Perspective from Franklin Templeton Fixed Income Group®
US Economy’s Rebound on Track, but Inflation Takes a Pause
The US economy’s performance thus far in the second quarter looks on track to return to its pattern of moderate expansion, in our view, reversing the softness seen at the beginning of 2017. The robust foundations provided by labor, housing and financial market strength remain in place, supported by the post-election improvement in consumer and corporate confidence, even if this economic cycle is unfolding in a different way than previous ones. Up to now, and for reasons that are yet to be fully understood, the labor market has not produced any noticeable increase in wage inflation, though it appears close to full employment. Although we are cognizant this weaker correlation between employment and wages may persist for some time, if the labor market continues to tighten, then it seems likely to us the historic pattern of higher wages feeding into broader inflation seen in past economic cycles will eventually reassert itself, allowing the Fed to move closer to the normalization of monetary policy.
The second reading of first-quarter US gross domestic product (GPD) growth, which saw the initial annualized rate of 0.7% revised up to 1.2%, helped to ease concerns about the sluggish start to the year, as did ongoing questions about the impact of seasonality on growth statistics. But more compelling evidence that the US economy could be regaining its footing came with April’s consumption report, in which consumer spending posted a respectable gain of 0.4% month-on-month, while March’s figure was amended from unchanged to a rise of 0.3%. Reassured by such data, most estimates for second-quarter growth predicted a solid rebound back above the 2% trend rate that has been characteristic of the US economy in recent years, with some outliers projecting a sharper acceleration to over 3%.
The labor market report for May showed additional hiring of 138,000, around 50,000 below consensus expectations, and also included a sizable reduction in April’s strong jobs gain. Nevertheless, the unemployment rate continued to move lower, with the reading of 4.3% marking the lowest level since 2001, while measures of labor participation and underemployment declined as well. In keeping with the pattern that has generally prevailed as the labor market has tightened during the current economic cycle, there was little sign of a sustained build-up in wage pressures in May’s report, even though April’s personal income release had shown an outsized gain in wages and salaries. Average hourly earnings ticked up 0.2% month-on-month—with April’s reading revised down to the same level—to leave the annual rate unchanged at 2.5%.
Elsewhere, a survey comparing job openings with hirings underlined the strong demand for workers, as well as the difficulties facing companies in their efforts to recruit employees with the appropriate skills. The Job Openings and Labor Turnover Survey report covering April found openings had risen sharply from the previous month to more than 6 million, while hirings shrunk to just over 5 million, leaving the spread between the two nearly 150,000 higher than in March.
Broader inflation data maintained a recent trend of softer-than-expected readings. Though the Fed’s favored measure—the core personal consumption expenditures (PCE) price index—posted a 0.2% rise month-on-month in April, the annual rate fell 0.1% to 1.5%, its lowest level since December 2015. The equivalent annual headline PCE figure showed an even larger drop, down by 0.2% to 1.7%. The current absence of inflation pressures was also apparent in consumer price indexes, which registered similar falls at the core and headline level over the same period, to 1.9% and 2.2% respectively.
However, minutes released from the Fed’s meeting in May revealed that policymakers were relatively sanguine about the softer inflation data, seeing the dip as “primarily reflecting transitory factors,” such as lower cell phone charges. Citing the need for a further removal of some policy accommodation soon, as long as economic data came in as expected, the minutes reinforced sentiment among market participants about the probability of another increase in interest rates at the Fed’s next meeting, which was duly confirmed by policymakers in mid-June. But sentiment about the path for monetary policy for the rest of the year was less certain, and in the run-up to June’s meeting, market participants were more or less evenly split about whether interest rates would rise again during the year.
Even though US interest rates appeared set to rise, the US dollar lost ground for the third consecutive month, ending May at its lowest level on a trade-weighted basis since the US presidential election. The move in the dollar was partly explained by the ongoing strength of the euro, which has rallied strongly since the start of the second quarter on speculation about a potential tapering of bond purchases by the ECB.
