Weekly Economic Briefing

02 May 2017

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Global Overview - Cooling at the margin

That there has been a recovery in the pace of global economic activity, concentrated in the industrial sector, over the past 12 months is undeniable. In the year to February 2017, global industrial production increased by 3% in volume terms, up from 1% in the year to February 2016. The growth rate of global export volumes picked up by a similar amount. Most parts of the world have enjoyed better industrial growth over this period, though there have been leaders and laggards. Among the large advanced economies, Japan witnessed the biggest improvement, while in the emerging world Latin America improved the most, though this was merely a slowing in the rate of contraction. Emerging Asia remains the fastest growing region.

The latest PMI data suggest that this healthy industrial growth should continue through at least the next few months. Since the start of the year, JP Morgan's global manufacturing PMI has averaged levels not seen since 2011, though conditions did dip in April. We are also monitoring the recent disconnect between the 'soft' PMI data and the 'hard' industrial data (see Chart 1). Whereas the trend in the global industrial activity moved up in lockstep with the manufacturing PMIs through most of last year, the growth rate of industrial activity softened in Q1 even as sentiment data stayed at elevated levels. A few cases in point: the Eurozone manufacturing PMI hit a five-and-a-half year high in March, but manufacturing production growth has remained tepid, growing little over the past 12 months. A similar pattern is evident in the emerging world, where the manufacturing PMI has picked up to 2011 levels, but manufacturing growth has been decelerating of late. Even in the US, growth in capital goods orders is below the rate implied by the current level of new orders in the ISM index, though April's ISM correction brought the two  into closer alignment. The wedge between hard and soft data has also been evident in the aggregate data. The level of the global composite PMI is consistent with global GDP growth of around 3.5% for 2017, but our most recent tracking estimates are closer to 3.25%. This implies that there are modest downside risks to consensus growth expectations for this year though our tracking estimates would still represent a meaningful improvement on both 2015 and 2016.

Sentiment overstating growth
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US - The same ol' winter blues

Confirming what was already evident in the partial indicators, the economy began the year on a soft footing. According to the first estimate, GDP increased at just a 0.7% annualised pace in Q1, marking yet another winter of below-trend growth. Some of this regular Q1 weakness may be accounted for by a kind of residual seasonality. Although the Bureau of Economic Analysis has taken corrective steps to improve its own seasonal adjustment process, the median Q1 growth rate has been just 1.0% since the recovery began: 1.4 percentage points (ppts) below that of the next weakest quarter (see Chart 2). The four expenditure components of GDP where this residual seasonality has been most pronounced over the past seven years are personal consumption expenditures; the change in private inventories; government spending; and goods exports. Although goods exports actually grew quite robustly this time around, each of the other categories was very soft; inventories subtracted 0.9 ppts from growth in the quarter, government spending subtracted 0.3 ppts and personal consumption spending made its smallest contribution to growth since the final quarter of 2009.

Familiar winder weakness...
...understates underlying growth

Nevertheless, even by the low standards of the current recovery this was a disappointing Q1 out-turn. So, should we be concerned about the future of the recovery? And might the Federal Reserve's (Fed's) plans to lift interest rates two more times and begin reducing the size of its balance sheet before the end of the year be derailed? It would be premature to say yes to either. Setting aside the fact that the first estimate of GDP is based on only partial and selective survey data and hence there are typically significant revisions to the quarterly profile of growth over time, a variety of other information and indicators are indicative of more healthy underlying growth. Take real consumer spending: some moderation was to be expected due to the recovery in headline inflation that has slowed real income growth and the tightening in auto lending standards that is underway. However, a run rate closer to 2% would be more consistent with the fundamentals (see Chart 3), including positive consumer sentiment and solid employment growth. Second, measures of large and small business sentiment remain at healthy levels, as are leading indicators of firms' capital spending, despite some pull-back in April. Fixed business investment made a strong contribution to growth in Q1 and although the official measure of capital goods orders has softened over the past three months, we anticipate some reacceleration in the months ahead. Meanwhile, conditions in the housing sector – especially the emerging shortage of single-family homes – also point to further growth ahead and we are especially encouraged by the way that mortgage applications have held up despite higher interest rates.

