Let’s get it over and done with

by: Han de Jong

This is our last Weekly for the year. But the title refers to the Fed, not the calendar year – nor our Weekly. The US FOMC is meeting this Tuesday and Wednesday. It is a close call whether or not they will start the tapering of their asset purchases. It would be wise in our view, for the Fed to provide some more clarity on how and when it wants to proceed. If not, uncertainty will persist, which will likely prove bad for the real economy and for equity markets. Should they decide to announce tapering, I think that we could see some ‘buy the rumour, sell the fact’ behaviour, with a more positive tone appearing after the inevitable initial volatility.

Key data on the global economy included robust US retail sales, strong Chinese exports and weak European industrial production data, while Greece is sinking deeper and deeper into deflation. On balance, our main scenario of a gradual but material improvement in global economic growth remains on track.

Clarity on the taper would be welcome

Financial markets are nervous about the Fed’s tapering. Equities are correcting and have been displaying perverse ‘good is bad’ behaviour in recent weeks. Volatility is on the rise. Corporates have held back on investment spending with the uncertainties over policy issues as a possible explanation. Fed policy may be one of the uncertainties. It seems to me markets are pressing the Fed to show the colour of its money.

We have thought for a while that the Fed would wait to announce tapering until March, as economic data is arguably not compelling enough to give the Fed sufficient comfort to start earlier. The distortion to the data following the government shutdown also argues for the Fed to wait. It must be said, however, the chances of some sort of an announcement this week have increased materially. It is clear that the US labour market is improving at a reasonable pace. In addition, last week’s US retail sales data was very solid, indicating that consumer spending growth is gaining momentum. Also, a budget deal was reached last week and accepted by the House of Representatives. While the Senate still has to give the deal the OK and while the deal is not particularly impressive, it takes budget uncertainty and the risk of another shutdown out of the equation.

Another area of consideration for the Fed is the likely reaction in markets. When Bernanke announced tapering last May, markets responded particularly badly. Bond yields rose sharply, potentially weighing on the recovery in the housing market and causing more than a couple of ripples on financial markets around the world. At that time, the markets were taken by surprise. The situation is now very different. The economy is stronger. Yields are higher and the yield curve much steeper, leaving less room for a further rise. The Fed has had time to explain that tapering and policy tightening are not the same, so expectations for official rates should remain better anchored. Last, instead of being taken by surprise, a large number of market participants and Fed watchers are now expecting something. They would be disappointed if the Fed did not create more clarity. At this stage, it could be argued that continued uncertainty would be worse than the tapering itself. I am not convinced that tapering will start in the very short term, but I do believe that it is likely the Fed will create more clarity. If they do so, either by announcing tapering or by laying out some sort of a credible path to tapering, markets would likely be relieved. As stated before, however, it is a very close call.

Another European summit coming up: no crisis atmosphere

European leaders will gather for their December summit this week. They have planned to reach an agreement on the single resolution mechanism, part of the banking union. Such deadlines are often missed and the issues involved are complex and controversial. However, it looks like the summit will be able to reach a deal. This shows the commitment of all involved to establish the banking union and, more generally, to move ahead in building a governance structure that will secure the euro. I regularly ask people if they believe the euro crisis is over. The majority don’t. And I think they are right. However, it is also correct to say that many key battles in this war for euro sustainability have been fought, and won! And that it is hard to see what can happen that would force the policymakers yet to throw in the towel on the euro.

Meanwhile, Ireland has exited its bail-out programme. The country was the second to knock on the door of the IMF, the ECB and the European Commission for financial support, which was provided with the usual conditionality attached. Ireland managed the three-year programme relatively smoothly and successfully. The public finances are much improved, though a decent amount of work remains to be done. In addition, the problems in the banking sector are being addressed, though here, too, some work still needs to be done. In any case, competitiveness is much improved and some growth has come back in the economy. The end of the bail-out programme was greeted in Ireland as a return to sovereignty over economic policy. That is fine. One hopes that Irish policymakers use that freedom better than they did before the crisis.


