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Ever since the global economy bottomed out at some point towards the middle of 2009 we have been optimistic about the US. Having enacted TARP, and forced its banks to write-down their bad debts, it was in a stronger position than most major economies. Poor GDP data for the first quarter of this year, which following the second set of revisions showed a drop in output of 2.9% on an annualised basis, shook the confidence of some.
Although the impact of the poor winter weather was more severe than we had at first thought, we have stuck to our position that it was nothing more than a temporary setback – a ‘blip’ if you will. The latest employment situation report, which showed that non-farm payrolls rose by 288k in June, appeared to validate our call as the Dow Jones pushed through 17,000 for the first time. As we set out below, based on a combination of monthly expenditure data, survey-based indicators such as the PMIs and information from the labour market, we expect to see a strong rebound in growth in Q2. We are looking for a figure of around 6% on an annualised basis, with risks to the upside.
Small drop in demand, bigger drop in supply in weather-affected Q1
The expenditure data for Q1 are unusual in so much as weaker-than-expected final domestic demand occurred alongside a substantial negative contribution from inventories. In the normal course of events, as our scatter plot shows, when growth in final domestic demand falls, firms tend to overproduce, resulting in a positive contribution from inventories and vice versa. In our view, the poor winter weather led to some reduction in demand – consumers made fewer visits to the shops – but it led to an even bigger reduction in supply. Fewer goods and services were produced than were required so inventories were run down. If we are right, not only is final domestic demand likely to bounce back in Q2, but inventories should make a significant, positive contribution to growth.
Evidence to date for Q2
The monthly profile for personal consumption expenditures has been noisy, but on the basis of data for April and May the household sector ought to make a clear, positive contribution to overall GDP growth. The Markit PMIs strengthened considerably through May and June, with the composite output indicator reaching a new record high. To us, this suggests a significant amount of restocking has taken place. On the basis of the available information on the expenditure side, put together with a judgment that the negative contribution from inventories in Q1 is likely to be wholly reversed in Q2, we would look for a figure for overall growth in Q2 in the region of 6% on an annualised basis. Arguably, the labour market data paint an even stronger picture. Non-farm payrolls came in better than expected at 288k in June, taking the six-month moving average to its highest level since the crisis hit. If we assume that productivity growth through the first half of this year was in line with its post-crisis average, then by themselves the labour market data would be consistent with growth substantially north of 6% through Q2.
UK housing market boom continues apace
Data published last week by the Nationwide showed that UK house prices rose by 11.8% in the twelve months to June, moving above their pre-crisis peak for the first time. According to the more comprehensive ONS measure, this particular milestone was passed as long ago as last October, and by April prices were almost 7% above the levels seen in January 2008. Whatever data source is preferred, it is clear that prices continue to rise rapidly. And this is taking place despite a slowdown in mortgage approvals, which fell further to 61.7k in May. Some have argued that the Mortgage Market Review (MMR) has produced a meaningful reduction in the supply of credit, and that is why approvals are slowing. We are not convinced. An alternative explanation, which we prefer, is that the MMR, which requires banks to obtain detailed evidence on the ability of borrowers to make repayments, has temporarily lengthened the time it takes for applications to be processed. If this is the case, approvals are likely to slow until the new systems have bedded in, before rising again – perhaps sharply.
Other data released confirmed that UK productivity fell a little further during the first quarter, as employment once again grew faster than GDP. In that regard, it is noteworthy that the employment component of the composite PMI reached a new record high of 58.2 in June. It is the dire performance of the supply side of the UK economy, against a backdrop of rapid growth in demand, that is now putting pressure on the MPC to at least contemplate a tightening of policy – as we warned that it would more than one year ago. The expectation that the UK will be the first major economy to increase its policy rate pushed sterling to a new multi-year high of $1.72 last week. But much more important than the timing of the first rate rise is the pace and the extent of those that follow it. And here, against a backdrop of rising inflationary pressures, the MPC will disappoint, keeping the real policy rate of interest substantially negative for a number of years to come. That is why we stick to our position that now is a good time to take profits on sterling.
‘Modalities’ of ECB’s TLTRO’s create perverse incentives
The decision of the ECB’s Governing Council to do nothing at last week’s policy meeting came as no surprise. More interesting, however, were the TLTRO ‘modalities’ published afterwards. Banks that exhibited positive net lending over the twelve months to 30 April 2014 will, it transpires, be able to use money obtained through TLTROs as they see fit. There is no requirement for them to increase eligible lending – lending to the non-financial private sector other than to households for house purchase – still further. There will be no requirement to repay the TLTROs early so long as overall lending does not decrease. Banks for whom net lending was negative in the twelve months to 30 April 2014 – predominantly banks in the Periphery – can actually further decrease their lending, albeit at a slower pace. Even if banks ignored the ECB’s terms and conditions completely, they would still get two years of cheap money – they would just need to repay it in 2016 rather than 2018.
In short, the TLTROs will do nothing to solve the banking crisis, or indeed to address the problem of stubbornly low inflation. Instead banks will be incentivised to borrow money at 0.25% through TLTROs and simply invest it in high-yielding peripheral government bonds.
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