Standard Life Investments

Weekly Economic Briefing


Global Overview - Serving up a recovery

One of the big stories of 2017 has been the robust recovery in the global industrial production and goods trade cycles. However, less attention seems to fall on the services sector, even though this accounts for more than two-thirds of global GDP, and creates more jobs than any other part of the economy. Here the narrative has also been generally positive. Survey data suggest that global services activity has moved up a gear over recent quarters to a two year high (see Table 1). This reflects an improvement in reported new business, optimism around future activity, increasing backlogs of work and rising employment intentions. Overall, these data provide some comfort that the improvement in activity seen since last year has extended beyond the industrial sector. Indeed, this should help reinforce the view that while a further acceleration in global activity looks unlikely, the recent cyclical upturn does not look set to peter out.

We can identify some interesting nuances at the country level from our heat map. The improvement in services activity has been easiest to see across the developed economies. In particular, survey data from the US and Eurozone suggest strong growth relative to history. Activity looks more muted in Japan. While this still represents an improvement on 2016, the still subdued activity in this sector reflects the importance of external demand in Japan’s recent growth upswing. The UK is something of an outlier, with services activity having stuttered as rising inflation weighs on consumer spending power. Survey data from emerging markets is generally pointing to subdued activity relative to history, although this may well reflect structural deteriorations in growth over the past decade. Indeed, from a cyclical perspective, the services sectors in both Brazil and Russia are showing signs of improvement following a deep recession, likely helped by falling inflation and lower interest rates. Activity in India, meanwhile, looks to have softened, reflecting continued fallout from demonetisation and a new sales tax. In China, rebalancing to the services sector remains a policy priority, although survey data do not seem to corroborate the strong services activity reported in national accounts. More generally, poor data availability around this sector makes it hard to judge the progress of any rebalancing efforts.

Servicing a recovery
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US - Servicing more with less

The US is primarily a services economy. As of the second quarter, value-added in private services-producing industries accounted for 68.9% of GDP, up from 65.7% immediately before the financial crisis, and equal to an historic high. With the government sector accounting for another 12.8% of GDP, private goods-producing industries now make up only 18.4% of the economy, and manufacturing’s share has fallen to a new low of 11.5%. However, economic trends in the services sector often receive a smaller amount of coverage in private sector macro analysis than their dominant and still rising share of aggregate activity might suggest. There are three main reasons for this. The first relates to the nature of the services cycle, which both lags the cycle in goods activity and has lower amplitude. The second relates to the smaller average size and prominence of services sector firms, which means that a smaller proportion of activity is undertaken by corporations that are listed on equity markets. The third relates to data constraints; comprehensive estimates of services activity are published with a longer lag than goods activity, and services activity is also harder to measure.

Firing on all cylinders... ... But still no inflation pressures

Nevertheless, we can build a picture of current service sectors trends from a range of partial indicators, including monthly employment, consumer spending and survey data. Beginning with the survey data, which are the most timely of the three, growth in services activity did not decelerate as much as growth in manufacturing activity in the wake of the 2014 collapse in oil prices and hence has not rebounded as much either. However, it has picked up and currently implies that growth is close to its strongest of the entire expansion, which is impressive considering its age (see Chart 1). Importantly, new orders in the sector have been picking up of late from an already high level, suggesting that growth should remain robust until at least the early months of 2018.

Healthy growth in consumer spending is underpinning the solid growth we are seeing in services output. Real services spending growth is not as strong as when falling oil prices were boosting households' purchasing power, but it is still above its average over the past decade. And though growth in real services spending has been persistently below that of real spending on goods, services price inflation has on average been well above goods price inflation, meaning the services share of nominal spending has actually risen slightly during that period. Still, most of the slowdown in core inflation through 2017 has been accounted for by weaker services inflation, which is now almost a percentage point lower than when the unemployment rate was last at its current level (see Chart 2). What explains this weakness? There are clues in the labour market and productivity data. Over the past two years both services employment and hours worked have slowed significantly, while productivity growth in the sector has been picking up. Thus, even though nominal private services sector wage growth has also been on an upward trend over the period, unit labour cost growth has fallen to some of the lowest rates of the entire expansion. No wonder then that services inflation has been moderating.

Jeremy Lawson, Chief Economist, Standard Life Investments

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UK - Firing the starting gun

UK services activity has slowed. Thus far over 2017 the sector has grown at an annualised rate of 1.2%, half the pace of the 2.5% growth delivered in 2016. Much has been written about the impact of a household income squeeze on this important sector. Rising inflation has brought real household income growth to a standstill, despite continued robust employment growth (see Chart 3). When we look at some of the worst performing subsectors this headwind certainly seems to have weighed on activity. Growth within the more consumer-centric distribution (wholesale and retail), hotels and restaurants sector has slowed dramatically. Households are perhaps cutting back on meals out and nights away! Business services meanwhile have been more resilient, particularly financial and professional services. However, these have not grown strongly enough to offset the weakness among more consumer-centric businesses. Household spending remains a dominant driver of the UK economy.

Tightening purse strings Is the worst behind us?

