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Following a stronger than expected outturn for GDP growth in Q3 and evidence that the economy is carrying greater momentum into Q4, we have revised up our forecasts. We now expect GDP growth of 2.1% in 2016 and 1.4% in 2017, up from 1.9% and 1.2% respectively last month. However, with higher inflation set to eat into household purchasing power, we continue to expect growth to slow through 2017 and into 2018.
Real GDP up 2.9% in Q3, stronger than expected, strongest pace since Q3-14. Consumer spending drove Q3 GDP growth, though net exports, inventories and nonresidential structures also contributed to growth. Equipment spending and residential investment were weak once again. We expect real GDP growth around 2.0% in Q4 2016. Against a backdrop of modest growth and continued progress towards the Fed's dual mandate, we maintain our call that the Fed will tighten at the December FOMC meeting.
Employment costs continued to rise in Q3. Looking ahead, a tighter labor market should underpin continued wage growth.
The FOMC is unlikely to raise rates at the November 1-2 policy meeting since it is less than a week before the US elections. Moreover, there is no scheduled press conference following this meeting. However, current economic and financial market conditions point to a December tightening.
Economic growth has improved in the second half of this year from the lacklustre pace recorded in the prior three quarters. Additionally, the labor market continues to demonstrate strength, and inflation and market-based inflation expectations have moved higher.
Fed officials might signal explicitly in the policy statement that a December rate hike is likely, as it did in the October 28, 2015 policy statement ahead of rate lift-off. However, we would not be surprised if the Fed keeps its current language, which is sufficient to indicate a December rate hike is in the offing. This is especially the case with the markets already pricing in more than a 70% probability of a December rise.
Declines in labor market slack have led to gradual increases in wage gains. However, as Yellen points out, there is still some remaining slack as indicated by the pick-up in the labor participation rate amid a steady unemployment rate. This along with concerns about pushing the value of the dollar up too swiftly will keep the FOMC on a very gradual tightening path in 2017.
The key change to our forecast this month relates to monetary policy and the exchange rate. With inflation starting to fall and legislators in Congress set to approve a budget freeze for 20 years, the central bank (BCB) has started to ease monetary policy for the first time in four years, cutting interest rates by 25bp to 14% in October. We expect the BCB to speed up the pace of easing, with a 50bp cut at the end of November. Next year, we forecast further rate cuts and a continuation of the disinflationary process that has just started.
Meanwhile, a favourable external financial environment has led us to revise our FX rate forecasts and we now see the real (BRL) closing 2017 at 3.38 per USD, versus 3.55 last month. A stronger currency, a credible central bank and a more gradual assumption for interest rate cuts (versus our previous forecast) should ensure that inflation converges to the 4.5% target by Q2 2018.
National-level data suggest a 0.3% rise in Q3 Eurozone GDP. The French economy expanded by 0.2%, after stagnating in Q2. Spain continued to race ahead with 0.7% growth while Austria’s GDP expanded by 0.5%.
October’s rise in inflation in Germany, Spain and France shows the first positive contribution of energy prices to headline inflation since end-2013.
We examine the factors that have pushed down global interest rates and the outlook for the years ahead. Lower potential growth has been important in pulling down the ‘natural’ interest rate (R*). But other factors including demographics, changed saving/investment behaviour and financial crisis effects have also been important. Some of these factors will be enduring.
Lower potential GDP growth may have cut the natural rate (R*) by around 100 basis points (bp, i.e. 1%) since 2007 but other factors have become increasingly important over recent years and by 2015 may have been reducing R* by around 100bp in the US and as much as 150bp points in the Eurozone.
We believe demographic effects, some of which are embodied in lower potential growth, may have cut R* by around 100bp since the 1980s, with perhaps 30-40bp of this fall coming since 2007. ‘Savings glut’ effects may have cut R* by 30bp and lower public investment may have cut R* by 10-15bp.
