Perspective from the Franklin Templeton Fixed Income Group
IN THIS ISSUE
- Federal Reserve Grapples with Mixed US Data
- Global Economy Facing Challenges
- European Recovery Broadens and Strengthens
Federal Reserve Grapples with Mixed US Data
The first quarter of this year brought its share of disappointments in terms of US economic indicators. Weak consumer spending, combined with slowing factory activity and housing starts, in the opening months of 2015 all pointed to the likelihood of a meaningful moderation in US economic growth in the first quarter. Observers pointed to severe weather in January and February to explain poor data. But March also saw a major downward shift in job creation and in manufacturing data. Industrial production posted its biggest drop in more than two-and-a-half years in March as oil and gas well drilling plummeted. Declining investment in energy projects can be expected to have dented gross domestic product (GDP) growth in the first quarter overall. In addition, US home construction rose much less than a Bloomberg survey of economists expected in March, in spite of more favorable weather.
The question is whether this weakness will be prolonged, or whether we will witness a return to better growth trends, just as we saw in 2014, when growth shifted dramatically from an annualized rate of -2.1% in the first quarter to 4.6% in the second quarter. We think there remain grounds for cautious optimism on this score. Although deemed disappointing on some measures, retail sales did rise in March for the first time in four months as shoppers returned to stores after the winter cold snap. And although the overall trend during the past six months has remained decidedly mixed, we believe it is reasonable to expect that the substantial increase in new jobs over the past year, together with the significant decline in gasoline prices, should continue to boost consumer spending in the months ahead. On the corporate front, while industrial production figures have disappointed, expansion of the US services sector has continued apace, with the Institute for Supply Management’s Non-Manufacturing Index reading coming in at 56.5 in March, well above the 50 level that separates expansion from contraction. Just as significantly, lending both to businesses and to consumers has been picking up, showing there is demand in the economy. As energy prices have tended to stabilize, the upturn in demand has begun, finally, to be seen in some inflation figures, with producer prices in the United States rising in March for the first time in six months.
But in financial markets, early signs that US growth might be firming have been obscured to some degree by the sluggish growth in corporate earnings, caused in part by the upward lurch in the value of the US dollar, by the downturn in the energy sector’s fortunes and by weak global growth.
And, in our view, there can be little question that the spate of decidedly mixed economic data of recent weeks leaves the US Federal Reserve (Fed) facing a policy dilemma at a crucial juncture. The Fed noted in March that economic growth had “moderated somewhat,” an admission that indicates some hesitancy about the timing of interest-rate hikes. No doubt recent data disappointments will serve to cast some doubt on an initial rate hike occurring in June. In particular, the weak nonfarm payroll numbers for March (and downward revisions to figures for previous months) could be used as excuses for the Fed to sit on its hands for a while yet before moving to normalize monetary policy. Nonetheless, some senior Fed policymakers continue to believe that the “temporary factors” that hurt US economic growth in the first quarter are likely to quickly dissipate and that the economy should accelerate in the months to come.
In a nutshell, the Fed seems to be wrestling with itself about the actual timing of rate increases. With the Fed’s dilemma potentially causing anguish among market participants, the central bank has been trying to communicate that rate increases, when they come, will be small and gradual, in keeping with its own reduced projections for economic growth up to the end of 2016. The Fed’s efforts to calm markets are laudable, and weak first-quarter data may suggest it can continue to be patient before making a move. At the same time, the Fed no doubt hopes that after six years of near-zero interest rates it can normalize policy sometime soon, with Fed Chair Janet Yellen stating on March 27 that the Fed might not even wait for healthier core inflation and wage growth before raising borrowing costs.
Global Economy Facing Challenges
In its latest World Economic Outlook (WEO), released in mid-April, the International Monetary Fund (IMF) said that global growth remains moderate, with “uneven prospects” across different countries and regions. Global growth, having come in at 3.4% in both 2013 and 2014, is now seen by the IMF as picking up only slightly to 3.5% in 2015,1 with modest improvements from the so-called advanced economies offset by weaker growth from emerging and developing economies, and with Russia and Brazil particularly weak. The IMF believes global growth should pick up further in 2016, to 3.8%.1 We think global growth moving up to 3.5% this year and showing signs of improvement should not be considered too bad a prognosis, and it would bring the world back in line with long-term trends for global economic expansion. Throughout the mid-1980s, and again in the mid-1990s, real GDP growth in the world also hovered around 3.5%, according to the IMF’s WEO data mapper,2 although we may currently be seeing a rebalancing of growth away from some developing markets toward some developed ones.
Longer term, however, the issues of population aging, slowing investment and declining productivity gains are beginning to impact a number of emerging markets as much as they are advanced economies, pushing down potential growth rates in the eyes of some observers. The world’s second- and third-largest economies in particular face some nagging medium-term challenges. Japan is now well over two years into “Abenomics,” a set of policies meant to combine fiscal expansion, monetary easing and structural reform in a bid to extract Japan from deflation. The results so far have been relatively disappointing, with the country falling into recession again in 2014. Although the decline in the value of the yen and cheap oil have lately helped boost economic data again, some structural reforms have been slow in coming, and it is not at all clear the long-term decline in the Japanese economy is over.
