Current negative sentiment in markets reflects perceived US / Chinese economic divergence. Chinese weakness is widely thought to be intensifying, dragging down global growth, while the US economy is deemed sufficiently solid to keep the Fed on track for an early rate hike. The suggestion is that equity investors face an unappealing combination of softening corporate earnings prospects and a higher discount rate (with real Treasury yields rising recently despite falling nominal rates).
The combination of Chinese economic weakness and US solidity at mid-year had been suggested by narrow money trends at the start of 2015. Six-month growth of US real M1 was rising strongly while the corresponding Chinese measure* had fallen to its lowest level in data extending back to 2000 – see first chart.
Current trends, however, are giving an opposite message. Chinese real M1 growth has revived, with recent policy easing suggesting a further lift, while US growth has fallen sharply, dropping below the Chinese level in July for the first time since 2013.
This suggests that Chinese economic growth will recover by end-2015, if not before, while US strength will fade. A US slowdown may arrive too late to prevent a Fed rate hike but would be likely to push back any follow-up move.
The combination of Chinese economic revival with a Fed back on hold would probably be viewed positively by equity investors.
The risk, of course, is that the US economy slows “too much”, resulting in earnings concerns outweighing relief at Fed tightening being pushed back. To rule out this scenario, it is important that US real money growth stabilises or recovers. Inflation trends should be helpful near term, with recent further commodity price falls suppressing headline consumer prices.
The view here remains that current global economic weakness is being exaggerated and that underlying momentum has recovered since the late spring. While today’s Chinese Markit / Caixin manufacturing PMI survey for August was softer again, Japanese and Eurozone readings strengthened – second chart. Yesterday’s US Philadelphia Fed survey was also solid**. The Chinese Markit PMI undershot the official PMI measure in July and may underrepresent larger companies benefiting from stimulus measures; by contrast, the Market News International business survey improved sharply this month.
*Using ”true” M1, including household as well as corporate demand deposits – see previous post.
**The New York Fed survey was notably weak but this may reflect a large fall in the Canadian dollar, which is an important influence for some state manufacturers.
Chinese monetary trends suggest an improving economic outlook. With recent easing measures yet to have their full impact, money growth may lift further during the second half.
The preferred monetary aggregate here is the narrow “true M1” measure, comprising currency in circulation and demand deposits of corporations and households. As previously discussed, the official M1 aggregate omits household demand deposits, making it less reliable as a leading indicator, particularly when the outlook for consumer spending is shifting.
Six-month growth of true M1 rose to 4.8% in July (9.9% annualised), the fastest since December 2013 – see first chart. The increase has been smaller in real terms (i.e. relative to consumer prices) but growth is nonetheless above its average over the past three years.
The six-month change in real true M1 bottomed in December 2014, recovering in early 2015 – second chart. Six-month industrial output growth reached a trough in March, moving higher through July. With real true M1 still accelerating, output growth may remain around the current level or rise further into the autumn.
True M1 expansion picked up strongly in 2008-09 and 2012 after reserve requirements and interest rates were cut – third chart. Recent reductions have been larger than in 2012. Monetary trends have already responded to these actions but a further positive impact is likely.
UK labour market tightening stalled in early 2015: employment and aggregate hours worked fell by 0.2% between the first and second quarters, while the unemployment rate edged up from 5.5% to 5.6%.
The issue for the MPC is whether this setback is temporary, reflecting slower first-quarter GDP expansion and pre-election hiring caution, or indicates a weaker growth trend and / or stepped-up productivity performance.
Vacancies, a leading indicator of employment, provide tentative support for the former hypothesis. The official vacancies series (a three-month moving average) declined between February and May but recovered in June – see first chart. Similarly, claimant count unemployment – which now includes those transitioned to universal credit – fell by 4,900 in July, the most since April.
Annual weekly earnings growth (three-month average) declined from 3.2% in May to 2.4% in June, reflecting a slowdown in volatile bonuses. The ex bonus measure was stable at 2.8%, with the private sector component at 3.3%. With average weekly hours down slightly from a year ago, hourly ex bonus earnings growth rose to 3.1%, a four-year high – second chart.