Financial crisis effects look to have been significant in 2007-16, especially balance sheet effects which are continuing to linger. But the effect of wider credit spreads has waned in the US, while lingering in parts of the Eurozone.
The ‘term premium’ embodied in long-term yields may have fallen by as much as 100 basis points due to QE and some of this impact will linger for years due to ‘stock effects’. In addition, we estimate that a global ‘safe asset’ shortage may have cut 50-100 basis points from US 10-year yields.
Our baseline forecasts imply a partial but not complete unwinding over the next decade of some of the drags on R* that have developed since 2007. We expect ‘terminal’ nominal short yields at 2.75% in the US and Eurozone and 3.25% in the UK. But in a plausible downside scenario these numbers could be 1.4%, 1.8% and 2.5%.
The success story of Eastern Europe has been largely based on cheap and relatively skilled labour, which attracted large volumes of FDI. Now, however, demographics and rising wages appear to be bringing this model to an end. The economies will now need to do the hard work of further improving the quality and efficiency of allocation of their labour to stay competitive.
With the working age population declining by 0.3%-0.8% per year and employment growing by 1.5%-3%, labour market tightness in Eastern Europe has reached historical highs. Unemployment has already undershot its structurally optimal levels: employers are faced with thousands of jobs unfilled and significant upward pressure on wages. As a result, unit labour costs are beginning to outstrip productivity growth in most of the region, and have been doing so for over two years in Hungary. Meanwhile, exchange rates are doing little to offset this loss of competitiveness.
As a result, policy makers and employers alike face an immediate challenge. The former want to ensure that labour shortages do not negatively affect FDI, one of the key elements of the region’s growth model. Employers, in turn, need to ensure their demand for labour is met without cutting too deeply into their profitability.
The ability of corporates to absorb higher wage costs varies across the region, but is lowest in Hungary, where profitability is razor-thin. Meanwhile, policy makers, having implemented a range of reforms to increase labour participation since 2010-2011, also have limited room for manoeuvre. Their short-term response has been to encourage labour migration from Ukraine. However, the latter’s demographic situation is even direr than that of the CEE, and hence will not provide a sustainable solution.
Looking across the region, we find Hungary most exposed to the labour market crunch, with immediate consequences for its competitiveness, growth and inflationary pressures. The other countries in the region all exhibit signs of excessive labour market tightness, but with somewhat more room for manoeuvre in the coming years.
Exports fell back across the region in September in both nominal and volume terms. We continue to project a gradual recovery in exports but, as highlighted by September's disappointing trade data, the trend improvement in trade is likely to be gradual, with the monthly numbers susceptible to periodic reversals.
GDP growth in Q3 came in at 0.5%, above the consensus of a 0.3% increase and well ahead of HM Treasury’s pre-referendum forecast of a contraction of 0.1 to 1%.
On another positive note, the headline sales balance of October’s CBI Distributive Trades increased from -8 to +21, the highest level since September 2015.
But the same month’s CBI Industrial Trends Survey was mixed. The Survey’s total orders balance fell to a joint 12-month low, but export growth reached the highest since August 2014.
The headline balance of the GfK consumer confidence survey slipped from -1 in September to -3 in October. But this was above the survey’s long-run average of -9.
As of 28 October, sterling had drifted down another 0.4% against the dollar since the start of the week, taking the total decline since 23 June to more than 18%.
Gilt yields surged on the back of global trends and the diminishing chance of the MPC cutting rates when it meets next week. Meanwhile, equity prices dipped slightly.
We judge the risk of recession to be unchanged from last week at 20%.
Economic activity expanded by 2.9% y/y in August. However, the seasonally adjusted data were much less positive, with activity shrinking by 0.1% on the month and up just 1.5% y/y.
Looking forward, we continue to expect seasonally adjusted growth to rebound to 1% q/q in Q3, implying a significant recovery after a 0.2% q/q contraction in Q2. For 2016 as a whole, we forecast GDP growth at 2%.
