and not just from the US administration. The IMF’s recent ‘Article 4’ assessment argued for Germany to reduce its current account surplus, which is the world’s largest and hit a record 8.5% of GDP in 2016. Germany, for its part, has argued that factors beyond its control are to blame (market forces, demographics).
US Q2 GDP figures are due on 28 July. We expect these to show that the US economy expanded more quickly in Q2 than in Q1. The BEA will publish its annual update to GDP figures on 28 July. However remaining ‘residual seasonality’, which appears to dampen Q1 GDP figures, is not set to be addressed until 2018. Consumer spending in Q2 was likely boosted by a couple of temporary factors (delayed tax refunds earlier in the year being one) and hence we expect a softer spending picture through Q3, but certainly not a sharp drop-off. Indeed, one source of optimism is the recent NY Fed survey (Chart 7) showing a pick-up in expectations for household spending growth and a survey high (34.8%) of...
...respondents saying they are better off than a year ago. The solid consumer backdrop is being helped by steady rises in employment, with non-farm payroll gains picking up again in June (Chart 8). Indeed, Fed Chief Yellen stated recently that jobs gains were more than sufficient to provide jobs for new entrants to the labour force. Furthermore, and counter to the situation in the UK, the lack of pay growth is not providing the hit to household real spending power as it is in Britain, with US inflation having softened over recent months and still well below pay growth. CPI inflation has fallen from 2.8% in February to 1.6% in June; there are temporary factors at play (cellphone charges, drug costs), but these are likely to remain drags for a time yet.
Chart 9 shows that the absence of upward momentum in pay growth is evident across most of the main measures that the Fed tracks. Alongside the recent leg down in inflation, this seems to be a source of increasing division on the Federal Open Market Committee (FOMC). Indeed, the doves on the Committee have been more vocal of late, arguing that it would be sensible to wait to see how inflation and pay growth pan out over the next few months, before putting through another Fed funds hike. We continue to see December as the most likely timing for this, provided that inflation does not weaken further and that pay growth holds up.
In Fed Chief Yellen’s recent monetary policy testimony, she talked of interest rates not needing to rise much further to get to a neutral policy stance, sparking further speculation that the Fed was not gearing up for an aggressive run of rate hikes over coming years. We agree the Fed will move cautiously, certainly more so than its current ‘dot plot’ implies (3 hikes next year and the year after). However, we note that Dr Yellen did say that the neutral rate is quite low by historical standards and that factors holding it down will diminish somewhat over time. Indeed, Chart 10 shows how estimates for this have come down since 2000. Our current view envisages two hikes next year and one the year after.
Dr Yellen’s 12-13 July monetary policy testimony dampened rate hike expectations and pushed down on Treasury yields (Chart 11), but these had been on a sharply rising trend in the days before. Indeed, following the Sintra Economic Forum at which global central bankers appeared to contemplate policy normalisation in a coordinated way, US Treasury yields rose markedly. Looking at the next few months, the Fed beginning to unwind its balance sheet could prove to be a key influence on yields, which we see rising to 2.50% by end-2017. It is possible the Fed announces the start date for this unwind at its 26 July meeting, although we suspect a September announcement is more likely, starting unwinding in October.
In US political wrangling, we seem to be no further forward than a month ago. There are no material signs of progress towards a deal to raise the debt ceiling, whilst the latest indications are that this needs to be achieved by October. On health care, Republicans are now considering if they can advance another new Republican health care bill to repeal and replace Obamacare, with a Senate vote expected on this shortly. If they cannot, the focus is likely to turn to whether work on a bipartisan bill is then the necessary next step. The passage of health care reforms are fiscally important to the Trump administration, to help fund elements of the tax reform plans that the President seeks. So with health care talks slow to progress, we could see these proposals (further) on the back burner.
