The global economy behaved well while I was on holiday. Global growth is far from impressive, but picking up. The US growth story is becoming very compelling; the eurozone experienced some volatility in cyclical data in recent months, but seems to be doing all right; Japan appears to be weathering the post-tax hike challenges relatively well; Chinese leaders have managed to stabilise growth and exports, and corporate investment intentions globally are strengthening. Unfortunately, as risks stemming from economic imbalances are thus easing, geopolitical risks are increasing.
Unfortunately, as risks stemming from economic imbalances are thus easing, geopolitical risks are increasing.
Nick Kounis Head of Macro Research
Europe diverging or is it noise?
Cyclical economic indicators have been volatile and disappointing on balance in recent months in Europe. More accurately, this applies to the eurozone. The UK, for example, has shown remarkable strength and continues to do so. The drop in business confidence in the eurozone and weak industrial output data in recent months look somewhat odd as the global backdrop is one of improving cyclical conditions. As I find it hard to see compelling arguments why the eurozone recovery would stall while other economies appear to be picking up, my intuitive response is that it is simply noise or reflects short-term volatility in the business cycle. But I need at least an occasional good number to be able to stick to my relative optimism. Recent weeks have produced a couple of these.
The biggest positive surprise came from Markit last week when they released their preliminary business confidence indices for July. Confidence in eurozone manufacturing inched higher (from 51.8 to 51.9) when a modest drop was expected. But the big surprise was service-sector confidence, which jumped from 52.8 to 54.4. As a result, the composite index also rose against expectations for an unchanged reading, cancelling out a two-month slide. I must immediately confess that the authoritative German Ifo index of German business confidence posted a third consecutive monthly decline in July. That index now stands at 108.0. This is still higher than the long-term average of some 101, while the series typically moves within a range of 90-115. And France remains a weakling, with confidence falling according to two different gauges. The Belgian index of business confidence, seen as a good indicator for the eurozone as a whole in view of the early-cyclical nature of the Belgian economy, also weakened in July and has now fallen in four of the last five months. On the other hand, Dutch producers' confidence improved a little in July, reaching its highest level in three years. So the story continues to be mixed.
The ECB monetary statistics were somewhat encouraging. M3 growth strengthened a little in June: 1.5% yoy, better than May's 1.0% and April's 0.7%. Loans to the private sector (after adjustments for securitisations) continued to contract, but the pace of contraction is easing: -1.1% yoy, versus -1.6% and -1.4% in April and May, respectively.
Another hopeful sign was the Q2 unemployment data in Spain, showing a drop from 25.9% in Q1 to 24.5%, which was better than expected. When Spanish labour-market indicators started to improve in the course of last year, the initial response of many commentators was that the improvement was due to a strong holiday season providing many temporary jobs and that the data was likely to deteriorate again after the summer. That has not happened. Employment has been growing and continues to grow. This is happening despite the fact that lending to non-financial corporations is falling at a rate of over 9% yoy.
Overall then, I believe we should stick to our view of continued recovery in the eurozone. But that recovery is modest, vulnerable and volatile.
Geopolitics could derail the recovery
Tension over Ukraine continues to build. This could have a material impact on the eurozone economy. If the conflict with Russia escalates further, increasingly severe sanctions (and possible tit-for-tat retaliation by the Russians) will not only hurt the Russian economy, but the eurozone economy as well. The ball appears to be firmly in Mr. Putin's court. He can choose to de-escalate the conflict or go the other way. His foreign policy has recently given him a very high approval rating at home, suggesting that his instinct will prevent him from easing the conflict. But the deteriorating economic situation is a serious threat to that popular support. In our main scenario for the eurozone we are assuming no significant further escalation and no sustained significant stepping up of sanctions. If that assumption turns out to be wrong, all bets are off.
US recovery compelling
Almost a month ago, US Q1 GDP growth was revised down for a second time, to -2.9% after it had been reported as a 0.1% rise in April, which was revised down to -1.0% in May. Such a sharp (downward) revision, particular at the second revision stage, is highly unusual. It most likely shows how difficult it has been to measure economic activity at the start of the year due to the severe winter and the introduction of Obamacare. We consider the significant contraction of the economy as an outlier, an odd number that does not fit in with other economic indicators.
