Investment - Articles - Q2 2011 outlook by John Greenwood,Invesco's Chief Economist

 
•   UK forecasted 1.5% real GDP growth and 3.9% inflation in 2011
 
•   Japan has responded with discipline to the twin disasters of the Tohoku earthquake and tsunami of March 11, but the radiation problems at the nuclear power plant at Fukushima are proving much more intractable

 
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     Inflation concerns increasing in the US and developed economies, and emerging economies of Asia & Latin America as commodity prices rise
   
 
•   Strong growth in exports of goods in North East Europe while the recession will persist well into 2012 for southern and western Europe

 INTRODUCTION: TWO DIFFERENT TYPES OF INFLATION

 Between September 2010 and the Japanese earthquake on 11 March 2011, equity and commodity markets have enjoyed an extended rally, driven principally by the prospect of sustainable economic recovery in the leading economies, particularly in the United States. Two major factors in the upturn in US markets since September were the announcement in August followed by the implementation from November of QE2, together with the fiscal stimulus agreed between the Obama administration and the Congress in December. QE2 will terminate in June and is not expected to be renewed, while the fiscal stimulus will fade gradually during the second half of 2011. Markets will therefore face significant challenges in the period ahead.

 In addition, inflation concerns have been rising, not only in the US and most developed economies, but also in the emerging economies of Asia and Latin America as commodity prices - especially energy and food prices - have continued to rise. The immediate trigger for commodity price rises was a series of environmental problems such as floods and droughts affecting agricultural commodities, exacerbated by political tensions in the Middle East and North Africa affecting energy prices, together with continuing anxieties about the stability of the financial systems in the developed economies affecting precious metal prices. However, there has been one main, underlying driver: the strong economic recovery in emerging economies.

 The key question for markets over the next few months is the sustainability of economic recovery and the extent of the inflationary threat. In my view the answer is different for the developed and emerging economies.

 In the developed economies money and credit growth have been very weak over the past year and more, and fiscal retrenchment is widespread, meaning there will continue to be excess capacity available to meet any upswing in demand. For these economies, therefore, the upturn in inflation does not represent a threat of sustained inflation, but is best understood as a shift in relative prices or in the terms of trade, with the rise in imported commodity prices leading to a temporary rise in headline prices and a lesser rise in core price indices (which generally exclude food and energy). The rise in such prices will erode consumer incomes and spending power in the commodity-importing economies in the short term, and encourage a shift of resources away from consumption and housing towards investment and production in the deficit economies in the longer term. This is part of the needed macro-economic rebalancing of economies in the aftermath of the global economic crisis of 2008-09.

 In the emerging economies where economic recovery has been strong, notably in Asia and Latin America, money and credit growth has been much faster, thanks to healthy balance sheets in the banking, corporate and household sectors. The problem is that easier credit, exacerbated by investment and carry-trade inflows from the developed economies, has already generated sharp property price increases across much of Asia, and as domestic spending continues to strengthen it is now threatening a more deeply embedded inflation at the consumer price level. Unless monetary conditions are tightened through higher interest rates, increased reserve requirements or currency appreciation, there is a significant risk that central banks in these emerging economies may be compelled to curtail money and credit growth more forcefully, putting an end to the economic upswing. Emerging markets therefore face a year of further policy-tightening measures which are likely to undermine equity and bond market performance in these regions.

 To summarise: developed economies mostly face a shift in the composition of inflation with higher commodity and goods prices but relatively lower service prices and an erosion of real incomes against a background of weak money and credit growth, whereas emerging economies are experiencing a much more rapid rate of growth of money and credit which has already triggered property price increases, and could threaten a more prolonged bout of generalised inflation if not brought under control.

 Meanwhile the sovereign debt crisis in the euro economies has spread to Portugal.  This is merely the latest example of sovereign balance sheet vulnerability in the euro-area that has become common to many developed economies. The recurrent euro-zone crisis has resulted from a decade of over-expansion either of the banking systems or of government spending commitments to their populations. Since governments nowadays feel obliged to step in and prevent massive failures in the banking system (as they did in Iceland and Ireland), the liabilities of banks have ended up as obligations of governments. Consequently, no matter whether the source of the problem was private or public debt, government balance sheets have become dangerously extended. In my view the debt crisis in the euro-zone will continue for several more quarters, and more economies will be tested since market participants are highly sceptical of the interim solutions offered so far, either on the fiscal side or on the monetary and banking side.