With growth strengthening and deflation risks having faded, the ECB remains of a mind to wind down its QE operations. Communications though have been difficult. At a meeting of central bankers in Sintra, ECB President Mario Draghi spoke of reflationary forces replacing deflationary ones, causing the euro to rise and the curve to steepen. And at July’s Governing Council, maintaining its easing bias on QE and stating that inflation was not yet where the ECB wanted it was not enough to prevent the euro from rising to a near 2-year high against the USD of $1.1684. Even careful communications seem insufficient to prevent the tightening in financial conditions which the ECB is striving to avoid.
Unless the eurozone’s ‘taper tantrums’ become severe, our baseline case of QE tapering over H1 2018 will hold. But ‘core’ inflation, at 1.1% in June, remains well below the ECB’s ‘just below 2%’ target. Indeed one surprise to the ECB is that pay growth remains soft, despite unemployment declining to an eight year low of 9.3%. In his post-meeting press conference Mr Draghi suggested that this dislocation was probably transitory. But it is possible to explain labour market capacity using wider jobless measures, similar to the US (Chart 14). Here the wider definitions have not fallen as quickly, perhaps partly explaining low pay growth and weak underlying inflation.
Preliminary Eurozone Q2 GDP figures are due on 1 August and are likely to show the economy expanding at a pace broadly in line with the +0.6% q/q in Q1. One factor supporting Q2 growth momentum has been the industrial sector’s performance which, in the three months to May, has seen output expand by 1.0% 3m/3m, the strongest three month period since December. However the Euro has been on a rising trend over recent months, with €:$ currently now some 7% firmer than it was at the start of May, making life more difficult for manufacturers focused on exporting to outside the Zone. With the Euro’s recent charge showing no signs of reversing out just yet, we expect this to take the edge off further industrial sector gains over the months ahead.
The Euro has had a head of steam behind it in recent days; €:$ reached its highest in almost 2 years at $1.1684 on 24 July, currently $1.165. Recent moves have reinforced the Euro’s upward momentum through 2017 overall. Indeed, in trade weighted terms, the Euro’s recovery this year has outstripped sterling’s (Chart 16). The latest leg up came after the ECB’s 20 July policy conference. Despite President Draghi’s efforts to emit dovish tones, the Euro behaved as if it was having a minor QE taper tantrum. The relatively solid Euro area economic backdrop and a USD on the back foot have also been Euro supportive factors lately. Note that our end year goal for €:$ remains at $1.14; whilst this been overshot in recent days...
...we expect the USD to find its feet before end-year. We look for $1.18 for end-2018. Although the Euro didn’t absorb Draghi’s dovish tones, bond markets appear to have listened more. Following the 20 July meeting, there was a pretty muted reaction in core Eurozone bond markets, but peripheral yields saw a bigger move. Spanish 10-year yields have fallen 9bp since the ECB meeting, whilst Portuguese 10-year yields are around 16bp lower. One reason for the bigger reaction in peripheral bonds might be that QE purchases have broadly pushed down on Euro area yields, sending investors in search of higher yielding (peripheral) bonds. If the bond market suspects that a dovish Draghi means more QE for longer, then one can see why peripheral yields might have seen the bigger reaction.
Brighter news has even reached Greece. Following July’s agreement over the latest bailout review, the European Commission recommended the closure of Greece’s Excessive Deficit Procedure. That change would leave just France, Spain and the UK under EDP monitoring. Following 7 years of austerity, Greece has cut its deficit from a peak of 15.1% of GDP in 2009 to run a surplus in 2016. The improvement in the fiscal position and sentiment has led the government to begin work on its first bond issuance since 2014. Whether Greece returns to debt markets on a more permanent basis remains to be seen. Particularly given market borrowing costs significantly exceed those of Greece’s official loans. For now we suspect that any new primary issuance would be more symbolic than material for Greece’s financing needs.
To find out more about how currency markets could be affected this month, and the potential impact on your business, speak to the dealing desk today on 0800 056 6339.