Vive la Revolution
2017 is a critical year for European politics not to mention the triggering of Article 50 and Trump.
After the Tories lost their majority following the 8 June General Election, they have been forced into a ‘confidence and supply’ arrangement with Northern Ireland’s DUP. The deal gives the government an effective majority of 13, fewer than the 17 the Tories’ had before the vote. That leaves the UK with a more uncertain political backdrop, with questions asked as to whether the government could collapse and how long Theresa May will remain as PM. The smaller government majority could also complicate the passage of Brexit legislation. Overall we still favour the pound standing up from its current rate of $1.27, though we judge that the net downside risks have risen. We are edging down our end-2017 call to $1.30 whilst we look for $1.32 end-2018. The monetary policy arena has also evolved over the month with the June meeting minutes and vote count having a particularly hawkish feel to them. However our view is that the soft economic backdrop will dissuade the MPC from hiking rates on 3 August.
We reaffirm our view that global growth looks set to be stronger this year than last; we continue to forecast 3.6% for this year and 3.9% for next. Further we now see a more solid 3.6% this year, largely reflecting our upgrades to Chinese and Euro area 2017 growth predictions. We expect China to grow by 6.7% this year and 6.3% in 2018, despite the authorities pressing ahead in addressing financial risks and excess leverage. May’s monetary data showed China’s Total Social Financing running below New Yuan Loans. This implies that credit from the ‘shadow banking’ sector is being repaid, in turn providing a hint that the authorities’ clampdown may be working.
We continue to judge that the US economy has decent momentum and that the lacklustre Q1 GDP print will not be repeated in Q2 or in subsequent quarters this year. The recent weak spot in US economic releases has been the housing sector with housing permits and starts having fallen back, but we suspect this will not be a continuing drag on momentum. Our 2017 GDP growth forecast stands just 0.1ppt lower than last month at 2.4% with 2018 unchanged at 2.6%. We expect the Fed to announce it is to beginning to shrink its $4.2trn QE holdings shortly; we look for an announcement at the 20 September FOMC meeting, with the roll-off commencing soon after. We have lowered our expected path for the Fed funds rate, to allow some offset to the tightening set to come as the balance sheet is reduced. We expect one further 2017 Fed funds hike, in December, now only two in 2018 and just one in 2019 (previously three in both).
Eurozone growth is revving up. We now see euro area GDP growth at 2.1% in 2017 (previously 1.9%) and 2.0% in 2018 (1.9% previously). The brighter growth outlook was acknowledged by the ECB in June as it removed its easing bias on interest rates. We still expect the ECB to taper its €60bn per month asset purchase programme over Q1 2018, with an announcement this autumn but with no change on rates until 2019. In politics, French President Macron cemented his Presidential election victory with a large majority for his centrist reformists in the National Assembly, providing a solid platform for his reform push. Further south, Greece finally reached an agreement on its latest bailout review, nine months late, allowing €8.5bn in aid to be disbursed.
After the General Election the Conservatives’ ‘confidence and supply’ agreement with Northern Ireland’s DUP leaves the government with an effective majority of 13, fewer than the 17 the Tories’ themselves had before 8 June. Of course, it is now more vulnerable than previously to parliamentary defeats (i.e. the DUP pulling its support as well as Tory backbench revolts). Markets could be haunted by fears over the government falling, (another) snap election and a Labour victory. But governments with wafer-thin majorities have gone full, or close to full-term in the past (e.g Oct 1974 and Apr 1992), albeit with bumps along the way. But how long Theresa May will remain PM is unclear.
Many attribute the Tories’ poor showing to increased youth turnout. This claim seems overdone though. As there are no official data on voting by age, we have to rely on polls. A recent Ashcroft poll shows a rise in the under 25s turnout to 72% from 44% in 2015 and that 67% of them voted Labour, 18% Tory. The UK has 5.6m 18-24 year olds, so the additional Labour advantage from the higher turnout would be 767,000 (1180 per seat), 2.4% of the total vote. Other polls suggest the effect is lower. This factor undoubtedly did help Labour to gain seats, but it does not explain why the Tories’ lead over Labour (in terms of votes) was just 2%, down from the 20% lead polled at the start of the campaign.