Durable goods orders remain on a disappointing trend. Weak foreign demand, a strong dollar, and depressed oil & gas activity will continue to drag on business investment.
The relative rankings in the EM vulnerability scorecard have not changed much over the last six months. Turkey, South Africa and Brazil remain at the bottom of the rankings i.e. the most vulnerable, while Thailand, the Philippines and Korea score as the least vulnerable.
South Africa's relative position has weakened the most over the last six months, scoring worse because of the continued deterioration in its growth outlook relative to other EM, and the bounce in the real exchange rate since earlier in the year (thereby offering more scope for a setback in the future)
Brazil's ranking has improved slightly, reflecting greater hopes of its recession ending, combined with decreasing risk in its banking system and more protection from higher real short-term interest rates (because of falling inflation).
China's score has improved slightly over the last six months, in part because of the fall in its real exchange rate over that period (less scope for it to fall in the future). However, its credit indicators continue to 'flash' red.
September’s Eurozone money and credit data offer a mixed picture. Although overall loan volumes continue to recover despite the uncertainty created by the UK’s Brexit vote, lending to corporates – which we see as essential to a future recovery in investment – remained flat for a second consecutive month. While this is unwelcome news for the ECB, we do not think it necessarily justifies further QE at its current pace, but rather additional measures to boost lending.
Unemployment in Spain fell to 18.9% in Q3, the lowest level since Q4 2009. The figure marks a continuation of the overall trend of strong job creation that began in 2014 and provides PM Mariano Rajoy a further boost as he prepares to face another investiture vote. Rajoy will be re-elected as prime minister in a second vote on Saturday after the announced abstention by the Socialist Party.
Thus far the economy has displayed impressive resilience to the referendum result, exceeding even our above-consensus expectations. The only negative from today’s data was the enduring weakness outside of the services sector.
The monthly data suggests that the economy carried solid momentum heading into Q4. The economy is not out of the woods yet, and will face a major challenge next year when higher inflation begins to bite the consumer. But even so, we are likely to revise up our above-consensus forecast for 2017 GDP growth following today’s data.
New home sales increased 3.1% in September, but there were downward revisions to sales in prior months. Despite large downward revisions, new home sales remain on a positive trajectory.
Over the last year or so, there has been a notable tightening in bank liquidity which has been an important transmission mechanism in driving non-oil GDP growth lower. But we believe that these liquidity (and funding) pressures will ease somewhat over the coming months and further out, aided by heavy borrowing on the international bond market, as well as from a gradual pick-up in oil prices and a progressive easing in fiscal tightening from 2017. The partial sale of Saudi Aramco, mooted for 2018, could also dramatically improve liquidity. But liquidity pressures will remain an issue in the coming year at least.
The tightening in bank liquidity has been driven by the plunge in oil prices and fiscal tightening. It has been reflected in a number of ways. Deposit growth has fallen from a recent peak of 10.1% in June 2015 to -2.9% in August. Growth in lending to the private sector has slowed only modestly to 7.6% in August, aided by liquidating other assets. Even so, the loan-to-deposit ratio surged by nearly 6 percentage points to 90.8% this year, while banks’ ratio of liquid assets to total assets has fallen too. Furthermore, interbank rates have risen, with three-month SAIBOR reaching 2.4%, up from less than 1% between 2008 and 2015.
Meanwhile, Saudi’s debut international bond issue – the largest ever emerging market bond sale at $17.5bn – was highly successful and improved investor sentiment towards the country. The issue was heavily oversubscribed enabling an increase from the planned US$10-15bn and a tightening in the pricing, that left the 10-year notes yielding just 3.25%, only 30bps above higher-rated Qatar and 150bps above US treasuries. Its success and the increased prospect of further such bond issues over the next three to four years, will reduce the need for domestic bond issues and reduce the pace of decline in net foreign assets.
