Perspective from the Franklin Templeton Fixed Income Group
IN THIS ISSUE
- US Likely Inching toward Interest-Rate Hike
- China Intervenes to Prop Up Growth and Calm Its Stock Market
- Greek Battle Disguises Eurozone Improvement
US Likely Inching Toward Moderate Interest Rate Hike
US Federal Reserve (Fed) Chair Janet Yellen gave the clearest indication yet that the central bank is likely to start raising interest rates later this year when she said in a speech on July 10 that she expected it would be “appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy.” As usual, the Fed chair hedged her bets somewhat, saying she wanted to see further improvement in labor market conditions and greater confidence that inflation would move back up to 2% in the next few years, but, based on current trends, it seems that small, incremental hikes in base interest rates are looming on the horizon.
Undoubtedly any decision on monetary policy normalization will have to take into account some of what is happening outside of America’s borders, including the hazy economic outlook for China, the slowdown in other large emerging markets and the uncertainties that continue to plague the eurozone. Any move toward US monetary policy normalization would come in spite of an appeal from the International Monetary Fund (IMF) that the country delay raising interest rates until next year. The IMF expressed concerns over the rise in the value of the US dollar, which has gained about 20% against a basket of currencies in the past year and led to a deepening trade deficit. More gains by the dollar—abetted by expectations of rate rises—could leave growth in the United States “significantly debilitated,” according to the IMF.
But we believe purely US domestic factors continue to argue in favor of lifting short-term benchmark rates from the “at or close to zero” level where they have been stuck since 2008. Most tellingly, the US nonfarm payroll report for June showed that the US economy has continued to create plentiful jobs, which has led to a fall in the unemployment rate to 5.3%. After the first quarter’s negative economic growth, the increase in employment has fed through into some spending indicators and to a real estate recovery, with the S&P/Case-Shiller index of home values in 20 cities rising 4.9% from a year earlier in April. Additionally, car sales have been buoyant for several months. All in all, recent data would seem to confirm the Fed’s view that first-quarter 2015 weakness was “transitory” and that the US economy regained its footing in the second quarter, perhaps setting the stage for a more robust second half of the year.
The US economic picture, however, is not entirely unblemished. Productivity gains have been weak, the participation rate (meaning the percentage of the labor force in employment) declined to 62.6% in June—the lowest level since 1977—and hourly wage growth was flat in the same month. In spite of the drop in gasoline prices, consumers have remained cautious, as a 0.3% drop in retail sales in June suggested. Such factors explain the restraint that the Fed has continued to show, even as it leans toward rate rises. Meanwhile, manufacturing output was flat in May and June.
But one can be reasonably sanguine on at least some of these points. The Institute for Supply Management’s purchasing managers’ index (PMI) showed that US industry has continued to expand, and while weak retail sales betray consumer caution, The Conference Board’s consumer confidence index for June was still much higher than a year ago.
However, the lack of growth in hourly earnings is something of a conundrum (average hourly wage growth was flat month-over-month in June and up over the past year by just 2%). The growth in contract employment, automation and crowd sourcing could well be having a negative influence on wage increases and sapping the bargaining power of full-time employees. However, hikes in minimum wages in a number of states and reports that prominent companies are having to offer higher pay to attract workers may start to show up in wage statistics in the months ahead. Meanwhile the employment cost index (ECI)—which is compiled by the Bureau of Labor Statistics on a quarterly basis—suggested relatively solid 2.8% gains in wages in the year to end-March. Many observers expect hourly wages to pick up and become visible in statistics if and when the economy expands.
All in all, the Fed continues to expect inflation to rise gradually toward 2% over the medium term as the labor market improves further and the transitory effects of energy price declines and other factors dissipate, but the pace for hikes in interest rates could well be moderate, as the Fed has been indicating.
China Intervenes to Prop Up Growth and Calm its Stock Market
It is generally felt that the wild, retail-driven speculation on the domestic Chinese stock market has little relation to economic fundamentals. China’s domestic stock markets doubled in value in the space of less than a year only to fall by 30% during three weeks in late June through early July, before rising sharply again after central bank intervention. The stock market is just a small part of the Chinese economy, and a previous boom and bust in Chinese equities in 2007–2008 had little impact on consumption, retail sales or industrial production.
Yet jitters on the Chinese stock market have caused unease among observers because of the potential fallout for the world economy. They have come amid some reports suggesting that even the reduced economic growth figures that the Chinese authorities have been presenting of late have been enhanced by a decline in the cost of imported commodities—which helps the trade balance and hence the ultimate GDP figure. This unease has been compounded by the downturn in exports to China (and to Asia in general) that a number of countries have been reporting. Chinese imports slumped by 17.6% in May (year-over-year), according to official data from the General Administration of Customs, and by a further 6.7% in June (year-over-year).
In spite of the Chinese stock market’s relative unimportance, the Chinese authorities have pulled out all the stops to ensure that equity volatility does not spill over into the wider economy. The People’s Bank of China cut interest rates four times between November and the end of June, with the last of these cuts seen in part as an effort to prop up stock prices. Bank reserve requirements were also cut for similar reasons. Fiscal stimulus has also been introduced. Thus, extra liquidity is flowing through the Chinese economy, which may help stimulate growth not only in China but also in many emerging markets that export to China. Additionally, government spending on infrastructure has helped stabilize industrial activity, and property prices in major cities have started to tick up again after long being in the doldrums. The major shift toward reflationary macroeconomic policy would seem to trump events on the stock market in determining Chinese growth. China recorded 7% annual growth in the first quarter of 2015 and again in the second, which was slightly better than analysts’ forecasts, while measures of monthly activity showed bank lending increasing in June and a rebound in factory orders. The decline in Chinese imports seems to be tapering off, while Chinese exports rose in June, breaking a three-month slide. Chinese GDP growth is well below the double-digit rates the country achieved a decade ago, but with the Chinese economy now considerably bigger than it was then, we remain confident that even with a moderate deceleration in annual growth, the country will continue to contribute significantly to the global economy.