Investors have been fearful of the market fallout from a rise in US official rates in September or December. In the event, it has been the unfixing of another central bank-controlled price – the RMB / US dollar exchange rate – that has triggered turmoil.
The official explanation is that the change to the daily fixing mechanism is intended to allow the currency to be more market-driven. The question is what is meant by “more”. The only formal constraint on depreciation imposed by the new mechanism is that onshore spot can fall by no more than 2% per day. If the market were allowed free rein, the currency would probably move 10-20% lower in short order, causing major global financial and economic disruption.
The majority view is that the authorities will step in to prevent a decline of more than about 5%, suggesting that the market-driven regime will last only one more day, given a 3.5% drop over Tuesday-Wednesday. A larger fall is deemed unlikely because:
A big devaluation, if it were desired, would have occurred instantly.
A lower currency is unlikely to boost exports and growth much, if at all, because of parallel depreciations of EM competitor currencies and negative global financial / economic spillovers.
The authorities have stepped up fiscal easing recently and are probably relying on this, rather than an export boost, to revive growth.
A big fall would displease the US administration, threatening a veto of RMB inclusion in the SDR – a key official goal.
A big decline would run counter to desired economic “rebalancing” from exports / low value-added manufacturing to consumption / services.
The majority view is plausible but confidence in the authorities has been shaken by the recent stock market debacle. There is also concern that the decision to unpeg the currency is the result of an internal power struggle and there may not be a coherent longer-term plan.
The currency announcement has overshadowed economic / monetary data suggesting that growth remains weak but has recovered since early 2015:
Annual industrial output growth was 6.0% in July versus 6.8% in June but the decline reflected an unfavourable base effect. Output was unchanged month-on-month in July following a large 1.5% gain in June. Six-month growth has revived to 3.5% from a low of 1.8% in March – see first chart*.
Housing demand continues to recover, with sales volume up by an annual 21% in July.
Six-month growth of real (i.e. CPI-adjusted) M2 rose to its highest since October 2012 in July, partly reflecting “stock market QE” – officially-ordered bank loans to other financial institutions to fund price-keeping operations.
Core CPI inflation – excluding food and energy – was stable at 1.7% in July; producer price deflation mainly reflects commodity price weakness – second chart.
Global equity markets may remain under pressure until the RMB stabilises and policy intentions become clearer. The liquidity backdrop, however, is still supportive, with global real money growth – on both narrow and broad definitions – respectable and well ahead of output expansion. Bears are making comparisons with the 1997-98 Asian currency crisis but this actually proved positive for global stocks as Fed tightening was aborted – the MSCI All-Country World index rose by 12% in US dollar terms in the 12 months following the breaking of the Thai baht / dollar peg on 2 July 1997.
*Based on World Bank seasonally-adjusted level data.
Bank of England Governor Mark Carney managed to suppress hawkish dissent at the August MPC meeting but the latest Inflation Report forecast creates a strong presumption in favour of an interest rate rise before year-end.
It was always unlikely that more than one or two mavericks would defy Governor Carney’s recent signal that it would be premature to act before “the turn of the year” by voting for a hike in August. The silent hawks got their revenge by pushing through a rise in the inflation forecast two to three years out, putting them in a solid position to carry the day in November, barring downside data surprises or adverse financial market developments.
The best summary measure of the MPC’s collective view is the mean forecast for inflation in two years’ time based on unchanged policy. This was raised sharply from 2.35% in May to 2.60% in August. The 0.6 percentage point overshoot relative to the target is the largest positive deviation in the MPC’s 18-year history and sends a clear signal that rates need to start rising soon if the path back to neutral is to be “gentle”, as Governor Carney has promised.
Sterling initially fell on today’s news, with the market giving more weight to the 8-1 August vote than the hawkish forecast – wrongly, on the assessment here.
(A monetarist gripe: The structure of the Inflation Report has been changed, with a previous chapter on “Money and asset prices” replaced with “Global economic and financial developments”. There is no reference to money anywhere in the book – striking even by the Bank’s standards.)