But it should still be emphasised that Saudi Arabia faces massive challenges in implementing post-oil plans, with many events that could evoke a market reaction.
It took longer than expected, but the recession seems now to be over. According to the GDP proxy, the Argentine economy expanded by 0.2% m/m in August after four consecutive monthly falls. Real bank credit has stopped falling, while the construction sector is also starting to recover on the back of public works being reactivated. Finally, the weakness in retail sales now seems to be moderating, and declining inflationary pressure coupled with improving consumer sentiment should secure a recovery in this area of the economy in the coming months.
After shrinking by 1.2% this year, the economy is expected to rebound to 3.6% growth in 2017, boosted by a recovery in real salaries, increased FDI inflows and a pick-up in Brazil, the country's biggest trade partner.
However, some old challenges persist. With mid-term elections due next year, the government will take a more gradual approach on its fiscal consolidation plan. Indeed, it has recently increased its primary deficit target for 2017. But given the country's bad track-record on this front, foreign investors may not be prepared to give President Macri the benefit of the doubt for another year.
The European Commission has asked the Italian government for clarification over its 2017 budget. But the numbers involved are marginal and PM Renzi will use this to fuel anti-EU rhetoric to try to win votes in the referendum.
Yesterday, Monte dei Paschi di Siena unveiled its new business plan. The plan still entails some significant risks, including low private appetite for the capital increase and bond-to-equity conversion if the ‘no’ side wins the referendum.
The Japanese economy continues to struggle to gain any momentum and Q3 GDP is likely to ease on the back of weaker household spending. And while industrial production and goods export volumes both reported solid increases in Q3, this momentum is unlikely to be maintained given the outlook for the yen.
We suspect that the BoJ will take a cautious approach to any adjustments to its monthly asset purchases going forward as it juggles keeping the 10-year yield within a tolerable range while being aware that any perception that its actions amount to tapering could lead to renewed yen appreciation. We still look for an increase in asset purchases, although this is expected to be more geared towards non-JGBs.
Consumer confidence fell 4.9 points to 98.6 in October, retracing gains of the past two months. Consumers are likely responding to negative rhetoric surrounding the election.
Current conditions fell 7.3 points to 102.6, six-month expectations down 3.3 points to 83.9.
In recent years, the questions regarding India’s ability to repeat China’s record of sustained, fast growth have become more persistent. At the same time, the Modi administration appears determined to put India on the global manufacturing map. We outline the path that India needs to take to realize its industrial aspirations, but are of the view that it is poorly positioned to achieve these, given current trends.
The National Manufacturing Policy (NMP) aims to raise the share of manufacturing in India’s GDP to 25% by 2022 and create 100mn additional jobs in the sector. To realize this vision, the Modi government has launched the “Make in India” campaign that encourages global companies to use India as a manufacturing export hub.
However, manufacturing’s share in GDP has fallen by 1 percentage point since the NMP’s launch in 2011 and the sector’s job creation has been just 1.6% per year. The recent underperformance is partly because of weak demand. But at the heart of India’s industrial malaise is poor productivity, aggravated by the hangover of ill-judged policies of previous decades.
We do not think that India has the luxury to follow a sequential approach to industrialization à la China. We would suggest a multi-pronged strategy targeted at boosting FDI, raising productivity and diverting rural labour towards industry, maximizing the advantages of competitive labour costs and a vast domestic market.
Indeed, the latter provide India with an edge in the current environment, when the viability of an export-led manufacturing model is increasingly being questioned.
But India fares poorly on most parameters that we think are necessary to boost manufacturing output (such as the investment climate). In line with this, we expect manufacturing growth to stagnate around 7% pa over the next 15 years, leaving its share in GDP at just 17%. As a result, GDP growth may dip to around 5% by 2030.
The dramatic fall in sterling threatens to push up inflation and squeeze consumers’ purchasing power. But it also offers upsides and not just via the conventional channel of a boost to net exports.
