Macro Weekly – Redeeming a promise

by: Han de Jong

  • Industrial output growth strong in many countries
  • US and UK lagging
  • UK looking vulnerable, is it Brexit-fear?
  • Confidence indicators are turning down, where to next?
Macro-Weekly-4-August-2017.pdf (147 KB)

Business confidence indicators have strengthened for some time. In fact, many of these indicators have reached remarkably high levels in recent months. Economists have been surprised and disappointed by what they call hard data such as output growth, employment, GDP etc. The confidence data are thought to describe what is going on in the economy, but the optimism reflected in them was not matched by this harder data. This is now changing. The strong confidence indicators appear to be redeeming their promise, at last.

Some qualification of the data is in order. This data can be erratic from month to month, can sometimes be flattered by base effects and there are differences in definitions. However, the picture is quite clear: robust momentum in Asia and the eurozone, modest growth in the US and disappointing performance in the UK.

The relatively good performance in Asia and the eurozone is most likely due to a variety of factors. The stimulus Chinese authorities have provided in the past is clearly still effective. Their more recent efforts to slow lending growth have not yet affected the economy. But we still believe they will and we continue to expect some slowing going forward. For now, however, the Chinese economy is gaining some momentum and the countries in the region are benefitting as evidenced by Korean and Taiwanese export growth, while Japan is probably also enjoying the ride.

Stronger growth in Asia is undoubtedly also a tailwind for the eurozone, but these economies are also experiencing stronger domestic demand growth, as, for example, evidenced by German factory orders. They grew by 1.0% mom in May on the back of a strong increase of domestic orders and by 5.1% yoy.

Recently published GDP numbers for the eurozone confirm the positive trend. GDP grew by 2.1% yoy in Q2, the strongest since 2011.

The US is lagging

The US is clearly not the growth engine for the global economy it so often is. In fact, economic data has generally disappointed recently. I think this is partly noise and partly simply a reflection of the short-term up and downs in an economy. In addition, we need to bear in mind the US economic recovery is in its eighth of ninth year as opposed to the eurozone recovery, which is really only in its fourth year or so. There is more slack and pent-up demand in the eurozone than in the US. Finally, there may be a lagged effect of the dollar’s appreciation of the second half of last year, while the Fed’s four rate hikes since late 2015 are in contrast to the ECB’s policy which has consisted of sustained asset purchases since March 2015.

Despite US growth momentum lagging the eurozone’s, it is hard to see the US economy getting itself into a situation where one would have to fear for a recession. The late-cycle excesses that typically occur before a recession simply aren’t there. In addition, while the yield curve has flattened since early this year, it is far from inverting, the typical financial market signal of an approaching recession.

That does not mean that a recession couldn’t start during the next 12 months or so. But, in my view, this would require a Fed that is too hawkish. And that, to be honest, is certainly not impossible. The Fed has so far dismissed surprisingly low inflation as ‘transitory’. I think that is a mistake. If I am right and inflation will remain below the Fed’s target of 2% for a long period despite reasonable growth, the risk is that the Fed’s estimate of the neutral level of nominal interest rates may be too high. They could, therefore, easily tighten more aggressively than is warranted and then the economy can bear. The fact that Janet Yellen’s term as chair will end early next year complicates matters as it is unclear to what extent policy consistency is guaranteed under her successor.

Is the UK showing Brexit-fear

The UK economy did not fall into a hole after the Brexit referendum last year. This had the Brexiteers ridicule the scaremongering Remainers. The most recent developments in the UK economy should make them think twice. The exit from the EU is unprecedented, making it impossible for econometric models to produce reliable forecasts. We simply do not know how economic agents will behave under these circumstances. What we can observe is that growth of industrial output in the UK has fallen significantly behind that in other countries. And this is despite significant tailwinds. As other countries, the UK must be benefitting from stronger world trade growth. In addition, the depreciation of sterling following the referendum must have strengthened UK competiveness. If anything, UK industrial output growth should be stronger, not weaker than in other countries. For lack of other obvious explanations, this strongly suggests that we are experiencing effects of the Brexit process. Companies seem to have scaled back investment plans, etc. GDP growth has held up reasonably well (even though the yoy growth rate has now fallen below that in the eurozone which is a rare development) but is highly dependent on consumer spending. In turn, strong consumer spending has relied on a drop in the savings rate, an unsustainable development. In our view, the UK economic outlook is not bright and we repeat our view that the Bank of England is unlikely to raise rates against such a background.

Confidence indicators turning down

As I mentioned above, business confidence indicators have been on a steady rise for some time, essentially since early 2016, reaching multi-year and in some cases multi-decade highs. Such indicators cannot continue to rise. What goes up must come down. A number of these indicators have softened a touch recently. The question is how worrying that it. I think not very. I see no reason why the economic expansion should not continue for some time yet and I do not see any reason for a sharp deceleration. The biggest two risks, in my view, are that Chinese policymakers step on the brakes too forcefully and that the Fed tightens too aggressively. As the business confidence indicators are a reliable guide for gauging what is happening in the economy, we need to follow them closely to see if the decline in some of them becomes more widespread and how sharply they will come down in the months ahead. At least for now, I think we are in a good place.