The monetary policy arena has also witnessed much debate. At June’s meeting, three MPC members voted to raise the Bank rate by 25bps to 0.25%, with the tone of the minutes striking a hawkish tone overall. Members expressed concerns about CPI inflation rising to 2.9% and at what the committee considered to be rising domestic inflation pressures. Chief Economist Andy Haldane, who backed steady policy this time, argued that it might be ‘prudent’ to raise rates in H2 this year, despite Governor Mark Carney insisting that ‘now is not yet the time’. The curve is sceptical over prospects of an early hike (as we are), but the risks are tangible.
Hawkish undertones were already evident in May’s Inflation Report when The BoE warned of a rise in domestically generated inflation pressures. It projected unemployment (currently 4.6%) nudging down to the BoE’s view of the equilibrium rate of 4.5% and pay growth firming to 3.75% by 2019. It is easy to see why the BoE might believe this – it is consistent with a simple, recent ‘Phillips Curve’ (Chart 22). But we suspect that softish GDP growth will result in the jobless rate rising, and in any case, wage growth is currently falling – ex-bonuses, earnings are running at 1.7%. We expect that the MPC will accept this argument and forgo the temptation for an August hike. Our central case remains H2 2019.
The MPC has already underestimated the soft patch in the economy. In March it upgraded its ‘nowcast’ for Q1 GDP to +0.6% q/q from +0.5% - it currently stands at +0.2%. Also June’s minutes remarked upon the relative resilience of consumer confidence. True, the GfK measure has remained within narrow ranges recently, above long-term averages. But we would argue that it is consistent with the current pace of subdued consumer spending and that a period of very soft sentiment following the financial crisis was not a good guide to spending trends (Chart 23). We have nudged down our GDP forecast for this year to 1.6% from 1.7% and have held 2018’s at 1.7%.
The outlook for sterling is now cloudy and we recognise the need to review our end- year call of $1.35. The key potential downside is that markets fear that the propped up Tory government will fall, leading to a Corbyn-led administration. Such a scenario is not infeasible. But there is also talk of wider cross party participation in the Brexit debate which could result in a more sterling-friendly process. And even in the absence of an H2 2017 rate hike, the curve could be a little steeper, helping the pound. Overall we still favour the pound firming from its current rate of $1.27, though we do judge that the net downside risks have risen. We are edging our end-2017 call down to $1.30 and we now look for $1.32 end-2018 (88p and 90p versus the EUR).
We reaffirm our view that global growth looks set to strengthen this year, with economic data continuing to point to momentum having firmed in recent months. The factory sector certainly seems to have joined the party. Global manufacturing PMIs have been robust for a while (although they have slipped recently). Moreover estimates from Dutch research institute CPB suggest world industrial production is continuing to gain impetus, growing by 3.3% in the year to April, with the most marked recovery occurring in advanced economies. In addition the CPB’s analysis also concludes that the pace of growth in global trade has picked up over the past six months or so.
We have maintained our 3.6% GDP growth prediction for 2017, while we continue to look for 3.9% in 2018. Although our 2017 forecast is unchanged, it now looks more ‘solid’. Indeed our 2017 forecasts for the Euro area and China have been upgraded, only partly offset by idiosyncratic (and modest) downgrades in the US, Japan and India, making our 2017 prediction a high 3.6%. We expect China to grow by 6.7% this year (prev. 6.6%) and 6.3% (prev. 6.2%) in 2018, with data continuing point to solid momentum in the Chinese economy – notably, Q1 GDP was recorded slightly firmer than expected at 6.9% y/y. This is despite the authorities pressing ahead with macroprudential reforms. Indeed the ...
... robustness of the growth backdrop has added impetus to efforts from the Chinese authorities in addressing financial risks and excessive leverage. The latest monetary data for May recorded Total Social Financing running below New Yuan Loans, implying that ‘shadow bank’ financing is beginning to weaken and deleveraging is in train. Chart 3 shows that category data supports this view. Both entrusted loans and bank acceptance bills, popular shadow banking instruments, witnessed net redemptions in May. Net corporate bond issuance was also negative, also supporting the deleveraging argument. Of course, it is too early to draw firm conclusions after one month of data and we would feel more confident if this trend continues over the summer.
In developed economies, soft wage growth has given some central bankers justification for a dovish stance, despite tightening labour markets. In its 2015/16 Global Wage Report the ILO noted that in 2015, wage growth in major G20 economies had risen to a 10-year high of 1.7%. More recently, evidence suggests that pay trends have firmed further, but not as much as metrics such as unemployment imply. It may well be that globalisation of markets (labour and product) have made domestic slack less relevant to determining prices (including wages). In that respect, note that wage trends in emerging economies (outside China) appear to be weakening again. Coupled with upward trends in (global) productivity (Chart 4), this seems set to put a lid on price pressures.
