Global Economic Perspective: August
August 17, 2016

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Perspective from Franklin Templeton Fixed Income Group

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Investors Shrug off Disappointment in Headline US GDP Growth

Preliminary readings for US economic growth in the second quarter of 2016 fell short of the market’s broad expectations. However, the majority of the miss was the result of a shift in the volatile inventories component. As inventories can fluctuate significantly from period to period without much change in the net result over the longer term, we would not be inclined to draw any broad conclusions with respect to US growth prospects, particularly since the 1.2% annualized growth estimate was accompanied by solid consumption readings.

US retail sales increased by a robust 0.6% from the prior month in June amid a strong rebound in nonfarm payroll figures following a weak May reading. In addition, the readings for May and June job gains were revised upward, and wages continued to firm. While the headline unemployment rate actually rose slightly to 4.9% in June and remained there in July, the increase was largely driven by an improvement in the labor force participation rate. The general direction of high frequency data releases such as initial and continuing unemployment claims painted a picture of a labor market approaching full employment as they continued to trend downward while total job openings improved. Additionally, Employment Cost Index figures released in July for the 12-month period ended in June 2016 showed an overall increase of 2.3%. The wages and salaries component of the index increased at a rate of 2.5% for the 12-month period ended in June 2016, while the benefits component increased at a rate of 2.0% for the same period. While slowing somewhat, these figures are additional evidence that labor conditions should be supportive of further gains in consumer spending.

Common gauges of manufacturing activity consolidated in July, evidencing further stabilization in the manufacturing sector as the effects of the US dollar’s sharp rise earlier in the year began to wear off. Among other positive developments were increases in production, while new orders and new export orders remained solidly in expansionary mode. Gains in the services sector also slowed slightly from the prior month’s level. Within the details of the report, increases in new orders, new export orders and the backlog of orders were supportive of further growth. Headline inflation figures remained muted during June as increases in energy and other items outweighed a notable decline in food costs. In comparison with year-ago figures, the price of services accelerated while that of goods declined.

The above-mentioned references to improved economic activity were reflected both in the minutes from the US Federal Reserve’s (Fed’s) June meeting as well as in a statement released toward the end of July. Notwithstanding the slightly hawkish tone of these communications, the committee again declined to raise rates for the time being. Most measures of US labor market conditions since the May employment report have suggested that the month’s weak reading was likely an aberration rather than the start of a negative trend. The June meeting minutes also alluded to concerns with respect to the impact of the upcoming (at the time of the meeting) Brexit vote on financial markets, although the vote’s outcome appears to have been largely discounted by global markets following a brief initial bout of volatility.

Indeed, fixed income investors appeared to shrug off the disappointing second-quarter GDP reading as evidenced by a tightening of spreads in both the investment-grade and high-yield market sectors. While we think decent consumer sector performance, even impeded somewhat by corporate investment and government spending, appears capable of delivering more trend-like growth over the second half of the year (barring some kind of unexpected shock), we also believe the adoption of a coordinated approach involving additional fiscal measures would offer welcome support for economic growth. While this approach has been championed by Fed Chair Janet Yellen, whether it actually comes to pass may depend on an improvement in the political climate.

Support Among Developed Markets for Coordinated Approach to Economic Policy Likely to Grow

US monetary authorities are not alone in contemplating alternatives to monetary policy. Both Japan and the eurozone appear to have reached a point where quantitative easing may be doing more harm than good. In both cases, central-bank bond purchases have resulted in flatter yield curves as investors bid bond prices up. Over time, this has resulted in negative interest rates which, in turn, have adversely affected the banking sector’s ability to generate income from its existing assets. From this perspective, adopting a coordinated approach to expansionary measures would be helpful in relieving these unintended effects on the bond market.

The government of Japanese Prime Minister Shinzo Abe may have tacitly acknowledged this limitation when the Bank of Japan announced only a token increase along with a review of its quantitative easing measures amid weakness in the domestic stock market and the ongoing appreciation of the Japanese yen. The Ministry of Finance announced a new package of fiscal measures shortly afterwards, and we think the Japanese government may be signaling its intent to adopt a new approach in terms of both fiscal and monetary measures to attack the problem of slow growth.