US Treasury yields also drifted toward the bottom of their trading range for the year to date, amid fresh political problems surrounding the Trump presidency and heightened concerns about its abilities to effectively implement policy. Despite the administration’s missteps, we still view its policy stance as likely to enhance growth—for example, through deregulation—even if the timeline for its more ambitious fiscal programs seems to be stretching further into the future. In our view, it is important to remember that prior to the presidential election, benchmark Treasury yields were around 40 basis points lower, indicating it is not just equity markets that believe the election’s outcome has improved the outlook for economic growth.
Oil-Price Volatility Overshadowed by Gulf Political Crisis
Oil prices had another volatile month, peaking in mid-May as the Organization of the Petroleum Exporting Countries and other major oil producers agreed on a deal to extend existing production cuts for another nine months. But disappointment that the cuts had not been extended for a longer period, combined with expectations that US shale oil production would continue to add to global supplies, soon saw oil prices come under renewed pressure, hitting their lowest levels of the year so far by early June.
Oil’s losses occurred despite the sudden outbreak of a political crisis in the Persian Gulf, as a group of countries, led by Saudi Arabia and the United Arab Emirates, broke off diplomatic relations and transport links with Qatar. One of the world’s largest producers of liquefied natural gas, Qatar has long used its significant energy-derived wealth to pursue an independent political path, particularly in terms of its support for various Islamist groups across the Middle East that have been widely viewed as threats by the rulers of many other Arab countries. Qatar’s recent opening up of ties with Saudi Arabia’s main rival Iran may have been one of the triggers for the rupture in relations between the fellow members of the regional Gulf Cooperation Council.
Elsewhere, South Africa’s economy unexpectedly moved into recession, after a contraction in the final quarter of 2016 was followed by a decline of 0.7% quarter-on-quarter over the first three months of 2017. The economy’s weakness at the start of the year came as a surprise—as consensus forecasts had predicted growth of around 1%—but was broad-based, affecting all sectors except agriculture and mining. The subsequent period has seen further problems, with an upsurge of political concerns due to the sacking of the country’s respected finance minister by President Jacob Zuma, which led Standard & Poor’s to cut South Africa’s credit rating to one level below investment grade. However, rival rating agency Moody’s decided against such a move, arguing that South Africa’s strengths such as low levels of foreign-currency debt, deep domestic markets and a well-capitalized banking sector went some way toward offsetting its political and economic problems.
By contrast, Brazil exited its deepest-ever recession in the first quarter, with growth of 1% compared to the previous three months marking an end to eight consecutive quarters of contraction. The turnaround was mainly due to an outsized soybean harvest, but similarly to South Africa, did not capture the impact on the economy of the country’s most recent political crisis, which initially appeared to threaten the position of President Michel Temer. The current president only came to power in 2016, after the previous incumbent was impeached for budgetary irregularities. Although President Temer survived a ruling by Brazil’s electoral court, which potentially could have removed him from office, questions remained over his ability to see through a program of labor and pension reforms, which is widely viewed as essential to bridge the country’s budget deficit of over 9% of GDP.
Though political problems in South Africa and Brazil continue to mount, the notion that such risks are predominantly confined to emerging markets has been disputed by the upheavals in the political landscape across Europe and the United States since the global financial crisis. Some market participants might argue that recent electoral results indicate the high-water mark of populism (and its potential to induce political upsets) has been reached, but we believe whichever markets investors are considering, it is increasingly important for them to recognize the influence of politics on economic fundamentals.
