Weekly Economic Briefing

06 June 2017

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Global Overview - Consumer culture

Private consumption is the mainstay of economic activity in the developed world, accounting for the lion's share of the value of final output. In fact, the ratio of consumption-to-GDP has been on an upward trend over recent decades, though the ratio is currently below its 2009 peak (see Chart 1). This has two important implications for economic activity. First, a higher contribution from private consumption to overall activity may serve to moderate the business cycle as household spending tends to be a more stable component of GDP. Second, excess reliance on consumption may reduce an economy's growth potential over the long term.

But are current consumption trends consistent with these hypotheses? Growth did slow at the beginning of 2017, in part because the pick-up in headline inflation over the previous 12 months eroded households' purchasing power. However, the extent of the moderation likely overstated the underlying trend. Labour markets continue to improve across the major economies, and energy inflation is now past its peak – boding well for real income growth. Indeed, the first readings of partial indicators in Q2 are consistent with a modest rebound in the quarter, supporting our forecast for the global upswing to continue.

The second hypothesis is more controversial. The empirical evidence in the US suggests that when the share of consumer spending is high, growth in private investment spending and the overall economy tend to be below trend. One explanation is that a consumer-driven economy may be prone to a 'crowding out' effect if it results in a permanent decline in private saving rates. Of course, extrapolating past trends and applying them to the future can be dangerous. Indeed, country examples of consumers aggressively running down savings or running up debt have been scant since the financial crisis. There is a variety of reasons for this, including slower growth in median household wealth; lower expectations for future income gains; tighter household lending conditions; and more general balance-sheet repair. Though these factors moderate the amplitude of the cycle, they may have the benefit of extending its duration.

Power to the people
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US - Misleading signals

A very soft Q1 GDP print, slowing employment growth, a rapid deterioration in the Citi Economic Surprise Index (CESI) and a flattening yield curve; in normal times these developments would be considered a warning signal that the recovery might be in jeopardy. But these are not normal times and in each case there are good reasons to think that the signal is not as alarming as it might seem. Let's take each in turn. As we explained after the first estimate for Q1 GDP was published, first quarters have been much weaker than the average across other quarters during the current expansion due to residual seasonality. Importantly, partial indicators suggest that growth will return to a healthier rate in Q2. Business sentiment indicators remain at elevated levels; capital orders and shipments are trending up (albeit modestly); growth in industrial production is running at a clip that has not been seen since mid-2014; and outside the auto sector, consumption growth has been picking up in recent months. Growth is not strong by historical standards, but that has been the story of the entire recovery.

What about the labour market; should we be more concerned about the weakening pace of employment growth? We do not think so. While firms are adding fewer 'heads' to their payrolls, growth in the number of hours worked is growing at a stronger pace (see Chart 2), implying that employers are simply choosing to use their existing workforce more intensively; a natural choice during the more mature phase of the cycle when there is less 'idle' labour and those still looking for work tend to be less employment-ready. We are also encouraged by the fact that job layoff rates and jobless claims remain close to historic lows; if labour demand really were weakening in a way that signalled the imminent end of the cycle, layoffs would be trending upwards as they were in the two years leading up to the 2008 recession.

Focus on hours not just heads
'Suprises' more noise than signal

Even more care has to be taken when trying to extract signals from the CESI. Although the index can be useful for gauging when expectations for the economy have become stretched relative to the near-term trend in the data, expectations themselves are naturally self-correcting and the inherent short-term noise in economic data generates regular 'surprise' cycles. For example, the CESI hit 73.6 in September 2008 when the economy was in recession and the global financial crisis was just about to intensify. Conversely, the CESI was if anything trending up from early-2015 till mid-2016 even as the composite manufacturing and non-manufacturing ISM index was trending downwards (see Chart 3).

We pay more attention to changes in the yield curve given that curve flattening is a signal that the cycle is maturing and monetary policy is becoming less accommodative, while inversion has preceded every recession going back to the 1960s. That said, though the 2s10s curve has flattened by 40 basis points (bps) since December, at 88bps it remains at levels consistent with the later middle stage than the end of the cycle. Further curve flattening is likely, but as long as Federal Reserve (Fed) policy remains contingent on the state of the economy and not ahead of the curve, there is nothing to fear in the slope just yet.

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UK - Back to the polls

Taking the temperature of the UK economy is tricky at present. We know that the first quarter was weak, with growth revised lower to 0.2% q/q. However, when gauging growth rates in Q2 we have to rely more on 'soft' survey data, with hard activity data released with long lags. This presents two challenges. First, sentiment-based indicators have recently provided some misleading signals around the strength of the economy. Indeed, surveys suggested that growth was weaker than materialised immediately after the referendum, and firmer than delivered at the start of this year. Therefore, we need to interpret these with caution. Second, survey data have been 'choppy' of late, making it harder to identifya strong signal. One way of addressing this is by looking at the trend in these data (see Chart 4). The three-month moving average of the manufacturing PMI survey has been rising steadily, likely supported by better global trade growth. The trend in the services equivalent has been more stable, albeit at solid levels. Overall, the composite PMI surveys are consistent with growth around 0.5%q/q according to Markit, a noticeable improvement from the first quarter and above our forecasts. However, we will need to watch the hard activity data closely to be confident that this better sentiment is being reflected in rising activity rates.