 In financial markets the divergence between the easy monetary stance in the developed economies and the tightening monetary stance in emerging economies has already caused a wide divergence of performance between equities in the two arenas. Since these two contrasting policy stances are likely to remain in force during the remainder of 2011, the performance divergence may be expected to continue. However, the longer term prospects for both areas are promising provided that the EM policy-makers are successful in bringing inflation under control. The current hiatus in EM performance should therefore be regarded as merely a mid-course correction with the possibility of several years of business cycle expansion still ahead for both developed and emerging markets.

 UNITED STATES

 US real GDP growth maintained its moderate momentum in 2010 Q4, growing at 3.1% on an annualised basis, and 2.8% over the year as a whole. The improvement in consumer spending that had become evident in late 2010 has continued with retail sales growing at a robust 1.0% month-on-month in February, following upward revisions to data for December and January. Consumer confidence has also maintained its improvement since the trough of 2008-09, with the Michigan index reaching a three-year high of 77.5 in February, although it has fallen back to 67.5 in March. Business equipment investment has weakened, however, slowing to 7.7% in the GDP statistics for Q4 following its recent peak of 24.8% in 2010 Q2. This trend has continued in early 2011 with orders for non-defence durable goods excluding aircraft falling in both January (-6.0%) and February (-1.3%), though adverse winter weather may have played a part in these declines. However, other forward-looking indicators such as the PMI for manufacturing have been upbeat, increasing to a 7-year high of 61.4 in February, while the PMI for non-manufacturing industries hit a 5 year high of 59.7 in February. 

 Three areas of the economy have shown consistent weakness during this recovery: housing, non-residential construction and the labour market. Although housing has remained depressed, and non-residential construction is still falling, there are at last some signs that the prospects for employment are improving.

 On the housing front, starts, completions, permits, new home sales and existing home sales have all remained weak, troubled by excess supply, continuing mortgage loan delinquencies and record high foreclosures. Meanwhile house prices as measured by the Case-Shiller 20-city composite have been falling since July, and in January fell back almost to their lows of April 2009. The failure of the housing and commercial real estate sectors to recover so far are acting as a continuing drag on growth, adversely affecting both the investment and consumer spending components of GDP.

 Non-residential construction is roughly the same size as the housing sector, but started to decline in 2008 rather than 2006 for the housing sector. The problem here is that US regional banks are heavily exposed to commercial property, and the sector appears to have a considerable decline still ahead of it, with expenditures likely to fall to the $400bn mark before any revival can be expected (see chart below).

 US Expenditure on non-residential construction expected to continue falling

 Source: Datastream, 28 February 2011

 The job market, in contrast, has started to brighten up. Household employment data show monthly increases averaging 219,000 for the three months January-March, while the non-farm payroll data show an average increase of 159,000 per month over the same period. Due to the relatively rapid increase in the size of the labour force the unemployment rate had not fallen much until the start of 2011, since when it has declined from an average of 9.6% in Q4 to 8.8% in March.

 The Federal Reserve will complete its current program of $600bn of US Treasury purchases at the end of June, setting the scene for the next stage of monetary policy. In the next phase it is likely to change the language in its regular FOMC statement, ending its commitment to maintain low interest rates for "an extended period," and to indicate the need for a gradual withdrawal of monetary accommodation. Given that banks are still not increasing their total loans (adjusted for changes in coverage in the Fed's H8 release) and therefore Fed ease is not being transmitted to the markets and the economy in full measure, I do not expect rate hikes to begin until 2012 when the unemployment rate has fallen further. On the fiscal side the 100% capital depreciation allowance will end in December, and unless there are any new stimulus measures, the overall stance of fiscal policy will become less expansionary towards yearend.

 For the year as a whole I expect real GDP growth of 3.0% with headline CPI inflation of 1.8%. Provided that corporate profits can continue increasing at a healthy rate, this combination should be positive from an investment perspective. However, the withdrawal of QE2 and the prospect of gradual tightening of fiscal policy could prove challenging for risk asset markets in the second half of 2011.

 THE EUROZONE

 The contrast between the strongly recovering north eastern part of the eurozone (France, Germany and the Benelux, and stretching into Switzerland and parts of Scandinavia that are outside the common currency area), and the anaemic or still recessionary southern and western periphery persists. The recovery in the north and east has been driven by strong exports and a rise in consumption and investment, highlighted by Germany's 4.0% real GDP growth (year-to-year) in 2010 Q4, led by a 17.9% increase in plant and equipment investment, and 15.7% growth in exports of goods and services. Business confidence has rebounded with the IFO index reaching a new high in February, and export orders for plant and machinery growing at 47% in the three months November-January.