Poor production data for the eurozone

Eurozone industrial production fell 1.1% mom in October – very disappointing – though September’s number was revised from -0.5% to -0.2%. These poor numbers appear to be at odds with business confidence data which has been strong recently. So what do we make of the production data? A couple of points need to be made. First, the production data in the eurozone can be volatile and is certainly prone to sometimes significant revisions, which can occur even after a long time. Second, while the September and October data disappointed, October registered a 0.2% rise yoy, the same as in September, which was actually the best yoy reading in two years. Third, the main, though not only, culprit in October output data was the energy sector, where output fell 4.0% mom. Last, the divergence between confidence and hard data cannot last for very long. In our opinion, confidence data has a better track record for describing what is going on in the economy, so we expect the gap between production and confidence to be reduced by an improvement in the production data in the months to come. Energy production remains a caveat. So far, the weather in Europe has been relatively mild moving into the winter, which will have kept energy use and production in check.

Another gap is opening up in France. In this case it is between the Banque de France’s Business Sentiment Index and the PMI. The PMI has recently weakened, which has been in contrast to developments in most other eurozone countries. This has raised concerns over the French economy. But the Banque de France’s gauge of business confidence continues to improve. The November reading was the fourth consecutive monthly rise and the highest in over two years. While concern over France is understandable, I am inclined to think that some of the short-term anxieties are perhaps a little exaggerated. The Banque de France’s measure of confidence has a much longer track record and seems to have a stronger relationship with output trends.

Greek deflation is rapidly getting worse. The November consumer price level was 2.9% lower than a year earlier, down from -2.0% in October and 0.0% in January. Conventional wisdom has it that deflation is bad as it raises the burden of debt in real terms and may lead consumers to postpone spending, which is thought to be bad for overall demand in the economy. I question whether this logic applies to a country like Greece where the downturn is enormous. The increase in the real burden of debt is due more to the decline in activity than the decline in prices. The economy has shrunk by a quarter or so. How much additional damage does a 3% decline in prices do? In any event, an increase in the real debt burden is more of a concern to foreign creditors than to the Greeks. As far as deflation making consumers delay spending, Greek consumers were never going to be the ones pulling their economy out of depression. The only way out for Greece is to increase exports by improving competitiveness. Falling prices are helping this process, which was confirmed last week by the Q3 national accounts data. The Greek economy was 3.0% smaller in Q3 than a year earlier. That does not sound great, and it isn’t, but it was the best performance since early 2010. On a seasonally-adjusted basis, our estimates point to the second consecutive quarterly rise. Furthermore, exports were up 5.7% yoy, the most positive driver.


UK, Japan and China

UK industrial production growth continued to strengthen in October (+0.4% mom and +3.2% yoy), underscoring the recovery in the UK. The housing market seems to be gaining momentum particularly rapidly. The RICS survey for November showed continued strength. Expectations for sales rose sharply again to a new all-time high. It could be that the surveyors are a little unrealistically euphoric after a period of hibernation. But apart from that possibility, these indicators are already starting to look ‘frothy’.


Japanese data generally confirmed the ‘so far, so good’ theory. True, Q3 GDP growth was revised down a little, but other data was stronger. October industrial production was revised higher, machine orders and machine tool orders are gaining momentum, the eco watchers survey improved, while the percentage of vacant office space in Tokyo declined in November, continuing a trend that started just over a year ago.

Chinese data was mixed last week. Growth of industrial production was a little lower than expected, but retail sales growth accelerated from 13.3% yoy in October to 13.7% in November. Exports were also very strong. Some commentators suggest that the recent strong improvement is due to exporters overstating exports. That is hard to verify, we will have to wait and see.

All in all

All in all, we end the year on a positive note. The global economy is gaining momentum and we think it will reach trend growth in 2014. Inflation is set to remain low and imbalances are set to shrink further. As always, there are risks and challenges. For example, we may be wrong thinking that the tapering by the Fed will be taken relatively well by financial markets. In Europe, the euro crisis could re-escalate or the Asset Quality Review of the banks’ balance sheets may lead to unpleasant surprises. In emerging economies, growth may weaken or their financial markets could get hit by capital outflows when the Fed tapers. Last, there is always event risk and geo-political risk.

We would like to take this opportunity to thank our readers for their interest in our work and their support and wish everybody a healthy and happy 2014.