Solid sentiment
Slower, not lower

Against this backdrop there have been renewed concerns around the housing market. UK building society Nationwide reported last week that its measure of house prices had fallen for a third consecutive month – the first time since the crisis we have seen three declines in a row. The UK boasts a large range of house-prices measures, all based on different methodologies. If we take a simple average of five commonly used measures it becomes clear that price growth has slowed, but values are not falling across the board (see Chart 5). This would be consistent with evidence from mortgage lending, with new approvals having only moderated slightly in recent months. Overall the market looks to be softening, rather than falling over.

Stepping away from the short-term data flow, this week's general election has the potential to shift the economic outlook given material differences in the policy agendas of the two parties. The Conservative lead has narrowed to six percentage points based on an average of the past 10 polls, although recent UK polling history suggests wider margins for error around any seat estimates. The Conservative manifesto represents greater continuity with current policy settings, with the onus still on tightening fiscal policy, albeit more slowly. The Tory immigration target raises concerns around long-term growth and cements the view that this party would look to leave the EU single market. Labour proposals set out material increases in current and capital expenditure, partly funded by higher tax rates for corporates and higher earners. This looser fiscal setup, alongside the lack of an immigration target, has the potential to support near-term growth. The Labour manifesto also signals a potentially softer approach to negotiations with the EU. However, Labour proposes a number of interventions in labour and product market regulations, which risk creating material economic distortions. Overall, the manifestos leave us pessimistic that the policy agenda heading into the next parliament will help reverse the structural deterioration in growth seen over recent years. Worse, some of the policy choices being made could exacerbate this trend.

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Europe - Populism is dead; long live populism

The success of Emmanuel Macron in France and failure of the populist PVV party in the Netherlands have many asking whether the populist moment has passed in Europe and, specifically, whether this is thanks to the economic upswing that has been building through 2017. Certainly, the latest data releases suggest that there is more to be optimistic about. Eurozone GDP growth for Q1 was revised up to 0.5% quarter on quarter (2% annualised). Furthermore, 'soft' indicators remain buoyant: the Eurozone composite PMI for May came in at 56.8 – the same level as the previous month representing a six-year high. Drilling into the detail, the manufacturing PMI rose to 57 in May, from 56.7 in the previous month; another six-year high. Similarly, the European Commission sentiment survey registered a strong reading for its broad economic sentiment index at 109.2 in May after a marginally stronger 109.7 in April, the heights of which have not been seen since before the financial crisis hit. However, Eurozone aggregates can often obscure what is going on at the country level – for those concerned about the outlook for populism, we need to examine trends at the member-state level.

Corporates feeling good
Italian consumer feeling the struggle

Taking again the PMIs and the EC survey as an indicator of sentiment as well as business intentions, companies seem optimistic in core countries like Germany and France, and also in peripheral countries such as Italy and Spain. Although some of the latest readings saw a slight downtick, the data can be quite volatile and the point estimates and longer-term trends remain consistent with an improving business environment (see Chart 6). So, corporate sentiment is good; but what about consumers? The electorate is made up of individuals rather than companies, so how consumers feel about their circumstances is an important aspect to consider in the populist context.

The latest data releases provide a useful case study if we compare Germany, which faces a general election in the autumn, with Italy, where an election is due by 2018, but speculation is rife that one will be called earlier.  While overall Eurozone consumer confidence is at a multi-year high of -3.3, Germany posted an even more robust 3.1 in May. Conversely, Italian consumer sentiment posted a dismal -15.7, falling further from April's -14.6; so, not only is the level lower than its core counterparts and Eurozone aggregate, but the direction of travel of consumer sentiment through the past 12 months has been negative (see Chart 7). Perhaps this should come as no surprise; the unemployment rate decreased only slightly to 11.1% in April in contrast to Germany's 3.9% rate. Importantly, youth unemployment remains elevated, even following improvements, at 34%, implying that one in three people under 25 in Italy that want a job cannot find one. In Germany, it is one in 14 people. The political pressures that the refugee crisis and historical corruption claims have brought about are harder to quantify, but just as important for voters. Crucially, it is this mix of economic and political disillusionment in Italy that helps explain why the populist Five Star Movement garners 30% support in polls while in Germany the populist AfD sits in fourth place at 8%. While economic sentiment is only part of the story, it warrants careful watching in Italy where populism is far from dead.

