Announced: MPC rate decision
Actual: 1.50% Consensus: 1.50% Previous: 1.50% Phatra: 1.50%
Policy rate on hold, stronger bullish signal sent
The Monetary Policy Committee (MPC) voted five to two to hold the policy rate at 1.50%. The number of dissenting votes, to raise the policy rate to 1.75%, increased from one member in August. The rationale of raising rates is “ to curb financial stability risks that could affect the sustainability of economic growth over the longer term and to start building policy space.”
” Nevertheless, the statement said that despite continuing to gain further traction, “the Thai economy would be subject to downside risks and uncertainties.” Hence the MPC viewed the current accommodative monetary policy stance “as appropriate given the inflation target.” However, the MPC sent a strong signal that while monetary policy should remain supportive, “the need for currently accommodative monetary policy would be gradually reduced.” This is a reinforcement of bullishness in the August MPC minutes, which stated that “should economic expansion continue and inflation move more firmly within target, the need for currently, extra accommodative monetary policy would start to be reduced.”
Growth continued; external risks emphasized
The MPC continued to be bullish on domestic demand. However, the September statement also referred to external risk factors. Growth in merchandise exports was “expected to slow down somewhat due to trade protectionism measures between the US and China,” but the effect may be moderately neutralized by “benefits from the relocation of production bases to Thailand.” Headline inflation was expected “to rise slowly in line with the previous assessment,” despite downside risks from volatile fresh food prices. Core inflation, however, “was expected to increase at a lower rate than previously assessed” due to “the gradual build-up of demand-pull inflationary pressures.” On financial stability, the MPC viewed that it remained sound overall. However, it is especially concerned about “competition in the housing loan market which led to looser credit standards”. Note that after the MPC vote was released, the baht exchange rate against USD strengthened to 32.44 (at 3.35 p.m.)from Bt32.55/USD (at 2.00 p.m.).
Downward revision for 2019 inflation
The MPC maintained its GDP growth projections at 4.4% for 2018 and 4.2% for 2019. The MPC slightly upgraded 2019 private consumption and investment from its June forecast (see Table 1) while goods export value was downgraded to 4.3% from 5.0% due to trade protectionism measures between the US and China. Also, the MPC revised down government spending in 2018-2019 due to constrained budget disbursement. Although the MPC revised up domestic demand growth and Dubai oil price assumptions in 2019, headline inflation in 2019 was slightly revised down to 1.1% from 1.2% in its June forecast. Core inflation in 2019 was also revised down to 0.8% from 0.9%. The risks to its inflation forecast are still skewed downward as fresh food prices could fluctuate sharply and structural changes might contribute to more persistent inflation than in the past.
Announced: August exports
Actual: +6.7% Previous: +8.3% Consensus: +4.5% Phatra: +6.2%
Solid exports, trade balance deteriorated as imports surge
August export value was recorded at US$22.8bn, rising 6.7% YoY. Imports hit the highest value in 64 months at US$23.4bn, up 22.8% YoY in August. The surge in imports caused the trade deficit to widen to US$588mn, from the US$516mn deficit in July.
Export value is solid, averaging at US$21.1bn a month YTD. We expect exports to remain firm with growth at about the mid-single digits for the rest of the year. The trade tension between the US and China and the slowdown in global growth should be headwinds for Thai exports next year, in our view. A surge in the import bill would deteriorate trade and the current account surplus in 3Q.
Automobiles and energy-related exports still firm
Exports of agriculture and manufactured products grew at a moderate rate. The main growth drivers for August were automobiles and energy-related products (petroleum, chemicals and plastic products), rising 17.4% and 19.3%, respectively. Food exports especially frozen fruit and frozen/processed chicken also performed well. Meanwhile, export growth of electronics and parts softened in August, rising only 3.0% YoY, driven by hard disk drives (-0.3%) and IC (-0.6%), partly a result of base effect.
In terms of markets, exports to ASEAN-5 and CLMV strongly expanded at more than 30% YoY. Also, exports to Japan improved to 14.6% YoY. All three markets have performed very well YTD. Meanwhile, exports to the US, China, Korea and Taiwan have weakened.
Surge in energy and gold imports
August imports rose strongly by 22.8% YoY, driven by a surge in energy imports (+37.9% YoY) and gold (+268% YoY). The import growth excluding gold rose 13.9% YoY. In addition, imports of steel surged 31.6% YoY. Meanwhile, imports of computer and parts and electrical machinery were strong, which is positive for exports in the coming months.
Announced: Wednesday, 19 September, 5:00pm ET
Actual: 6.50% Previous: 6.50% Consensus: 6.50% BofAML: 6.50%
Copom keeps the selic on hold at 6.50%
The Copom (monetary policy committee) kept the selic rate on hold at 6.50% (from a hold decision in the previous meeting). The decision was unanimous and in line with our and market expectations. On activity, the statement noted that recent economic activity indicators show the economic recovery remains on track, albeit at a slower pace than anticipated at the beginning of the year. The statement highlighted that external scenario remains challenging, with lower appetite for exposure to EMs, mainly due to ongoing normalization of interest rates in some advanced economies and higher concerns over global trade. The BCB changed its wording on inflation, stating core inflation measures are currently at “appropriate” levels (vs “low” levels in the previous statement), including the components most sensitive to the business cycle and monetary policy.
BCB inflation number above 19 target under 4.1 BRL
BCB inflation forecasts increased overall compared to those presented in the August minutes, mainly due to upside revisions in assumptions for the BRL. Under the market scenario, inflation forecasts decreased to 4.1% for 2018 (from 4.2% previously) and increased to 4.0% for 2019 (vs 3.8% previously). The market scenario considers the selic ending 2018 at 6.50% and increasing to 8.00% in 2019-end, and the BRL at 3.83 in 2018 and at 3.75 in 2019 (from 3.70 in 2018 and 2019 previously). Under the reference scenario, with constant selic at 6.50% and BRL at 4.15 (vs 3.75 in the August minutes), inflation forecasts rose 20bp to 4.4% in 2018 and 40bp to 4.5% in 2019. In our view, this suggests the BCB will need to hike rates soon if the BRL remains at current levels, as BCB forecasts show 2019 inflation above the 4.25% target.