Sharp declines in the exchange rate in 1992 and 2008 were followed by sizeable gains to GDP from net trade. There is little reason to think that this won’t be repeated. And the likelihood that sterling will remain depressed for some time should reduce the odds of the boost to output being subsequently eroded.
Admittedly, evidence on the sensitivity of UK trade volumes to the pound’s value is mixed. While goods exports appear fairly responsive, the opposite is true for imports. And the elasticity of services exports to the exchange rate is low, bad news for an economy where services account for 40% of total overseas sales.
But if UK firms respond to the lower pound by raising their sterling prices, revenues will increase irrespective of any rise in export volumes. A look at the historical performance of export volumes and values suggests that such ‘pricing to market’does take place.
Those extra revenues will provide firms with the resources to pay higher dividends and wages and/or increase investment. So sterling’s fall could boost GDP via multiple channels.
The nature of UK outward and inward investment means that the cheap pound is also bolstering the UK’s external balance sheet. Q3 is likely to have seen the country’s net foreign asset position move into positive territory for the first time since 2009.
Nonetheless, the lower pound is set to be a mixed blessing for the economy. Not least, the direct consequences for the all-important consumer sector are gloomy. And given the unprecedented situation facing the UK, any reassurance from historical falls in sterling needs to be taken with more than the normal degree of caution.
Following yesterday’s very strong PMI readings, today’s Ifo release confirms that the German economy is holding up well despite an initial post-Brexit vote slump.
Meanwhile, French business confidence moderated slightly in October, but still suggests quarterly growth of 0.3% in Q4, in line with our forecasts of annual growth of 1.3% for this year.
The national oil company decided to proceed with the swapping of 39% or US$2.8bn of its US$7.1bn bonds maturing in 2017 by scrapping its self-imposed 50% participation threshold, as we had expected.
The operation spares the country US$1.9bn of payments over the next 15 months, which will likely allow the company to muddle through for another year. However, the risk of default will persist, increasing again in Q4 2017 when US$2.0bn in amortizations will come due.
Q3 GDP growth surprised on the upside, growing by 0.7% on the quarter, with the increase driven by consumption and another large rise in construction investment. Year-to-date growth performance warrants an upward revision to our current full-year growth forecast of 2.7%. But we are cautious about the momentum continuing in Q4.
On the back of the US Fed's inaction in September and relatively calm financial markets, Bank Indonesia has cut its policy interest rate by a total of 50bp in consecutive cuts in September and October. In its latest comments, BI views global growth as uncertain and assesses that the domestic economic recovery is limited. As such, against the backdrop of fewer rate hikes in the US, we believe that the BI will continue to support growth. Thus, further rate cuts cannot be ruled out. However, the BI has unloaded a total of six cuts this year and we want to wait for the Q3 growth data (published in early November) before deciding whether BI will ease policy again.
September monthly economic data were slightly downbeat as nominal export growth fell back into negative territory after recording the first annual rise in nearly two years in August. Meanwhile, the private consumption indicators were patchy, with retail sales growth staying robust but motor vehicle sales growth losing momentum. However, the latest data do yet not warrant a change in our growth forecast for 2016. We maintain our view that the economy will grow by just over 5% pa in 2016 and 2017.
‘Flash’ Eurozone PMIs surprised on the upside in October, with the composite indicator rising to its highest level since the start of the year. A sharp rise in new orders and backlogs of work bodes particularly well for the economy at the start of Q4. Today’s release is consistent with our view that growth in the region will remain at 0.4% in Q4, where we estimated it increased to in Q3. Moreover, rising price pressures support our view of QE tapering after March 2017.
Meanwhile, Spain seems to be set to get a new government later this week, while the CETA negotiations are reaching “crunch time”. Given the news following this weekend’s “emergency meetings”, it seems unlikely that the EU-Canada summit will be held this week.