With this in mind, how might households and broader services activity fare going forward? The Purchasing Managers’ Index for the sector jumped in October to 55.6, suggesting an improvement in activity heading into Q4. However, while the headline reading increased, signals around new business and hiring were less encouraging. Indeed, the improvement in the headline reading merely took the index back to its early 2017 level. The worst of the household income squeeze may soon be behind us and there are already signs that the rate of pass-through from sterling’s depreciation is starting to ease (see Chart 4). However, while this effect may not be as pronounced, it will still represent a drag on purchasing power. Moreover, weak productivity growth is likely to remain a weight on real incomes, savings rates are already low and interest rates look set to start rising slowly. On balance we expect only a slow improvement in household spending over coming quarters.

The Bank of England delivered its first rate hike in more than a decade last week, in spite of a lacklustre services backdrop. While it acknowledged subdued domestic demand, the Bank felt compelled to raise rates as rapidly declining slack increases the risk that inflation remains elevated for longer. The move had been well telegraphed, meaning most attention was drawn to signals around future policy. On this front, the Monetary Policy Committee signalled a cautious approach; repeatedly stressing that tightening would be gradual and limited. Indeed, the Bank dropped its comment that markets should price more interest rate tightening over coming years, seemingly endorsing the two rate hikes embedded in market pricing between now and the end of 2020. This caution reflects a challenging policy environment. Brexit negotiations are heading into a critical period, with difficulties around agreeing the terms of the UK’s exit raising fears that a transition arrangement may not be agreed. The slow and steady approach likely represents a more comfortable middle ground for the Bank. The start of a hiking cycle will ease concerns that it is falling behind the curve in the face of a supply shock, while also giving it room to react in either direction in a highly uncertain environment. On balance, the Bank looks likely to deliver one rate hike next year and two in 2019 - contingent on the UK securing a transition arrangement.

James McCann, Senior Global Economist, Standard Life Investments

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Europe - Are you being served?

The Eurozone continues to power ahead, with GDP growing 0.6% quarter-on-quarter (q/q) according to the Q3 advance release last week. This follows an upward revision to growth to a whopping 0.7% q/q in the second quarter. When we look at the breakdown of the Eurozone economy, the services sector is by far the largest contributor to growth, accounting for 73.4% of value-added. Comparatively, industry including construction accounts for 25.1% of value-added, and agriculture, fishing and forestry just 1.6%. Drilling down, some member states are more services-centric than others. For example, the French services sector accounts for 78.8% of value-added in the economy, while Germany’s services sector is smaller at just 68.9% (see Chart 5). However, it is the Irish services sector that stands out on the graph; the services sector share of activity fell to 59.7% in 2015 from 71% the year before. However, this is due largely to the calculation of industrial value-add in the context of intellectual property ownership, which has skewed GDP headline and industry weighting figures.

Heavyweight sector Diverging opinions

Given the importance of this sector for the Eurozone economy, it is worth checking in to see how expectations are shaping up for the next twelve months. The European Commission’s services confidence indicator has risen consistently in recent months to 16.2, a ten year high. Using a three-month average to smooth through monthly volatility in the series, both current and expected demand continues to rise in the services sector. Current employment sentiment has picked up after weakness earlier in the year, while expected employment is at a decade high. However, the Services Purchasing Managers’ Index series suggests a slightly softer picture. While the index is still registering an upbeat 55 in the October release, this is down from the peak in April of 56.4 (see Chart 6). Again looking at the three-month moving average, services activity expectations have come down from close to 68 at the beginning of the summer to 65. This is still a very strong reading for the series and  the fact it has held steady for a few months suggests a moderation at strong levels rather than a dramatic deceleration in the services sector.

These surveys provide insight not just for growth in the sector, but can give clues about prices going forward. Services sector inflation accounts for a 45% weight within Eurozone headline inflation, and 63% of the weighting in the all important core inflation figures. On a positive note, this price growth in the sector had been accelerating for much of this year, peaking in April at 1.7% in seasonally adjusted year-on-year terms (y/y), before stabilising around the 1.5% y/y mark over the summer. Some small components of services inflation provided outsized contributions to the robust core summer numbers, with passenger transport by air (5.8% y/y), transport by sea and inland waterway (4.1% y/y), package holidays (4.5% y/y) and accommodation services (5% y/y) all running strong in July. This could be a symptom of improving demand for holidays, or perhaps more likely volatility in these components. Indeed, the latest data showed a clear deceleration in the annual services inflation rate to 1.2%y/y, although we do not have the full breakdown to establish where the weakness lay. While we await this detail, the broader trend supports our view for underlying inflation to grind only very slowly higher in the currency union.

Stephanie Kelly, Political Economist, Standard Life Investments

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Japan - Secret services

Analysis on Japan typically focuses on industrial activity given the bias of its largest companies to the global manufacturing cycle. However, nearly 60% of activity in Japan is in the domestic-oriented services sector. Tertiary activity has been given added prominence in recent years by the fact that policy settings under Prime Minister Shinzo Abe are firmly aimed at stimulating greater domestic demand. Unfortunately, excluding the period after the VAT hike, it is hard to detect a meaningful acceleration in the growth of services activity (see Chart 7).

