Monday, November 28, 2016

International Economic Week in Review

      Earlier in the week, Mario Draghi gave a speech where he noted three positive trends within the EU economy.  First, the banking sector was far stronger now than immediately after the recession.  Tier 1 capital increased from 7%-14% and lending to business was up.  Second, domestic demand growth now accounted for 1% of overall GDP growth.  This is in contrast to export demand, which contributed little to growth in the last 12 months.  Finally, the unemployment rate has dropped from 12% to 10%.  While this seems high by western standards, it does indicate the EU economy is making progress.  In other EU news, Markit released their latest flash estimate for the EUs manufacturing, service and composite indicators.  The service reading was 54.1, an 11 month high.  Manufacturing was also 54.1 as was the overall composite reading.  It appears that the ECBs bond buying program has been successful.

     Earlier in the week, newly appointed BOJ member Masai gave a speech that highlighted various risks to the international economic order:

The election of Donald Trump as U.S. President, Brexit, and the weak state of the European Union's financial sector have been named by Bank of Japan board member Takako Masai as possible causes of future global economic weakness and wild financial market swings.

Since Trump’s election, equities have rallied and global bonds have sold off.  The drop in bonds was so severe that the BOJ used its yield curve control program to halt the sell-off.  While some have argued the bond sell-off is overdone, there is no denying that the reflation trade now dominates global investment thinking, indicating that Masai’s concerns are well justified.  Other news showed a weak economy.  Exports declined 10.3% Y/Y while the Markit manufacturing flash estimate was 51.1, a number that, while positive, is statistically weak.

     The UK’s ONS released their second estimate of 3Q GDP, which was unchanged from the first report of a 2.3% Y/Y increase.  Services were the sole source of growth, rising .8% Q/Q.   Production, in contrast, decreased .5% as 3 of 4 subsectors decreased.  The UK’s Brexit quandary deepened.  Some governmental factions continued to push for a complete withdrawal while an increasing number of business leaders began advocating for a “soft Brexit,” which would comprise a multi-state withdrawal lasting over 2 years.  This would allow additional time for businesses to more gradually change their policies and structures, preventing severe economic disruption. 

     The RBA’s Christopher Kent gave a speech that not only contained a clear explanation of the current state of Australia’s economy, it also included an assessment of the economic conditions at the state level.  Kent described the macro level economy in the following terms:

The economy continues to adjust to the end of the resources boom (Graph 1). Our expectation is that GDP growth will be close to potential growth over the next few quarters and pick up to be a little above potential thereafter. The unemployment rate, which has declined over the past year by more than expected, is likely to edge just a little lower over the next two years. That implies that there will be some spare capacity in the labour market for a time. Inflation is low. In year-ended terms, we expect underlying inflation to remain around 1½ per cent for a few quarters before gradually increasing to more normal levels. That profile follows from the forecast for the growth of labour costs to rise gradually and is consistent with the medium-term inflation target.

Kent’s analysis also contained a positive assessment of the overall terms of trade:

One notable aspect of our latest forecasts was the upward revision to the outlook for Australia's terms of trade. Prices of bulk commodities have risen this year and contributed to a rise in the terms of trade of about 6 per cent in the June and September quarters. That's the first rise in the terms of trade in some time. Our forecasts are for the terms of trade to remain above the low point reached earlier this year (and about 25 per cent above the average of the early 2000s before the boom). While our forecasts are uncertain and subject to various risks, the upward revision represents a marked change from the pattern of the past five years. Our assessment, based in part on liaison information, is that the improved outlook for commodity prices is not likely to lead to a noticeable pick-up in mining investment (in the near term at least). Even so, if our forecasts are right, the terms of trade will shift from the substantial headwind of recent years to a slight tail breeze providing some support to the growth of nominal demand

The biggest reason for better terms of trade (the difference in price between exports and imports) is the rise in industrial metals prices, which is captured by the daily DBB ETF chart: