Tuesday, July 21, 2015 :29 PM / ARM Research
Review of Global Economy and Markets
Over the next few weeks, we will feature excerpts from our core strategy document – The Nigeria Strategy Report. The report communicates our understanding on key happenings in global and domestic financial markets in H1 2015 and provides our insight on what we believe will be the major themes underpinning investor sentiment over the rest of the year.
In contrast to expectations for strengthening US GDP and subdued oil prices to underpin higher global growth, disappointment in the former on account of a stronger dollar, adverse weather and cutback in E&P capital spending, amid static trends in the latter, has tempered growth optimism. In addition, markets had to grapple with sustained slowdown in EM, led by China, and resurrection of Grexit crisis following the election of the leftist Syriza party in Greece. Politics also dominated investor sentiment on the local front, with six-week deferment of the 2015 general elections from initial Valentine’s day date amplifying sell-offs across domestic financial markets.
Whilst global financial markets have digested the weak global growth picture enough to allow extra time for global central banks to pursue extension of ‘easy money’ policies, determination by the US Federal Reserve to raise rates and political brinkmanship in Greece drive scope for heightened volatility over H2 15. On the domestic front, delays by the Buhari administration in providing visibility on policy trajectory could stretch out uncertainty overhang across capital markets. We begin the series with a look at the major themes that dominated the global economic and financial landscape in the first half of 2015.
US slowdown frontruns tamer global growth prospects
Coming into 2015, IMF expectations were for sustained improvement in the US economy and tamer oil prices to over-ride adverse impact of EM growth deceleration on global GDP growth. Whilst oil prices remained soft relative to 2014, momentum in US GDP floundered in Q1 15, allowing further downdraft across EM to dampen global macro-economic conditions. Consequently, the IMF lowered global 2015 GDP growth expectations 30bps, from prior forecasts, to 3.5% YoY.
In Q1 15, U.S. GDP contracted 0.7% YoY on account of several factors: slowdown in exports due to continued dollar strength (Q1: +6%, 2014: +11%); port congestion issues following labour disputes at the large West Point shipping terminal; reduction in oil and gas capital spending; and, for the second consecutive year, adverse weather shocks.
Other economic metrics also showed signs of weakness with the pace of job creation shrinking to an average of 208k new jobs over the first six months of 2015 vs. H2 14 mean of 281k (2014 avg: 260k). The flaccid signals from unemployment and GDP combined to put off fears of interest rate hike by US Federal Reserve and largely account for the less-than-stellar performance of US equity indices over H1 15.
Across the Atlantic, European Q1 15 GDP printed at 0.4% QoQ (+1.4% YoY), underpinned by strength in France (+0.6% QoQ), Germany (+0.3% QoQ), Spain (+0.9% QoQ) and Netherlands (+0.3% QoQ) which offset weakness in Greece (-0.3% QoQ). The uptick in economic activity also saw the region come out of four-month deflation in April when CPI came in flat YoY before climbing 0.3% YoY in latest reading in May. The rise in consumer prices despite deflationary impact of lower energy costs provide early evidence of the stimulatory impact of ECB’s bond buying program which began in March.
The commencement of the LSAP program provided welcome distraction to European equities (Q1 15: Eurostoxx +17.5%) despite fresh turmoil in Greece, after January’s election brought the left-leaning Syriza party to power. Consequent brinkmanship by the Alexis Tsipras-led Syriza government, on structural reforms previously agreed with Greek creditors, has re-awakened prospects for a ‘Grexit’ which has intermittently weighed on market sentiment across the euro area – in particular over Q2 15. Largely reflecting investor concern over the Greece debacle, Euro-area financial markets gave up some of Q1 15 gains, nonetheless they have outperformed US equities YTD (See Figure 2).
Outside the euro zone, the UK economy expanded 2.4% YoY in Q1 15, though on a QoQ basis, real GDP rose at its slowest rate in three years (+0.3%). Concerns over underlying economic conditions heightened after UK inflation turned negative in April, for the first time in 55-years, on lower transport costs. The deflationary pressures and slowing economic growth tempered previous optimism about BoE rate hike. Whilst surprise on the political front following a majority victory in polls by the Conservatives provided uplift for UK financial markets, heightened possibility of ‘Brexit’ together with spillover from ‘Grexit’ acted to dampen market expectations over Q2 15.
Japan recovered from recession in Q1 15 with GDP printing at 3.9% YoY driven by recovery in household consumption (+0.9% YoY) and capital spending (+2.7% YoY). The improvement in consumption largely reflects lesser drag on household spending from the April 2014 sales tax hike whilst increased profits of Japanese companies on yen weakness provided the platform for higher capital spending.