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Japan & Developed Asia - So far, so good

Japan has been the star pupil of the global economy year to date, with a model quarter in Q1. Not only was growth strong, at 2.2% q/q annualised, the balance of growth was much better as overseas strength was matched by a domestic demand revival, contributing 1.6 ppts annualised. What was particularly welcome was the rebound in private consumption, rising 1.4% q/q annualised. What is less clear is why consumers have opened the 'purse strings' at this point and whether it can be sustained. Given that real earnings peaked in Q2 last year and have been in freefall since, it feels uncomfortable labelling this the start of a domestic demand surge. An alternative explanation is that tighter labour market conditions are restoring confidence in wage bargaining power, pushing up expectations for future earnings. However, this runs contrary to the unambiguously disappointing outcome of the spring wage negotiations, with the pace of average and base-wage growth stalling. A further possibility is that household balance sheets have finally been repaired thanks to higher nominal incomes and a rising savings rate. This sounds more plausible, but the higher saving rate may also be explained by changes in cohort behaviour as elderly participation rises. For now, we are keeping an eye on the outlook for wages in 2018, with a good year for profits and higher inflation raising the prospect of break-out wage growth for the 2018 Shunto negotiations. It is also clear that the yen will have a big impact on both these areas.

Belated recovery
Contrasting fortunes

For the time being, the positive data continues to roll in. On the household side, core spending appeared to bottom in April while retail sales continued the recent improvement (see Chart 8). Furthermore, the positive job-market data continues to defy gravity, with the job-to-applicant ratio at 1.48 times the highest level since February 1974. The unemployment rate is also hovering at its lowest level since 1994. May's consumer confidence survey printed higher too, up 0.4 points to 43.6, but also served as a reminder of Japan's unique challenge. Inflation expectations, which have witnessed a sustained decline over the last two years, remain stubbornly low despite better price trends and healthy conditions in the labour market. The message from corporate Japan is less ambiguous. Exports have strengthened, especially for technology-related products and capital goods, profitability is healthy and even capital investment is picking up. To underline the trend, April's industrial activity jumped 4.0% m/m and is expected to rise 2.7% q/q in Q2 based on the published production forecasts.

The upbeat mood contrasts with more sombre readings elsewhere in the region. The latest manufacturing output in both Korea and Taiwan surprised on the downside in April, dropping 2.2% m/m and 0.6% m/m respectively. There was also evidence that PMIs have peaked, with regional manufacturing measures weaker in May as China import growth moderates and the electronics upturn appears to have peaked. There may be sectoral factors at play here. Japanese industrial activity has been boosted by electronic components production, while South Korea has seen weakness in this sector (see Chart 9). While electronic component production has periodically diverged, the mixed message raises questions about the sustainability of demand.

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Emerging Markets - Demonetisation's true impact

This past week saw first-quarter growth data released from two ends of the EM spectrum with somewhat surprising results. Brazil, in the midst of yet another political crisis, surprised on the upside; and India, the favoured EM, surprised on the downside. Brazil's strong Q1 growth was the result of an unusually strong harvest and rapid growth from the agricultural sector. With political uncertainty expected to further dampen investment and consumption spending, the Brazilian economy will find it difficult to match its Q1 performance. The India data confirms our below-consensus view of growth and at 6.1% year-on-year for the quarter ending in March was significantly below the consensus expectations. For this week's report we take a deeper look at the underlying growth conditions in India.

Government support
Weak consumer demand

Despite high expectations, India's economy has yet to show signs of dynamism, and although recent weakness was largely self-inflicted as a result of demonetisation, growth is unlikely to significantly accelerate this year. This is largely a result of still-weak private demand and the declining scope for government support. The government has been the driving force in India's economy, with government consumption the main contributor to growth over the past year (see Chart 10). Furthermore, it's likely that actual private consumption was less than official data was letting on. Since the Indian government revised the GDP accounting framework, the GDP data has shown numerous inconsistencies with underlying monthly indicators, notably on consumption (see Chart 11). For the second half of 2016, even as private and government consumption data showed healthy trends, both industrial production and import growth were steadily declining. It would be difficult to satisfy such high rates of consumption growth with neither domestic production nor imports satisfying that demand.

However, this past quarter was perhaps the first since the statistics were revised that GDP data more accurately reflected underlying conditions. Growth slowing to 6.1% is more representative of an economy beset by weak private investment, moderating exports and the deleterious impact of the demonetisation policy. Most indicators have shown slowing economic activity since mid-2016 and this past quarter growth finally reflected the slowdown. Looking forward, government spending may not be as supportive of growth over the next year due to continued fiscal consolidation and implementation of the GST but private consumption will get a boost from normality returning to the cash economy. In this respect the data looks to finally be reflecting stronger domestic demand with non-oil, non-gold imports increasing 4.6% month-on-month (m/m) in April following 4.3% m/m growth in March. Perhaps it was unrealistic for investors to expect improvements in the short term, the largest reforms being undertaken in India are domestically oriented – improving efficiency and stamping out corruption – and unlike externallyoriented reforms, will not result in an immediate growth improvement. Although there are still bottlenecks holding growth back, this domestic agenda puts India in a small group of EM economies that is attempting hard reforms to the domestic status quo. The impact will not be immediate, but should eventually reap benefits.

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