Weekly Economic Briefing

04 July 2017

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Global Overview - Cruising altitude

After an unexpected mid-cycle stall, the last 12 months have seen global industrial production stage a sustained recovery. Year-to-date, global industrial production has expanded by an average of 3.0% year-on-year, nearly twice the rate in the same period last year. This improvement has been flattered by both inventory restocking and better trading conditions in commodity-related sectors. With these factors affording only temporary support should we expect this manufacturing comeback to continue? One sign that the cycle was starting to peak would be an overshoot in the inventory cycle. We have been closely monitoring the gap between manufacturing sentiment and industrial activity for signs that demand expectations are running too far ahead of reality. Fortunately, there are few signs of excessive inventory accumulation. According to global PMI data, the ratio of new orders to inventory continues to rise, boding well for future production. Furthermore, the gap between global sentiment and production has started to narrow. Crucially, while global manufacturing sentiment has moderated a little, it is better production activity playing a bigger role here.

Another concern is the potential for an idiosyncratic sector shock, such as the 2014/15 commodity-related distress. Our analysis reveals that sentiment in the auto sector is most at odds with the trajectory of production (see Chart 1). For a production lift to narrow that gap, we would need sales volumes in the key US market to re-accelerate. Unfortunately, the industry has already been pulling forward demand from the future, with auto loans being offered at record terms, while auto securitisations are above the last cycle's peak. Furthermore, the rapid rise in lease-financed vehicles, which account for 25% of US car sales, is starting to hit second-hand prices as these vehicles come off lease. Unsurprisingly, we have already seen sentiment readings correct in May/June and the mood could further darken in the event of a further pick-up in defaults or rising rates. Fortunately, these auto financing practices appear to be restricted to the US, meaning the transmission to other markets through consumer credit channels appears unlikely. That should allow sectors that are earlier in their cycle the opportunity to contribute more.

Mood set to darken?
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US - Peak industrial growth?

The US industrial sector has staged quite a turnaround over the course of the last 18 months. After production growth declined from 5.7% to -4.5% in six-month annualised terms between July 2014 and June 2015, it has subsequently accelerated to 4.1% as of May. Can any further improvement be expected? Or has growth likely peaked for this cycle? We can come at this question from three different angles. One is to look at recent trends in the forward looking new orders components of the manufacturing PMI data. That data suggests that industrial growth is either at or will soon peak as the three-month moving average of an equally weighted Markit and ISM index peaked in March and has since dropped back to levels consistent with solid growth but now with further acceleration (see Chart 2).

Manufacturing sentiment peaking...
With the inventory cycle

Another is to look at the extent to which the recent industrial cycle has been driven by inventories; the larger the inventory contribution, the less likely it is that current growth rates will be sustained unless there is a sharp pick-up in the demand for industrial goods. That data also implies that the cycle may be peaking. Over the course of the past three years the US has completed a full inventory cycle, with the six-month annualised growth rate of durable goods inventories (ex-transportation) and core capital goods inventories initially peaking in October and July 2014 respectively; ebbing in January 2016; and then peaking again in April at a rate just below what was recorded in 2014 (see Chart 3). At this stage there is little evidence in the core capital goods data to suggest that firms' equipment investment is accelerating in a way that would make up for the probable slowing of inventory growth through the rest of the year.

A third angle is to look at the composition of industrial growth to understand whether the acceleration was broadly based or concentrated in a smaller number of components for which momentum will be difficult to sustain. Looking at the disaggregated data the first thing we notice is the importance of the oil and commodity price cycle. Mining production growth jumped from an annualised -14.6% in the six months to April 2016, to 15% in the six months to May, with oil and gas drilling production growth hitting an extraordinary 155.6% in April. In contrast, the manufacturing cycle has been more muted, especially when we account for the fact that the components of manufacturing activity most closely tied to the commodity price cycle - petroleum and coal products; food and beverages; and metals and mineral products - have seen some of the strongest growth in recent months. With commodity prices having faded in recent months, and the base effects from earlier weakness dropping out of the numbers, industrial growth will need to find an alternative driver. That driver is unlikely to be auto demand now that car sales are on a declining trend and credit availability is deteriorating after a very strong cycle up until late 2016. The upshot is that from almost every angle we look - manufacturing sentiment, the inventory cycle and the composition of the growth pick-up - it appears that the drivers of growth will likely soften in the months ahead. We are certainly not expecting another industrial recession, but investors will probably need to get used to less favourable industrial news in the months ahead.

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UK - Uncertain times

The narrative around UK manufacturing has been upbeat over recent months. Indeed, there is hope among sections of the Monetary Policy Committee that better performance here could help offset the anticipated weakness in services as rising inflation weighs on consumers. While the exit from the European Union (EU) creates uncertainty around the longer-term outlook for manufacturing, it has been enjoying two tailwinds of late. First, global trade and production have improved. Second, a significant depreciation in sterling is expected to support competitiveness - although we have warned that this effect will be muted by the high import content of exports. Certainly sentiment around the sector has improved. The Purchasing Managers' Index averaged a three-year high of 55.9 in the second quarter - although a softening in June suggests that momentum may be fading. However, better sentiment has yet to be reflected in hard production figures. These have been volatile over recent months, but even when trying to smooth through 'noise' by looking at just manufacturing there have been few signs of sustained improvement up until April (see Chart 4). While figures for May and June may be better, we would be sceptical that the sector- which accounts for just 10% of economic activity - is set to grow strongly enough to offset anticipated weakness in services.

