‘Central banks are ready for anything’
July 11 2016 09:10 PM
Christopher Dembik is the head of Macro Analysis, Saxo Bank.

By Christopher Dembik

• The outcome of the UK referendum will increase volatility in the coming weeks in financial markets and could penalise economic growth if the uncertainty around the UK exit process is not quickly removed. The rapid and efficient actions of central banks, especially the Bank of England and the Swiss National Bank, have helped to stop the panic in the aftermath of the referendum. However, new actions may be needed in case of higher volatility.
• Leading indicators confirm a deteriorating global economic outlook, which confirms that the return of sustainable growth is far from assured. The global manufacturing PMI is about to enter into contraction which could lead to a downward revision of IMF growth forecasts at the end of the quarter.
• In Japan, the upcoming Upper House election that will take place on July 10 is the main political event to look at this month. The Liberal Democratic Party of Prime minister Shinzo Abe is in position to win the election. However, the economic policy that will be implemented by the government in the coming months to counter the failure of Abenomics remains unknown. The option of “helicopter money” is clearly on the table in the medium-to-long term.

Global overview: Indicators point to slowing growth
Growth in the US, Europe and China is very disappointing as indicated by the Citi economic surprise index although the US has improved over the last weeks, which reduces the risk of recession in the short and medium term. After a good start early in the year, growth is showing significant signs of slowdown in Japan since the beginning of June. In the course of two weeks, Japan economic surprise index dropped from an annual high of 76.8 to 40. Uncertainties about the consequences of Brexit will certainly weigh on business confidence and on investment in the medium-term, which could accelerate the economic slowdown, at least for Europe.
 The negative trend in the manufacturing sector confirms the risk of global slowdown. The global manufacturing PMI is at a critical level at 50 in May and should come into contraction in the coming months. Due to the weakness of the economic activity in developed countries and the structural challenges of emerging countries, the official targets of global growth will certainly not be achieved. By the end of the third quarter, it is likely that the IMF revises downward its forecast for global growth which is currently comprised between 3.1% and 3.2% (3.4% at a first estimate). The current level of global growth remains below the annual average growth of 3.46% over the period 2000-2007. In the US, Markit manufacturing PMI has made a rebound to 51.4 in June but the trend remains fragile since the beginning of the year.
United States: Fed on standby in July
At the occasion of its June meeting, the Fed held rates steady and signalled a shallower pace of rate rises next year and in 2018 and lowered its long-term projection for interest rates to 3%. The central bank still wants to normalise its monetary policy but it looks more and more challenging considering the slowdown in job creations and the international context. The Fed of New York Nowcast for Q2 GDP shows slowing momentum. In those circumstances, it is very unlikely the Fed will be able to hike rates twice this year. The central bank has a very narrow window of opportunity to act. A rate hike is unconceivable on July 26-27 given the uncertain consequences of Brexit and seems compromised in November because of the US presidential election. The only viable option is a single hike for the balance of this year in September if economic and financial conditions are favourable. Currently, the market anticipates no hike in 2016. The probability of rate hike in July is at 4% and in September at 15.5% according to Bloomberg. Given the experience of the Bank of Japan, the Fed does not believe monetary policy is the panacea to strengthen growth and avoid an economic slowdown. Janet Yellen rightly pointed out at the last meeting that one of the main causes of lower growth is low productivity. In that sense, she takes on board the concerns expressed by her predecessor, Alan Greenspan, when he said “we are in trouble basically because productivity is dead in the water”. From a macroeconomic perspective, the productivity growth in the US has never been so low for such a long period of time since the early 50s. This is a major long-term challenge for the US economy and a key point to watch in the upcoming meetings. The answer to low productivity is to promote workforce excellence, through training, and robotise production process. The Fed has clearly little or no way to fight the structural transformation of the US economy.
Western Europe: High risk of slower growth in coming quarters
Brexit was a shock because of the huge gap between market expectations and the official outcome of the UK referendum. Although it is still too early to assess exactly the economic implications of Brexit, it is likely that the uncertainty surrounding the political process that is about to start will have a negative effect on investment and growth in Europe. The release on July 5 of UK services and composite purchasing manager surveys will give a clue about business sentiment after the decision to leave. However, it will be necessary to wait until mid-July to know business reaction clearer in the United Kingdom when few reports tracking business activity and concerning the recruitment process will be published. In case of higher market volatility, the BoE and the ECB are ready to intervene in order to provide more liquidity to the market. Considering yield premium in the euro area and the financial situation in the United Kingdom, there is no need for emergency ECB / BoE response for the moment. From our point of view, Brexit is more a political breakdown than an economic and financial meltdown.