On hold but ready to act if risks worsen
The statement repeated that the macroeconomic scenario continues to justify a stimulative monetary policy – i.e. with rates below neutral – but added that such stimulus will start being reduced gradually if expectations of future inflation and/or its balance of risks deteriorate in the relevant monetary policy horizon. The bank is suggesting it remains comfortable in keeping the selic rate on hold for now, but added a tightening bias in the event that inflation expectations start to rise. In our view, the wording “gradually” implies that the plan is to start the eventual hiking cycle with a 50bp hike, i.e. with no interest rate shock. That said, the dynamics of BRL and expected FX passthrough impact could change this. For now, we continue to expect the BCB to remain on hold at 6.50% until year-end.
- We recently cut our German GDP growth forecasts to 1.7% for this and 1.6% next yr., below Bundesbank and consensus forecasts.
- 2019 growth is helped by a small fiscal sprinkle. But if growth slows further, deficit rules limit policy options.
- Politics have complicated. The government almost broke twice since July. State elections are coming. Next year looks tricky.
It didn’t take much to cut our forecasts last week
We recently cut our forecasts for Germany last week (in conjunction with Euro area forecast changes). We now expect 1.7% growth this year and 1.6% next, down 40bp and 20bp, respectively. This puts us below Bloomberg consensus (by 20bp per year). Our forecasts are now also below Bundesbank’s own (2.0% for this and 1.9% for next year, released in June). Does Buba detect something really positive in the current situation that we are missing? We don’t think so. Effectively, it took very little to get us to the new numbers: half of the downgrade comes from incorporating 1H GDP data and revisions. The rest come from auto-sector effects on 3Q.
Buba unlikely to give up on strong 2019 story though
We would even argue that if trade wars intensify further from here, our outlook could start to look optimistic. But we wouldn’t think Buba to give up on optimism for 2019 to argue growth is strong, inflation recovering and monetary policy ripe for normalisation. They can point to government’s fiscal sprinkle and wage growth improvement.
As much fiscal sprinkle as the rules allow
If Buba has set its mind on policy normalization, what can be done if growth unexpectedly deteriorates further? Conventional wisdom suggests that Germany has deep fiscal pockets that go unused due to orthodox policy choices. We have repeatedly argued that it’s a bit more complex than that. The policy choice was made once and for all when the deficit rule was embedded in the constitution in 2009.
One year later post-election, politics have complicated
Rules can be changed, but that needs political will. Politics have complicated a lot though. Germany’s CDU/CSU (Christian Democrats) and SPD (Social Democrats) grand coalition (GroKo) has nearly broken apart twice over the last three months, without much market attention. Upcoming state elections in Bavaria and Hesse (14 & 28 October) could raise tensions again. True, unlike in Italy, Germany’s fiscal trajectory is not at risk. And unlike Brexit, there is no ticking clock for German politics (other than the next regular federal election in 2021). But to us, the fragility of Germany’s political economy and the potential for overhaul seem to be underestimated.
Germany: Stability used to look different
Bundesbank conveys confidence amid weak data We cut our forecasts for Germany last week (in conjunction with Euro area forecast changes). We now expect 1.7% growth this year and 1.6% next year, down 40bp and 20bp, respectively. This puts us below Bloomberg consensus (20bp per year). Our forecasts are now also below Bundesbank’s own (2.0% for this and 1.9% for next year, released in June). Unlike other national central banks, Bundesbank (Buba) only releases forecast scenarios in June and December. But it does provide a qualitative assessment of the economy in its monthly report. In September, it emphasized optimism amid weak July data. In short, its view is that 3Q18 started off weak, but once car sector-specific factors (related to the change in emission testing standards effective since 1 Sep) fade again, economic expansion should resume.
It didn’t take a lot of push for our forecast cuts
Does Buba detect something really positive in the current situation that we are missing? We don’t think so. Effectively, it took very little to get us to the new numbers: c.30bp of the total cut was down to GDP revisions and weaker-than-expected 1H18 growth. We agree that car industry specifics are at play in 3Q, but with the carryover for manufacturing output standing at 1.6ppt for 3Q after July data, even August/September stabilization wouldn’t be enough to offset an impact on 3Q GDP growth. We cut 3Q growth forecasts to 0.2% qoq before resuming the average 1H pace (0.4%) again thereafter. That explains the rest of our forecast changes. If trade wars intensify further from here (and in particular if the US administration’s focus were to shift to EU cars again), our outlook could start to look optimistic.
But Buba is unlikely to give up on the robust 2019 story
Come December, Buba might struggle to maintain its growth scenario, at least for 2018. Its forecast implied quarterly growth rates of c.0.5% for 2Q-4Q18. But revisions and 2Q (0.45%) already lowered the carryover for the year by c10bp. Buba has offered glimpses of concern in between the optimistic headlines: once the car sector normalizes, the expansion should resume, but without a compensating bounce-back. Foreign demand and trade wars are risks. Some labour market indicators suggest a slowing unemployment decline. And we paid particular attention to what wasn’t said: a large section was dedicated to now-casting tools, but without a now-cast for weak 3Q.
Absent further bad growth news, we don’t think Buba would give up on a 0.5% qoq profile for 2019 though, possibly even a bit more than that. Wage growth has been aligned with its expectations (2.9% for this year) and it can always argue that the government’s fiscal sprinkle, which it only partially embedded in the June exercise, will compensate for external weakness. In other words, absent further data deterioration from here, we think Buba rhetoric will remain that growth is strong, inflation recovering and monetary policy ripe for normalization in 2019.
Compromise is not always optimal, and not always possible
If Buba has set its mind on policy normalization, what can be done if growth unexpectedly deteriorates further? Conventional wisdom suggests that Germany has deep fiscal pockets that go unused due to orthodox policy choices. We have repeatedly argued that it’s a bit more complex than that. The policy choice was made once and for all when the deficit rule was embedded in the constitution in 2009. Since 2016, federal Berlin cannot run fiscal deficits anymore, or at least not by more than 35bp of GDP. At 0.10% of GDP in 2017, the structural deficit allowance doesn’t provide much wiggle room (surpluses stemmed mainly from other government levels and social security).