Will this turn into a spectacular recovery? No. But does it need to for the Fed to continue gradually removing policy accommodation? No. As long as growth picks up again in Q2; the labour market continues to recover; the gradual upward trend in underlying inflation is maintained; and leading real and financial indicators do not begin to roll over; the Fed should take another step along the road to normalisation in June.

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UK - Tide Turning?

UK growth has been surprisingly resilient in the wake of the EU referendum, helped by an undeterred consumer. However, as we move into 2017 there are signs that activity is softening. The preliminary estimate for Q1 GDP growth came in at 0.3% quarter-on-quarter (q/q), down from 0.7%q/q at the end of last year. The majority of the slowdown can be attributed to weaker services activity, with this sector growing just 0.3%q/q. Within services it was the more consumer-centric industries that struggled (see Chart 4). Retail trade alone shaved 0.1 percentage points off headline GDP growth, while accommodation services were also weak. This would be consistent with the ongoing squeeze in household incomes as inflation accelerates. However, consumers are not cutting back across the board, with robust growth in food and beverage services suggesting that they are still finding room for a night out. Growth in all the other large sectors of the economy also slowed (see Chart 5). Industrial production was up 0.3%q/q, although this was held down by a large fall in the volatile energy sector. Manufacturing was better at 0.5% q/q, but still down from 1.2% q/q in Q4. Finally, construction activity was weak at 0.2% q/q. 

Households feeling the strain?
Slower across the board

As always, we need to be careful when interpreting preliminary growth estimates. First; these are prone to revision with the preliminary reading containing only 44% of the data used in the final report. Second; weak growth across one quarter does not necessarily constitute the start of a slowdown. National accounts data can be volatile and growth came in at 0.2% at the start of both 2015 and 2016, before accelerating again. Therefore, we need to see sustained signs of weakness to be sure that growth is genuinely weakening. At this stage we can just draw some interesting observations. The seeming deceleration in consumer spending would be consistent with the view that households will not be able to fully offset the ongoing shock to real incomes through lower savings. Moreover, there are few signs that other parts of the economy are growing strongly enough to compensate for a smaller consumer impulse. Beyond this we will have to wait and see how the economy fares in Q2.

The Bank of England (BoE) will look at the GDP report through a similar lens. It revised its forecast for Q1 GDP up to 0.6%q/q in March, so the headline will come as a disappointment. However, the Bank forecasts the final vintage of GDP, and has argued that the ONS has a bias to revise its preliminary forecasts higher over time. Therefore, it may expect any undershoot in the final estimate to be smaller. If the Q1 report is unchanged this would mechanically bring the Bank's growth forecast down to 1.8% in 2017, from the implied 2.1% expected in March. While this alone would be unlikely to materially shift views within the MPC, the details of the disappointment will cause concern. In particular the Bank's forecasts are for households to absorb much of the shock to their incomes through lower savings. These data suggest that households are at this stage spending less freely than the BoE anticipates. If this continues, further downgrades to Bank forecasts will be required. Overall, the Q1 report is likely to reassure the Bank that its accommodative policy settings are appropriate – although it will continue to watch the data closely to see if this represents a blip rather than a shift down the gears.