Nonetheless core inflation readings dipped to 0.6% in April as base effects from the VAT hike in 2014 dropped off the chained CPI readings. Whilst sub-par inflation readings raised prospects of increase in BoJ’s 80trillion yen LSAP program, the BoJ maintained status quo throughout H1 15, in line with comments by Governor Haruhiko Kuroda that current yen levels (YTD: 3.4% to 123.54) were close to historical real effective exchange rate lows. The rebound in economic growth and continued earnings support from a weak yen helped underpin 16% jump in Japanese equities in H1 15 to 15-year highs.
EM economies slow further
Similar to 2014, the slowdown across EMs continued with Chinese GDP growth clocking a six-year low of 7% in Q1 2015. Slowdown was evident across key growth metrics with fixed-asset investment rising 13.5% YoY - the slowest pace since 2000, while at 5.6% YoY, industrial output grew at its weakest since the global financial crisis in 2008. Similarly, power output, a proxy for economic activity in China, declined 3.7% YoY – the largest fall since the 2008 crisis. The progressive stream of weak economic data drove the PBoC to twice slash policy rate by 25bps to 5.1% and cut reserve ratio requirements three times in H1 15 to 18.5%.
The monetary policy accommodation was complemented by fiscal actions as China’s central authorities instituted a 1 trillion yuan debt swap which would see local municipal papers exchanged for central government bonds. Despite the moderating economic fundamentals, Chinese equities continued to outperform major global equity indices climbing 51% from 2014 year end till mid June, spurred by the prospect of greater policy accommodation by Chinese authorities. Nonetheless, a sharp correction starting in mid-June which pared H1 15 equities performance to 32% has exposed the fragile nature of the market rally and raises concerns over China’s economy.
Similarly, Brazil’s recovery from recession in Q4 14 proved to be short-lived with GDP shrinking 1.6% YoY (-0.2% QoQ) in Q1 2015. The negative headline reading was driven by weakness across household consumption (-1.5%), investment (-1.3%) and government consumption (-1.3%) which offset growth in the external sector. The shrinkage in fiscal expenditure stems from new Finance Minister Joaquim Levy’s drive to turn a fiscal deficit of 6.5% of GDP in 2014 to a primary surplus in 2015 via cutback in welfare benefits. Other indices of economic activity also emitted adverse signals with depreciation in the Brazilian real (YTD: -15%) underpinning an uptrend in inflation over H1 15 to 8.47%— above the target range of 2.5% to 6.5%.
Consequently, the Brazilian Central Bank hiked its key Selic rate 275 basis points over the first half of 2015 to 13.75%. In line with the economic pressures and tighter fiscal conditions, Brazilian equities posted a modest performance (+6%) over H1 15.
Elsewhere, a combination of weaker oil prices and western sanctions drove 2.2% YoY contraction in Russian GDP in Q1 15. Akin to Brazil, lagged impact of 2014’s 85% depreciation in the Russian rouble resulted in inflation climbing 440bps over H1 2015 to latest May 2015 reading of 15.8% YoY. Nonetheless, as sanctions rhetoric cooled with a fragile truce holding up in Ukraine, the Russian rouble has started to stabilize (YTD: +12%), providing cover for the Russian central bank to aggressively ease monetary policy with cumulative interest rate cuts of 275bps over H1 15 to 11.5%. Largely reflecting the rebound in the exchange rate, firming oil prices and thaw in geo-political tensions Russian equities rallied 18% over H1 15.
In contrast to the weak economic picture across other BRICs, India’s economy rose 7.5% YoY in Q1 15 spurred by increased business confidence from the reform-minded Modi’s government and gains from lower energy prices. The latter was evident in inflation which declined to 5.1% YoY providing ambit for the RBI to ease interest rates over H1 15 (-75bps to 7.25%). Nonetheless, Indian equities put in a lackluster shift (+1%) over H1 15, largely reflecting net short FPI positions.
Tightening financial conditions and spillover from Greek drama dim growth outlook
Into the second half of 2015, prospect of lift-off in US interest rates amid continued monetary accommodation in other DMs and concerns over ‘Grexit’ should dominate sentiment across financial markets. Whilst previous bullish forecasts of US growth have tapered following the disappointment in Q1 15 with the US Fed’s target range now at 1.8%-2% vs. 2.3%-2.7% previously, comments at June 2015 FOMC suggest that the US Fed views the depressed growth picture as largely transient.