That means that even if the government could strike a compromise on how to ease, the total volume of fiscal easing may be constrained unless we find ourselves heading into severe recession (not our base case). W Euro Area Economic Watch | 21 September 2018 3
One year later, electoral math is getting increasingly complex
Of course, constitutions can change again. But a 2/3 majority in the lower and upper houses is required to get there. Political gridlock and instability in Berlin do not exactly provide the right conditions for such change. Germany’s CDU/CSU (Christian Democrats) and SPD (Social Democrats) grand coalition (GroKo) has nearly broken apart twice over the last three months, without much market attention. In early July, CSU leader and interior minister, Seehofer, threatened to break the coalition over border closure conflicts. Last week, SPD took a hard stance on the fate of the former president of the constitutional protection agency. A compromise was struck both times, but at non-negligible political costs to all parties (at federal and state level) and the chancellor herself. Press reports on Chancellor Merkel’s struggle to maintain support within her own CDU/CSU parliamentary group are becoming more frequent.
The lack of clarity on her succession as CDU leader may be, for now, a key ingredient in the grand coalition’s survival, Upcoming state elections may (for now) put some glue, too, though that could change when they’re over. In Bavaria (14 October) and Hesse (28 October), state elections could renew tensions in Berlin again. In both states, polls suggest that current majorities should change. In Bavaria, the CSU is increasingly unlikely to defend its absolute majority – held almost without interruption since the 1950s. A coalition partner will need to be found.
In Hesse, the current CDU/Green coalition, too, is unlikely to return to majority, possibly requiring a third coalition partner. This has ramifications for Berlin, not least by further fragmenting the distribution of votes in Germany’s upper house. Bavaria’s and Hesse’s state governments hold six and five seats out of 69 in total, respectively, and changes are likely to be to the detriment of Chancellor Merkel’s CDU/CSU group.
The Groko is already short of majority in the upper house, anyway. Legislative gridlocks are rising at a time when many structural issues need tackling: demographic ageing and pensions, nuclear exit, the impact of protectionism on Germany’s growth model, profound long-term changes to the car industry, Euro area institutional setup, just to name the evident ones. 2019 could be Germany’s moment Even before recent events, we argued that the GroKo was intrinsically unstable.
Conflict could arise any time, but we think mid-2019 could be a particularly intense period. Post European elections, Eastern German state elections will come into focus, where polls suggest right-wing AfD support north of 20% (Saxony, Saxony Anhalt, and Brandenburg vote in the autumn).
These coincide with the half-term of the current grand coalition when the SPD plans to assess the success of the GroKo. With two years to go to the next (regular) general election, CDU internal leadership discussions are unlikely to be delayed much further. Market participants already have their hands full following the evident risks: trade wars, Brexit and Italy (from a European perspective). Complications in Spain (see here) and an increasingly fragile German government are somewhat falling off the radar.
True, unlike in Italy, Germany’s fiscal trajectory is not at risk. And unlike Brexit, there is no ticking clock for German politics (other than the next regular federal election in 2021). But to us, the fragility of Germany’s political economy and the potential for overhaul seem to be underestimated.
- Inflation was in line expectations at 2.8% yoy in August. However, core inflation accelerated to 2.1% from 2.0%.
- We maintain our inflation forecast at 2.5% yoy for end-2018 but reduce our forecast for end-2019 to 1.8% from 2.0%
. • We expect the BoC to hike 25bp on Oct 24. We then expect four more hikes after that to the end of 2019.
Core inflation above the mid-range target
Inflation in August was in line with expectations at -0.1% mom nsa (consensus expected -0.1%, BofAML +0.2%) to put the annual inflation rate at 2.8% yoy (consensus expected 2.8%, BofAML 3.1%). Part of the relief in inflation was due to lower prices of gasoline and services related to the end of the summer season (travel tours, airfares) but also due to lower prices for telephone services. The average of the three core measures that the central bank follows increased to 2.1% from 2% in June (Chart 1).
We continue to expect inflation at 2.5% for end-2018
We maintain our forecast of 2.5% yoy for end-2018 but lower our forecast for end-2019 to 1.8% from 2.0% (Chart 2, Table 1). Despite the monthly contraction due to a slowdown in gas price and in a lesser extent due to a contraction in airfares, we expect oil prices to continue with an upward trend, which should continue to push both items to the upside. In addition, we maintain our view that retaliatory tariffs are likely to increase the prices of some consumer goods in coming months, adding pressure to inflation.
We expect a hike in October, and another in Dec/Jan
We expect the Bank of Canada to hike 25bp at its next meeting on 24 October as inflation pressure continues. Core inflation continues to the upside and is now above the 2% target. Seasonally adjusted headline inflation shows an upward trend and is now above 2.5% (Chart 3). We expect the BoC to hike at least four more times after October to the end of 2019 to put the overnight rate target at 2.75% by end-2019. Both headline and core inflation are above the target and yet the real rate remains well below the neutral rate (Chart 4).
Downside risks to our monetary policy call
We see downside risks to our call because the BoC tied future actions to NAFTA negotiations. Our baseline is that Canada will reach an agreement with the US in September and will join US and Mexico in a trilateral trade deal. Under our baseline, a hike in October has a very high probability. But if trade negotiations break, the BoC may want to wait, as monetary policy would face downside risks to growth (from lower exports) but upside risks to inflation (from potential tariffs and FX pass-through).
- Spain outlook decelerates but still decent growth. But fiscal challenges are large.
- Irrespective of whether there is a budget this year, higher taxes look likely.
- Political stability remains challenging, but even without a budget, it is hard to envisage elections before 2H 2019.
Growth ok, fiscal balances are not
Last week we cut our Spanish GDP growth forecast to 2.6% from 2.7% in 2018 and to 2.1% from 2.3% in 2019. The dominant themes in our conversations with clients are the speed of deceleration of the economy, whether the budget will go through (and whether the government will survive) and which taxes will increase. We are not worried about the deceleration; what we are seeing is not far from what we were expecting. But the fiscal situation remains complicated. Irrespective of whether there is a budget this year, higher taxes look likely sooner or later. And, given recent political dynamics, corporates and the upper part of the income distribution are likely to feel the brunt of any increases. Moreover, even without a budget, it is hard to envisage elections before 2H 2019, unless the government’s ability to deliver on anything else is challenged even further.
Should we worry about the deceleration?
No, at least not yet. But the Spanish press has been full of headlines about this lately as if it is an unexpected event. What we are seeing is not far from what we have been expecting. We cut out forecasts for next year by 20bp, but we have only returned to what we were forecasting a year ago for 2019. What we are seeing is just a normalisation of the economy, given fading headwinds and a long period of exceptional growth above potential.