 Growth in exports of goods and services drives strong growth in Germany

 Source: Datastream, 31 March 2011

 However, elsewhere in the eurozone, especially in the southern and western periphery the rolling sovereign debt-cum-banking crisis means that economic weakness and recession will persist well into 2012. The underlying problems - the slump in money and credit growth, the on-going private sector balance sheet repair, necessary fiscal consolidation, and prolonged internal deflation to restore external competitiveness and overcome large external imbalances - would all have been much more easily treated if currency devaluation and an independent monetary policy had been possible. As members of the currency union, such a strategy is ruled out. Having benefited during the boom from inflows of money and labour, the peripheral economies are seeing money flows reverse, with outflows of capital and labour to areas where employment prospects are better.

 Consequently Portugal, following Greece and Ireland, is experiencing a drastic loss of credibility in the ability of its government to refinance its obligations as they mature, and will be forced to apply to the EFSF for a substantial loan to tide it over. After Portugal, there is a significant probability that either Spain or possibly Belgium will suffer the same loss of financial market confidence. The Euro-zone crisis will therefore continue to trouble financial markets until the fiscal control and supervision issues as well as the underlying monetary and banking issues have both been adequately addressed.

 As elsewhere in the developed world commodity price increases have raised reported inflation rates, pushing the overall euro-zone CPI increase to 2.4% in February, and a flash estimate of 2.6% in March. Even in the crisis economies of Greece and Ireland the deflation that had gripped each economy has temporarily been reversed by increased commodity prices (and additional taxes) to CPI inflation rates of 2.2% in Ireland and 4.2% in Greece. However, disinflationary or deflationary trends are likely to re-assert themselves over the next year or so.

 We expect overall real GDP growth in the eurozone to be 1.8% in 2011, concealing a wide divergence of performance between the core and the periphery. The combination of very low overall rates of growth of money and credit together with considerable slack in employment and capital equipment will restrict inflation to 2.2% on average in 2011.

 UNITED KINGDOM

 Real GDP growth had been somewhat better than expected in 2010 Q2 and Q3 (at 1.1% and 0.7% quarter on quarter respectively), but declined abruptly by 0.5% in 2010 Q4, largely due to a bout of extreme cold and snow in December. In the absence of adverse weather conditions, growth would have been roughly zero or flat according to the National Statistics office. With inflation rising to 4.4% on the CPI measure in February and wage earnings for the whole economy only growing at 2.3% in January, most households are seeing real income declines that are likely to continue through the entire year. This means that personal consumption, by far the largest component of GDP will at best be very weak, and may even decline over the year as a whole.

 UK Inflation remains elevated

 Source: Bloomberg, 31 March 2011.

 In these circumstances the Coalition's fiscal strategy has been designed to reduce the structural budget deficit and hence the amount of official borrowing as quickly as reasonably feasible. The Budget of March 23rd reaffirmed this broad strategy, without significant changes in target or timing, despite the downgrading of economic growth forecasts by the OBR. The Budget also offered a few inducements for growth but countered them with additional taxes on North Sea oil producers and an increased levy on banks, effectively denying them the benefit of the lower corporate income tax rate.

 Against this sombre background, the MPC at the Bank of England has so far kept Base Rate at 0.5%, although there are now three votes out of nine for a hike in rates. If the underlying sub-par rate of GDP growth was the only problem, the answer would be fairly simple - namely to keep monetary policy on an expansionary or accommodative course until inflation was forecast to approach its target. But with CPI inflation now at 4.4% year-on-year and more than double the 2% target, the question is whether there has been a series of external shocks that cannot adequately be handled by tighter monetary policy, or whether there has been some inherent failure of monetary policy. The mainstream line from the MPC has centred on the first of these explanations, offering four main reasons for the series of inflation shocks: the weakness of sterling, externally-driven commodity price increases, a high degree of pass-through by firms, and government-mandated VAT and fuel duty increases. All of these do indeed provide a measure of comfort to policy-makers. But given that inflation rates in the US and the Euro-zone are far lower than in the UK, this defence misses some key, quantitative issues.

 The reality is that the UK has a far larger financial sector than other similar-sized economies, and the growth of bank balance sheets, bank credit and money had all been allowed to run rampant. The rapid growth in broad measures of money and credit continued until the second half of 2009, and the economy is therefore still in the two-year period during which monetary growth can be expected to impact goods and service prices. Against a backdrop of falling real incomes, real GDP growth is likely to be disappointingly low this year and very dependent on exports and business investment while inflation, reflecting the overhang of easy money from the past, will exceed the 2% target for the entire year. I am forecasting 1.5% real GDP growth and 3.9% inflation in 2011.