Lower Inflation Forecasts Support ECB’s Continued Dovish Stance
Updated GDP data revealed that the eurozone’s first-quarter growth was a little better than first thought, with the numbers revised up from 1.7% to 1.9% year-on-year, as the performance of the French, Italian and Greek economies improved. The strength of a leading manufacturing survey for the region, which hit a six-year high in May, suggested the pickup was likely to extend into the second quarter. Indeed, the employment component of the survey reached a record level, raising hopes for further job creation across eurozone economies, many of which still have significant slack in their labor markets. However, the latest inflation data showed regional price pressures remained subdued, easing to an annual rate of 1.4% in May at the headline level.
The ECB’s June meeting broadly reflected these trends in growth and inflation. The central bank’s updated forecasts for annual growth up to 2019 were each bumped up by 0.1%, but it continued to envisage a slight slowdown, from 1.9% for the current year to 1.7% in 2019. Some of its corresponding inflation numbers, however, received a larger downward adjustment, with the forecast for 2018 cut from 1.6% to 1.3%, while the estimate for 2019 saw a more modest reduction from 1.7% to 1.6%. Given the weak inflation outlook, it was little surprise the ECB resisted calls for an announcement regarding when it would begin to taper its bond-purchasing program, with ECB President Mario Draghi emphasizing the continued need for a “very substantial degree” of stimulus to support stronger inflation. Nevertheless, the central bank updated its forward guidance by dropping a reference to further cuts in interest rates if warranted, a move President Draghi subsequently confirmed as signifying policymakers were no longer worried about a potential slide into deflation.
We are encouraged that the ECB has again resisted calls to signal a tapering of its quantitative easing program. By stressing the time potentially needed to reach its inflation target of close to 2%, the central bank has underlined that while the current recovery may be broadening, its momentum is not yet self-sustaining, and that the risks from a premature removal of monetary stimulus still far outweigh the possibility of a surge in prices due to an overly loose monetary stance.
The outcome of the UK general election produced yet another political upset, as the ruling Conservative party lost its parliamentary majority. UK Prime Minister Theresa May had sought a fresh mandate from voters, principally to strengthen her authority during forthcoming Brexit negotiations on the terms of the United Kingdom’s departure from the European Union (EU). But despite a strong Conservative lead in the polls at the start of the campaign, the result produced a “hung” parliament, with no single party having a majority, forcing Prime Minister May to seek to form a minority government with the support of a small party from Northern Ireland.
The UK election result has clearly increased political uncertainty but, in our view, could also increase demands from the UK parliament for greater transparency during the Brexit negotiations, which are due to begin shortly. A weakened minority Conservative administration would also seem more vulnerable to the possibility the UK parliament could reject an unpopular Brexit deal. Indeed, the greater the parliamentary demands and constraints on the UK government during its negotiations, the more likely we anticipate a “hard Brexit” scenario to be—particularly if EU negotiators are emboldened to take a tougher line—potentially leaving the United Kingdom without a deal to replace the current European trade agreements.
The first round of France’s parliamentary elections pointed to an eventual sizable majority for French President Emmanuel Macron’s fledgling En Marche party, which fielded parliamentary candidates for the first time. A majority in the French parliament was seen as essential for President Macron to carry out his proposed reform program, centered on the labor market and welfare system, and aimed at halting any further deterioration in the country’s economic fundamentals. Two major concerns in France—a high debt-to-GDP ratio and a sizable budget deficit—have generally been uppermost in investors’ minds. President Macron has said he is committed to meeting EU rules and reducing France’s deficit below 3% of GDP, but this has seemed somewhat at odds with his other promises to boost some areas of public spending.
In Spain, after concerns about a capital shortfall (resulting from non-performing real estate loans) had triggered a run on the deposits of one of the country’s medium-sized lenders, the bank was sold to a larger competitor for a nominal sum. The demise of the Spanish lender marked the first time the new European system for unified banking supervision had been employed since its establishment more than two years ago, with eurozone officials stepping in to take control of the bank after declaring it “failing or likely to fail.” Although holders of the bank’s shares and junior bonds lost their investments, the rapid resolution and lack of contagion from the situation was widely judged to be a successful outcome for European financial regulators.
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