We want to try and cover a few areas this week. According to the headline data, the US economy remained weak in Q2 and the European economy slowed a bit. There are grounds for both optimism and pessimism, but with the bias always these days towards dovishness, we expect Central Banks to remain primarily in easing mode with the US Federal Reserve on the side lines.
Let’s start with a look at the US GDP report. In the second quarter, the US economy grew at 1.2% (Quarter on Quarter, Seasonally Adjusted Annual Rate) compared to 0.8% in the first quarter (revised lower from the previous estimate of 1.1%). On the surface, this was a poor report, indicative of an economy operating at stall speed. Chart 1 below shows both the quarter on quarter and year on year changes in GDP since 2010, and what can be seen is that the US has not seen 3 such consecutively low quarterly growth numbers since the end of the last recession. In year on year terms, the current 1.2% growth rate is now back to almost the lowest level since the end of the recession.
Chart 1 – US Real GDP since 2010
If we take a step back, and look at nominal GDP now going back to the 1980s, we can see that the year on year growth rate is at levels associated with recession. Indeed, the current 2.4% growth in nominal GDP is the slowest since the end of the last recession. Now, we doubt that the Fed needs much excuse to refrain from further rate increases, and ahead of the election we can see how they can hide behind the very mediocre GDP numbers.
Chart 2 – US Nominal GDP growth (year on year) and the Fed Funds rate
As noted above, there are grounds for both optimism and pessimism for the US. On the optimistic front, the consumer revved into life in Q2 with Personal Consumption Expenditures (PCE) seeing the second best quarter since the last recession, as measured by contribution to GDP. Offsetting this strong consumer performance was a dreadful corporate performance as measured by Gross Domestic Private Investment (GDPI). The optimists will argue that GDPI will likely rebound after such a weak quarter, and assuming that the consumer remains as robust, we can look forward to much better economic output in the second half of the year.
However, what if the rebound in GDPI is disappointing, and the consumer suddenly hunkers down again? What caught our eye was the decline in the personal savings from 6.1% in the first quarter to 5.5% in the second quarter. Is this a sign of confidence about their future prospects, spending income they expect to receive tomorrow. Or have consumers dipped into savings yet again to sustain current lifestyle despite little prospect of a pay rise ahead?
As far as we are concerned, it could go either way. The risks from abroad remain, and any new strength in the Dollar would quickly become a headwind again. Furthermore, although inventories did decline in Q2, there is room for a further decline after many quarters of inventory building. On an optimistic note, it would appear as if year on year corporate revenues were basically flat in Q2 after five consecutive declining quarters. If this stabilisation marks the beginnings of an improvement for the corporate sector, we should expect Gross Private Domestic Investment to either stabilise or improve.
Our best guess at this stage? We guess that the data will show a modest improvement in the US economy in the second half of the year, but likely not sustainable. We expect the economy to continue growing well below pre crisis growth rates and the risks of a recession will remain elevated in 2017.
Moving onto central bank meetings, as expected, the US Federal Reserve made no changes to policy, and very few changes to their statement, albeit inserting a sentence noting that near term risks have diminished. As noted above, we can easily envisage the Fed remaining on the side lines until after the election in November.
The other main central bank meeting last week was the Bank of Japan, where market expectations of more stimulus were disappointed. With a pre-announced fiscal stimulus of approximately US$275 billion (more than 5% of GDP) expectations were high that the BoJ would work alongside the Government and expand stimulus. In the event, the only actions were to increase their buying of equities via ETFs and to increase US Dollar liquidity lines.
Not only did these actions fall well short of expectations, but we simply do not see the economic benefit of a central bank buying equities. Ok, the supporters of such policy will argue that this is designed to increase investor confidence which will help the economy. In practice, we do not see this happening, and even if there was the tiniest economic benefit, the long term costs will outweigh any benefit. For example, if the BoJ becomes the buyer of last resort in equities (as they have in the bond market), what will equity holders then think when/if the BoJ announces an end to their equity purchases? We doubt this would be a positive, and the BoJ now risks being unable to reverse a policy that is economically unjustified.
What kind of saved the day for the BoJ was the announcement of a review for the next meeting of how they can reach their 2% inflation target quickly. This is central bank speak for, ok we haven’t hit our target after three years of trying, so we are preparing plans for more of the same in the hope that it will work. With Kuroda telling us that he is legally prevented from employing “helicopter money” (we suspect that this will change in time), the market now expects more QE and perhaps another rate cut to even greater negative rates in September.
All of this brings us to the next couple of quarters or so as being pivotal for global policymakers. Japan is in an impossible situation and it seems that markets are losing patience. If the BoJ launches another huge stimulus package in September, and the markets react poorly, then the BoJ could sustain an irreversible hit to their credibility. In the US, if the economy recovers, then surely the Fed have to raise rates and risk a financial market sell off. If the economy doesn’t recover, then surely it is so close to stall speed that recession risks rise quite quickly.
So, from an economic and central bank perspective, the next couple of quarters would appear to be very important. Furthermore, the political agenda alongside Brexit and potential China concerns will keep life very interesting. To date, financial markets continue to ignore any and all risks and seem happy to suckle on the monetary policy teat. We are very unsure as to how long markets can continue in this vein, although we have to admit that they have remained more resilient than we have expected for a long time now. We continue to see no value in mainstream assets for buy and hold investors (time horizon measured in years). From a trading perspective, we continue to believe that a flexible approach suits the current environment, especially when trying to control risk. We have backed away from our bearish views modestly in recent weeks but we are keenly watching for signs of a bearish reversal.
Stewart Richardson
Chief Investment Officer