Nonetheless, the reduced number of FOMC members calling for a greater than 25bps rise in interest rates using the FOMC dot plot at the June meeting, and emphasis by Fed Chair Janet Yellen about no preset tightening cycle, speaks to a symbolic vs. significant rate hike in H2 15.
Set against the backdrop of sustained policy accommodation in Europe and Japan, a rise in US interest rates and even further USD appreciation raise scope for heightened volatility akin to the ‘taper tantrum’ of June 2013 as investors frontload reaction to the changing interest rate differential.
Outside the US, whilst Europe appears to have turned the corner, the recurring Greek debt debacle continues to pose risks to financial markets in the euro area. Over H2 15, the prospect of ‘Grexit’ draws closer as lack of progress on negotiations to permit release of funds to Greece raises prospect of default on €18.7billion worth of payments falling due in the period. Most Greek debt due over H2 15 are to the IMF & ECB (64%) with the remainder comprising of short term t-bills largely held by Greek banks. Whilst IMF debt ranks highest in seniority, the absence of a cross-default clause on the IMF obligation and administrative procedures which could technically delay default definition lessens risks.
Beyond a freeze on future funding, main risks to the global economy stem from a default on ECB obligations due over July 2015. Here, a default should result in a freeze in emergency lending assistance (ELA) to Greek banks which could pave way for abandonment of the euro and the return of the old Greek Drachma – a scenario which could significantly roil global financial markets. In this event, the Euro-zone stands most at risk as, via all its agencies: ECB, various governments and the EFSF, the region collectively holds 68% of Greece’s outstanding €312 billion debt. Of this figure, private creditors, largely Euro-zone banks, hold about 11% with the rest held by multi-lateral organizations like the IMF.
On the face of the debt concentration holdings, as Greece’s main creditors are official (not private) entities with no obligation to subject themselves to accounting rules requiring mark-to-market valuation or minimum capital requirements, direct fall-out from the crisis appears limited. Nonetheless, indirect contagion to global markets could arise from the emergence of anti-establishment/austerity bashing parties like Syriza in periphery countries such as Ireland, Spain, Portugal and Italy. Amid commencement of negotiations by the Conservatives over UK’s status in EU (so called ‘Brexit’ talks) the actualization of ‘Grexit’ raises the prospect of similar departures which could undermine market confidence in the euro project leading to increased volatility across global markets.
Over in Japan, after three years of Abenomics, focus now shifts to Shinzo Abe’s third arrow as comments by the BoJ which hint at limited yen downside from current historical lows suggest scant scope for expansion in the QE program. On this wise, progress on legislative bills before the Japanese Diet aimed at loosening Japan’s restrictive labour laws and tax changes aimed at incentivizing Japanese corporates to increase capital spending are going to be closely watched by markets. Aided by sustained recovery in GDP numbers from the weaker base induced by 2014 VAT tax hikes, Japan’s economy should show improvement over H2 2015.
On the other hand, the tightening financial environment and still bearish energy prices drive scope for extension of EM growth slowdown. The newfound determination by Chinese authorities to prevent a hard landing suggests further growth deceleration would be met by more loose monetary policy—in the form of interest rate cuts and reduction in reserve requirements—and fiscal stimulus via more swaps of local government paper for central government bonds. In addition, following the sharp correction towards the end of June, Chinese authorities should implement measures to smoothen the pace of market downturn
Russia’s economic outlook remains hinged on developments around Western sanctions. Whilst a truce continues to hold in Eastern Ukraine, increasingly belligerent rhetoric by Russia and US-EU over troop and weapons movements suggests scope for imposition of stringent sanctions persists. Incorporating still subdued oil price outlook, a recessionary prognosis for the Russian economy over H2 2015 does not seem far-fetched.
Similarly, the outlook for Brazil’s economy remains dour due to subsisting commodity price weakness and fiscal consolidation. Sustained tightening by the monetary authority in response to inflationary pressure and greater prospects for exchange rate weakness post hike in US interest rates burnish a cloudy outlook for Brazilian equities over the rest of 2015. Contrary to tepid outlook across other EMs, India’s growth outlook remains robust, hinged on structural reforms and tamer oil prices.
In sum, the shrinking US growth optimism drives a moderation in IMF’s forecasts of DM growth to 2.4% YoY, while ongoing deceleration in China, prospect of ‘Grexit’ spillover and tighter financial conditions due to US rate hike leads to 60bps cutback in IMF’s EM growth expectations to 4.3% YoY.
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