Treading water?
A renaissance in car production

Looking at the breakdown of production, we can see some clearer trends at subsector level. Intermediate good output has shown signs of improvement and is up 1.3% y/y, in line with the trends we have seen in global activity for these goods. Interestingly, another area which has shown signs of an uptick, albeit with lots of volatility, has been capital goods. Domestic investment has been sluggish since the referendum result, suggesting that this might reflect the better global backdrop or even currency effects. The strength of consumer spending in the UK has been until recently a key reason for explaining the resilience of the economy after the referendum. However, this does not seem to have led to a significant upturn in the production of either durable or non-durable consumer goods, which have stagnated (0.1% y/y) and fallen (-3.2% y/y) respectively over the past 12 months. Finally, the biggest soft spot has been in energy production (-3.9% y/y), although these data are highly volatile and affected by variable North Sea crude output and even the weather.

One of the success stories over recent years has been the auto sector. Output growth has been running at an average annual rate of more than 6% over the past five years and is well above its pre-crisis peak (see Chart 5). However, there are concerns building around the outlook. We have highlighted the cyclical challenges in global auto production in the global overview section of this week's briefing. However, the UK faces some idiosyncratic challenges. The Society of Motor Manufacturers reported this week that investment in the sector has plummeted to £322 million over the first half of 2017. This is well below the run rate of the £1.7 billion invested last year, which was down on £2.5 billion in 2015. The report flagged uncertainty over Brexit as a key reason for this caution, highlighting the importance of securing a smooth transition out of the EU and an eventual agreement that minimises trade barriers between the UK and its largest trade partners in Europe.

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Europe - Full speed ahead?

The Eurozone has been riding high on a cyclical upswing this year, supported by external and internal demand. A key facet of this story has been the global trade cycle supporting industrial production (IP), which grew at a solid 2.8% (six-month annualised) to April in the Eurozone. Drilling down, intermediate goods, which carry the largest weight at 33% of the IP index, grew at a robust 5.7% in six-month annualised terms while capital goods, with a 29% weighting, grew at a weaker 0.86% due to a softer outcome in April. Consumer goods grew at 3.5% on a six-month annualised basis, underlining the strong consumer demand supporting industry, both within the Eurozone but also in the form of export demand. The only evidence of weakness came through energy output. In level terms, energy output contracted 3% on a six-month annualised basis. This may be partly accounted for by weaker demand in a number of European countries that experienced an unusually mild winter.

Unreasonably weak
No sign of levelling off

Another way to cut through the industrial production story is to identify trends in the most important manufacturing sectors, given that manufacturing accounts for 86% of industrial activity (ex-construction) in the Eurozone. These include machinery and equipment, metal products, food products and motor vehicles. Machinery and equipment output - which accounts for just under 10% of total production - rose 6.3% (six-month annualised) to April, while metal products, with a 9% weighting, rose a sturdy 8.2%. Food product output grew 0.8% on the same measure to April - turning positive for the first time in five months suggesting further positive momentum. The weak link of the sector story is motor vehicles output, which contracted 1.8% (six-month annualised) in the latest release (see Chart 6). This sector accounts for 7.6% of total production, so developments here are not immaterial for the outlook and warrant monitoring.

Naturally, questions are emerging about how things may progress through the coming months as the impulse from the global trade cycle remains supportive, but less powerful. Survey data gives us an insight, albeit imperfect, into more recent sentiment and near-term intentions. The latest June release suggests that consumers and producers have had another month of optimism - in line with a consistent upward trend in sentiment that we have noted through the year thus far. The EC survey registered a further rise in overall economic confidence to 111.1 in June, the highest level in the decade since the financial crisis. Consumer confidence has risen to a whopping 16-year high at -1.3; this should be supportive for the demand side of the equation. Encouragingly, industrial confidence in June registered a six-year high of 4.5 in the EC survey, underpinned by strong, steady production expectations, the rising volume of order books and declining stocks of finished products. PMI survey results chime with these positive readings in the EC survey. The manufacturing PMI rose to 57.3 in June - a six-year high - citing punchy new orders (58.6) and, importantly, high expectations of future output at a record 63 (see Chart 7). This all implies that the prognosis for Eurozone industrial production remains robust. Nonetheless, if the global trade impulse becomes less powerful, it will be important that the domestic investment recovery continues to help underpin production at home.

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Japan & Developed Asia - Masters of their own destiny?

