Global industrial production growth went through a soft patch in Q3 2014, with a sharp contraction in August in particular. But business surveys at the start of Q4 2014 so far point to a rebound in the momentum of industrial activity for advanced economies (see chart 1). Four points matter for investors: the sustainability of the recovery, the divergence across economies, the implications for inflation and the outlook for monetary policy.
First, seven years into the global recovery, questioning its sustainability cannot be avoided in the face of continued geopolitical risks, a further slowdown in China and the anticipated start of the Fed normalisation in 2015. Employment and credit dynamics in particular are important to monitor to assess if the base for sustained growth is in place. Those indicators currently reveal an increasingly differentiated picture between economies where domestic demand recovery is ongoing and those where reliance on external demand is high and additional policy action is needed. The US ranks first in our cyclical scorecard, which takes into account the momentum of industrial production, employment, inflation and credit growth to the private sector. Positive labour market dynamics and a recovery in credit to the private sector support final demand in the US. The Euro area now ranks worst, mostly due to very weak industrial activity, continued credit de-leveraging and very low inflation. The risk of the Euro area falling back into recession in 2015 cannot therefore be fully dismissed. While business surveys suggest the recovery in other advanced economies remains on track, signals from the demand side need to be monitored closely. Our proxy of final demand in major economies fell slightly below the pace of industrial activity in September, a warning signal for the outlook (see chart 2).
Second, we see a strong case for diverging growth paths within developed economies into 2015. In our view, the US economy is able to deliver acceleration in growth, despite risks of another downturn in the Euro area and stagnation in Japan, for four main reasons. First, fiscal austerity is largely behind us (a conclusion valid for advanced economies as a whole, as IMF estimates fiscal tightening in 2015 will be less than 1% of GDP based on the cyclically-adjusted budget, except for Australia and Japan). Second, there has been no monetary policy shock or policy mistake affecting business or consumer confidence; in contrast policy uncertainty has been falling in the US (measured by www.policyuncertainty.com). Third, household incomes benefit from lower energy prices and an expected recovery in wages in the US as labour markets tighten. Fourth, consumer confidence is above historical average and still rising in the US where consumer balance sheets have been repaired. This is not to say that the malaise surrounding the global recovery, which arises from an unusually slow pace of world trade, falling commodity prices, low wage inflation in major economies and weak balance sheets in the private or public sector, will disappear. Those sources of malaise will remain but will be disproportionately affecting the Euro area (which is reliant on net exports for growth), Japan (where consumption is hampered by falling real wages and the prospect of medium term fiscal consolidation) and Australia (lower terms-of-trade drag down incomes).
Another cyclical divergence is building further between emerging markets (EM) and developed markets (DM). The rise in EM PMI manufacturing is lagging that of DM (see chart 3). BRIC countries register below 50 PMI with the notable exception of India. Of course the absolute pace of EM growth remains above that of DM but their outperformance vs. DM, which had been narrowing over the past few years, is bound to be reduced further in 2015. The housing sector adjustment in China will drive growth further down in 2015. Softer commodity prices are a net negative for growth, budget and current account balances as regards EM external borrowers. Differentiation within EM should also grow. The prospect of Fed tightening will likely prevent a number of EM central banks (eg. Turkey, South Africa, Malaysia…) to respond fully to lower inflation and growth as heavy foreign capital inflows over the past few years could reverse, with a potentially destabilising impact for their economies. In contrast, EM manufacturers geared to US recovery (tech economies in Asia, Mexico) and EM reformers (India) should do well. In particular, India’s GDP growth could well close the gap with that of China in 2015, after it underperformed China by 2% to almost 3% since 2012.
Third, with diverging growth dynamics but overall subdued global growth (with world GDP growth at trend at best in 2015), disinflation trends are unlikely to dissipate anytime soon. Low and falling oil prices will exacerbate the downward trend in headline inflation in major economies into Q1 2015. Yet this should be seen as an income boost for consumers and a factor reducing costs for producers. This factor has already affected output prices in the manufacturing sector, with the component for the Eurozone PMI manufacturing below 50 in September and October 2014. But what matters if sustained growth recovery is to continue to coincide with falling inflation, is whether we see signs of demand-related resilience in inflation. The answer remains yes for the US and the fast erosion of labour market slack paves the way for an acceleration in wage inflation in 2015 and resilient core inflation. But in the Euro area and the UK, prices charged as reported in PMI services were below 50 (ie the expansionary threshold) in October, which is concerning. The coincidence of negative growth surprises and downside inflation trends has recently raised alarm for policymakers both in the Euro area and in Japan. This has major monetary policy implications.
Fourth, against this macro backdrop, monetary policy divergence between the US and the Euro area or Japan is set to grow. The tensions with the faster than expected decline in unemployment in the US and low CPI is likely to be resolved by an accelerated increase in wages in our view. Meanwhile, the interaction of low inflation with growth stagnation could be toxic in the Euro area. Inflation expectations as measured by the 5y5y year inflation swap (1.86% as of 17 Nov 2014) are well below the 2% target. With the ECB likely to revise downward growth and inflation forecasts at its December meeting, the case for sovereign QE to fight deflation risks is building and could be implemented by the end of Q1 2015 in our view. The prospect of large, open-ended balance sheet expansion would send the signal that the ECB is ready to do “whatever it takes” to avoid deflation. Growing monetary policy divergence between the Fed and the ECB by 2017, both on rate policy and balance sheet trends, points to large EUR depreciation vs. USD. The case for additional BoJ easing is complicated in the near term by political uncertainties. In our view medium-term fiscal consolidation plans need to be reaffirmed after early elections to avoid any destabilisation in the JGB market, which by forcing even more BoJ support, would have the potential to create a JPY crisis. A new medium-term fiscal plan would keep the policy mix JPY negative in addition to maintaining domestic confidence in the ultimate success of the 3 arrows of Abenomics (eg. ending deflation), hence consistent with portfolio outflows by domestic investors. The current pace of BoJ balance sheet expansion (as decided at the BoJ meeting on Oct 31st) is consistent with USD/JPY at 120 but a rise in US bond yields would be needed to be consistent with such levels.
Chart 1: G10 PMI and IPI: rebound in IP on track for Q4 2014
Sources: Bloomberg, Haver. Data as of 6 November 2014
Chart 2: Consumer spending in major economies does not justify faster industrial activity
Sources: Bloomberg, Haver. Data as of 6 November 2014
Chart 3: Emerging market (EM) PMI lagging the recovery in developed market (DM) PMI
Sources: Bloomberg, Haver. Data as of 17 November 2014
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