Indeed, higher oil prices (in an economy particularly sensitive to those), a low savings rate, moderating employment growth and still weakly growing wages will not help private consumption, which we expect to decelerate slightly. Meanwhile, capex has been doing well and will continue to do so, but acceleration is hard to see, given global and local uncertainties, and slightly less accommodative monetary policy.
Also, external demand and the stellar performance of Spanish exports have been an important source of growth in the past few years, which is now being called into question with the weakness of foreign demand and the trade war uncertainty (and integration in the German production chain). As we discussed at length last week, external traction will take time to improve, if at all; hence, net exports won’t be able to provide further acceleration.
The good news is that with all these fading tailwinds, the Spanish economy will still be growing above potential next year (which is somewhere between 1% and 1.5%), similar to what we expect for the Euro area.
But we should worry about the medium-term fiscal picture
We have highlighted this before: strong growth has helped hide the lack of structural consolidation of public finances. To some extent, the causality should actually be reversed. Beyond decent potential growth (by European standards), the Spanish cycle has been boosted by a moderate pace of fiscal retrenchment lately – over the past few years, the European Commission (EC) data has pointed to some net fiscal loosening. And the latest EC forecasts have the structural balance above 3% at the end of 2019, without including measures on pensions implemented in mid-2018, which would put the structural budget deficit at close to 3.5% of GDP.
In other words, the Spanish government still has a structural budget deficit above the 3% SGP framework. And this is clearly highlighted by our risk management approach to debt sustainability which shows a tiny percentage of scenarios that would lead to declining public debt profiles, absent strong policy action (Chart 5).
In the meantime, the cycle, ignoring potential policy changes we discuss later in the piece, will help improve the overall budget deficit. At constant policies, we still forecast a budget deficit of 2.7% this year, although recent weakness in the GDP deflator could prevent Spain from exiting the excessive deficit procedure. In 2019, the budget deficit should be slightly below 2.5%. In other words, the economy that, at the end of 2018 will have grown in nominal terms almost 17% since the end of 2013, will have only managed to reduce the budget deficit by 4.5ppt of GDP (and less than 3.5 ppt of GDP when looking at the primary balance). This clearly reflects the severe challenge for public finances and the lack of proper effort in the last few years (and to some extent the procyclicality of fiscal policy in the country). Hence, we insist on several points we have made before. First, the pension system in Spain has a sustainability issue. More than half of the budget deficit this year will be driven by the gap in the pension system. The pension system is quite generous, compared to peers (see coverage ratio in Chart 6) but some of the long-term challenges have been at least partially corrected by past reforms that delinked pensions from inflation, and introduced an intertemporal budget constraint to the system. Also, starting in 2019 a life expectancy adjustment was set to be in place.
But as part of the negotiations to approve the 2018 budget, the previous government agreed to restore the link between pensions and inflation and the life expectancy adjustment was pushed at least until 2023. In other words, the budget for 2018 de facto questioned the reforms that improved the sustainability of the system and certainly questions the political capital for dealing with this issue in the short run.
Chart 7 and Chart 8 help understand the big picture a bit better. Chart 7 shows that Spain is 6ppt below the Euro area average when it comes to government expenditure of GDP. Chart 8 shows that the gap when it comes to revenues is 8.3ppt of GDP. What this suggests is that part of the solution for fiscal challenges in Spain will involve closing the bigger gap on the revenue side. Irrespective of whether this happens this year, the direction of travel is clear, in our view. This is even more evident given that, as we argued before, the strong presence of a far left force like Podemos in Parliament forces everyone else to move slightly to the left. And, given the resistance to address the pension problem in the short run, taxes are likely to move higher well before the pension system is made sustainable.
Still challenging parliamentary arithmetic One of the dominating themes of our conversation with clients, beyond the speed of deceleration, is whether the budget will go through and which taxes will increase. Indeed, there has been wide speculation on taxes in the context of the budget negotiations: a tax on banks’ profits (now morphed into a financial transaction tax), higher corporate taxes by eliminating some exemptions and deductions, greater excise taxes, a tax on technological companies, an increase in the savings tax, and a rise in income tax for the upper distribution of income. We insist that the direction of travel, whether this year or next, is for higher taxes. And, given recent political dynamics, corporates and the upper part of the income distribution are likely to bear the brunt. In the short run, we insist on the complicated parliamentary arithmetic. The current government has 84 seats (out of 250) and it requires several parties to approve a budget. Among those, some could oppose tax increases (the Basque party PNV, for instance).
Others, the Catalan secessionists, have shown of late resistance to support any budget unless some charges are dropped on their jailed leadership. All in all, it is far from clear that a budget for 2019 is within reach. Does that mean we are heading for a new election soon? Even without a budget, a new election is not necessary. A budget can be extended, for instance. And even the budget is not something that needs to be dealt in the very short run. The government plans to present a budget in November. It would need to be voted on by parliament in February/March. And then European elections are in May.
So even without a budget, it would be hard to see an election before 2H next year (elections are to be held in 2020 at the latest). But as we argued before, this will be a strategic decision. We were expecting this government to push ahead on measures for which there was a parliamentary majority previously – some even blocked by the old government. So far, the government is delivering. Exhuming Franco’s remains and ending special legal protection for lawmakers will keep the government busy for the next few weeks. Other measures like the socalled gag law and the “sun tax” are also likely to be addressed.
As long as the government is able to deliver on some of its promises it is likely to continue, in our view. Of course, the situation remains fluid and there are plenty of risks. Recent developments where Prime Minister Sanchez has been accused of plagiarism could force him to resign if this is proved, although it seems unlikely at this point. Any parliamentary process would likely require the support of the Catalan secessionists and there support has been called into question in the past few weeks. If the government’s ability to deliver is questioned, then we could still have elections soon.
Catalonia: a smaller issue for now at least
We still don’t think a proper solution for the secessionist push is within reach. Negotiating does not seem to be an option given the secessionist side wants to discuss a legal referendum, which the Spanish government cannot do and there is no parliamentary majority for this. Escalation remains and will continue to be an ongoing risk. The next few months, particularly in October, will mark the anniversary of important developments last year. But government attempts to dampen the Catalan confrontation have worked at least partially, limiting the impact on growth of a protracted and escalated confrontation so far.