But whereas the world has grown used to Japanese stagnation, it is now having to come to terms with a slowdown in China as well. We would note that in absolute terms, 7% Chinese growth in 2015—the government’s official target—is worth more than growth of over 11% in 2005 since the Chinese economy is so much bigger than it was 10 years ago. And China has the fiscal and monetary flexibility to keep its ongoing shift to a more domestically driven growth model on track. However, “managing” slowing growth is hard, especially when the Chinese economy contains many imbalances (such as what many observers regard as huge, wasteful fixed income investments, debt-fuelled property speculation and a poorly regulated shadow banking sector, among others).
The global economy faces more immediate challenges as well. One in particular is the reaction of emerging markets to the possibility of the first base-rate rise in the United States in nine years. The jury is still out as to whether financial markets could see a repeat of the “taper tantrum” that provoked a sharp (but short-lived) selloff in late 2013 after the Fed hinted it would begin to curtail its monthly asset purchases. But talk of US rate hikes has fed into US-dollar strength, which has been pinching a number of countries that price public and private debt, as well as imports, in the American currency. However, at this stage, we think fears relating to US-dollar strength may well be exaggerated. Recent data disappointments in the United States may well serve to curtail any further substantial dollar strengthening, and the Fed itself has made it quite clear that any rate rises will be small and gradual. We also believe the global economy as a whole should continue to benefit from the ample liquidity being provided by the Bank of Japan and European Central Bank (ECB) through their quantitative easing (QE) programs even as the Fed moves to normalize policy.
European Recovery Broadens and Strengthens
Investors have continued to pour record amounts of money into eurozone assets over recent months, emboldened by the prospect of an economic recovery as the ECB’s QE policy has suppressed borrowing costs and cheapened the euro. Given the example set by US equity markets after the Fed stepped in to buy government debt in two successive QE programs, investors appear convinced that the rally in European financial markets has considerably longer to run, as the ECB program officially began only in March and the central bank has given no hint it will stop its asset purchases until the QE program is set to end in September 2016. At that point, the ECB may have poured an extra €1.1 trillion into financial markets.
The stellar performance of many US assets after the Fed stepped in to become the largest buyer of government debt between 2008 and 2014 seems to be on the minds of many investors. By early April, a considerable portion of eurozone government bonds were being issued at extra-low yields. The Spanish government recently managed to issue short-term debt at a negative yield, while outside the European Union, Switzerland became the first government in history to sell benchmark 10-year debt at a negative interest rate. This trend has created a powerful incentive for investors to own higher-risk assets such as corporate bonds and equities that pay a higher dividend. Although European bond yields might not look so aberrant in light of the region’s current low levels of inflation, it is unprecedented to see almost one-quarter of European government debt offer negative nominal yields. European growth is still less firmly established than in the United States, yet benchmark bonds there offer better yields than those offered by Italy and Spain—two countries that were at the center of the sovereign bond crisis just three years ago. Debt levels throughout the eurozone remain elevated, and, in spite of improvements, European banks remain highly leveraged. Yet European bond prices are clearly under the influence of ECB bond-buying that seems apt to compress bond yields until the QE program finishes. For many investors, the only alternative to accepting ultra-low government bond yields is therefore to move into riskier assets, which is likely what the ECB would favor.
Indeed, an increased appetite for risk is not only to be seen in higher asset prices, but also in the real economy, with substantial improvements in lending for the past two quarters, according to the ECB’s lending survey. Better demand for business loans in particular could translate into higher investment and job creation. The decline in the value of the euro since the middle of 2014 has also been providing a boost for eurozone companies that have foreign-based revenues.
All in all, currency and oil-price weakness has been feeding into early signs of a deepening recovery in the eurozone, as can be seen in a variety of data, including eurozone industrial production, consumer and business confidence measures, and retail spending. With the ECB’s bond-buying underpinning confidence, we believe this upturn in data could well be maintained for some time to come.
What could go wrong? Most obviously, the cheering that has greeted improving growth in the eurozone has to some extent drowned out concerns about the consequences of a possible Greek exit from the eurozone. The mainstream view seems to be that the rest of Europe can cope with “Grexit.” As the continuous slide in peripheral eurozone bond yields shows, there is certainly no contagion from Greece. The radical left government in Athens has pulled off the extraordinary feat of alienating pretty much every potential sympathizer among other eurozone governments, and the feeling is that a eurozone without Greece can prosper just fine. Greek debts have been ring-fenced, with the European financial sector’s exposure to Greece pared back considerably since the last sovereign crisis of 2010–2012. Yet, even as negotiations over extending further help to Greece go down to the wire, Greece’s government has run out of money and is unable to meet the substantial debt repayments it faces this year. With rumors swirling, there remains a possibility that the Greek situation could unravel very quickly, leading to the country’s chaotic exit from the eurozone that would only serve to underline the deep intrinsic flaws in the euro project.
Less dramatically, low interest rates and complacency about the recent upturn in growth could encourage governments to stave off structural reform. For example, in mid-April, France announced it was targeting lower structural budget cuts than those requested by the European Commission in Brussels. More generally, while the eurozone is being lifted by currency weakness for the moment, prospects could be dimmed by signs of a sustained slowdown in large emerging markets like China, as well as by any prolonging of the recent weakness seen in the United States. Alternatively, however unlikely it might seem, an unexpectedly sharp rise in inflation could bring the current low interest-rate environment into question. For the moment, however, we can expect, in the words of ECB President Mario Draghi, “the economic recovery to broaden and strengthen gradually.”
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What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.