NN IP: Nervousness ahead as US government spending debate nears

Senior Economist Willem Verhagen gives an update on the state of the economies of the US, the Eurozone and Japan, while Senior Emerging Markets Strategist Maarten-Jan Bakkum shares his views on the latest developments in emerging markets.

The most obvious source of volatility in the US remains in the political realm. So far the Trump administration has not made any material economic policy changes. Perhaps this is not a bad thing for an economy which is perfectly capable of standing on its own feet guided by very gradual Fed tightening. In the medium term, the risks are very big indeed and can be summed up as a clash between Trump’s stated policy preferences and political, constitutional, economic and international constraints. This could result in policy action with far-reaching and possibly destabilizing consequences. For investors the important point is that we may already see some of that in the near future.

Congress needs to pass a FY2018 spending resolution (which basically authorizes the government to spend on discretionary items) as well as an increase in the debt limit in the next 1-2 months. Trump insists on funding for his Mexican wall to be included in the spending resolution and some conservative GOP Senators may well support him in this. Even if they do not, the spending resolution will need at least 60 votes in the Senate which requires Democratic support. Of course Senators from that side of the aisle are never going to agree to funding for the wall. The risk of a government shutdown is thus substantial. One way to overcome this hurdle is for Congress to pass a Continuing Resolution with no conditionality attached, which authorizes spending for a few months into the new financial year. This is of course kicking the can down the road but by the time Congress reaches “the can” again they may well be in the middle of debates about tax reform which will allow Trump to score points on that front. It is important to remark that, in principle, the debt ceiling debate is a separate issue but in the past the two were often linked. No one really knows when the US Treasury will run out of extraordinary measures and what will happen if they cannot meet required payments on what is seen as the ultimate global safe and liquid asset.

US economy maintains decent cruising altitude

From the perspective of the real economy the US remains on a cruising altitude of 2-2.5% with the usual quarterly volatility. With the expected revision of Q2, GDP growth in the first half of this year should come out around 2% with solid contributions from consumer spending and non-residential private investment. By contrast, residential investment disappointed a bit and the latest soft housing market indicators suggest this may continue in the current quarter. Inventories were a drag, which is expected to wane in the second half of this year. Non-residential investment spending is expected to remain relatively robust, as capex intentions in businesses surveys are at their highest level for this recovery. From a fundamental perspective, capex is driven by ongoing profit growth, business confidence in the resilience of final demand as well as the need for investment in labour saving technology as full employment draws nearer.

Underneath the strength of consumption is the observation that the labour market continues to steam ahead with a 3-month trend in payroll growth just shy of 200K and an unemployment rate of 4.3%. The latter was pretty stable between September 2015 and September 2016 around 5%, but has fallen over the past year in the face of a participation rate that has hovered in the 62.6-63% range. The latter is the resultant of a demographic drag and an increase in prime-age participation. This is undeniably a strong labour market and given the current level of the unemployment rate one can understand why many FOMC participants want to bring the policy rate back to neutral to avoid labour market overshooting.

That having said, wage growth remains pretty subdued for now and continues to hover around 2.5%. We expect this to gradually grind higher as the unemployment rate falls further, but our confidence in the strength of this mechanism is not what it used to be. One further interesting observation about the consumer is that backward revisions now reveal that the savings rate is much lower than first estimated. The flipside of this observation is that the response to the increase in household balance sheet quality has been bigger than thought at first, even though the sensitivity remains below pre-crisis levels. At any rate, there is less room for the savings rate to fall sustainably than thought before. Having said that, the recent rise in consumer confidence suggests it may still grind a bit lower.

The Fed will need to balance robust growth, a tightening labour market and easing financial conditions against the string of disappointing readings on core inflation and wage growth. The minutes of the July FOMC meeting contain strong hints that Yellen believes that sticking to the game plan of gradual tightening measures is the best way to navigate these cross currents. For this reason we hold on to our Fed call, but reiterate that the risks are very much tilted to the side of a more dovish Fed. In particular, our fear remains that inflation expectations have slipped below target so that inflation will settle below 2% once the economy reached full employment. In this respect, Yellen’s speech at Jackson Hole did not give any additional insights for the near-term policy outlook. In the past she used this venue mostly for thorough and well-founded discussions about several economic puzzles and issues and not so much to signal a change in policy.

Eurozone zone growth is heating up

Switching to Euroland, the most important news on the real side of the economy is that growth has shifted in higher gear over the past three quarters. Whereas before growth momentum was hovering a bit above 1.5% it now seems to have settled in the 2-2.5% range which is well above potential. In this respect, it should not be too surprising that the unemployment rate continues to fall and now stands at 9.1%. From a regional perspective, it is encouraging to see that the traditional laggards Italy and France now seem to be catching up. From the perspective of demand components, both consumer and investment spending are growing at a decent pace. As we argued before, the drivers here are the potential for a reduction in what is still a high level of private savings, pent-up demand for durable goods, easing credit supply, low borrowing costs, rising levels of confidence and strong employment growth. All in all, the region is thus characterized by a pretty robust feedback loop between income and spending growth, which is receiving support from the financial sphere as well as from confidence. What’s more, fiscal policy is not likely to throw a spanner in the works this time around.

