Upward revisions, at last!

by: Han de Jong

It has required a significant amount of patience, but upward revisions to growth forecasts have, finally, arrived. Last week, the ECB, the Bundesbank and the UK’s OBR raised 2014 GDP growth forecasts. The beginning of a trend?

Having surprised markets by cutting rates last month, ECB president Mario Draghi was less dovish than expected this time. I am struggling to understand these swings.

The majority of economic releases during last week supports the view of a stronger global economy. There are some signs that market participants are getting over the ‘good news is bad’ fallacy.

A milestone: upward revisions

Economists’ forecasts often lag the cycle rather than leading it. As economic conditions gain or lose momentum persistently, economists raise or lower their economic forecasts, following yet another good or bad piece of data. The most interesting phase in the cycle is a turning point. When economists stop revising their growth forecasts downward and, instead, start raising them, you know that something positive has happened. (Much) earlier this year I made the forecast that after a very long period of constantly revising growth forecasts downward, economists would start raising them some time later this year. This moment has, finally, arrived. Last week, the ECB raised its forecast for 2014 eurozone GDP growth, albeit by a meagre 0.1% from its September forecast. The Bundesbank raised its forecast for German GDP growth in 2014 by 0.2%, while the OBR in the UK bumped up its 2014 forecast by no less than 0.6%. A typical case of rational exuberance, perhaps? Now, let’s hope that this sets the stage for a prolonged period of upward revisions

Mario, why so erratic???

Mario Draghi was less dovish than market participants had expected/hoped for at the ECB’s press conference last week when he announced that nothing was changing in the ECB’s policy stance. This was a stark contrast to last month when the ECB surprised the market by cutting rates. The result was that market participants were disappointed last week. In my opinion, Draghi could and should have at least made an effort to sound more dovish than he did. My way of reasoning is straightforward. Inflation is currently below the ECB’s target and, even on the ECB’s own forecasts, set to stay below target for the next two years. Money growth is decelerating. M3 growth amounted to 1.4% yoy in October, down from 3.5% at the end of last year. In the good old days, the ECB had a ‘reference value’ of 4.5%. It is fair to say, I think, that money growth is also below target. Credit growth to the non-financial corporate sector is negative. So that must also be considered ‘below target’. Economic growth is perhaps picking up, but certainly not high and the economy is running well below capacity. Also ‘below target’. And on top of this, the trade-weighted exchange rate of the euro is up some 8% yoy. This must be considered an unwelcome monetary tightening. It would seem to me that all these factors lead to the conclusion that monetary conditions are too tight. I admit that perhaps we need to let last month’s rate cut have its full impact, but I don’t understand why the ECB President is more dovish than expected one month and then less dovish than expected a month later. If negative interest rates are not really a significant option and asset purchases are difficult, why not at least try to talk the currency down a bit? Everybody else is doing it! As it happened, Draghi managed to talk the euro higher!

To its defence, the ECB can argue that inflation, money and credit growth etc. are all below target not because monetary conditions are too tight but because the monetary transmission mechanism isn’t functioning properly. If that is their assessment, they must decide whether or not they can do something about it. They could try to set up something similar to the UK’s ‘funding for lending programme’. In any event, lethargy is undesirable.

It is not our main scenario, but there is a risk that the ECB is letting the eurozone economy slip into deflation. What then?

The best defence against damaging deflation, in my view, is growth. And it looks like the eurozone economy is developing some more growth momentum. The PMI surveys in most countries showed strength, though not in France. The services sector PMIs were weaker than the manufacturing ones, though not in Germany where the manufacturing PMI rose from 51.7 in October to 52.7 in November, while the services PMI jumped from 52.9 to 55.7. On the downside, German factory orders were weak in October, falling 2.2% mom after a 3.1% rise in September.

Momentum building in the US

While economic data was mixed in the US, the picture that is emerging is unambiguous: economic growth is strengthening. Most business confidence indices support an optimistic view at this stage. In addition, personal spending data was strong in October and after two weaker months, vehicle sales accelerated in November, reaching their highest level since 2007. Consumer confidence was also strong. The University of Michigan’s index rose from 75.1 in November to a preliminary 82.5 in December, getting close to the levels reached before the budget impasse. This suggests that the government shutdown temporarily affected confidence. Q3 GDP growth was revised up substantially: 3.6%, versus 2.8%. That is a substantial revision for a second revision. It was mainly driven by stronger stock building. Inventories actually contributed 0.8% more to growth than earlier expected. Nevertheless, that is too simple an explanations. Part of the inventory build came through imports, which shaved 0.2% off GDP. Initial jobless claims, as well as labour-market stats such as jobless claims (298K and the lowest in a while), the ADP numbers on job creation (215K, the highest in a year) and the payroll data (203K, better than expected), are all saying that the improvement of labour-market conditions is continuing and strengthening. New home sales for August were weak, but they rebounded strongly in September, suggesting the economy is adjusting to higher mortgage rates. On the other hand, mortgage applications were soft in the latest week.

No more “good is bad”?

Financial markets have been in ‘good is bad’ and ‘bad is good’ mode for months. Weak data spurred risky assets on as market participants interpreted weak data as increasing chances of prolonged ultra-easy monetary policy, which was seen as supportive of risky assets, while good data were deemed to bring tapering and rate hikes closer. I argued here some weeks ago that this line of thinking will ultimately be a fallacy and will have to change sooner or later. Risky assets can only perform well if corporate earnings and credit quality improve, which can only happen in a scenario of decent, preferably accelerating economic growth. Last Friday saw perhaps the beginning of the change in attitude. As Friday’s economic data was strong, it was initially interpreted as bad for equities, but then the market changed its mind. I suspect the fear for tapering is overdone. We think the biggest impact of tapering will likely be the announcement effect, which we may already have behind us. And despite the significant rise in bond yields on either side of the Atlantic during the ‘tapering dry run’ from May to September, equity markets in the US continued their upward trajectory, suggesting they are resilient.


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