However, the recent sharp gyrations in stock prices may have a number of indirect consequences. Margin lending to buy shares may well decline as humbled investors deleverage, but there is the danger that fresh liquidity will go into different speculative bets—money might again flow into real estate ventures, for example—thus holding out the possibility of fresh problems sometime ahead. The stock market whiplash also poses a credibility problem for the Communist regime, particularly with regard to its economic and financial liberalization program, of which the progressive opening of the domestic share market was meant to be a part. Wild swings in the market, just like the authorities’ intervention to prop it up, could well delay the development of fully functioning capital markets as an alternative to bank loans. Propping up share prices—as the Chinese authorities have been doing in recent weeks through bans on short selling and feeding cash to brokers to buy shares—represents a distortion in the allocation of capital. However, some observers might remark that the rolling-out of quantitative easing programs in developed markets over the past six years has also distorted financial markets.
Greek Battle Disguises Eurozone Improvement
After laborious negotiations during the night of July 12–13, Greece agreed to a third bailout totaling €86 billion—or, more precisely, it reached an agreement on a process to launch negotiations on a new program of aid from the European Stability Mechanism. Perhaps the most interesting aspect of the bailout agreement is a provision that forces the Greeks to transfer up to €50 billion of state assets to a new fund to recapitalize Greek banks, reduce debt and make new investments.
But Greece has received two previous bailouts since 2010 that have failed to provide a definitive fiscal cure. With little by way of investment or industry, and with generally poor demographics, Greece’s overall economic viability remains in doubt, as does its capacity to carry through the drastic reforms that its creditors have exacted as the price for a third bailout, especially as resistance hardens to the measures and onerous oversight insisted upon by the international lenders. Reforms will have to be meticulous and excruciating for Greece to stand any chance of eventually paying its own way, but it is by no means certain that after five years of austerity and a 25% drop in the size of the economy, another severe dose of the same will solve Greece’s long-term problems.
In the circumstances, one might seriously question Greece’s ability to pay back any of its existing debt (about €320 billion), never mind yet another bailout. The IMF, skeptical of the plan outlined on July 13 and somewhat removed from European sensibilities over the issue of debt relief for Greece, has pressed for more precise details on how the new plan will stabilize Greek finances in the short term as well as over the long run, and it has called for “dramatic” measures to lighten Greece’s debt burden. Yet on the question of restructuring the country’s debt or canceling it altogether, the summit agreement is somewhat (and potentially purposefully) vague. “Nominal haircuts” on Greece’s debt “cannot be undertaken,” it says, but “longer grace and payment” periods might be considered.
Overall, while Europe has avoided “Grexit” (meaning a Greek exit of the currency bloc) in the immediate term, the Greek economy remains in intensive care. It is, of course, possible that the agreement on a third bailout clears all the hurdles placed before it and that the shock therapy to which Greece is being subjected quickly sparks an upsurge in confidence among international investors and Greeks themselves. But that might be a tall order. Unless business confidence and recovery can be fostered in the coming months, the country may continue to face a highly uncertain economic and political outlook, even should the radical left government of Prime Minister Alexis Tsipras manage to survive its own internal contradictions.
Nobody has come out of the Greek crisis shouting victory. Since Tsipras came to power in January, tempers have flared, insults have been hurled, a rift has appeared between a generally more conciliatory France and less pliant Germany, and the idea that the European “union” is a solid entity where solidarity between countries can be taken for granted has taken a serious hit. The threat of Grexit seems likely to reverberate through the European Union for some time yet. The impasse that Greece’s radical left government has found itself in could either sharpen or dull electoral appetite for a change to the traditional center-left/center-right divide that dominates European politics. In this regard, Spain’s general election in November will provide a useful indicator of the spread of populism in European politics. Meanwhile, countries such as Poland and the Czech Republic that are supposed to adopt the euro in the years ahead might now have second thoughts. And the imbroglio surrounding Greece will undoubtedly be used by those campaigning for the United Kingdom’s exit from the European Union in a referendum to be held in 2017.
European bond markets initially welcomed the deal made at the July summit, although the narrowing of spreads for peripheral bonds over German Bunds was relatively muted, perhaps signaling a measure of skepticism among investors about the ability of the eurozone to survive in the absence of a formal mechanism that ensures the sharing of liabilities among member states. But the widening in spreads at the height of this most recent crisis was also very mild when compared with the 2010–2012 period, suggesting European markets remain fairly sanguine about the state of the region’s economy. Indeed, with the exception of Greece, the European economy has continued to motor along. Sentiment continues to be cushioned by ECB bond-buying and subdued energy prices. The banking system has been strengthened, fiscal policy is broadly neutral, and the euro remains weak, helping exports. The ECB’s latest quarterly banking survey showed that, with ECB support, banks are easing credit standards for loans to enterprises—an encouraging sign, as the chronic weakness in loan activity has been blamed for the absence of any meaningful recovery in the eurozone. In a similar vein, the Markit composite eurozone PMI, which combines measures of manufacturing and services activity, has continued to indicate healthy expansion, rising in June to its highest level in four years.
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