Nudge up growth on solid 3Q
The third quarter is looking solid for the UK after strong July services growth and decent retail sales for August. We are now tracking 0.5% qoq growth in 3Q, and we now ‘mark to market’ our 3Q growth forecast which had previously been 0.2%. That raises our 2018 growth forecast to 1.3% and 2019 to 1.1%, both up 10bp. A heatwave does not change the big picture A heatwave driven consumer spending pop doesn’t change the big picture. Average GDP growth of 1.3% annualized over the past 18 months tells a story. We expect payback in 4Q for 3Q’s strength, as the latter is not supported by consumer spending surveys, income growth or wealth.
Tax receipts also suggest consumer momentum weakened in late summer in contrast to retail sales data. Meanwhile, recent Brexit developments could weigh on growth later this year. We forecast 0.2% qoq GDP growth in 4Q. Global growth not the boost it was UK and Euro area PMIs are highly correlated. The latest reading for the latter suggests the UK manufacturing PMI could get close to signaling a UK sector contracting. That highlights the broader point from recent revisions to some of our key global forecasts. Global growth may not be the tailwind it was earlier this year. This is another reason why we expect slowing into the 4Q.
Inflation up then down
We raise our near-term inflation forecast after this week’s upside data surprise. But we expect most of that surprise to unwind in a few months. Further ahead, we cut our inflation forecasts on the assumption that the forthcoming utility price cap cuts utilities inflation next year. We expect CPI inflation to trough at 1.7% next summer. The dilemma that is not a dilemma Some observers have characterized this week’s data as a dilemma for the BoE.
Above target inflation requiring rate hikes despite weak growth. We see things somewhat differently. Growth averaging 1.3% annualised does not look above potential to us. 0.5% would but that looks like a blip to us. Meanwhile core inflation was 2.1% in August, down 60bp in 10 months with further to fall. Unless commodity prices surge further headline inflation will fall back to core by this time next year. Traditionally central banks would look through energy inflation.
So we think little has changed. Growth averaging at or below trend and domestic inflationary pressures soft. Could the next BoE hike come as early as February? This has been a particular focus of client conversations this week. If everything goes right with Brexit negotiations from here on so a deal is done in November, voted through the UK parliament before Christmas, growth remains solid into 4Q and inflation keeps surprising on the upside then yes.
That timeline looks questionable to us, especially after Salzburg and PM May’s speech. Central case we continue to assume one hike a year from the BoE with the next hike in May, assuming a Brexit ‘deal’. UK Macro Viewpoint: Making sense of Brexit scenarios 16 August 2018 details our view on the alternative Brexit scenarios.
The joys of summer
Strong summer consumer spending growth adds to other signs that the UK is heading for around 0.5% qoq growth in the 3Q. Our tracker sits 0.4%/0.5% (Chart 16), so today we raise our 3Q growth call to 0.5% from the previous 0.2% qoq. We argue below that there is a lack of fundamental support for the summer surge. So we assume payback in the fourth quarter, with GDP growth slowing to 0.2% qoq. Together this raises our 2018 growth forecast to 1.3% from 1.2% and our 2019 forecast to 1.1% from 1.0%.
Retail strength not supported by anything
If retail sales are beating income growth – saving is falling – that suggests either wealth is growing rapidly, interest rates are below neutral or it’s a blip. By eliminating the first two explanations we settle on the blip story. Retail strength has not been supported by income (Chart 9) and looks out of whack with surveys (Chart 10) and tax receipts (Chart 7). While employment in the retail sector has been particularly affected by the shift to on-line retailing, accelerated declines in retail jobs recently compares to apparently accelerating in-store retail sales volumes (Chart 11). Real house price inflation sits close to 0%. Falling housing transactions suggests the recent strength in household goods sales will correct (Chart 13). The latter contributed a quarter of yoy retail volumes growth in August (Chart 14). Retail sales growth looks to be much stronger than historical relationships would suggest
Meanwhile the one off nature of the outperformance, following several quarters of retail sales slowing to and then growing in line with income, suggests the interest rate explanation isn’t right either. One potentially counter-intuitive possibility is that households ramped up spending ahead of expected interest rate hikes. The August hike was widely trailed in the media for instance. Perhaps that explains the particular strength of furniture sales in August, which are perhaps funded by credit. We should caution that retail sales are not a perfect measure of consumer spending. Retail sales are an imperfect indicator of only 40% of consumer spending (retail goods). In sum, we think it is reasonable to go for the blip explanation, driving our forecast of a growth correction in 4Q
PMIs point to steady growth
This forecast revision sits oddly with our recent cuts to growth in the Euro area and some other countries (see Global Economic Viewpoint: Keep an eye on EM 20 September 2018, Ethanomics: Trade “wars:” more to come 19 September 2018, and Euro Area Economic Viewpoint: Euro area: We give up, for now 17 September 2018). That also leads us to the blip explanation. Though the less stellar global outlook shows up via the UK manufacturing PMI (Chart 15). This is why we see only 0.5% qoq GDP growth despite 3 monthly retail sales growth of 1.9% in August. We expect manufacturing to contribute just 0.03ppts to 3Q growth and possibly detract from 4Q. The warm weather may well have boosted construction as well as retail sales. Some correction in that sector in 4Q would also drag on growth.
Slow growth remains the big picture If 3Q growth prints as we now forecast it would be the first quarter of 2.0% or higher annualised growth since 4Q 2016. If our forecast is right, the 18 months to 3Q 2018 will see average annualised growth of 1.4%, below the Bank of England’s estimate of UK potential growth (1.5%). Yet the BoE is hiking because it says growth is above trend and will remain there. The question for the BoE is whether growth will pick up and if it does not might trend be weaker than 1.5%. On the former our blip explanation suggests some caution. We also do not expect much change in growth trajectory if there is a Brexit deal. The story of the past few years has been, in our view, one of surprisingly robust GDP growth given the headwinds to growth. If Brexit effects, interpreted widely as uncertainty and a real income squeeze from sterling, have had a surprisingly small impact on growth so far then why should relieving either boost growth much? We put this in more detail here UK Economic Watch: Making sense of summer Brexit shenanigans 10 August 2018. In any case it is not clear to us that Brexit uncertainty will be lifted that much. Yes the risk of no deal will fade on a deal. But future UK/EU trading relationships will likely remain as uncertain as ever, perhaps moreso if MP Michael Gove’s recent argument proves to be right, and any skeleton agreement before next March can/will be changed by the government post March.
