Macro Weekly – Brexit and a possible Fedxit

by: Han de Jong

  • Mrs May reaches deal with EU, but loses part of her cabinet
  • German economy contracts in Q3, but this is due to temporary factors
  • Jerome Powell pre-announced December hike but also talks about headwinds
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British PM Theresa May and her team have reached a deal with the EU about how the UK will leave the EU. In the immediate aftermath several ministers and junior ministers resigned. The PM then headed to parliament where a ‘lively’ session took place. Meanwhile, a number of senior members of the Conservative Party are preparing a leadership vote to get rid of Mrs May. I must say, I was never her biggest fan, but I really feel sorry for her and I am very impressed by her persistence and attitude (not that my opinion/admiration matters, of course).

It remains hard to say how this will develop further. My understanding is that Mrs May has a good chance to survive the party leadership challenge. Whether she gets her deal through parliament remains to be seen. Don’t be fooled by the emotion shown in the parliamentary debate. That was a chance for MPs to let themselves be heard, too good an opportunity for politicians to miss. But when it comes to voting, they must and will consider the alternatives. Rejecting the deal will cause significant chaos. It risks the UK crashing out of the EU without a deal, which will be a shock to the economy. Rejecting the deal may also lead to general elections and the chance that Labour will gain a majority with Jeremy Corbyn replacing Theresa May as PM. Our baseline scenario, therefore, is that parliament will eventually approve the deal, but our confidence level is relatively low. The chance of a total political stalemate and chaos is significant.

The German economy contracts in Q3

German GDP contracted by 0.2% qoq in Q3. This was slightly worse than expected and the first negative growth number since early 2015. But things aren’t as bad as the number suggests. Admitted, growth has slowed this year, but the main problem in Q3 was the car industry. The new emission testing procedures that started in September appear to have caused a significant drop in production. German car production was 20% lower in Q3 than in the same quarter last year and 23% lower than in Q2 2018. As car production accounts for almost 4% of German GDP, this has had a big negative impact on overall GDP. While car output is unlikely to be very strong in the period ahead, October saw a meaningful improvement. October production was 22% above the average monthly and 7% higher than in October 2017. One has to be careful with all these numbers, they are volatile and not seasonally adjusted. But it is safe to assume that German car manufacturers will get their act together and that a bounce in production and therefore in the growth of overall German industrial output and GDP growth is likely to occur in the months ahead.

The ZEW index for Germany, which measures economic confidence among analysts, weakened in November. Confidence has fallen all year, albeit from exceptionally high levels. The subseries reflecting the confidence level in the current situation in Germany appeared to stabilise in August-October, but fell sharply in November. I suspect that this is at least partly due to the problems in the car sector becoming obvious and the turbulence on equity markets. My best guess is that the sharp drop in November is temporary. Also note that the index is still much higher than late 2014 when the economy weakened significantly.

China stimulus working?

We have long argued than an underlying slowing of the Chinese economy may be an important factor in the slowing of world trade growth and in the growth rate of the industrial sector in many countries. Bear in mind that many Chinese data do not support that theory as they have remained relatively robust. It is clear, however, that Chinese policymakers have changed direction in recent months, putting less emphasis on deleveraging the economy and more on providing support for growth. Whether they are doing that because the economy may have slowed more than they are willing to tolerate or whether they are, proactively, trying to compensate for possible negative effects of the trade conflict with the US is not clear. Perhaps it is a bit of both. In any event, it is clear that public investment growth has slowed very significantly since the middle of 2016. That seems to be a reflection of the policymakers’ efforts to deleverage. As my colleague Arjen van Dijkhuizen recently wrote[1], the more recent efforts to support the economy may be starting to produce results. Growth of public investment has picked up recently. In addition, the growth rate of investment in fixed assets in manufacturing has accelerated since March, when the yoy growth rate amounted to 3.8%. The October number was 9.1%.

Mixed US data

Recently released US data was mixed. Two closely followed indices of business confidence moved in opposite direction in November. The so called Empire State index, a survey among 200 executives in the manufacturing sector in the state of New York, rose from 21.1 in October to 23.3 in November. It has essentially been moving sideways at a high level this year. The Philly Fed index, which is based on a survey among 125 chief executives in the district of the Philadelphia Fed, fell from 22.2 in October to 12.9 in November. The November reading was the second lowest in the year and also the second lowest since November 2016. This survey is conducted in the first week of the month and the result may have been affected by the stock market turbulence of October. US retail sales were strong in October, rising 0.8% mom after a small drop of 0.1% in September. So the consumer appears to be still going strong.

US inflation remained modest in October. Headline CPI inflation accelerated from 0.1% in September to 0.3% in October as the yoy rate moved up: 2.5% versus 2.3%. However, core inflation amounted to a slightly more modest 0.2% mom and yoy rate eased from 2.2% to 2.1%. Shelter costs remain the main culprit. Excluding shelter, core inflation was a mere 1.6% yoy. I realise people have to pay for their homes. But my point is that the tightness in the labour market and the high degree of capacity utilisation are not (yet?) generating meaningful and problematic inflation.

Jerome Powell identifies headwinds for the US economy in 2019: Fed may pause!!

In a ‘Global Perspectives’ session at the Dallas Fed, Jerome Powell, Chairman of the Federal Reserve system, made it quite clear that the Fed is on course to raise rates again in December. No surprises there. What was a surprise is that he mentioned headwinds to US growth in 2019, suggesting that the Fed may pause its tightening some time next year. He identified exactly the factors why we have long thought the Fed will pause, or even end its tightening for this cycle in 2019. Powell said that global trade poses a downside risk to the US economy. He also said that the fiscal stimulus will fade next year and that previous rate hikes are already starting to make themselves felt. On that latter point, we have highlighted that car sales and home sales have softened this year. These sectors are interest rate sensitive. So, indeed, previous hikes are starting to have an effect. I would add that inflation remains very subdued so there is no need for the Fed to be aggressive and risk overshooting and in doing so, causing a recession. In fact, Powell seems to be keen to try and avoid an overshoot. An early pause in the tightening cycle would increase the chance of the current cycle becoming the longest period of uninterrupted economic growth on record (records going back to the late 1800s).

It remains to be seen to what extent these considerations are going to be reflected in changes in the ‘dot plot’, the projections of FOMC members of future rate hikes. So far, the median projection is for 5 more hikes this cycle. The market is pricing in only 2 to 3, our view has long been 3. If the Fed actually delivers the 5 they are currently still projecting that would require an adjustment in markets which might be painful for risky assets around the globe. If, on the other hand, the median projection comes down a little at the December FOMC meeting, that would be a great relief for risky assets.

[1] 14 November 2018 – Short Insights – China: first signs of support kicking in