Services stable End of the run?

Digging deeper into the data, it becomes clear that there are more dynamic changes at a sector level. Tourism activity has been on a pronounced upturn as policy has reversed previous yen strength, while the government has looked to upgrade its tourism infrastructure and reduce visa restriction. However, more recently, the six-month moving average has moved starkly negative, raising questions about whether the tourism bonanza can be sustained (see Chart 8). Another positive contributor to services activity growth in the early part of Abenomics was medical, healthcare and welfare services. However, here too the pace of activity has moderated of late. This appears to reflect a steep drop-off in care provision for the elderly as labour shortages begin to bite. One sector that has been less ably supported by policy settings is financial services. Activity here has been largely stagnant since the VAT hike, reflecting the challenges of operating within a world of low and negative interest rates across the curve at the same time that credit demand remains lacklustre.

Should we expect the services sector to start contributing more? Judging by the jump in the October Purchasing Managers’ Index reading to 53.4, its highest level since August 2015, the mood is far from moribund. The most recent Tankan survey also pointed to a noticeable improvement in sentiment in the wholesale, information & communications technology, and business services sectors. Unfortunately, we have seen bullishness in the services sector in the past, without it translating to a meaningful deviation in sector activity. We think there are a number of factors that will determine whether tertiary activity can deliver a more sustained increase. First, we need to see signs of pricing power being returned to the sector. The Bank of Japan’s measure of services prices points to a meaningful slowdown in services price pressures over the last 12 months, with a flat year-on-year reading in September. That this has occurred at a time when input costs have been rising points to persistent demand deficiencies. The second requirement is for services sector employment to continue to grow. While Abenomics has done a very good job at creating jobs here, there has been a moderation in employment growth in recent months. Given labour market metrics, one might assume that labour supply issues have begun to hamper hiring efforts. Faced with this dilemma, employers will be forced either to bid-up wages for more productive employees, find alternative labour sources or use existing labour more productively. The rewards of a rejuvenated services sector should not be underestimated. With incomes rising across Asia, successful service champions in Japan would be well placed to exploit growth opportunities elsewhere in the region.

Govinda Finn, Japan and Developed Asia Economist, Standard Life Investments

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China - Taking their word for it

The services sector in China is held up as one of the main drivers of growth as the economy rebalances. But how fast is the sector growing, and can we get an accurate picture from the data? Strong services sector growth is acknowledged as one of the main reasons why GDP growth has barely slowed this year, despite investment growth moderating from 9.2% in Q1 to 5.5% in September (see Chart 9). Headline nominal services sector growth has averaged 11.5% year-on-year (y/y) for the past four quarters, showing noteworthy stability since 2012 (averaging 12% y/y despite large fluctuations elsewhere in the economy). With investment, which makes up 44% of the economy, slowing in nominal terms and faster in real terms, and retail spending also slowing steadily, are parts of the services sector growing fast enough to account for the difference? And if so, which sectors?

Weaker non-services 'Other' category dominates

Unfortunately, data scarcity makes accurate measurement difficult. There are relatively few high-frequency indicators that cover service sectors and some that previously existed have been discontinued. Take tourism for example; it is well understood that tourism, both international and domestic, is growing rapidly (one only needs to look at revenue figures for the travel company Ctrip to see growth in the sector). However, official statistics for the tourism industry were discontinued in 2016, leaving a dearth of official data sources to measure its growth. The other glaring issue is the fact that most of the services sectors anecdotally identified as the fastest growing, including such diverse sectors as IT, healthcare, education, and entertainment, are all lumped together in one national accounts category aptly named ‘others’. This category, which counts as the fastest growing segment of services is also the largest, comprising slightly over 40% of all service industries (see Chart 10). The “others” category has accelerated to nearly 15% y/y growth in nominal terms and comprises approximately 15% of GDP. Thus, fast growth in this category could make up for the shortfall accounted for by weaker investment and retail sales but it is difficult to understand which segments are growing and how fast without other data. While those sectors are likely experiencing growth, the lack of data also serves to embolden China’s sceptics who see the opacity (and strength) of that category as a tool to smooth GDP data.

All too often analysis on China’s economy can be dominated by anecdotes, where impressions can drown out the data; however, for this increasingly important part the economy economists are unfortunately left with few options. One can assume the economy is transitioning from consumption of goods to consumption of services as the economy rebalances, and assume household spending on parts of the ‘new economy’ is increasing, but there is little official data to back it up. So what is known? Household expenditure data can offer a glimpse, at least for healthcare. Household spending on healthcare is up 13.1% year-to-date through Q3, offering some confirmation that healthcare services are indeed seeing strong growth. Moreover, there have been data improvements recently; the National Bureau of Statistics began breaking out the ‘others’ category and providing data on IT services and business leasing in Q1. Hopefully this trend continues and more data is eventually provided on such sectors as education, R&D, environmental services, and entertainment. Until then, it is difficult to say that rebalancing has even begun.

Alex Wolf, Senior EM Economist, Standard Life Investments

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