Beyond Bulls & Bears

Fixed Income

Global Economic Perspective: December

Federal Reserve Points Cautiously toward Rate Rise

With 321,000 jobs added, the initial US nonfarm payroll report for November was much stronger than markets expected and brought job growth this year close to levels last seen in the late 1990s. Added to upward revisions in September and October jobs data, the nonfarm payrolls data reinforces the view that whatever is occurring in the rest of the world, the US economy appears to remain firmly on track to record reasonably strong growth in the months ahead. And while fourth-quarter gross domestic product (GDP) growth this quarter for the United States is expected to be lower than the third-quarter rate of 5.0%, there is renewed optimism that the country’s economic expansion is being put on a sustainable footing.

Perhaps even better than the raw jobs numbers were signs that wages, long stagnant, might finally be moving upward. According to Bureau of Labor Statistics figures, average hourly earnings rose by 0.4% in November over the previous month and 2.1% from a year earlier. Such rises are still modest. Combined with an unemployment rate that remained stuck at 5.8% and a historically low labor force participation rate, these results were taken as indicating some remaining slack in the labor market. However, combined with low inflation and falling energy prices, a brightening jobs picture helped a small rebound in US consumer spending in October after a flat September.

Corporate data have also been relatively upbeat. US manufacturing output recorded its largest increase in nine months in November and industrial production surpassed its pre-recession peak. As for forward indicators, the November Institute for Supply Management purchasing managers index (PMI) readings for the manufacturing and nonmanufacturing sectors alike remained well above the 50 mark that separates expansion from contraction. New orders have been strong, while nonresidential fixed investment grew at an annualized pace of over 7% in the third quarter, according to the Bureau of Economic Analysis.

One important factor in America’s revival is the fall in oil prices. International Monetary Fund Managing Director Christine Lagarde said that lower energy prices would help accelerate US growth to 3.5% next year from a projected 3.1% in 2014. Although cracks have begun to appear in the US high-yield bond market in which energy sector-related issues have grown in recent years and which now make up a sizable part of the noninvestment-grade universe, and although energy-related capital spending could be expected to slide, falling oil prices are thought to be overwhelmingly good for the US economy because they typically stimulate consumer spending and hold down inflation. The lower costs should support economic growth by helping boost corporate earnings and, if they last, might lessen the pressure on the Federal Reserve (Fed) to raise interest rates at anything more than a very gradual pace.

Nonetheless, while the Federal Open Market Committee (FOMC) under Chair Janet Yellen is considered dominated by policy doves, the improving jobs picture has pleaded for “normalization” of interest-rate policy after six years of close to zero base rates. Indeed, in early December, FOMC Vice Chair Stanley Fischer opined that, even allowing for low inflation, short-term rates were too far below normal at a time when the US labor market was normalizing rapidly. Thus, while inflation expectations have remained low (in part because of low oil prices and the strong US dollar), and while wage growth has remained modest, it might take an unlikely drop in core inflation—core personal consumption expenditures excluding food and energy prices rose an annualized 1.6% in October—to stave off some initially moderate tightening of base rates in the months ahead.

In any case, Yellen dismissed low headline inflation as “transitory.” Instead, backing up our view that the futures markets have heretofore shown themselves to be a little overconfident that the first rate rise will not be seen until near the end of 2015, the FOMC’s statement of December 17 stated that “increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated.” Yet the statement was marked by caution, with the FOMC saying it could be “patient” in its moves to normalize policy. Just as revealingly, the FOMC’s own “dots” chart, which shows the interest-rate expectations of individual FOMC members, suggested that FOMC members now believe interest rates will be a bit lower at end-2015 than they thought when they made their last forecast in October.

The caution displayed in the latest FOMC statement on future policy tightening was undoubtedly designed to reassure investors at a very sensitive time in global markets. Indeed, how delicate prospects are for investors can be seen in the continued performance of longer-dated paper. As we move into a new year, we would hope that low inflation, the fallout (however slight) from weakness in the global economy, and a determination by US policymakers to refrain from scaring financial markets should avoid a disorderly unraveling of the bond market.

Winners and Losers from Oil Price Decline

Due to an excess of supply rather than a lack of demand, crude oil prices have declined rapidly in recent months. By mid-December, ICE January Brent—the international oil benchmark—was being quoted at under US$60 a barrel, almost half the price level of mid-June. As the majority of global economies are oil importers, this price decline is likely to add to global growth and that of large emerging-market oil importers like India. Other positive effects for net oil importers include potential improvements in trade and current account balances, as well as fiscal deficits. The oil-assisted drop in inflation should help contain interest rates and provide a boost to investment and consumption. At the same time, the drop in oil prices has bolstered much-needed economic reform in certain economies. In November, both Malaysia and Indonesia moved toward cutting fuel subsidies. India and Egypt have also made similar policy commitments to improve their public finances.

