Resilient to weakness in emerging markets

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Economic data out of the eurozone and the US suggest that advanced economies are relatively resilient to the weakness in emerging markets (EM) so far. Though downside risks from emerging economies were once again underlined by further weakness in China’s industrial sector in September as well as ongoing falls in emerging markets currencies. Meanwhile, the Fed is trying to re-calibrate its message following the adverse reaction to the September FOMC meeting, with Chair Yellen playing down external headwinds and saying that a 2015 lift-off is still on the cards. The return of negative inflation in Japan – and before long the eurozone – means that expectations of further QE from the BoJ and ECB are likely to build.

The ECB and the BoJ look set to move in the opposite direction by further expanding their QE programmes before long. Nick Kounis Nick Kounis Head of Macro Research

European and US data holding up

Financial markets have been fretting about EM weakness for weeks and the negative sentiment has continued this week. This was fuelled by another poor China PMI reading and ongoing falls in EM currencies. Against this background, eurozone and US economic data painted a picture of resilience. So far domestic fundamentals are offsetting external drags.

European business surveys doing well

The eurozone composite PMI – which captures business activity across the whole economy – slipped to 53.9 in September from 54.3 in August. This took the indicator only back to its July level and it remains consistent with GDP growth of around 0.5% qoq or 2% on an annualised basis, so not bad at all. Meanwhile, Germany’s Ifo business climate indicator edged up in September from an already high level (to 108.5 from 108.4). It was particularly encouraging that the expectations component jumped to reach its highest reading since April.

Better profit growth

The expectations component is a good lead indicator of analysts’ earnings expectations for Europe’s stock-listed companies 12-months ahead (see chart) as well as overall GDP growth. It therefore suggests that the cyclical upswing is still firmly on track. Indeed, stronger capital spending and hiring should follow. There were signs of that in this week’s data as well. Annual growth in bank lending to non-financial corporations rose by 0.4% in August, up from 0.3% in July. It is still modest but it has improved a lot recently after months of contraction.

US economy riding high

On the other side of the Atlantic, US economic growth for Q2 was revised up another notch. It is now recorded at 3.9%. That is partly reflecting a rebound from a particularly weak start to the year. Nevertheless, in the four quarters to Q2, the economy expanded by 2.7%, which is above its trend rate.

Graph: German Ifo and analyst earnings projections

Consumer driving growth

The US economy’s strength is being driven by buoyant consumer demand. Consumer spending rose by 3.6% in Q2 according to the final estimate. This means it has now grown at 3.5% or above in 4 out of the last five quarters. This reflects the ongoing strength of the jobs market as well as record levels of household wealth.

Housing also supportive

In addition, the US housing market is also supporting economic activity. Residential investment surged by 9.3% in Q2. New home sales jumped to a 7-year high in August, suggesting that the strength in homebuilding will continue.

Business catching up

Investment in machinery has been a missing ingredient from this picture. However, core capital goods shipments are pointing to better times ahead. They were up by 4.2% in the 3-months to August. Finally, the Markit US manufacturing PMI was stable at 53 in September.

Weakness in China’s industrial sector

Overall, the US and eurozone look to be still on track for a moderate economic recovery. However, the main threat to these economies as well as to global growth is emanating from the emerging markets, and there has been more reminders of this over recent days. The Caixin China manufacturing PMI declined to 47 in September from 47.3 in August, taking it to the lowest level since March 2009. Manufacturing is the weak spot of China’s economy and the larger services sector has proved more resilient, but there can be little doubt that the authorities face a challenge to keep the slowdown in the economy gradual. We expect further monetary easing going forward.

EM currency weakness resumes

Apart from China, the other risk related to the EM outlook reflects significant capital outflows. There were more signs of this as well, with EM currencies resuming their decline on China worries, as well as Fed hike expectations (see below). The Malaysian Ringgit, South African Rand and Colombian Peso saw the largest declines, with falls in excess of 3.5% over the week. Capital outflows are leading to a tightening of financial conditions, which is bad news for economic growth.

Coping with the drag from EM

The advanced economies are being negatively impacted by this weakness. For instance, US and eurozone exports to the BRIC economies are down sharply this year (see chart). However, it seems that domestic positives have helped to offset this external drag. This should remain the case if – as we expect – China manages a soft landing and emerging markets avoid a systemic crisis. Advanced economy demand should also support EM exports over time. This should allow the global economy to sustain a moderate pace of expansion.

Recalibrating the Fed’s message

Fed Chair Janet Yellen’s communication following the FOMC meeting earlier in the month was widely interpreted as raising the chance that the Fed would wait even longer before hiking interest rates. It also weighed on risk sentiment, as markets put more emphasis on the Fed’s worries about the growth outlook rather that the prospect of low rates for longer. Since then, various FOMC officials have tried to re-calibrate the message. Chair Yellen became the latest on Thursday, signalling that a rate hike this year was still likely, while trying to play down the likely impact of external headwinds.

Graph: Advanced economy exports to the BRIC countries

ECB and BoJ set for further monetary stimulus

The ECB and the BoJ look set to move in the opposite direction by further expanding their QE programmes before long. The BoJ’s key inflation measure (CPI ex-food) fell into negative territory in August for the first time since April 2013. Figures next week for the eurozone could show headline inflation becoming negative again in September. Core inflation (ex-food and energy) is higher (closer to +1%) in both cases and central banks should usually ignore the effects of energy price swings. However, both are facing a continued long-period where inflation is nowhere near the central bank target. This raises the concern that inflation expectations will become dislodged.

ECB officials grapple on timing of move

Various ECB Governing Council members have given speeches over recent days. In general they point to the likelihood of further monetary easing, but there are mixed messages on how quickly this may come. In general, some Executive Board members (Draghi, Praet and Coeure) are suggesting that there will be no hesitation and that they will act with force. On the other hand, some national central bank governors have said they need more time, with no discussion of new measures until December.

October versus December

Our base case is that the ECB will step up QE before the end of the year. We see October as more likely than December at this stage, though the mixed messages from officials have made us less certain about this.


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