Peter Rawson-Harris, Research Analyst, Macquarie
Wednesday 08 June 2016
Monthly economic commentary: May 2016
Peter Rawson-Harris, Research Analyst, Macquarie
Economic and market highlights
The global economy remains stuck in a low growth trap, according to the latest Organisation for Economic Co-operation and Development (OECD) economic outlook. More immediate themes attracting the attention of investors are the impending “Brexit” vote and June’s Federal Open Market Committee (FOMC) meeting, at which members will consider whether it is appropriate to lift United States interest rates.
Long bond yields in developed markets show little signs of buoyancy with the US and United Kingdom adding a single basis point to 10-year rates in May. Yields in most other developed markets continued to sell off in response to fears around the growth outlook and difficulties with generating inflation. Short yields in the US are responding to greater likelihood that interest rates will increase this year.
Major equities markets have had mixed results. The confluence of a more dovish US Federal Reserve (Fed), the implications of a Brexit and the stabilising effects of stimulatory policy in China do not make for a clear signal. The last few months have seen prices of risk assets supported but the coming month will see the outcome of two major catalysts critical to future market direction: the UK’s referendum on membership to the European Union, and a possible June or July interest rate rise in the US.
The recent hawkish tones of the Fed communications have produced a renewed strengthening of the US dollar, which gained against major currencies. The recent strength of the Yen driven by traders covering short positions subsided. The Reserve Bank of Australia rate cut and increasing prospects of US interest rate rises produced a 5.1 per cent weakening of the $A/$US exchange rate.
A backdrop of declining growth
International Monetary Fund (IMF) forecasts of global economic growth have crept lower, with successive iterations weaker than the previous set. The recovery was steadily becoming long and shallow. At the end of 2015, the IMF estimate of real economic growth for 2016 was 3.56 per cent. Several months later, in a preliminary estimate of growth in 2016 for the full year, the IMF revised this downward by 40 basis points to 3.16 per cent. Global growth continues, but at a rate that leaves it heavily exposed to risks.
Source: IMF WEO, MWM Research, May 2016
The OECD echoes similar concerns in its latest economic outlook, highlighting that monetary policy alone will not be effective in stimulating growth and inflation, and suggests coordinated monetary and fiscal policy.
Earlier this year, the market was gripped by mounting fears of a global recession. Several factors were at play: oil was selling off aggressively; data on the Chinese economy was deteriorating; the tone of Federal Reserve statements and communiqués had been relatively hawkish; while other central banks were navigating the limits of monetary policy as they sought to arrest deflationary forces, and stoke inflation and consumption.
Despite the consensus view that the poor economic fundamentals are necessitating a long and shallow recovery, more recently, markets have been reasonably resilient. Since the depths of the first quarter sell-off, oil has firmed and there has been a cyclical improvement in Chinese data. Even though the Fed has adopted a slightly more hawkish tone of late, judging from the impressive comeback in risk assets, global markets appear prepared to leave the anxiety behind. Many markets have recovered much, if not all, of their losses from earlier in the year. The equity market in the US, represented by the S&P500, is sitting at the key 2,100 level, which the market has not been able to meaningfully break through for almost a year. A broader measure of global equities, the MSCI World Index, sits around 7 per cent beneath its 2015 peak. Now is the time when investors begin to question whether the fundamentals have improved enough to justify further strength in risk assets. This would necessitate the S&P500 making all time highs. Consideration of the monetary and fiscal policy backdrop, economic fundamentals, and the earnings outlook may suggest that things have not improved sufficiently to justify another sustained rally in equities.
Flocks of confused birds
The latest set of minutes released by the United States FOMC reads with a slightly more hawkish tone than pundits and market participants were expecting. A few months ago, in the wake of January market meltdown, the tone was decidedly dovish and a few months before that it was hawkish. If you find all this flip-flopping confusing, don’t worry. You’re in good company.
To dispel some of this confusion, the FOMC supplied criteria in typical prosaic fashion which, if met, will trigger another increase in interest rates.
Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labour market conditions continuing to strengthen, and inflation making progress toward the Committee's 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.
Such explicit indications of the “what, when and why” of interest rate increases are unusual but it has had the desired effect. At one point during the turmoil of the first quarter sell-off, market pricing of Fed futures implied that there was only a 15 per cent chance interest rates would be greater than 50 basis points by December. The same futures contract, which corresponds to the December 2016 FOMC meeting, is now priced at 83 per cent. The FOMC have been going to great lengths to ensure markets reflect what the Fed believe is a realistic chance of higher interest rates, lest the market be induced into another panic-stricken sell-off when caught unaware.