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Europe - Distorted signals

The Eurozone economy is booming according to a range of survey indicators. Let's start with the PMI. The manufacturing survey is currently sitting at a six-year high of 56.8, having risen a full five points since August last year. The services equivalent dipped slightly in April, but at 56.2 is still signalling growth at multi-year highs. The composite of these indicators is consistent with robust GDP growth around 0.6%q/q in the Eurozone according to their provider (Markit). Other sentiment surveys tell a similar story. The European Commission's Economic Sentiment Indicator, which takes a composite of industrial, services, household, construction and retail confidence, jumped last week to the highest level seen since the financial crisis struck. The only problem is that these signals do not really match what is happening on the ground in terms of hard data – particularly around industrial activity. For instance, manufacturing production in the Eurozone has been flat over the past six months in annualised terms (see Chart 6). Indeed this sector, which accounts for around 17% of the Eurozone economy, looks likely to deliver only a very modest positive contribution to Q1 GDP. With this in mind we have not revised up our expectations for Q1 GDP growth and beyond, in the wake of the recent swathe of upbeat sentiment surveys.

Spot the difference
Seasonal swings

The European Central Bank (ECB) has been taking note of the improvement in survey data. Indeed, at last week's policy meeting Mario Draghi emphasised that these indicators have strengthened confidence that the current economic expansion will "firm and broaden". Moreover, the central bank continues to signal that the risks to this upturn are reducing, although these remain tilted to the downside. However, this more upbeat tone on the growth outlook has not led to any shifts in the central banks' policy signals. Markets continue to watch this rhetoric carefully for signs that the ECB is starting to plot a path towards policy normalisation. Instead Draghi resolutely stuck to the current script; the ECB's forward guidance still signals a willingness to reaccelerate asset purchases if needed and that rates will remain at current, or lower levels, well past the horizon of these purchases. Indeed, Draghi noted that changes to this easing bias had not even been discussed on the Governing Council.

Part of this reluctance to shift signals and expectations relates to the inflation backdrop. Recent data have been heavily distorted by the timing of the Easter holidays. Core inflation, which the ECB will follow most closely at present, fell sharply in March before rebounding to a four-year high in April (see Chart 7). This volatility makes it hard to extract any underlying signals from the price side. Draghi has stated that we need to see a sustained, durable and broad-based pickup in underlying price pressures. The developments in inflation after the Easter volatility has passed will be a critical signpost for how the ECB starts to shift its policy settings. In the first instance this might come in some small tweaks to the central banks' forward guidance. The next big decision will come in September, with the central bank likely to announce how asset purchases will evolve in 2018 at this meeting. If core inflation shows signs of picking up in line with the ECB's forecasts we expect the central bank to announce a shallower pace of purchases.

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Japan & Developed Asia - All consuming

It may have taken nine years, but according to the Bank of Japan's Outlook Report published last week the economy is now operating with a positive gap, defined as when actual GDP exceeds estimated potential GDP. However, any celebrations are likely to be short-lived. Governor Kuroda remains under pressure as price data continue to disappoint, with the year-on-year (y/y) growth rate of the CPI excluding fresh food and energy – the Bank's preferred inflation measure – falling back into negative territory in March; at -0.1% versus +0.1% in February. Furthermore, beneath the positive growth headlines a rather unbalanced picture emerges, with net exports driving activity while domestic demand remains largely stagnant (see Chart 8).

Export dependent
Spending spark

Until recently, the contribution from the household sector had proven to be one of the biggest disappointments; despite the improvement in aggregate earnings growth under Kuroda's watch due to stronger employment growth and moderate wage increases, private consumption growth has consistently lagged behind. More recently there have been signs that this extreme consumer caution may be fading. The most telling readings come from the Cabinet Office Synthetic Consumption Index, which has staged a noticeable recovery so far this year. This in part reflects an improvement in consumer confidence underpinned by a buoyant jobs market (see Chart 9). It is also indicative of the fact that the outlook for disposal income is improving as the annual hiking of social benefit fees, which has served as a tax on incomes, is set to end in 2017. But before we conclude that the recovery in consumption demand is more than a 'one quarter wonder', we also need to see other corroborating evidence. Certainly, retail sales remain somewhat lacklustre, dropping 0.2% in Q1 2017 from Q4 2016, while the household consumption survey also registered a sharp drop in March even if the Q1 average did rise modestly. To get really excited about private consumption though, we need to see evidence that the incessant rise in the savings rate has peaked and households' efforts to rebuild their balance sheets is drawing to a close.

Away from the consumer, the trends in industrial activity have also been favourable with production rising modestly in Q1 after a 1.8% q/q jump in Q4. The driver here has been favourable external demand conditions, with export volumes to China and other parts of Asia increasing strongly. Breaking this export demand down by sector, it is clear that capital goods and materials orders have been driving the trend. Critically, the durability of the improvement in demand for capital goods appears to have come as something of a surprise to firms; as a result, inventories have been falling aggressively – boding well for future capex. Unfortunately, support for corporate investment from domestic demand trends remains weak. Low growth expectations and demographic headwinds are likely to continue to weigh on capital investment in Japan, even if labour and energy saving investments prevent a complete collapse in capex trends. This seems a long way from the self-help story, driven by idiosyncratic drivers at home, that was promised under the leadership of Shinzo Abe. Despite the disappointments, one should not write Japan off entirely. Recent data highlights that it remains well-positioned to benefit from an upturn in the global cycle.

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Emerging Markets - Measuring China's True Growth

To look beyond official headline GDP and get a sense of how economic activity is really faring we developed a model that incorporates high frequency data across most major sectors of the Chinese economy. Amid the proliferation of China activity proxies we sought to create an index that captures real monthly economic activity in a rigorous and comprehensive way, reflecting the fast changing structure of China's economy. Since we initially developed it in 2015, our activity indicator has highlighted both the sharp slowdown that took place in 2015 but was not captured well in the official figures, and also the recent surge in stimulus-driven activity. Based on the index, growth is now largely in line with official data after growth surged over the past two quarters (see chart 10). Despite stable official growth data, especially since 2012, our index shows that China's economy has exhibited a number of mini-cycles, sometimes referred to as CRIC (crisis-response-improvements-complacency) cycles, that fluctuated around policy and business cycles. Additionally, China's economy appeared to be on a structurally slowing trend following the global financial crisis, due to high debt levels, demographic trends and structural rebalancing that resulted in a naturally slower growth rate.  However, since 2015, both patterns have become more muted. The mini-cycles common since the crisis have become less pronounced and the underlying slowdown has been halted for now. This likely reflects the nature of the recent stimulus; through increased official government spending and rapid credit growth targeted at housing, authorities have engineered the longest upturn since the global financial crisis. Based on the underlying variables in the index, it is evident that the recent upturn was driven largely by improvements in industrial sectors; whereas according to our index, growth in services sectors has remained close to 8% (see chart 11). Above-target growth in the first quarter gives policymakers a buffer to let growth moderate and focus on taming financial risks through the rest of the year. However, growth at these levels is unsustainable; it is above potential (as signalled by rising core inflation) and fuelled by ever growing debt.

Growht surge
Growth being serviced

To build the index we used a mix of official data series, partner trade data and third-party survey data. We also created two sub-indices, one to proxy services sector growth and a second to measure adjusted industrial production using raw production volumes across all major sub-sectors. To capture services growth we used a weighted index of the main components of services activity – wholesale and retail sales; financials; real estate; transportation; hotel and catering; and "others". Once we selected the indicators, we converted the data into a GDP-like metric by regressing it on official GDP growth from 2005-12. We chose this period because our analysis shows the underlying data has a consistent relationship with GDP until 2012, but thereafter the correlation breaks down. This is either because GDP has been manipulated more since 2012 or the structure of the economy (rebalancing towards service sector growth) has changed so significantly that the relationship between the data series has broken down. We think it is a combination of both. We see our index as a good approximation for the economy's true growth rate, but acknowledge there are wide confidence intervals around any point estimates.  Moreover, though it is clear that stimulus has pushed growth back to target, it is equally evident that stronger growth has come at the expense of rebalancing.

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