We draw five conclusions from this week’s big macro events. First, China’s industrial sector is still slowing, but help is at hand: monetary conditions are easing and further stimulus looks likely sooner rather than later. Second, China and the Fed continue to cast a shadow over emerging markets and commodities. Third, the Fed looks to be still on track to raise interest rates in September, though China worries and market volatility have made investors sceptical. Fourth, the eurozone economy is on the path of steady recovery, with the composite PMI rising in August. Finally, Greece is set for new elections next month, creating uncertainty.
There are clearly risks of a financial shock to emerging market economies from the Federal Reserve raising rates
Nick Kounis Head of Macro Research
China slowdown ongoing
The China Caixin manufacturing PMI fell to 47.1 in August in the flash estimate from 47.8 in July. This took the index to the lowest level since March 2009, which was during the aftermath of the global financial crisis. The PMI is not as reliable an indicator of growth as in the US or eurozone, while it refers only to manufacturing, while services have been much stronger. Having said that, it does fit into a broader picture painted by recent data signalling that the economy is still losing momentum and there are downside risks to the 7% target.
Monetary conditions are easing
Recent data justifiably raise concerns about a hard landing for China’s economy. Investors question whether the authorities are doing enough and whether they can control the economy in any case. We continue to think that the authorities can and will do what it takes to turn the economy round. Stimulus often works with a lag and there are signs that it will start to gain traction before long. For instance, there are signs that monetary conditions are finally easing. Bloomberg’s monetary conditions index jumped higher in July, to point to a significant easing. This reversed the tightening seen since the start of the year. Money supply and lending growth are firming.
More to come
In addition, the depreciation of the yuan suggests that monetary conditions have eased further this month. Finally, we expect the authorities to take further steps in terms of policy rate cuts and reductions in bank reserve requirements. Our China economist Arjen van Dijkhuizen expects the PBoC to reduce its lending rate by 25bp and its required deposit reserve ratio by 100bp, as well as further yuan depreciation and fiscal stimulus. The first steps could well come sooner rather than later following the weak China manufacturing PMI survey.
Emerging market and commodity woes
Concerns about China, the yuan devaluation and the possibility of a Fed rate increase, have seriously hurt EM assets and commodities, while also souring investor risk sentiment more widely. At the same time, the slump in these markets is often taken as a sign that these economies are heading for a slump. For instance, China is the world’s biggest commodity consumer, so if oil prices are falling to (or below) the levels seen earlier this year, it is perceived as a sure sign of a sharper economic slowdown.
Supply glut is a key factor for commodities
However, weakness in demand is only a part – and not the most important part – of the story. Oil prices – and the prices of some other commodities – have been under pressure because of over-supply. To the extent that lower prices are driven by supply, this is actually beneficial to many net commodity consumers, which will see windfall gains.
Emerging market currencies heading lower
Concerns about the outlook, lower commodity prices and the yuan devaluation have put pressure on emerging market currencies. When the Fed actually starts to raise interest rates (see below) this will add to the headwinds emerging market currencies face, and we expect further weakness ahead. EM currency weakness may be part of the solution rather than part of the problem for some countries as it will allow them more freedom to decouple from the Fed’s monetary policy. However, there is an important caveat. Very sharp falls in currencies could prove to be destabilising and be counter-productive, especially for economies with high levels of foreign currency debt. In addition, financial conditions would tighten on the back of capital outflows.
The risks to EM from the Fed
There are clearly risks of a financial shock to emerging market economies from the Federal Reserve raising rates. These should hopefully be contained by the likely slow pace of Fed rate hikes and better EM fundamentals than in the past. Stabilisation in China’s economic growth and support from stronger advanced economy demand should also help.
Investors doubt whether the Fed will hike
Ironically, while EM assets are (supposedly) partly in tail-spin because of worries about a Fed rate hike, investors are increasingly having doubts about such a move. This reflects the ongoing worries about China and EM and the slide in commodity prices. In addition, the July FOMC minutes, published earlier this week, were seen as dovish, while US inflation was lower than expected. All this has led to a scaling back expectations of a rate hike over the last few days. This and lower commodity prices have supported government bonds and pushed down the dollar versus the euro.
We stick to September
We continue to expect a Fed rate increase in September. We think the FOMC will continue to put more weight on the ongoing improving domestic economy as well as strong job growth. In addition, we think investors may have put too much weight on FOMC discussion of some of the risks. The main message from the minutes, in our view, was that the conditions for a rate hike are ‘approaching’. Of course if conditions on financial markets were to deteriorate much more sharply, the Fed could still delay, but for now we think a September move is more likely than not.
Eurozone recovery still on track
The eurozone composite PMI rose to 54.1 in August from 53.9 in July. Weakness in France was offset by improving growth momentum in Germany, Spain and Italy. At current levels, the eurozone index is consistent with economic growth of around 0.4% qoq. The survey therefore suggests that the eurozone economic recovery remains on track. China is a risk to this outlook but eurozone domestic fundamentals are positive. For instance, the PMI survey points to stronger job growth.
Greece set for elections, raising uncertainty
Greek Prime Minister Alexis Tsipras resigned yesterday with the aim of triggering snap elections, with 20 September the likely date. Elections are not a done deal because the opposition parties have up to 3 days to try and form a new coalition government. However, new elections are very likely. The decision of Greek PM Tsipras to call early elections is no real surprise. The Syriza-led government had lost its majority. In addition, Mr Tsipras must know that given the bad news on the economy and the tough measures ahead, his government will only become less popular in the future.
Elections should not derail bailout
We do not think the elections will derail the bailout. Polls put Syriza out in front. The second biggest party (New Democracy) and other smaller parties (Potami and Pasok) also support the bailout. The Left Platform group – which is splintering from Syriza to form a new party (Popular Unity) – will probably not provide real competition. So the most likely outcome at this stage is a new Syriza or Syriza-led government.
Risk of unclear outcome
Still, there is always uncertainty surrounding opinion polls and we should be cautious in interpreting them. The UK election earlier this year is a good example. So there could be unexpected outcomes. In particular, if Syriza does less well than expected, it might find it difficult to form a new coalition government. For instance, there might be a situation where it does not have the number of seats to form a coalition with Pasok/Potami and the only option is a coalition with ND, which proves difficult to negotiate. In that case there might be a minority government of some sort, which could lead to instability.
Delay of ECB purchases of Greek bonds
One implication of the elections, is that ECB purchases of Greek government bonds could be delayed. The ECB has said that it does not necessarily need to wait until the first programme review in October before extending its QE programme to Greek government bonds. If the Greek government implemented significant prior actions before then, it could be enough to convince the Governing Council. However, the elections look like slowing the process of implementing prior actions in the next few weeks, so we may not see ECB purchases until later in the year.