Might trend be weaker than 1.5%?
We peg potential growth a little weaker than the BoE, at 1-1.5%. It seems to us that unemployment trends support growth having slowed below trend. As GDP growth has slowed so have falls in unemployment. Between June 2017 and April 2018 the unemployment rate fell only 10bp, compared to 50bp in the previous 9 month period. The BoE, however, seems inclined to interpret things more hawkishly, feeling that growth is above trend and likely to remain there, meaning more rate hikes are needed.
BoE rate hike in May
We expect one BoE rate hike next year, in May. Recently clients have focused more on February, and the potential for two hikes next year, twice the amount the BoE suggested in its August 2018 Inflation Report that it expected. The argument for February runs as follows. The BoE does not really believe its own forecasts. They are technically conditioned on a 100% probability of a deal. But once a Brexit deal is struck, in November in this scenario, the BoE will raise its growth forecasts (and will ignore lower inflation driven by higher sterling). Combined with recent robust inflation and growth readings, that will lead the BoE to hike in February and guide to a faster pace of hikes going forward. Recent reports that Mark Carney told the government the UK could in a deal scenario recapture three quarters of the growth lost over the past year supports that view, as do other comments attributed to Carney that the BoE would be unable to cut rates in a no deal scenario (as that removes the downside risks for the market). As a scenario it hangs together, but we question its likelihood. It assumes the best possible outcome at all stages of the process. A deal may be struck in December rather than November, meaning a UK parliamentary vote on the deal does not come until January. That is probably too late for a February BoE rate hike. The parliamentary vote itself may not be smooth. And economically, growth could slow into 4Q affecting the BoE’s hawkishness. Events this week at the Salzburg summit, where the message from the EU was tough, also challenge this scenario. So we prefer to forecast a rate hike in May as the most likely scenario. It gives more room for Brexit negotiations to run to the wire and for any political complications afterwards. It also gives the BoE time to observe the data flow for a bounceback from 4Q. Latest inflation surprise will probably reverse Inflation may not retain its recent hawkish tinge. For a start, we would question the widespread hawkish interpretation. Core inflation was 2.1% in August. Headline was boosted to 2.7% by energy effects. The BoE traditionally would look through energy-driven inflation as it will drop out of the inflation comparison in 12 months
Core inflation was boosted in part by volatile components, such as computer games prices and air fares. For instance, six month annualised non-energy industrial goods inflation slipped closer to zero in the latest data (Chart 18) while NIESR reports that trimmed mean inflation (excluding the upper and lower 5% of price changes) held steady at 1.0% in August. This suggests most of the upside surprise in August will unwind. NIESR say that the historical relationship between trimmed mean and headline inflation points to headline inflation of 2.1% in one year’s time. What historical relationships don’t capture is next year’s utility price cap, which will drag inflation down, along with perhaps continued fading of FX effects. If anything sterling suggests small downside risks to our inflation forecast (Chart 20). Accordingly we expect CPI inflation this time next year to read 1.7% (Chart 17), assuming commodity prices follow the futures curve. Of course, any further rises in commodity prices would keep headline inflation elevated for longer relative to core, and keep the real income squeeze going for longer. Our call is supported by some underlying strengthening in services inflation in recent months. Without that we would be looking at weaker inflation. Persistence weighted services inflation has risen back to a still weak 2.7% for instance (Chart 19). This supports our view that services inflation will gradually pick up over the next 18 months offsetting a continued slowing in non-energy goods inflation. For the BoE we do not think the latest reading changes very much. If anything it would make us more dovish. Higher energy price inflation is squeezing real income, keeping real wage growth around 0%. This should keep GDP growth weak (it is one reason we expect payback in 4Q) and thereby prevent further tightening of the economy. So perversely, higher inflation today begets lower inflation tomorrow.
Policy initiatives to cut tax and boost consumption
With the heating up of the US-China trade tension, Chinese policymakers are ramping up policy easing measures, as we expected. In addition to further credit easing and acceleration in infrastructure project spending, China is looking into a package of tax cuts and policy initiatives to stimulate consumption.
- The State Council on 20 September published guidelines to promote household consumption. Earlier this week, Premier Li Keqiang vowed to expand tax and fee cuts fees for the corporates and suggested the government is studying policies to “significantly lower corporate tax burden”. Further, he stated the government will reduce tariffs for certain imports.
- There are media reports that the government is considering cuts to value-added tax (VAT) and corporate tax, along with greater-than-expected deductible allowance in the upcoming personal income tax cut. These measures could be announced before the 4th plenary session of the 19th Central Committee of the CPC (likely in late-Oct).
Direction within expectation; timing and intensity are key
We think these countercyclical policy measures are aimed at boosting domestic demand, given there are increasing signs of a slowdown as the risks of US-China trade war have escalated. The policy direction is in line with our expectation, but the effectiveness will depend on the timing and intensity of implementation. We expect tax cuts and boost in consumption to help stabilize market sentiment in the near term. In particular, we think these will likely alleviate concerns about a sharp rise in labor costs due to enhancement of social security collection.
GDP – broad-based strength across industries
The June quarter GDP was a positive surprise, printing at 1.0%qoq and 2.8%yoy. This was ahead of market expectations of 0.8% and well ahead of the Reserve Bank of New Zealand (RBNZ)’s forecast assumption of 0.5%qoq. Growth was broad-based across industries, with 15 of the 16 industries higher in the quarter. Household consumption, fiscal spending and exports are offsetting weakness in private sector investment, which has slowed as capacity constraints and skills shortages are taking hold. The risk is weakness here dislodges household spending via a softening of labour market conditions, but we expect public spending will continue to support growth.
Soft versus hard data
The RBNZ under new Governor Orr has delivered two dovish surprises since becoming Governor earlier this year. This has been a response to a drop in business confidence and the risk this poses to second round impacts on hard data. See RBNZ: See you late 2019. Firms are signalling that investment and employment intentions for the period ahead are expected to deteriorate (Chart 3). Interestingly, firms are less negative on their own activity outlook versus the broader economy (Chart 2). Governor Orr has already achieved easier financial conditions indirectly via weakening of the broad NZD. Consumer sentiment fell to a six-year low in Q2, but households are still confident in purchasing major household items that should support near-term consumption activity (Chart 4). Monthly consumer confidence is released next week.