 JAPAN

 Japan has responded with dignity and discipline to the twin disasters of the Tohoku earthquake and tsunami of March 11, but the radiation problems at the nuclear power plant at Fukushima are proving much more intractable. Early private sector estimates of the scale of the reconstruction needs (excluding dealing with the nuclear plant) were in the range Yen 12-15 trillion (about 3% of GDP), but the government has put out a much higher estimate of the damage at Yen 25 trillion (5.2% of GDP) which includes an allowance for repair or de-commissioning of the nuclear facilities. It should be noted that the GDP (current value of output) losses will be significantly less than the overall losses of people, capital equipment, houses and infrastructure.

 According to a METI survey over 11,000 manufacturing sites were operating in the three affected prefectures, with annual shipment values of Yen 110 trillion p.a., or 3.7% of national industrial output (not value added as in the GDP), but as much as 9.5% of IT and communications equipment, 7.7% of electronic components , and 7.6% of wood products. Much of the reconstruction costs will be privately financed by earthquake insurance as well as other private sector sources, so not all of the cost will become a government obligation. Thanks to Japan's large stock of savings both at home and abroad there should be no difficulty in raising the funding needed to overcome the effects of the triple disasters.

 Nevertheless, the Japanese economy will undoubtedly experience a further short-term downturn following two negative quarters of GDP in 2010 Q2 and Q4. This will probably translate into another negative GDP figure in the April-June quarter due to earthquake-related disruptions such as the rolling black-outs in Tokyo and eight other prefectures, declines in output in the three affected prefectures of Iwate, Miyagi and Fukushima, and disruptions to supply chains in the electronics and auto industries. Conversely, substantial reconstruction efforts will be spread over many quarters, boosting GDP in subsequent quarters. Consequently with the economy already recovering from the 2008-09 recession, corporate earnings improving, and strong gains from overseas investments, it is unlikely that the triple disasters will cause Japan to be derailed from its existing macro-trajectory of gradual economic upswing.

 In response to the crisis the Bank of Japan began injecting funds into the money markets from Monday, March 14. By March 29 the BOJ's balance sheet had expanded from Yen 129 trillion to 149 trillion, while commercial banks' reserve deposits at the central bank had been boosted from Yen 21 trillion to 33 trillion. In addition, to deal with the rapid appreciation of the currency, a G7 intervention operation was arranged to lower the yen from 78 yen per US dollar initially to 81, and more recently to around 84-85. 

 The fastest growing segment of the economy is Japan's exports which have recovered just over half of their 2007-08 peak levels. Monthly exports were running at Yen 5,550 bn in March compared with a peak of Yen 7,024 bn in July 2008 and a trough of Yen 3,484 bn in February 2009. Strong growth in China and other parts of East Asia, in addition to Latin America will continue to power Japan's formidable export sector. Elsewhere domestic demand has remained subdued, and is unlikely to be affected in any major way by the post-earthquake reconstruction projects. Unemployment has fallen to 4.6% in February from its recession peak of 5.6% in July 2009, but still well above its pre-crisis level of about 4%.

 On the price front, the recent surge in food and energy prices has eased Japan's deflation, despite the strength of the yen, raising the year-on-year rate of CPI inflation to zero in February from a low of -2.5% in October 2009. Even so, the core CPI which excludes food and energy prices was still -0.6% in February, a testament to the tenacity of deflation trends that have persisted since 1998. My forecast is for real GDP growth of 1.1% in 2011, with a miniscule rise of headline consumer prices of 0.2%.

 NON-JAPAN ASIA

 Across the region the economic recovery from the global recession has continued to gain momentum. Strong balance sheets and very low interest rates have fostered easy credit conditions. Exports have once again led the recovery in the aftermath of the abrupt and severe global downturn in trade in 2008-09, but there is increasing evidence of domestic demand taking over the lead role as easy monetary conditions translate into faster spending on property, commodities and consumer goods and services.

 In China, industrial production accelerated to 14.9% in February, supported by strong growth in chemicals and machinery production. Fixed asset investment also picked up in January and February, underpinned by the construction of affordable housing. Growth in retail sales, however, slowed in February, perhaps affected by weaker consumer confidence in the face of higher inflation. Export growth has moderated slightly in recent months, while import growth has been strong, in part due to the surge in commodity prices. Due to the varying timing of the Chinese Lunar New Year holiday it is always difficult to be sure about underlying trends in exports and imports over the first three months of the year, but it appears that the strength of domestic demand is being reflected in a slight narrowing of the trade balance. The GDP target for 2011 remains at 8.0%, but in the recently adopted 12^th Five Year Plan for 2011-15 the long term target has been lowered from 7.5% to 7%.

