2015 is shaping up to be another year of more negative global growth surprises than positive ones. Financial market participants and policymakers have to ask how bad it really is. I would suggest to be patient. Global growth is perhaps not great, it is not a disaster either. And we continue to believe that growth will pick up. The picture that is likely to emerge in the course of the year is actually a relatively benign one with improving growth, modest inflation and central banks determined not to rock the boat.
The week just gone by was relatively light on economic data. Eurozone data had consistently surprised positively earlier this year, but that pattern is now changing. Perhaps expectations have adjusted to the relatively favourable performance or perhaps the tailwinds (oil, the euro exchange rate) have eased a little or perhaps the disappointments elsewhere are weighing on activity. Nevertheless, I don’t think recent data is particularly negative. Germany’s authoritative Ifo index of business confidence fell marginally in May (108.5 versus 108.6 in April).
The long-term average for this series is 101.4 and its range over the last 25 years has been 114-84. Having said that, it is true that the forward-looking part of the survey has now fallen for two consecutive months. This is essentially a trend we see in many other indicators in the eurozone. I simply do not see why growth in the eurozone should weaken significantly in the near term. In fact, I see reason for optimism. The credit channel continues to unclog. And the recent preliminary PMIs showed an improvement in the manufacturing sector after a one-month decline. Manufacturing is more cyclical and tends to be leading other sectors in the economy. The similar gauge in Japan was stronger in May than expected and registered its first rise after three monthly declines.
The big unknown really is the US. After a disappointing start to the year the US economy was expected to bounce back as the earlier weakness was thought to be caused by temporary factors. Recent data, however, is unconvincing. This raises the question as to whether we should still expect the economy to gain momentum soon or whether there is a more fundamental problem.
Consumer spending has not been poor, but consumers have certainly not (yet) spent their windfall from the lower oil prices. Various theories are offered as explanation. Some suggest that consumers are cautious because they continue to strengthen their balance sheets. That is not very compelling to me. Of course, if consumers do not spend their unexpected gain in purchasing power the inevitable result is that the savings rate rises and this can be seen as an strengthening of balance sheets. The problem is that we do not know if the rise in the savings rate was intentional or happened by default. Looking at consumer confidence surveys it seems to me that it is hard to argue that consumers are particularly worried. So my guess would be that it is by default. This is a pattern we have seen before following sharp declines in oil prices. So: let’s be patient.
Another explanation offered is that consumers will not spend their windfall if they think that the drop in oil prices will not last. That could be the case. Indeed, oil prices have risen sharply since their trough in January. On the other hand, we think current conditions in the oil market suggest there is a significant glut. In fact, we think that oil prices are more likely to fall in the near term than to rise. In any event, we believe that at least part of the fall in oil prices will prove to be durable. As a result, it seems reasonable to assume that consumer spending will strengthen in the course of the year.
Emerging economies not looking fantastic
Momentum in emerging economies has been relatively poor this year, at least in Asia and Latin America. I have commented many times before on this. We do not expect major changes on this front. That means that we do not expect a spectacular improvement, but, equally, we do not expect a material further deterioration either.
Taken together this means that we expect the global economy to show accelerating growth in the course of the year. Against that background, inflation should remain very subdued and central banks will be keen not to cause any shocks.
The ECB’s position is very clear. It has started a QE programme in March and, so far, feels that the programme is very successful. The recent sharp rise in bond yields came as a surprise and I see that commentators are trying to explain why it happened. It seems to me that the more difficult question is why investors were willing to hold so much paper at negative yields before they rose. Meanwhile, the sharp rise in yields, even if it was from hard-to-explain yield levels to still-extremely-low yield levels, has alarmed the ECB. And understandably so. I do not think that the ECB is worried about 10-yr Bund yields at 0.60% but if the rise were to continue and, as a result, the euro were to strengthen significantly, that would not be welcome. The ECB’s response has been clear. Through some statements and a commitment to increase purchases in the near term, the ECB has made its intentions very clear. They will try to resist a sustained rise in yields or the euro. And the market has listened: Bund yields have stabilised and the euro has given back some of the gains it had made.
US Fed’s position more complicated
The US Federal Reserve is in a more complicated position. It ended its QE programme over half a year ago and now has to determine when to take the next step in the process of normalising monetary policy, and what that step should be. Until recently, it seemed quite obvious. The economy was growing above trend, the labour market was getting tighter and it seemed just a matter of time for the Fed to raise rates. It still is, in our view, as we are optimistic on the cyclical outlook.
However, given recent economic weakness, the Fed cannot be sure that the economy will gain further momentum. In addition, there is a question as to whether or not inflation will accelerate. I attended a conference this week organised by the Bundesbank and the US National Association for Business Economics. Charles Evans, the president of the Chicago Fed was the keynote speaker. He held a compelling argument that the Fed should not be in any sort of hurry and should only move when it is absolutely certain its inflation mandate is achieved. The Fed has an inflation objective of 2%. This is an average they should achieve over a longer period. The measure used is currently standing at 1.3%. Evans pointed out that the Fed has undershot its inflation target since 2008. It is damaging to a central bank’s credibility to undershoot its inflation target for a long time as that will have an undesirable impact on the behaviour of economic agents. Evans believes, having undershot the target for almost seven years now, the Fed should aim to overshoot the target for a while in order to establish credibility that its target is a symmetrical target. If it was up to Evans alone, I think any tightening of US monetary policy would be in the distant future.
To be honest, I have a lot of sympathy for Evans’ argument. However, he is an acknowledged ‘dove’ and his view is clearly on the fringe of the whole FOMC. I pointed that out and asked him if he felt he would be able to convince his colleagues on the FOMC that they should hold off? His response was that he did not know. He added that the date of the expected first rate hike has been consistently pushed into the future for a long time. Our view remains that the first hike will take place in September. But we acknowledge that the risks that it will be later are considerably bigger than that it will be earlier. In any event, the Fed will be keen not to give rise to shocks on financial markets.