The Bank of England’s (BOE’s) Monetary Policy Committee cut its benchmark interest rate in the wake of the Brexit referendum while also announcing an additional package of measures, including corporate and sovereign bond purchases as well as a lending program for banks. Despite the uncertainty surrounding the mechanics and timing of the actual Brexit process, it ultimately appears likely to have a negative effect on UK economic growth. Recent readings from gauges of industrial activity have already pointed to a sharp decline in activity. While the BOE has publicly expressed its reluctance to pursue a purely monetary approach to the issue, having voiced concern over the potential effects of low interest rates on the banking and building sectors, concerns over the extent of a slowdown may have prompted the additional measures. Without the budgetary restrictions imposed by membership in the European Union (EU) and given the concerns raised with respect to further quantitative easing measures, the United Kingdom appears likely to eventually adopt a coordinated approach through the announcement of a package of fiscal measures later this year.

European economic data released in the immediate aftermath of the Brexit referendum were generally positive. Amid positive economic growth, the June unemployment rate of 10.1% indicated stability in eurozone labor market conditions. In addition, inflation ticked up to a still very low 0.2% in July versus the year-ago period, although core inflation remained at 0.9%. Lower energy prices stemming from the global glut of crude oil have produced a drag on inflation over the past few quarters. As a result, the headline annual inflation figure will likely tick up as those effects wear off. In the second quarter, the French economy stagnated, largely due to weak household spending and lower business investment, while the Spanish economy registered modest growth. Elsewhere in the region, Germany’s preliminary estimate of inflation data indicated year-on-year consumer price inflation rose slightly in July while the country’s unemployment rate declined. European policymakers continue to be confronted with a mixed economic picture stemming from a range of factors, including the unexpected influx of refugees, high levels of private debt and a perception of weakness in the financial sector, although this last factor has been mitigated to some extent by the results of the most recent European bank stress tests. At the same time, European political conditions continue to hold potential to destabilize the nascent recovery amid the unprecedented wave of populist protectionist sentiment that shows little sign of ebbing anytime soon.

Having already announced a major expansion of its asset purchase program earlier this year, the European Central Bank (ECB) appeared to be in watch-and-wait mode following the results of the Brexit referendum. Given the large number of uncertainties surrounding the event, ECB governors were likely anxious for more detail before rushing to commit to any specific set of measures, although ECB Executive Board Member Benoît Coeuré did suggest there was additional room to cut the deposit rate if benefits continued to outweigh costs. While there has been little talk of specific fiscal measures, EU officials have quietly allowed both Spain and Portugal to exceed official budgetary strictures, which could signal a growing willingness to move past traditional approaches in confronting the issue of slow growth. While monetary policy continues to play an important role, as evidenced by the recent actions of the BOE as well as an August rate cut by the Reserve Bank of Australia, the vast majority of stimulative measures undertaken since the 2008–2009 global financial crisis have favored monetary over fiscal policy for a number of reasons. As policymakers confront the limits of the monetary approach, conversations have increasingly turned to a discussion of potential alternatives to combat slow growth. Looking forward, we think this dialogue will likely broaden to include more countries in the months to come.

July Data Point to Continued Stability in Key Emerging Market Economies

Elsewhere, Chinese economic growth registered a positive 6.7% increase in the second quarter of 2016, which left it unchanged from the prior quarter. June data suggested further evidence of progress on the transition to a consumer-led economy as retail sales trended up. At the same time, industrial production and fixed investment were likewise supportive of the pace of growth. Private investment also reflected this transition as investment in traditional extractive industries lagged behind increases in service sectors such as information technology and health care. Industrial profits were another bright spot after recording a sustained decline during 2015. China’s annual Consumer Price Index (CPI) increased on a year-on-year basis in June, mainly driven by price increases across food, services, consumer goods and non-food items.

In India, the headline CPI reading for June remained at 5.8%, with food accounting for a good portion of the result. The prospects for Indian inflation received a favorable natural development in terms of a robust monsoon season that could help alleviate the sharp increase in food prices that has been a thorn in the side of the Reserve Bank of India’s informal goal of capping inflation at 5% by 2017. India’s manufacturing exports exhibited further stabilization during the month amid a monthly trade deficit that rose to US$8.1 billion in June on the back of gains in exports.

In Latin America, Brazil has been in wait-and-watch mode, with its National Congress recently back from winter recess. Much of Brazil’s immediate future depends on the actions that will be taken by the legislature as it resumes activity. Among the items awaiting a decision is a potential change in a repatriation bill that could help increase the government’s tax collections. In the meantime, the central bank’s monetary policy committee meeting minutes noted a number of balanced risks to its inflation target while policymakers remained hesitant to raise interest rates until a more favorable combination of economic factors supporting non-inflationary growth becomes evident.

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