The fortunes of Asia's developed economies have improved drastically over the last 12 months. This largely reflects their continued exposure to global forces rather than any great self-help story. In particular, the rebound in global trade has been a key factor, with improving demand from the US, Europe and China driving industrial activity higher. However, in recent months there are signs that the overseas growth impetus is fading, with industrial production losing its lustre. In Japan, industrial activity in May gave up most of its gains the previous month, dropping 3.3% month-on-month (m/m), while Singapore also witnessed a big contraction in the month, dropping 3.5% m/m. Elsewhere, Korea and Taiwan saw industrial production growth stall in May after dropping 2.2% m/m and 2.0% in April respectively. Of course, industrial output data is volatile and growth rates remain modestly positive on a six-month moving average basis. However, the uniformity of the recent downturn means it would be unwise to ignore the signals.

Selective memory
Non-starting motors

To assess the persistence of the latest weakness it is worthwhile digging into the sector level details. The obvious place to start is with electronic equipment, which contributes 48%, 29.4%, 23.4% and 8.2% to the share of industrial output in Korea, Taiwan, Singapore and Japan respectively. Sector-level production data suggest electrical component makers led other manufacturers in the recent improvement, with the pace of growth accelerating last summer. This in part reflected sensitivities to stronger consumption trends in H2 last year, with semiconductors shipments accelerating in line with the consumer electronic cycle. Unsurprisingly then, the continued disappointments in real income growth and a sluggish Q1 for consumption in developed markets has taken the steam out of the recent rally. In addition, signs of an inventory correction in China's smartphone market has further smothered demand for lower-cost chips. Unsurprisingly, the biggest loser here appears to be Taiwan, where electronics output dropped to -3.3 in May on a six-month moving average basis. However, the pattern has been different for those parts of the technology chain that are more exposed to memory chips, a place where Korea and Japan have a clear advantage (see Chart 8). Fortunately, the demand here looks more sustainable with the need for greater memory capabilities in smartphones and the growth in corporate demand for online storage and cloud computing services likely to prove supportive. These factors bode well for industrial output into H1 and suggest the stalling in electronics component output in Korea may be temporary, while growth in Japan may be sustained for a while longer.

One sector that looks vulnerable to a slowdown is autos. The countries most sensitive are Japan and Korea, where transportation equipment has a 19.2% and 16.3% weighting respectively. Here, too the latest readings were bleak, with Japan seeing an 11.7% m/m decline in output in May, pushing the six-month average growth rate negative, while Korea also witnessed a steep fall. The demand outlook is far less encouraging either with signs of distress in US auto loan markets weighing on sentiment (see Chart 9). If the auto sector was to splutter, the onus would once again fall on domestic sectors, which remain wanting.

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Emerging Markets - Cloudy outlook

Emerging market (EM) growth may have peaked in this current cycle with both survey and production data appearing to turn over in April and May (see Chart 10). Chinese demand has remained resilient, but is expected to weaken under tighter financial conditions. Additionally, external demand has been supportive, but recent White House rhetoric raises the risk that protectionism, which by now has largely been written off as a risk, once again threatens the EM outlook. Chinese survey data showed divergences since February highlighting the difficulties assessing how the country's economy is performing under tighter financial conditions. On the one hand, the official June NBS manufacturing PMI has remained within a tight range showing continued expansion since September 2016, with stronger new orders, new export orders and better production momentum. The non-manufacturing PMI improved recently as well, rising to 54.9 in June, with construction, transport and financial services showing strength. On the other hand, the Caixin/Markit PMI, which arguably better reflects the business cycle, has diverged from the official reading over recent months (see Chart 11). Although the two surveys do not always move together, past divergences occurred during downturns with the Caixin/Markit survey generally capturing weaker demand with more accuracy. Despite lingering mistrust of official data, near-term concerns about the resiliency of the current cycle were assuaged by a rebound in the June Caixin manufacturing PMI. The index returned to expansionary territory and improved over the May reading in line with the official survey.

Peaking growth
2015 collapse

Other data cloud the outlook, while our in-house industrial production index has closely tracked the official series over recent months; non-traditional metrics such as satellite tracking surveys that monitor industrial activity show activity to be slower than official data. The bottom line is regulatory tightening has yet to result in significant strains on the economy and growth across most sectors has been resilient. As the credit impulse continues to weaken, and the sectors that have driven growth up to this point, including property and autos, expected to slow, growth will likely suffer in Q4. Furthermore, questions remain over Trump's trade policies and the threat of protectionism continues to loom.

Elsewhere in EM, stronger European demand appears to be positively impacting on regional production and growth. Russian production has been strong in Q2 with construction and transportation sectors driving the boost in activity. IP growth surprised on the upside at 5.6% y/y in May, the highest print since Feb 2012. Domestic demand has shown signs of recovery as well: retail sales growth posted the second consecutive positive reading in May supported by improving real wage growth. Economic activity has also noticeably accelerated in Turkey with production and retail sales improving over the past two months. While this has undeniably been a result of rapid credit growth and expansive fiscal policy, strong external demand has also played a role with export volumes up over 10% y/y. Questions remain about the sustainability of Turkey's growth; growth has not been uniform across sectors and will likely suffer from the withdrawal of fiscal and credit stimulus.

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