Global Overview - Down but not out
Through the first months of 2018, there has been a clear moderation in the pace of global economic growth. The global manufacturing and services PMIs have both softened and are sitting below their 2017 averages. In six-month annualised terms, global industrial production is growing at its slowest rate in a year. Nowcasts for H1 growth are weaker than they were in H2 2017 in the UK, Eurozone, and Japan, and more or less unchanged in the US and for the EM average (see Chart 1). And the first official estimates of Q1 GDP growth are picking up the same patterns. So, how concerned should we be about these trends and do they represent a threat to our forecast for the global economy to grow above trend this year?
The short answers are ‘not very’ and ‘only modestly’. The first point to make is that some of the moderation in growth was natural and had already been factored into our forecasts. According to our Nowcasts, underlying growth in Japan and Eurozone was above 3% in Q4 and above 4% in the US. These were all so far above trend as to be almost impossible to sustain. The second is that activity data in the first quarter were almost certainly distorted by an unusually bad winter, especially in Europe and Japan where the loss of growth momentum has been most noticeable. This should unwind over the next few quarters. Most importantly, the fundamentals supporting the expansion remain sound. Although financial conditions are not quite as accommodative as they were through most of 2017, they remain looser than their long-term average in most economies. Within EM, sovereign and corporate borrowing spreads have widened as capital inflows have stalled thanks partly to a resurgent US dollar, but there are few systemic imbalances. Survey data may not be as strong as in late 2017 but most stabilised in April and levels remain well above their averages over recent years, with capex intentions still strong. The 70% rise in crude oil prices since June is weighing on consumers’ purchasing power, but healthy labour market trends are keeping real disposable incomes growing solidly. Meanwhile, the impact of the giant US fiscal stimulus is still to be felt. The upshot is that sequential global growth has probably peaked for this cycle - but we are not ringing the alarm bells yet.
US - Just a minor blip
The US economy is no stranger to Q1 growth disappointments. Since 2010, growth in the first quarter of each year has averaged 1.1% q/q annualised, less than half the 2.4% delivered on average over the rest of the year. Put in the context of this residual seasonality, the slowdown in activity seen at the start of 2018 looks mild. Headline growth moderated to 2.3% y/y annualised, down from 2.8% at the end of last year, though the discrepancy is larger when we look at final sales to domestic purchases, which strips out net trade and inventory effects. This measure of domestic demand slowed from 4.5% q/q annualised in Q4, to 1.6% in early 2018, likely reflecting a degree of payback from unsustainably strong growth. Indeed, the average annualised growth rate over these two quarters of around 3% is a better reflection of underlying momentum in the economy.
Digging deeper, we can identity a few weak spots that were primarily responsible for the slowdown. Consumer spending growth dropped to a five-year low of 1.1% q/q annualised, reflecting weak spending on goods (particularly autos), but more resilient demand for services. This moderation in the wake of strong Christmas spending is expected to prove temporary. Consumer confidence remains robust, the labour market continues to churn out jobs, wages look to be rising (albeit slowly) and individual tax cuts reached pay cheques only in late Q1. Indeed, March retail sales delivered a solid end to the quarter, and we would expect this momentum to continue across a broader range of spending into Q2. Otherwise, government consumption slowed to 1.2% q/q annualised, in the wake of a bumper end to last year. The Bipartisan Budget Agreement reached in February will significantly increase both defence and non-defence expenditures over coming years. This should translate into sharp increases in government consumption and investment towards the end of this year and into 2019 (see Chart 2). Finally, while overall fixed investment was slower than the 8.2% annualised growth delivered at the end of last year, at 4.6% this was still pretty robust. Moreover, the slowdown was almost entirely accounted for by stagnant residential activity, following a huge 13% advance at the end of last year. Aggregate investment is expected to continue its strong run. Sentiment among both small and large firms is still upbeat despite some recent moderation (see Chart 3), a tightening labour market is encouraging capital spending and cashflow is being boosted by profit growth and tax cuts. Indeed, the Tax Cuts and Jobs Act provides full and immediate expensing for investment, with this incentive expected to provide a moderate boost to capex projects as we move through the year.