This drop in oil prices has placed downward pressure on the currencies of commodity producers, which have suffered major declines in recent weeks. Other currencies have performed comparatively better. The Thai baht, Indian rupee and Philippine peso have lost much less against the US dollar compared to the Russian ruble and Colombian peso, two major commodity producers. As an oil producer, Mexico has also seen its currency fall against the US dollar this year; however, this fall has been relatively limited as the United States is one of its largest trading partners.

Earlier this year, investors seemed to make some welcome differentiation between countries with different perspectives. Even allowing for severe drops in some bond markets, emerging-market debt indexes generally seemed resilient given the volatility seen in currencies and stocks. However, by mid-December, panic started to affect investor sentiment toward emerging markets more broadly. This panic was a combination of the negative impacts of lower oil prices on commodity producers, as well as the rising US dollar. The Central Bank of Russia was forced to hike its main interest rate to 17% in an attempt to stave off a collapse of the ruble. Disruption could remain a feature of emerging markets for some time as investors begin to prepare to navigate what we think is a rising-rate environment in the United States and to come to terms with the softening of the Chinese economy. Though fundamentally strong economies are not exempt from the short-term destabilizing effects of the fall in the price of oil across emerging markets, we believe they should stabilize once panic dissipates and financial assets begin to benefit from fresh liquidity injections from the Bank of Japan and the European Central Bank (ECB).

European Outlook

As December rolled on, a glut of indifferent or disappointing statistics and stubbornly low inflation seemed to point the way to some form of “quantitative easing” (QE) for Europe involving the outright purchase of government bonds and other securities on the open market. The market’s expectation that the ECB will shortly intervene with further massive injections of money could be seen by the seeming lack of a market reaction to recent sovereign ratings downgrades. France’s credit rating was downgraded by Fitch in mid-December, but without any immediate effect on its borrowing rate. But for all of France’s problems, its 10-year government bond yields still stood near record lows of about 0.9% after the December downgrade. Italy too suffered a ratings downgrade in December, with Standard & Poor’s lowering its credit rating to just a notch above junk status. Symbolizing Italy’s even more entrenched problems, the country currently pays a higher yield on 10-year bonds than France (just over 2%). However, although Italian yields rose slightly due to the downgrade, the rise was not enough to eradicate the fall in yields over the previous month.

The likelihood of further ECB intervention was reinforced by the disappointing take-up of the latest ECB offer of cheap four-year loans to European banks under its targeted longer-term refinancing operation (TLTRO) and by the ECB’s own December forecasts for growth and inflation next year, in which the central bank had to pare the already-modest levels it was predicting last September. ECB doves can also point to data such as a slowdown in business activity (as shown by composite Purchasing Managers Index indicators for November) and a headline inflation figure that has remained well short of the ECB’s target of just under 2% as reasons for resorting to steadily more radical ways to boost the eurozone economy.

The political and social temperature has also begun to rise and contribute to the case for further stimulus. There have been general strikes in Belgium and Italy, many investors appear fearful that political miscalculation might see the far-left party Syriza elected to government in Greece, and populist left- and right-wing parties have been topping opinion polls in both Spain and France. Furthermore, on the European Union’s doorstep, fears have grown about the stability of the Russian and Ukrainian economies.

QE is not yet a done deal: Opposition from Germany may try to halt it, or at least undermine the size and scope of what the ECB is able to buy. German resolve to resist QE might be hardened by the surprising jump in industrial orders in Germany in October, along with improved business and consumer confidence in November in Europe’s largest economy. And questions remain about whether QE violates the European Treaty. Doubters might also argue that the inflation picture has been distorted not only by the fall in oil prices, but also by ongoing efforts in crisis-ridden eurozone member countries to restore competitiveness by lowering costs and wages.

On balance, however, with ECB President Mario Draghi apparently ready to override German objections, some form of QE seems likely. A move to buy government bonds would mark an important change in the ECB’s role and have profound political implications for the monetary union, in our view. With eurozone governments already obliged to submit their annual budget plans to the European Commission for assessment, ECB government bond purchases would mark a further step on the road to fiscal integration.

More concretely, a combination of low oil prices, monetary stimulus, some form of fiscal stimulus, and the successful implementation of labor and other structural reforms might mean that late-2014 marks a low point in the fortunes of the eurozone economy. Compilers of a closely watched investor sentiment index for the eurozone, the Sentix, say the economy is now entering a recovery phase after teetering on the edge of recession in the third quarter. By mid-December, oil prices had reached their lowest point in over five and a half years, freeing up spending power for businesses and households, while the decline in the euro—down over 10% against the US dollar since the beginning of 2014—has helped Europe’s exporters.

However, any upturn in the eurozone’s fortunes could be limited by an uncertain world economy, and the decline in the euro mitigates somewhat the positive effect of the drop in oil prices. As the disappointing TLTRO operations show, demand for loans has remained muted as banks, businesses and households continue to focus on deleveraging. We believe the drop in oil prices and the strengthening US economy should prevent a full-blown recession in the eurozone in 2015—with or without QE. But it might be too much to expect anything more than a gradual pickup in the eurozone until the structural reforms being laboriously pushed through in France and Italy begin to make themselves felt.

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