It is not representative of what is going on in the economy. In fact, the economy is doing quite well now. Jobless claims fell to 284,000 last week, the lowest since 2006, suggesting that the improvement in the labour market is continuing. Retail sales, which were published in the week before last, were firm and while the flash PMI was a little weaker in July, the Philly Fed index of business confidence shot up in July as did the Empire State index, measuring business confidence in the area of the New York Fed. In fact, this latter index reached its highest level since 2010 and is now above the 2005-2007 average.
The US housing market is showing a somewhat mixed picture. Prices are rising but the improvement in sales is very patchy. Builders' confidence has improved a little in recent months, which may signal that the recovery of the housing market will regain some momentum soon, but this clearly remains a vulnerability.
Last week's inflation numbers were on the soft side after having exceeded expectations for several months. This will be welcomed by the doves on the FOMC who prefer to postpone the moment of the first hike in interest rates as much as possible for fear of 'doing a 1937'. The Fed tightened monetary policy that year, which turned out to be premature and pushed the economy back into recession. As long as the cyclical data remains somewhat mixed and inflation stays low, the doves will have the upper hand, but the increasingly compelling recovery story suggests that that period will end within the next couple of quarters.
Japan holding on
Reading the tea leaves of the Japanese economy has been further complicated by the increase in the sales tax earlier this year. Such a move tends to bring economic activity forward and then leads to a sharp drop after the hike. This pattern is clearly visible in Japan. The important question is whether it pushes Japan back into contraction or not. Last week saw the publication of the Markit PMI of business confidence. Earlier this year, this gauge had moved around the 56 level. It then fell back to below 50 after the tax hike, but it has risen a little since, holding above the boom-bust divide of 50. The index weakened from 51.5 to 50.8 in July according to the preliminary reading. It suggests that the economy is not in the process of sinking into another downturn.
China: while I was away
Earlier this year fears for a hard landing of the Chinese economy made the headlines. We took the view that the policymakers would be able to stop the slide and perhaps turn it around. That is exactly what appears to be happening. Recent data on money growth, credit, retail sales and industrial production tell a consistent story. The loss of growth momentum has been halted and some acceleration is visible. Last week saw the release of the HSBC PMI for the manufacturing sector. While this is not our favourite indicator for the Chinese business cycle, it is all we have at this stage for July. The index registered its third consecutive monthly rise, reaching a level of 52.0. Other data in Asia is consistent with this. Taiwanese export growth, for example, has picked up recently.
IMF: backward looking pessimism
The IMF made headlines last week by downward revisions to their 2014 global growth forecasts. I am often asked how that sits with my optimism and if I really think that I know better than all the brilliant economists at the IMF. What people do not seem to realise is that this downward revision of the growth forecast was driven by the disappointing growth numbers in many countries during the early stages of the year. The large downward revisions to the US Q1 GDP growth number was mentioned above. As such, the lower growth forecast for the year as a whole is not a reflection of how the IMF thinks the economy will evolve from here, but it is purely a backward looking adjustment. Conclusion: it doesn't bother me and doesn't change my moderate optimism.
Capex intentions on the up
A disturbing feature of the global economy in recent years has been the low level of corporate investment spending. This is bad for two reasons. First, investment spending is an important demand component, and rising investment can help pull the economy onto a higher growth path in the short term. Perhaps more important, investment is required to secure future increases in productivity growth. Productivity growth, in turn, determines how fast economies can grow in the medium term. So poor investment activity by corporates reduces potential growth. But the good news is that things may be about to change. According to the Ifo World Economic Survey, capex intentions for the next six months are rising, and they are rising in a meaningful way. True, I sometimes have good intentions, but fail to deliver and the respondents to the Ifo survey may do the same, but this has historically been a reliable early indicator of investment spending. Fingers crossed.