The BCB cut the Selic policy rate by 25bp to 14% this week – the first rate cut in four years. We believe the Copom will lower the policy rate by an additional 50bps in November as inflation will continue to fall and the government is likely to approve a 'spending cap bill' in Congress before their next meeting.
With both inflation and economic activity falling at the margin, we forecast a total loosening cycle of 300bp by Q2 2017, taking rates to 11.25%. Meanwhile, we only expect inflation to converge to the 4.5% target by Q2 2018.
Canadian policy makers are facing mounting opposition to trade deals in their top two foreign markets. Failure to ratify new trade agreements will limit the potential upside of export growth in coming years.
The consumer took centre stage this week. September’s retail data saw sales volumes remain flat for a second successive month, though over the course of Q3 as a whole sales were up 1.8%, the strongest outturn since late-2014. This will help to ensure that next week’s preliminary estimate for Q3 GDP growth remains comfortably in positive territory.
Both the retail sales and inflation releases suggested that price pressures are on the turn. We expect CPI inflation to accelerate sharply from this point onwards, averaging 2.7% in 2017. This will severely squeeze household spending power and cause spending growth to slow sharply.
The labour market release was a mixed bag, with the level of unemployment rising slightly compared with three months earlier, but employment also increasing.
After the volatility of the previous couple of weeks, financial markets have been calmer over recent days. But with sterling now 18% below 23 June levels against the dollar, November’s MPC decision is no longer a foregone conclusion.
We judge the risk of recession to be unchanged from last week at 20%.
The ECB’s survey of professional forecasters showed that short-term inflation expectations have edged down further. Economists now see 2018 inflation at only 1.4%, rather than 1.5% previously, as they expect 2018 growth to be weaker (1.6% rather than 1.7%) and the output gap to close more gradually.
The controversial EU-Canada comprehensive trade agreement (CETA) has hit another roadblock, as the Walloon government in Belgium continues to reject the deal. This makes it highly unlikely that the deal can be ratified before the EU-Canada summit on 27 October. Meanwhile, we expect DBRS – the only agency that rates Portugal above junk status, thereby ensuring its eligibility to QE – to reaffirm its rating today.
A fiscal deficit of £10.6bn in September was the highest for that month in two years and left borrowing in the fiscal year-to-date only 5% down on the level in the same period in 2015-16.
So the OBR’s expectation for borrowing this fiscal year is looking more unattainable even before a likely downgrade to its growth forecast in the Autumn Statement. But with gilt yields still exceptionally low and the private sector at risk of retrenching, the case for a fiscal stimulus remains strong.
The central bank of Turkey (CBRT) unexpectedly paused its easing cycle today, leaving all its rates unchanged for the first time in eight months.
President Draghi was very tight-lipped at the ECB’s latest press conference and some long monologues on the detail of the recent Bank Lending Survey were reminiscent of a US Senate filibuster. While Draghi did not rule out any action in December, the reluctance to provide guidance on the form of any policy action at the next meeting is perhaps a sign of large divisions within the Governing Council over what the next step should be.
Based on Draghi’s latest communications, the ECB remains in data-dependent mode. We remain comfortable with our out-of-consensus assessment that the ECB will taper QE beyond the current March 2017 termination date.
Against our expectations and those of the markets, Bank Indonesia (BI) lowered its new policy tool – the 7 day reverse repo rate – to 4.75% at the October policy meeting. The move, the sixth rate cut this year, was facilitated by calm financial markets and low inflation but also perhaps spurred by concerns about the strength of the domestic economy.
However, going forward, we continue to expect that Indonesia's policy path will be largely determined by the US policy outlook. And as we expect the Fed to hike in December, we think that BI will now keep interest rates on hold.
Today’s fall in the euro dollar exchange rate suggests markets are expecting ECB President Draghi to signal decisive action in December later today. Our expectation is for more QE in the form of tapering from next March, less than the market is expecting.
The Eurozone current account surplus rose to €29.7bn in August due to further rises in the trade surplus and FDI inflows.
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