Neutral (real) interest rates (the rate at whichrealGDP is growing at trend and inflation is stable) have fallen globally over the past 30 years, probably for a number of secular reasons. This has brought about calls to rethink (i.e. raise) inflation targets so that real rates (policy rates net of inflation expectations) can deviate substantially from neutral, providing stimulus when needed. But an IMF staff paper shows that unconventional tools (QE & forward guidance) have provided stimulus equivalent to a real rate as low as -4%, negating any need to push up inflation targets. Moreover keeping targets steady reduces the risk of a loss of credibility which could arise if central banks consistently fail to achieve the new targets.
Long-term Treasury yields have fallen since the turn of the year as inflation expectations have unwound. Indeed, long term yields comprise expected future short- term interest rates (‘expectations component’) and a ‘term premium’, a catch-all incorporating the inflation outlook. We suspect the lack of a take-off in inflation will continue to restrain yields over coming months, but that the ‘expectations component’ does more heavy lifting as Fed rate normalisation progresses alongside balance sheet unwinding; we now see 10- year yields reaching 2.50% end-2017 (3.00% previously) and 3.00% end-2018 (3.25% previously). In the other geographies, where central banks are not in normalisation mode, lacklustre inflation may be the overriding factor and we do not expect yields to rise quite as much.
We continue to judge that the US economy has decent momentum and that the lacklustre Q1 GDP print of 1.2% will not be repeated in Q2 or in subsequent quarters this year. The manufacturing sector looks to be growing more robustly in 2017; Chart 7 shows that, even where the Philly Fed survey has eased back, it still points to manufacturing expansion at a pace last seen in early 2015. Outside of manufacturing, the non-manufacturing ISM has averaged 57.2 over the quarter so far, from 56.4 in Q1 and we expect consumption spending to provide a more solid contribution to growth in Q2 than in Q1. And on top of this, Q2 GDP should not suffer the ‘residual seasonality’ that likely dampened Q1 GDP growth.
The weak spot in US economic releases has been the housing sector, with the NAHB housing sentiment index sliding to its lowest since February, in June. Housing permits and starts have also fallen back, amidst reports of low supply of lots available to builders. If the slump in starts proves to be less than temporary that would dampen output of the construction sector and housing related consumer spending, pressing down on economic momentum. But we suspect a rebound is likely; reports of low ‘lot’ supply are not new and new and existing home sales tracked higher in May following the recent soft patch. Our 2017 GDP growth forecast stands just 0.1ppt lower than last month at 2.4% with 2018 unchanged at 2.6%.
One further test for the housing sector (with US mortgage rates tied to long term US interest rates) this year will be the Fed starting to shed its $4.2trn of QE holdings. We suspect the start of this will be announced at the 20 September FOMC meeting, but if not by the end of the year. The Fed has outlined its approach to balance sheet unwinding which involves it setting caps on the total roll-off permitted each month. For maturing Treasury securities, the cap will be $6bn per month, initially increasing in steps of $6bn at three- month intervals until it reaches $30bn per month. For agency debt and mortgage- backed securities, the cap will be $4bn increasing in steps of $4bn until it reaches $20bn per month, such that the Fed’s balance sheet shrinks by around $600bn per year once fully ramped up.
The Fed updated its view of its ‘dot plot’ on 14 June. The median rate has barely moved whilst the ‘central tendency’ has shifted down slightly; the Fed still sees one further hike this year and three the year after. We do not see rates rising this quickly, alongside balance sheet reduction. In last month’s Global we discussed the offset to rate rises that balance sheet reduction might require. Assuming the Fed announces the roll-off in September, and that gets underway without a sizeable shake-out in markets, we expect one further 2017 Fed funds hike, in December, only two hikes in 2018 (previously three) and just one hike in 2019 (previously three) when the pace of roll-off is nearing $600bn/year.
The Fed’s June policy statement said it is now ‘monitoring inflation developments closely’ following declines in PCE and CPI inflation from positions above 2% earlier in the year. Some on the Fed appear nervous that inflation is moving in the wrong direction at a time when wage growth has failed to pick-up steam. Chart 11, looking at core CPI and unit labour costs (ULC), suggests that ULC growth may slide further which, if translated to headline wage growth measures, implies these concerns may not fade quickly. Amidst these questions, several FOMC voting members are now sounding keener to wait before raising rates again. We suspect caution will win out, further reinforcing our view above that the Fed will wait until December for its next hike.