 In the NIE-3 economies (Korea, Taiwan and Hong Kong) and ASEAN-4 (Indonesia, Malaysia, the Philippines and Thailand) growth was a strong 5.2% (quarter-on-quarter annualised) in Q4 compared with 1% in Q3. Indonesia and the Philippines showed exceptionally strong growth, but in 2011 all have benefited from double digit growth of exports and rising levels of domestic consumption spending.

 Central banks across the region have responded to the upturn by raising interest rates, hiking reserve requirements, and tightening credit conditions by means of stricter loan-to-value ratios for mortgage loans or other explicit controls. However, it would seem that in most cases the tightening measures are so far insufficient. Money and credit growth rates are generally still rising, with the exception of China, but even here credit growth outside the formal banking channels appears to be undermining the authorities' attempt to tighten credit with minimal rate hikes.

 Credit growth still rising in Asia

 Source: Datastream, 31 March 2011. NICS = Korea, Taiwan, Hong Kong & Singapore

 As a result, inflation rates across the region are rising, triggered as elsewhere by soaring food and energy prices, but driven in a more fundamental sense by relaxed money and credit conditions. Average inflation for the region increased to 4.3% in January, up from 3.8% in December. In financial markets most regional currencies strengthened against the US dollar in February and March, but benchmark equity indices declined on concerns about further policy tightening and increased risk aversion amid growing political tensions in the Middle East and North Africa. I expect strong growth with rising inflation to continue for most of 2011.

 COMMODITIES

 The surge in commodity prices has been driven by one key underlying factor, but exacerbated by numerous smaller, more temporary events or disruptions. The primary factor underlying the strength of commodities has been the vigorous upswing in emerging economies, many of which are at a particularly commodity intensive phase of their development as they build the necessary infrastructure for a more advanced standard of living. In addition there has been a seemingly endless series of floods, droughts, crop failures, earthquakes and other natural disasters that have impacted individual commodity suppliers. On top of that, political uprisings in the Middle East and North African (MENA) region have disrupted the flow of oil and threatened the closure of critical pipelines and shipping routes.

 Commodity prices continue to surge

 Source: Bloomberg, 31 March 2011.

 All this is happening at a time when interest rates in the west are still very low and therefore investors are earning desperately low returns on deposits and other safe assets such as government bonds. In addition, many investors have not yet overcome their risk aversion from the recession, and consequently are under-invested in equities with liquid funds available to invest. Finally, the implementation of the Fed's QE2 program is heightening fears of dollar-based inflation, even though QE1 and QE2 have not so far added to the growth rates of money and credit in the hands of the public. The natural response is for investors to buy "real assets" such as commodities, both hard and soft, fuelling the speculative fever.

 How far can this commodity bubble go? Demand for commodities by genuine end-users -- as opposed to speculative demand -- in the developed west will likely remain subdued, in line with moderate economic recoveries. The critical question is what happens in the emerging economies. If the authorities in the emerging world begin to tighten monetary policies more aggressively, the prospects for further commodity price increases must be limited. If on the other hand - as seems likely to me - emerging market politicians and central banks remain "behind the curve" in their tightening strategies, then commodity prices seem likely to move higher before this phase of  the commodity bubble will be deflated.

 CONCLUSION

 2011 is likely to be a year of further economic recovery in the developed -- mainly western -- economies, constrained by household balance-sheet repair in the household and financial sectors of over-indebted economies such as the US, UK, Spain and Ireland, and a growing burden of public sector debt almost everywhere. In most developed economies levels of economic activity have not yet returned to pre-crisis norms, and high levels of excess capacity and unemployment persist. Nevertheless, even with only moderate rates of real GDP growth the rise in commodity import prices is triggering an upturn in headline and -- in some cases - core inflation. However, despite QE and very low interest rates, this episode of commodity-based inflation does not mark the start of a sustained inflationary upswing, as money and credit growth rates are negligible across the developed world. Consequently most developed economy central banks will not respond with rate hikes.

 By contrast, in the emerging world strong recoveries and rapid rates of growth of money and credit are fuelling a more fundamentally-based inflation. These recoveries should continue at a healthy pace in 2011, but policy-makers are already being confronted with rising inflation, requiring central banks to tighten further. In the past emerging economies tended to judge their interest rates in relation to levels in the developed world, but with the developed world struggling with the aftermath of banking crises and a balance sheet recession, those guideposts are no longer appropriate. Most emerging economies will therefore spend the balance of this year attempting to normalise rates, but will often find that they are behind the curve