Even before Brexit, the process of economic slowdown was triggered in Europe. It will only accelerate. The leading growth indicator CEPR EuroCOIN points to significant slowdown in the euro area in the coming quarters. The strategic mistake of the eurozone is to rely too much on monetary policy and to neglect to use fiscal policy. Declining interest rates represent an historic opportunity to invest, especially in infrastructure and new technology. In the case of Germany, only country to have very sound public finances, 80% of Bunds are in negative yields. Yet, the country does not borrow to invest. In September, the ECB will conduct a review of the monetary policy framework, especially regarding the corporate purchases that began on June 8 for a total of about £5bn par month. It will probably open the door to further easing in the medium term.
APAC: Japanese election and devaluation of the Chinese yuan
The main political event this month will be the upcoming Upper House election on July 10 which will be a referendum on the government’s policy. It is a low-risk election for the ruling Liberal Democratic Party and its junior coalition partner, Komeito, that are assured of keeping majority. However, there is little chance that they can win a super majority. The great uncertainty remains about the economic policy that the government will implement in the coming months. It postponed raising the consumption tax until the fall of 2019 and seems to have no concrete strategy in order to strengthen growth and inflation. Economic stagnation is set to continue with GDP expanding 0.5% in 2016 according to the World Bank. Risks are rising linked to higher yen and elusive consumption growth which may push GDP lower than expected. The current negative trend in the industrial production confirms the downturn and the failure of Abenomics. QQE caused a temporary burst of industrial production in Q4 2013 and Q1 2014 but it vanished very quickly. Another “lost decade” looms for Japan. To counter this risk, Japan could be the first country to launch helicopter money which consists, in theory, to make direct transfers to households and the private sector financed with base money. The idea is gradually gaining ground: the economic and tax committee of Shinzo Abe’s government proposed last year to unleash “vouchers” or “gift certificates” to low-income young people to stimulate nominal demand. It does not exactly correspond to helicopter money but it is the same logic aiming to boost consumption and, therefore, growth.  
The most undervalued risk this summer is a significant devaluation of the Chinese yuan. It is not yet well priced in by the market as investors were obsessed with the UK referendum. For now, the adjustment of the exchange rate against the US dollar, which has led the Chinese currency to lowest value since December 2010, went smoothly. It did not cause investor panic as was the case in January 2016. However, a more significant devaluation could occur. The evolution of China’s foreign exchange reserves can provide clues about a forthcoming devaluation. In May 2016, the reserves reached $3.1tn, which represents a drop of 16% compared to January 2016. The IMF established the country cannot afford to let its reserves fall under the minimum threshold of $2.8tn. Otherwise, the BPC would not have enough reserves to react to external shock and it would be forced to let the market decide the exchange rate of the yuan. Therefore, the next publication of China’s foreign reserves, on July 8, will be a key event for markets. In case China decides to accelerate the depreciation of the yuan, investors need to keep in mind it will have much larger implications and financial consequences than Brexit and it could reactivate the currency war.
CEE – Russia: Lowflation is the new normal
In CEE, focus will be this month on Hungary and Poland with the publication of inflation figures respectively on July 8 and July 12. Poland in is deflation since July 2014 and the situation is unlikely to improve in the medium term. In Hungary, inflation remains very weak. However, central banks of both countries have opted for interest status quo in the long term. They are facing a difficult challenge which consists in boosting inflation without penalising economic activity. The Hungarian central bank is expected to keep its base rate at 0.9% and the Polish central bank at a record low of 1.5% in the coming months. Despite deceiving economic growth in both countries in Q1 (-0.1% in Poland and 0.9% in Hungary), there is no political pressure for a return to easing.
Nordic: Turning points
The leading indicator CLI indicates a decoupling economic trend between the Nordic countries. On one side, Sweden and Denmark could experience further economic slowdown. On the other side, the economic growth in Norway could strengthen, driven by rising oil prices. The economic downturn has already started in Sweden. After a peak at 4.8% in Q4 2015, GDP is now declining. In Norway and Denmark, the turnaround is not yet observable in GDP figures but it should be noticeable by the end of 2016.
Mena: Turkey at a crossroads
Focus will be on Turkey this month with the publication of the last figures of CPI on July 4 and retail sales and industrial production on July 13. Despite political risk related to the strengthening of presidential powers and stricter control of the action of the central bank, the economic momentum remains positive in Turkey. GDP growth has declined since the beginning of the year but it is still above its moving average, especially thanks to strong domestic consumption and weak Turkish lira which boosts exports ($12bn in April).  

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