Macro Weekly – Bright spots

by: Han de Jong

  • We have made some material, but largely backward- looking adjustments to eurozone growth forecasts
  • Positive eurozone money and credit data
  • Eurozone confidence data continue to soften, but only modestly and still at high levels
  • Asian industrial production data improving
  • Political risk remains
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Financial markets have had a lot to worry about in recent months: surprisingly soft macro data in Europe and, to some extent, Asia; the escalating trade conflict; disagreement within the EU about migration; the new left-and-right populist government in Italy; continued Fed tightening, etc. In general, markets have not done too badly, in my view. Emerging markets have perhaps been the hardest hit with many EM equity markets in negative territory since the start of the year, bond yields up and many currencies under pressure. Commodities have also had a difficult time recently. Other markets for risky assets have done a little better.

The yuan seems to be a key driver

The two main problems, in my opinion, are the weakness in some economic data and the trade conflict, which has translated in pressure on EM currencies. On the latter, as my colleague Georgette Boele points out in her FX Weekly ‘FX Weekly – Steunniveau houdt nog stand’ (in Dutch only), the Chinese yuan seems to have played a key role. While it is not clear if the yuan has been driven recently by policymakers or by private sector flows, it is striking that the currency has lost some 4% since the middle of June. Other EM currencies have followed suit. A 4% depreciation of the yuan over a two-week period is a lot. During this period of rather sudden and sharp yuan depreciation risky assets have sold off. My interpretation is that the yuan weakness is causing nervousness in other markets. It is striking, for example, that the S&P500 has struggled during the period of yuan depreciation. The same is true, even more so, for commodities.

Enough is enough

Chinese policymakers can exert a firm grip on the exchange rate and I think they will not allow their currency to weaken much further. Perhaps the Chinese policymakers triggered the currency to weaken as a sign to the Americans that they will retaliate trade restrictions one way or another. If that is the case, they surely would not want to exaggerate at this point in time. A very sizeable depreciation would just lead to a further escalation of the conflict and may threaten financial stability in China. Besides, if Chinese policymakers are using the exchange rate as a policy tool, they will undoubtedly want to keep some of their powder dry. If, on the other hand, the yuan has been mainly driven lower by non-resident private-sector capital outflows, then allowing a further  depreciation could be a threat to financial stability. On balance, I therefore expect to see a little more stability before too long. That should support the mood on the markets for risky assets. The possibility of a further escalation of the trade conflict is obviously a serious risk here.

 

Finally some bright spots in the eurozone

Disappointing economic data in the eurozone has been a main characteristic of recent months. Looking at the most recent set of data, I think it is fair to say that some bright spots are starting to appear, although not everything is looking good. First, key confidence indices appear to continue to weaken in June, but the decline is limited and the absolute level of confidence remains high compared to history, The European Commission’s Economic Sentiment index, for example, fell from 112.5 in May to 112.3 in June. That is the lowest level since August last year. But excluding the period from August last year on, the June reading was the highest since 2007. The picture painted by the German Ifo index was a little worse, but perhaps the gap between the two reflects the fact that Germany business is more under pressure from the threat of restrictive US trade measures than other eurozone economies. Another indicator that isn’t looking great is French consumer confidence.

On the other hand, the ECB’s money and credit numbers provided some better news. M3 growth accelerated in May from 3.8% yoy in April to 4,0%. M1 growth accelerated from 6.9% yoy to 7.6%, having fallen in seven consecutive months. Growth of credit to non-financial corporates amounted to 3.6% yoy, against 3.3% in April, the highest since 2009.

Asian industrial production numbers improve

Data on industrial production in several Asian economies also improved in May. Japanese output growth stood at 4.2% yoy, versus 2.6% in April and a trough of 1.6% in February. Korean industrial production was a meagre 0.9% higher in May than in May 2017. That is by no means spectacular, but fractionally better than April, which was 0.8%, and a lot better than February’s trough of -6.8% yoy. With a growth rate of 11.1% yoy Singapore’s production numbers were simply impressive in May. The growth rate of industrial output in Taiwan eased a little in May, but stayed impressive at 7.05% (versus 8.82% in April).

It would seem to me that the soft patch so clearly visible in European data was mainly linked to decelerating world trade growth, which, in turn, was linked to decelerating growth in manufacturing. But with industrial production data in Asia improving, the fall in confidence in Europe bottoming out and money and credit data in the eurozone improving, I conclude that the end of the soft patch is coming in sight. I am not saying we will have a material re-acceleration any time soon, but at least we will not really have to fear for an actual downturn.

Downgrading eurozone GDP growth forecasts

Having said that, as the data has been considerably softer than we had anticipated earlier and given that the weakness has been more persistent than we had hoped for, we have lowered our growth forecasts for eurozone countries and, thus, for the eurozone as a whole. We now expect eurozone GDP to grow by 2.2% this year, against an earlier expectation of 2.8%. Next year’s forecast of 2.3% is reduced to 2.1%. Taken together, that is a material downgrade and it pushes our estimate for world GDP growth down from 3.9% to 3.7% this year. The cut in growth estimates for 2018 is largely, but not entirely, backward looking.