Higher hurdle to consider easier policy
Despite the robust print for GDP, we expect the RBNZ will retain a dovish tone to underpin a pick-up in sentiment, especially if recent loosening of financial conditions is unwound on the back of this data. However, there is likely to be some unwinding of market speculation that the next move in rates might be a cut. The hurdle to consideration of easier policy has been raised considering the risks posed by tight capacity and a rate cut would be a risk to policy credibility as it might further depress sentiment. It could be seen as an admission of uncertainty over the course of growth from here. We receive the September read on business confidence and outlook next Wednesday before the RBNZ Official Cash Rate (OCR) review on 27th September, with further updates on the sentiment surveys ahead of its forecast review on 8th November.
The 3Q CPI data is to be released on 16th October and could present as a potential higher hurdle to easier policy if the core sectoral factor model inflation continues to rise towards the mid-point of the RBNZ’s 1-3% target band (Chart 6). It reached 1.7% in 2Q from 1.4% a year ago. The currency has depreciated by more than 10% since the beginning of the year, suggesting stronger momentum in tradables inflation that has kept the headline rate in the bottom half of the RBNZ’s target band (Chart 5). Tradables inflation is at 0.1%yoy, while non-tradables inflation is at 2.5%yoy due to rising cost and wage pressures.
Announced: Thursday, 20 September 2018
August CPI %y oy Actual 2.3 Previous 2.4 Consensus 2.4
Source: BofA Merrill Lynch Global Research, C&SD, Bloomberg
CPI inflation ticked down in August
Headline CPI inflation ticked down to 2.3% yoy in August from 2.4% yoy in July, slightly below market expectations of 2.4% yoy. The underlying inflation, which nets out the effects of the government’s one-off relief measures, also edged down to 2.6% yoy from 2.7% yoy in July. Meanwhile, the sequential momentum in underlying inflation remained steady. The three-month average increase in CPI was 0.2% sa mom in August, unchanged from July.
Lower inflation of travel-related services vs higher rentals
The downtick of the headline CPI inflation was mainly due to softer transport and package tour prices. In particular, price inflation of transport and packaged tours moderated to 1.4% and 7.1% yoy in August from 2.3% and 9.9% yoy in July, respectively. This was in part offset by higher housing inflation (2.3% yoy in Aug vs 2.2% yoy in Jul) as earlier increases of newly-let residential rentals continued to feed through. Meanwhile, inflation of other major CPI items remained stable. Food inflation remained flat at 3.5% yoy in August.
Inflationary pressure building up
Looking ahead, we think CPI inflation prints in the coming months will likely remain above the 2.1% level in 2Q18 due to feed-through of higher food inflation in mainland China and earlier rises in residential rentals. Overall, we expect CPI inflation to pick up in 2018 (2.2% vs 1.5% in 2017) amid sustained above-trend growth momentum. However, we see upside risks to our CPI forecast as tight labor conditions pose upward pressure on wage growth.
Lebac unwind: second round with surprises
The impact of big Lebac maturities has been much softer than the one observed last month amid optimism about the IMF package.
- Maturities: $9.6b equivalent of Lebac matured on Tuesday of which $7.3bn were held by non-banks and $2.3 by banks. (see Table 1)
- Unwind plan: central bank (BCRA) offered $3.8bn in Lebacs to non-bank holders, or 50% of their holdings (banks are not allowed to buy new Lebacs).
- Money on the table: BCRA sold $3.8bn of 1-3 months Lebacs (86% at 1- month), at 45% yields, rejecting offers for $1.6bn.
- Lebac not rolled over was $5.8bn, of which $2.3bn was held by banks and $3.5bn non-banks. The stock of Lebac dropped to about $8.5bn of which around $7bn is held by non-banks (76% due in 1 month).
- Sterilization plan: BCRA plans to absorb the $5.6bn liquidity injection of Lebacs mostly through a 5% hike in deposit reserve requirements (they estimate at $3.8bn), offering 7-day Leliqs to banks for up to $2.5bn and government ARS Letes (Lecaps) for $2.7bn sold today (see Table 1).
- Liquidity contraction: BCRA estimates all the measures will contract liquidity by $2.5bn or ARS 100bn.
- Foreigners back? The government sold $2.7bn ARS Letes (Lecap) today at 4m, 5m and 12m paying 50%, 48.9% and 50.5% yields. According to Ambito and Cronista, about $0.9bn were integrated in USD, likely foreign investors, citing unidentified government sources and market estimates respectively.
- IMF and FX intervention: even if the plan does not foresee large USD selling, at least explicitly, BCRA said IMF agreed to modify the program so as to have USD resources ready to stabilize the FX market if needed after the Lebac maturities. Today they sold about $200mn.
Our view: proactive better than reactive This time BCRA took preemptive measures to contain the liquidity injection, an improvement versus last super-Tuesday. It hiked reserve requirements before-hand (and not after the maturities as last month) and it announced a tighter monetary plan targeting a $2.5bn net liquidity contraction (reflecting money demand is declining). So it is natural to expect less FX intervention this time (it sold $200mn in the first day this time vs $1bn last month), though we note BCRA already had sold FX for almost $600mn in the two days before the maturity (very active buying back of Lebacs).
Uncertainty on the FX/monetary system will persist
We believe FX volatility will remain high given binary events for Argentina in the next month (Brazil election, IMF program) and as the FX intervention constraints will persist, in our view. A large increase in the IMF package and a market friendly president in Brazil will help stabilizing the financial situation. A non-market friendly candidate being elected will be very negative for Argentine growth (elasticity around 0.3) and financial variables. If the increase in the total IMF package is not confirmed it could disappoint given market optimism.
Also, the market became more optimistic about an increase in the total IMF package for Argentina of more than $10bn, on top of the original $50bn (and not just bringing forward funds to 2019). This is behind the recent financial stabilization including the Argentina EXD bonds rally (145bp in 2 weeks in the 10y), and incipient foreign interest in peso assets mentioned above, a breather from the trend of exit of foreigners from local markets. This time the BCRA statement was more explicit on the IMF support to use USD to stabilize FX markets after the maturity, which may reflect progress on the new IMF program.
Market focus has been on the new economic plan
We spent three days in Turkey meeting policymakers, private sector participants and members of civil society. The CBT has delivered the single largest hike in the past 20 years. The economy is rebalancing. The debate is currently on how long growth might remain below potential. With the new economic plan, the government has recognized the rebalancing in the economy, and is willing to create space for potential fiscal risks.