On the nominal side of the economy, core inflation is beginning to show the first tentative signs of life as momentum has increased a little relative to the sideways trend seen over the past two years or so. Hopefully this trend will continue, but it is way too early to declare victory in this respect. When stripping out the most volatile components core inflation momentum continues to move sideways. What’s more, wage growth is not showing any signs of life. We do not expect a material improvement on this front in view of the US and Japanese experience, where wage growth only started to react to slack in a muted way when the unemployment rate was close to the NAIRU. Meanwhile, a cyclical pick-up in productivity growth could reduce unit labour cost growth somewhat.

There has been a lot of talk about the euro appreciation and the extent to which its effect on inflation will be offset by the improved growth momentum. First of all, we do agree that EMU growth momentum is less sensitive to the euro appreciation than typically seen in the past, because this time domestic demand growth is the main driver. Actually, this very fact may to some extent be a driver behind the appreciation because the marginal change in domestic economic strength over the past six months has definitively been in favour of Euroland. The decrease in perceived political risks has probably also played a role here. Nevertheless, we would point out that the appreciation has a direct negative impact on core inflation rates. To the extent that inflation expectations have become unanchored, lower core inflation rates will drag them down further. In this respect, the euro appreciation could leave a pretty persistent mark on inflation expectations.

Meanwhile, the effect of better growth momentum and a faster tightening of resource utilization on inflation remains pretty uncertain because of all the puzzles surrounding the Phillips curve. As we argued before, the Eurozone is still pretty far removed from full employment and substantial upward inflation pressure may not arise until the economy is very close to this point. Adding it all up, one can understand why the ECB could be a bit concerned about euro appreciation and does not want to see it continue. An added consideration here is that exchange rate expectations can easily embark on a bandwagon that will prove self-fulfilling for a time: A higher expected rate of appreciation will attract capital inflows which will make it a reality. At Jackson Hole, Draghi mostly declined to comment on the current policy outlook.

Japan: reflation is not easy

Even though the Japanese economy is unlikely to repeat the 4% growth rate seen in Q2’17, it seems growth momentum is improving relative to the pace seen over the past two to three years. During this period, Japan was buffeted by the aftermath of the 2014 consumption tax hike as well as the global disinflationary shock exerted by falling commodity prices and a stronger dollar. Average growth came out at a very strong 2.7% annualized in the first half of this year and was supported by both consumption and capex and government spending while net trade was a small drag. This is roughly four times Japan’s potential growth rate, so some slowdown is to be expected in the second half. One demand component that is already pretty certain to slow down is public investment which jumped more than 20% in Q2.

Nevertheless, the important underlying message here is that domestic private demand growth is finally recovering from its 3-year slump and returning towards levels seen in the Abenomics period prior to the consumption tax hike. Underpinning all this is a stronger feedback loop between domestic income and spending which is supported by rising levels of business and consumer confidence. In view of the fact that the unemployment rate now stands at 2.8% and the jobs-to-applicants ratio continues to rise, all this suggest that the Japanese economy should soon be in overheating territory. In fact, it may already be there. Still, the effect of this on wage and price inflation remains pretty muted for now.

Surely there is some effect as wages for part-time workers (who act as a marginal source of labour supply) are rising at a decent clip. One reason for the weak Phillips curve effect is probably that inflation expectations remain pretty sticky after two decades of below-target inflation rates. An added consideration here is that businesses may be reluctant to grant permanent wage increases given the uncertainties surrounding Trump’s protectionist agenda. Another reason for relatively weak wage and price inflation is that firms in some sectors (e.g. retail and restaurant/accommodation) has significantly stepped up investment in labour-saving technology to keep the lid on labour cost growth. From a macro point of view this will increase productivity growth and push the NAIRU at least temporarily lower.

What’s more, these sectors have already witnessed a substantial increase in profit margins over the past few years so that any increase in labour costs can be easily absorbed. The upshot of all this is that the BoJ’s inflation target is not within sight yet, a notion that Kuroda is slowly starting to recognize as the central bank is clearly in the process of slowly pushing the target ETA out into the future. Obviously this suggests that risks around the expected time of the increase in the 10-year yield target (middle of 2018) are on the side of this happening later.

Emerging markets: favourable growth environment continues

The macroeconomic picture of emerging markets remains remarkably stable. The economic growth momentum is still positive – it has been for about a year now – albeit less so than before. The level of economic growth continues to hover between 4.5% and 5.0%. Growth is driven by global trade, but increasingly by domestic demand.

Domestic demand growth is primarily benefiting from easier financial conditions, thanks to carry-trade-related capital inflows. Interest rates are coming down almost everywhere, slowly resulting in rising credit growth. Outside of China, EM credit growth bottomed in February. Since March, we have been seeing a slow recovery. Currently, credit growth is around 9%, which is still far away from the 21% post-Lehman peak six years ago and the 20-30% range in the years 2004-2008.

But as long as credit growth recovers, the prospects for domestic demand growth should continue to improve. This is still a benign environment for EM assets, the more because the improvements in growth are modest. A not-too-fast growth recovery helps preventing the build-up of macro imbalances, such as large current account deficits, a sharp rise in inflation or a fast build-up of non-performing loans in the banking system.

In this context it is relevant to note that in China, in the second quarter of the year, total domestic debt as a percentage of GDP did not increase, for the first time in three years.


 

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