No Hope for hay fever

Last week Yuriko Koike, the leader of Japan’s ‘Party of Hope’ and the main opposition to Japanese Prime Minister Shinzo Abe, unveiled her “12 zeroes” manifesto. The promise of ‘zero’ hay fever caught my attention: a welcome claim for the 25 million sufferers in Japan, but astonishing that politicians can claim to defy Mother Nature! If we made such a pledge in our marketing materials I suspect the regulator would have something to say about it…

What has also caught my attention of late is the impressive level of activity in Japan. Second-quarter real GDP was 2.5%, which is meaningfully above the assumed potential of 0.5 to 0.75%. Even more encouraging was the composition of growth, with private consumption and investment activity strong. The Tankan survey – a quarterly survey of business confidence – points towards a continuation of this trend into the second half of the year, as shown in Chart 1.


Source: Bloomberg

This pick-up in business activity is not unique to Japan. The rotation towards investment has been highlighted by central banks, in particular by the Bank of England in its August inflation report and its governor Mark Carney, who recently pointed out the increase in capital goods orders in advanced economies (Chart 2). I believe that this development is one of the most encouraging macroeconomic events that we have seen in a while.


Source: Macrobond. Capital goods are tangible assets such as buildings, machinery, equipment, vehicles and tools that a company uses to produce goods or services.

Global corporate profitability and elevated business confidence point to a changing dynamic in business investment, but only time will tell if this is the beginning of a trend. If so, we should expect higher productivity, healthier potential growth and less depressed neutral terminal rates – all of which will have an impact on monetary policy.

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Disappointing data and its dovish implications

Rates specialist Juan Valenzuela considers the latest US data release and how this could mean a more dovish Fed at its September meeting.

US data released on Friday undoubtedly disappointed. June CPI was weaker than expected – a negligible undershoot in itself, but the fourth time over four months that inflation data has surprised to the downside. Retail sales were also worse than expected; the weakness in private consumption is puzzling in light of strong employment data, a high savings ratio, good consumer confidence and a solid wealth effect.

Nevertheless this could have dovish implications for the Fed – a rate hike in September is much less likely and there is a chance that Fed members start revising down their dots for 2018 and 2019. With the market only pricing 50bps of hikes for 2018 and 2019, versus 150bps implied by the Fed projections, there remains a large discrepancy.

Where the Fed may keep to the hawkish side is by announcing a reduction of its reinvestments in September. Weaker inflation and retail sales should not be enough to derail this considering that financial conditions are looser (despite higher rates) and asset valuations ever higher, as risk markets remain unreactive to a pending reduction of the balance sheet.

The impact of the above on the US Treasury market is of most interest to us however. Treasury yields should still move higher, but driven by a generic move higher in global yields (global growth remains healthy and above potential) rather than a hawkish Fed. The focus on balance sheet management over hiking rates means that a flatter US curve is less likely from here – especially if the US Treasury considers issuing longer tenors. Finally, US inflation break-evens still benefit from suppressed valuations and if weaker inflation drives the Fed to commit more firmly to its inflation target, they should do well (keeping in mind that the base effects are less supportive now compared to Q4 2016 or Q1 2017).

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UK employment is not the full story

The dilemma for the Bank of England (BoE) intensifies in light of this morning’s May employment figures. UK unemployment has fallen further to 4.5%, versus the BoE forecast at 4.7%. To find a similarly low level you have to go back to the mid-70s, as shown in Chart 1. Moreover, the current level of unemployment is below where the BoE sees the natural level (the level of unemployment below which inflation should rise), all at a time when monetary policy is at emergency levels and inflation is well above the target.

Chart 1: UK unemployment

Source: Bloomberg as at 11 July 2017

And unlike in the US where the participation rate has been coming down, in the UK it has been increasing. Over the last three months the economy has created an impressive 175,000 jobs, taking the overall employment figure to 32m people, 324,000 higher than last year. The employment rate is 74.9%, the highest since comparable records began in 1971.

But employment is not the full story.

Real disposable income for UK consumers continues to be challenged by elevated headline inflation and low earnings. Leaving aside employment, the macroeconomic data has been surprising to the downside (Chart 2). The weak Q1 GDP at 0.2% will likely be followed by only a marginally better Q2 at 0.3%, and below what the BoE was expecting in its inflation report.

Chart 2: UK Economic Surprise Index
Source: Bloomberg as at 11 July 2017

On balance, the BoE has gained back some optionality. The market is now listening to its rhetoric and reacting to the macroeconomic data. In a speech on 20 June, MPC member Haldane complained about market complacency – but the market is no longer pricing the first rate hike in 2020 (a full hike is now priced for May 2018) so expectations appear to be much more reasonable.

I do believe that a removal of some of the emergency measures adopted in August 2016 is becoming more likely. But in the near term I don’t expect this to be a rate hike as the conditions set by the central bank are unlikely to be met. The economy remains weak and I am not hopeful that investment and exports will be strong enough to compensate for the weakness in consumption, while the chances of a smooth negotiation of Brexit are very slim. Instead, the BoE will leave the door open to a rate hike, but focus its efforts on the unwind of macro prudential measures, such as the countercyclical buffer and Term Funding Scheme.

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Challenging consumption in the US

We should not totally dismiss the weakness in Q1 GDP in the US. Private consumption disappointed – no question about it – while inventories detracted 1% over the quarter. But there were also reasons to celebrate. We saw a healthy increase in investments – and since an improvement in productivity requires capital investments, this is the main route to higher potential growth and a higher neutral rate of interest.

Furthermore, in contrast to the hard data, the soft data has not dipped materially and still points towards 2-2.5% growth, a level of growth that will continue eroding the limited amount of slack that exists in some areas of the economy. More globally, GDP growth ex-US is around 3.5%, a level of activity very much towards the upper-end of the range since the global financial crisis.

Arguably, the most relevant piece of data that we got on Friday (28 April) was the Employment Cost Index, which increased by 0.8% in the quarter (a level not seen since 2007) versus market expectations of 0.6%. This data, along with hiring relative to job openings from the JOLT report (the ratio continued moving lower) and the hiring difficulties across several districts highlighted in the latest Beige Book, point towards a full employment market – and one that could finally see pricing pressures (i.e. wage inflation).

We are likely to continue to see unemployment coming down (currently at 4.5% versus the 4.7% long-run level according to the Fed). The three-month average nonfarm payroll is still above 170k, a number that should naturally come down towards 50-100k as the Fed has been signalling for a while. Some might say this will be countered by a meaningful increase in the participation rate. But I think this is unlikely. The structural reasons that brought it down are not going away – after all, the baby boomers are not getting any younger.

Putting all the above together – healthy employment, better compensation along with elevated confidence – challenges the validity of the weak private consumption figures in last Friday’s Q1 US GDP release.

Pointing to healthy levels of economic growth

The March survey PMIs (Purchasing Managers’ Index) continue to point towards healthy levels of economic growth. Encouragingly, the pick-up in activity is very broad-based across developed and emerging market economies.

In GDP terms the current level is associated with a global real GDP above 4% (global nominal GDP above 6%). This level of output compares positively versus recent years.

Below we provide a summary of the Global Manufacturing PMIs.


Source: Bloomberg as at 9 February 2017

In the latest dataset, over 75% of the countries’ PMI indices were above 52, showing a good level of expansion, while just three economies were below 50, a level associated with a contractionary environment. This compares to a year ago when the proportion of countries above 52 was less than 50%.

In the coming months we will find out if this is simply a cyclical improvement or we are finally moving towards a structurally healthier level of global activity.

But for now the story is very encouraging.