The plan also indicated that the size of the stress on the banks’ balance sheet needs to be identified before a policy response. We believe the Turkey-EU relationship is likely to normalize as a reform action group met in August. Next to watch out for are new chapters for negotiation, advances in visa liberalization, and modernization of the customs union.
Rebalancing is on track
The economy is rebalancing as credit is decelerating in real terms; automobile sales are declining yoy. The output gap is likely to be negative in 2H18/1H19. The current account in August is likely to be in surplus on the back of high interest rates and a weaker currency. The slowdown is different from previous years as deleveraging (FX/TRY) is playing out along with domestic contraction in activity and strong net exports. Banks are expecting NPLs to increase and FX deleveraging to continue (e70%) but they argue that FX liquidity buffers (ROM, right-hand side swaps, correspondent account deposits, cash and securities) exist and the situation is manageable.
The upcoming rollovers of syndicated loans till end-October are: Akbank, Turkexim, Isbank, Vakifbank, and Yapikredi. CBT reiterated its tightening bias citing risks
The CBT thinks that the FX pass-through coefficient is higher than in previous years, which may lead to upside surprises in inflation. The central bank continues to stress fiscal and monetary policy coordination to help rebalance and fight inflation. Capital controls are strictly ruled out. If needed deposits would be fully backed and Treasury would support state banks.
New economic plan: rebalancing and TRY76bn in measures
The main highlights of the economic plan are a slowdown in growth to 2.3% in 2019, the current account deficit adjusting to -3.3%, and TRY76bn in fiscal measures (TRY60bn on the expenditure side), prioritization of public projects, and assessment of banks’ balance sheets for potential government support. We think local elections could constrain the extent of fiscal tightening. The market’s new focus is details and implementation of measures outlined in the plan. Strategy: high-conviction neutral view We believe Turkish assets are for the most part fairly valued, though some stocks appear undervalued. Most importantly, TRY is consistent with a current account deficit of 1-2% of GDP next year, on our estimates. While much better than most previous years, we think the current account needs to be at least as good to allow for gradual external deleveraging of the economy, which cannot be delayed any longer, in our view. Therefore, the bias is still for TRY to weaken further, or at best stabilize for a while
Strategy: high-conviction neutral view
We believe Turkish assets are for the most part fairly valued, though some stocks appear undervalued. Most importantly, TRY is currently consistent with a current account deficit of 1-2% of GDP next year on our estimates. While much better than most of the previous years, we think that the current account needs to be at least as good as that to allow for a gradual external deleveraging of the economy which cannot be delayed any longer in our view. So the bias is still for TRY to weaken further or at best stabilize for a while. Our global view also suggests that Turkey may underperform peers. In the next few months as we are tactically bullish EM. However, we favor current account surplus or commodity exporting countries (e.g. Russia, South Africa) over commodity importers with current account deficits (e.g. India and Turkey).
Meanwhile, if we are wrong, and EM experiences another round of pressure, Turkey is likely to underperform as well. In rates we think the level of real yields is not compelling enough to be bullish for now.
However, we will need to watch carefully for signs of inflation collapsing more quickly than expected next year which would obviously be bullish for TurkGBs. The key indicator to watch will be unemployment. External debt was somewhat cheap a few weeks ago but has rallied sharply now. We think after the effects of the credit downturn are fully factored in, public debt could be in the 60-70% of GDP range. This leaves a fair rating at around BB-, roughly in line with the current spread.
Bottom line: Play consumption over investment
We expect rural demand to pick up through end-2019 on the back of pricing power on a not-so-good harvest, MSP hikes and farm loan waivers. We estimate that farmer income will climb by 14.6% during the autumn kharif harvest from 11.6% in the summer rabi harvest and a drop of 4.5% in the autumn kharif harvest of 2017. April-August 2018 fruits and vegetable inflation has gone up 5.6% in contrast to the drop of 2.1% seen last year. In addition, we expect a step up in farm loan waivers to US$40bn by the summer 2019 general elections from US$25bn. On balance, we stick to our standing call that equities investors play consumption over investment into the summer 2019 elections. (See, Rural demand: Flat rabi sowing poses a risk 12 January 2018.) Do also read our equity research analysts here, Indian harvests: India has 2 harvests of about 3.5% of GDP each: the rice-dominated autumn kharif and the wheat-dominated summer rabi.
14.6% growth in farm income in autumn kharif harvest
We estimate that farmer income will climb to 14.6% during the autumn kharif harvest from 11.6% in the summer rabi harvest and a drop of 4.5% in the autumn kharif harvest of 2017 (Tables 1-2 present crop-wise details). This has essentially emanated from MSP hikes driving up farm prices. With a patchy monsoon, we have assumed that yield will be impacted (Exhibit 1). As a result, the growth in production will be lower than that of cropping. Cropping is finally ending at close to 2018 levels, as drought is concentrated in a few States (Table 3). (See, MSP hikes: All up to the rains 05 July 2018.)
Horticulture income set to go up as well
Income from horticulture should go up this fiscal (Charts 1-3). April-August fruits and vegetable price inflation is up 5.6% in contrast to the drop of 2.1% last year. Milk price inflation, at 3% FYTD, however, is lower than the 4.2% seen last year. Farm loan waivers to rise to US$40bn from US$25bn Rising farm loan waivers will also push up rural income as we approach general elections in summer 2019. We expect farm loan waivers to rise to US$40bn by then from US$25bn FYTD. Farm loan waivers support rural consumption, although they may eventually hurt rural credit culture. (See, Farm loan waivers: The good, the bad and the way out 06 July 2018.)
Step up in rural spend in run up to 2019 general elections
We expect all political parties to raise rural spend as we approach general electons. In general, political uncertainty supports rural demand as the bulk of the electorate lives in rural India. As it is, rural strain has led to the emergence of farmer movements in several states like Haryana, Gujarat and Maharashtra. In this context, recent opinion polls point to a hung parliament, with the BJP as the clear single largest party. As the next pointer, markets will track the early 2019 Chhattisgarh, Madhya Pradesh and Rajasthan state polls. Opinion polls give the Congress an edge so far. (See, Opinion polls point to hung parliament in 2019 20 August 2018.)