Political chaos continues, with the Russia election meddling investigation not helping the administration deliver policy. Reaching a deal that raises the US debt ceiling is one issue. The ceiling came back into effect in March and the Treasury is enacting extraordinary measures to get by. Markets have shown no concern that the US is running up against its debt limit so far, but as we get close to September, when the Treasury has said extraordinary measures will be exhausted, we expect concerns to rise. On other issues, the Senate is set to debate its own version of its Obamacare replacement Bill shortly, but any successful Senate version of the Bill would need to pass to the House. Progress in carrying forward fiscal and tax reform plans has been similarly slow.
Eurozone growth is revving up. Q1 data were revised up to show quarterly GDP growth of +0.6%, rather than +0.5%. This on its own has positive effects on our 2017 forecasts. In addition, we had been sceptical over the strength of surveys, tending to the view that key indices such as PMIs were overstating the pace of activity. This no longer seems to be the case. Accordingly we are now putting more weight on Q2 surveys, providing a second reason to upgrade our GDP numbers. We now see euro area GDP at +2.1% (previously +1.9%), Germany 1.9% (1.8%), France 1.6% (1.4%) Italy 1.4% (1.1%) and Spain 3.1% (2.8%). For the zone in 2018 we now have 2.0% (a small nudge from 1.9% previously).
The brighter growth outlook was acknowledged by the ECB Governing Council (GC), which at its June meeting pushed up its GDP projections, declared that the economic outlook is now broadly balanced and removed its easing bias on interest rates. But there is still little progress on inflation heading back towards its ‘just below 2%’ target. HICP inflation fell back to 1.4% in May (from 1.9%) while the core measure (ex-food, energy, alcohol & tobacco) eased to 0.9% (from 1.2%), its average over the past year. There are competing forces. Upside pipeline price pressures are more visible at the PPI level (Chart 14), which we would expect to be passed down the production chain. But (and as we wrote last month), pay growth remains muted. Annual hourly wage...
...growth edged back in Q1 to 1.4% from 1.6% in Q4. Importantly measures of inflation expectations have slipped (Chart 15), though this is also the case in the US, at least partly because oil prices have fallen. Our monetary policy forecast remains unchanged. We still expect the ECB to taper its €60bn per month asset purchase programme over Q1 2018 (although it might announce this in October, not September). And we do not expect the first rate hike (in the deposit rate) until 2019. Of course, softer inflation trends might result in a reappraisal of plans, as it could within other major central banks too.
French President Macron cemented his Presidential election victory with a large majority for his centrist reformists in the National Assembly- 308 seats for his own La République en Marche party, 42 for MoDem. But his honeymoon has been shortlived. Four ministers (including MoDem President Bayrou), have already resigned due to two separate scandals. Most involve MoDem, not LREM - note that Macron’s party commands a majority of the 577 assembly seats on its own and a faction of the centre-right is poised to lend support. Even so, this is not a great start and the new President will hope that he has not used up too much political capital ahead of trying to push his reform agenda through.
Greece finally reached an agreement on its latest bailout review (15 June), nine months late. This allows €8.5bn in aid to be disbursed and provides Greece the funds to cover €6bn of July bond redemptions. Ultimately the deal centred on additional fiscal measures from Greece and its European creditors agreeing to additional details on debt relief in 2018. It includes a further deferral of EFSF interest payments, plus maturity extensions. This was sufficient for Moody’s to upgrade Greece to Caa2, with a positive outlook. But a number of uncertainties remain, including when the IMF will contribute financially to the third programme and whether in the medium term Greece will be able to meet its fiscal and growth forecasts.
The Euro has enjoyed a positive start to 2017, rising 6.6% versus the USD and 2.5% in trade weighted terms (EER-19). Whilst a retracement in USD gains is part of the story, a fundamentally brighter growth picture in the zone has been too- consensus expectations (as well as our own!) for eurozone growth have been revised upwards in recent months. This improving outlook is feeding through into ECB policy, which took its first very small step towards normalisation in June and which we believe will help support an ECB tapering announcement in the Autumn. These factors should be euro supportive, particularly bearing in mind our view of a broadly weaker USD. Our end-17 €:$ forecast remains $1.14.
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.