Taken together, there are few reasons at present for alarm over the moderate slowdown in US activity seen at the start of this year. Indeed, heading into the quarter we had already built in a slowdown in activity based on the residual seasonality that we typically see in the national accounts. Moreover, the robust activity at the end of last year was unlikely to be sustained. Finally, when we break down the areas of weakness, there looks to be little cause to become more pessimistic around these parts of the economy. Indeed, robust fundamentals supported by loose fiscal policy are expected to propel US growth above potential this year and next. This implies that the bigger risk in the US is overheating, not slowing.
UK - Under the weather
After a disappointing first quarter, the UK economy seems to have bounced back only weakly in April. At 0.1% q/q, Q1 GDP growth was very weak. While the Office for National Statistics (ONS) claimed the bad weather in March had a limited impact on the data, we were initially sceptical of this assessment. Weather-sensitive sectors like construction and retail were reported as experiencing a soft patch, which is strongly suggestive of a weather shock. In addition, the construction sector was probably hurt by the collapse of Carillion, and the time lag involved in finding new contractors for various projects. Seasonal adjustment can be especially difficult in these circumstances. To the extent that the Q1 slowdown partly reflects these transitory factors, activity should have bounced back relatively quickly, potentially leading to a brief period of above-trend growth. Furthermore, the ONS has historically tended to underestimate the ‘true’ underlying rate of growth in its initial estimates, which may also provide some comfort that the reported weakness of Q1 is overstating more fundamental developments.
Unfortunately, early indicators of Q2 activity are not suggestive that a rebound in growth is imminent. PMI surveys point to a slight pick-up in activity, but the composite PMI (covering the manufacturing, construction and services sectors) for April failed to recover all of the ground lost in March (see Chart 4). The April survey also implied that jobs growth has slowed and inflationary pressures have eased. This chimes with the picture emerging from other survey data, included a limited recovery in the CBI’s retail survey for April, and a fall in consumer confidence. It is early days but these may herald a more genuine slowing of the economy than can be explained by mere weather effects. Given that many of the domestic headwinds facing the UK economy – squeezed real wages and political uncertainty – do not appear to have got any worse recently, it is possible that softer external demand, and most critically the recent slowing in Eurozone growth, is the real source of the UK's malaise.
Indeed, the worst of the real wage squeeze appears to be over, with growth turning positive in February. We expect this to continue, with support from both falling inflation and improving nominal wage growth. The Bank of England’s Agent surveys provide nascent signs that low unemployment and reported labour shortages are being translated into higher wage growth. For much of the post-referendum period, households have smoothed their consumption in the face of falling real wages by running down their savings. With the savings rate at extreme lows (see Chart 5), banks and consumers may be uncomfortable with pushing this process any further. Reported saving intentions have increased and credit conditions are tightening. There was an abrupt slowdown in unsecured lending in March, with net lending of just £0.3 billion, the weakest outturn since November 2012, though the stock of household debt is still growing. A key question for the economy is whether the recovery in real wages will be sufficient to support consumption in the face of any structural shift in household savings plans. Our view is that the return to real wage growth will provide an important spur to consumption, which, along with a recovery in the external environment, should see the UK shake off much of its early 2018 malaise, though underlying growth will remain below its pre-referendum trend.
Europe - A case of the winter blues
Following a gangbusters 2017, the Eurozone economy shifted down a gear in the first quarter of 2018. The Q1 advance GDP growth estimate came in at 0.4% q/q, following three successive quarters at 0.7%. The full expenditure breakdown won’t be available for another month or so, but we suspect that a weak external sector was the primary driver of the slowdown; that was certainly the case in France specifically, where we do have the breakdown. Although we should be careful generalising from one member state to the whole Eurozone, a weaker contribution from net trade would be consistent with the earlier appreciation of the trade-weighted euro, as well as the sharp moderation in the Eurozone manufacturing export orders PMI so far this year. The recent monthly ’hard’ data for the Eurozone haven’t been particularly encouraging either. Industrial production and retail sales growth both slowed sharply in recent months. Meanwhile, the latest composite PMI has fallen from a 12-year high of 58.8 in January, to 55.1 in April – albeit that's still well above the 50 breakeven mark, and the PMI reading more or less stabilised between March and April (See Chart 6).
Indeed, we are minded to see the Q1 weakness in the Eurozone as largely a one-off. Unseasonably severe weather; a bad flu season, particularly in Germany; and widespread strikes in France; have all been temporary weights on economic activity. That drag should fade as the weather returns to seasonal norms and employees recover and head back to work. A series of rolling strikes on the French railways is planned until June, although rejigged timetables are gradually lessening the disruption. More fundamentally, the drivers of above-trend Eurozone growth remain in place: decent employment growth, elevated consumer and business confidence, and favourable financing conditions should support both consumption and investment; and while net trade is unlikely to continue making such a large contribution to growth given the stronger currency, the strength of global demand means that a collapse isn’t likely either. We expect a slight bounce-back in Eurozone Q2 GDP growth, and continued above-trend, albeit gradually moderating, growth thereafter.
What could go wrong with this outlook? Eurozone broad money growth has been slowing, and might be expected to continue ticking lower if the ECB winds down its net asset purchase programme later this year – but we note that the latest ECB Bank Lending Survey points to a continued rise in credit demand by, and availability to, households and corporates (See Chart 7). Earlier euro appreciation may drag on net trade more than we expect – although the strength of global demand makes that unlikely. The Eurozone could suffer negative confidence effects in any trade war between the US and China – but the recent trade spat looks more bark than bite. And certain Eurozone economies, including Germany and France, could be running into supply constraints that put a lid on economic activity – although we suspect there’s still a reasonable amount of spare capacity across the currency bloc as a whole. For now, these all look like risks that merit monitoring, rather than reasons to alter our baseline expectation.
Japan & Developed Asia - When the tides goes out…
Japan has long been vulnerable to the vagaries of the global cycle. However, with policy settings firmly directed at domestic imbalances, one may be forgiven for assuming that economic activity has taken on a more homegrown flavour. In reality, there is no such evidence (see Chart 8). Few places benefited as handsomely as Japan when the industrial cycle accelerated towards the end of the year, with production jumping 1.6% q/q in the Q4. That has been followed by an almost complete reversal in Q1. To be fair, the domestic economy has fallen prey to some of the temporary factors weighing on growth elsewhere, with weather disruptions, Chinese New Year distortions and even political risk all at play. Unfortunately, despite most of the bad news now fading in the rear mirror, the economy is struggling to regain momentum. The April PMI rose modestly to 53.8 and remains in positive territory but some way below the January peak of 54.8, while the ‘hard’ data from March have underwhelmed.
One useful guide to future activity is the inventory cycle. The inventory-to-sales ratio allows us to assess producers’ confidence in the future outlook. Typically if an inventory build-up is unintentional, production tends to be cut back. On the other hand, if inventory increases are driven by a correct assessment about future demand, then further production increases are likely to follow. The inventory-to-sales ratio climbed 5.4% in the first quarter and is now at the highest level since August 2014. At the moment, inventory indicators are mixed. Though official inventory-to-sales ratios have picked up, neither the readings from the latest manufacturing PMI or the Tankan survey pointed to excesses. The sector composition is more informative. The rise in the inventory-to-sales ratio has been most pronounced among electronic parts and devices producers, rising 21.8% in the quarter (see Chart 9). We have retained a relatively upbeat view on the semiconductor cycle, given greater geographic and sector adoption. However, if demand here falters, we would expect to start to downgrade our outlook for industrial activity – with obvious risks to our full-year 1.0% y/y growth forecast.
The other key consideration for the outlook is whether the recent lull in consumption activity will persist. A 0.7% m/m drop in March retail sales came as a negative surprise as we had expected a rebound from the weather-affected start to the year. This left Q1 retail sales 0.6% lower than in the previous quarter. Looking forward though, the issue is whether income growth continues to rise and the savings rate falls further. The Shunto outcome represented a modest improvement over 2017 and should underpin modestly stronger nominal household income growth over the next 12 months. Real incomes remain vulnerable to material yen depreciation or an energy price surge, but in their absence we expect inflation to remain modest. The key question on the consumption side is whether savings rates in the key 30s and 40s cohorts will rise along with incomes. We are increasingly of the view that some form of wage policy will be required to push base pay growth to a level high enough to instil greater confidence about the future, incentivise more spending and also make it more likely that the 2% inflation target will eventually be achieved. If this was to occur, Japan would finally ignite its own growth engine. But we are doubtful it will occur.
Emerging Markets - Steady but no acceleration
These are trying times for emerging markets (EM) as a US rising dollar puts pressure on EM assets, and geopolitics continues to create uncertainty. The recent sell-off in Argentina raises some alarm bells regarding a stronger dollar and rising vulnerabilities in some countries. However, aggregate EM fundamentals remain solid. In earlier reports we highlighted the trajectory of the US dollar as one of the biggest questions facing EM this year. Dollar weakness over 2017 contributed to positive performance in EM assets, and a favourable liquidity and risk environment. Market consensus appeared to favour the view that dollar weakness would continue as the weight of growing fiscal and current account deficits weighed on the dollar. But with US rates moving higher and policy divergence between the US and rest of the world continuing, the possibility existed that higher yields and the effects from tax repatriation would push the dollar higher. While the path of the dollar is critically important, the other (arguably more important) factor that will shape how EM assets perform this year is whether growth holds up to expectations.
Most forecasts, including the IMF and global investment banks, are calling for EM growth to continue picking up and the EM-DM growth differential to continue widening. This is crucial for EM assets, as most research shows that a key determinant of capital flows into EM is the growth differential with DM. With a stronger dollar, higher US yields, and supply-driven oil price gains putting pressure on EM assets, the EM macro backdrop will be the key factor to watch going forward. Given the recent weakness across EM and sharp sell-off across externally vulnerable EM economies, negative economic surprises could add to the volatility.
Judging by the first four months of available data, as well as our Nowcasts, EM growth appears to have been broadly stable in Q1 compared with Q4, with the potential for a slight weakening in sequential terms (see Chart 10). A notable feature of this recovery is how the EM-DM growth has tended to be smaller than in past cycles. Despite a healthy year-on-year growth rate, EM growth slowed in quarter-on-quarter (q/q) terms through second half of last year. In particular, the recoveries in Brazil and Russia, which were expected to power the overall EM recovery, unexpectedly faltered (see Chart 11). The weakness appears to have lasted in Brazil with industrial production, retail sales, and the monthly GDP indicator all softening over the first quarter. Russia appears to be improving from the Q3/Q4 2017 trend, but not as much as expected. Industrial production, retail sales and exports have all improved from recent trend, and the monthly GDP indicator showed a pick-up in Q1 growth. However, sanctions cloud the outlook. While they are unlikely to cause significant macroeconomic stress, they will negatively affect business confidence and reduce private sector investment. Chinese growth has held steady so far in 2018, surprising on the upside; policy loosening and a surprisingly strong housing sector sets the possibility for growth to continue beating consensus. Additionally, the Indian recovery looks healthy, pointing to further acceleration. We are encouraged by the relative stability of aggregate EM growth, but if the EM-DM growth differential narrows rather than increases while the dollar pushes higher, there may be more volatility in EM assets ahead.