Aaron Lewis, Research Analyst, Macquarie
A slowing Chinese economy and angst over a possible US interest rate rise
Economic and market highlights
Despite the recent turmoil in financial markets, the US outlook for economic growth remains robust. While interest rate markets are increasingly pricing in the probability of a delay in interest rate rises, a slim chance still exists that the Federal Reserve will surprise markets by acting this month. This change marks the end of seven years of Zero Interest Rate Policy in the US and the first rate increase since 2006.
However, in our view, the recent volatility will likely make a cautious Federal Open Market Committee (FOMC) delay the decision as they wait to see how consumers and businesses respond to recent events.
Uncertainty around the continued slump in oil prices, falling inflation expectations and the slowing of China’s economy create a confluence of ’known unknowns’ the exact effects of which can only be determined in hindsight. US nonfarm payrolls, one of the month’s most anticipated data releases, was in line with consensus but inflation and wage growth remain subdued. However, a sharp upward revision to US second quarter real gross domestic product (GDP) growth does suggest that the economic recovery is increasingly entrenched.
Another disappointing Caixin Flash Purchasing Managers Index (PMI) suggests manufacturing activity is still contracting in China and the possibility of a ’hard landing’ is still very much in the public consciousness.
July’s reading was the lowest since March 2009 and one of a number of catalysts of the market rout. We believe that fear exhibited by investors is overdone, although it is not the first time that global markets have been shaken after an unexpected Flash PMI reading.
In a signal that policy makers in China are serious about the 7 per cent GDP growth target, China’s central bank has cut interest rates by 25 basis points and the required reserve ratio by 50 basis points. We see this as modestly positive for the market and the economy and likely to alleviate fears of a ’hard landing’ in China. Our forecast for Chinese GDP growth in 2015 is 7.2 per cent, slowing to 6.5 per cent in 2016.
Bond markets have not escaped the volatility seen in equities. Long US yields have sold off over the course of the month, reflecting a diminishing probability of a US rate rise this month and declining inflation expectations.
Australia’s bond yields, remaining highly responsive to macroeconomic developments, have unsurprisingly followed suit. A similar pattern is emerging in the UK, with the Bank of England talking down the chances of a rate rise.
German and French short yields are stuck in negative territory as quantitative easing continues, while the long end has fallen along with major developed markets. Credit spreads have also widened as bond markets cut risk exposure in light of weak commodity prices and heightened uncertainty in relation to China’s slowing economy.
A sense of panic overcame developed market equities as investors responded to a rout in the Shanghai Composite, a constant stream of news about China’s slowing economy and the prospect of interest rate normalisation in the US.
Weak commodities and falling inflation expectations were also amongst a confluence of factors, which fuelled a global sell off. As a result, the Volatility Index has spiked, reaching its highest level since February 2009 in the thick of the global financial crisis and exceeding levels achieved during the Flash Crash in May 2010 and the US credit rating downgrade in August 2011. We think the correction in equities is overdone.
Emerging market currencies have struggled over the month, with many hitting multi-year lows as capital flows back to safe havens. China has joined the ranks of other emerging markets in competitive currency devaluation, widening the trading band of the renminbi, permitting it to fall 1.9 per cent.
The Australian dollar has continued its descent against the US dollar, allowing the Reserve Bank of Australia to keep interest rates on hold for the time being. The quantitative easing currencies of the yen and euro have both seen a considerable strengthening lately as carry trades unwind and capital flows from emerging markets to the perceived safety of regions supported by unconventional monetary policy.
To lift or not to lift
The market is interpreting the latest set of meeting minutes from the FOMC as a sign that the US this month rate hike is becoming less likely, and that the first move may in fact be in December or potentially early 2016.
The FOMC’s view is that criteria for an increase in interest rates are close to being met, but there was a clearly more dovish tone adopted, citing inflation risks to the downside caused by continued pressure on commodity prices, depressed inflation expectations and an appreciating US dollar. This led to a broad sell-off in bonds across the yield curve.
We are currently attributing a 30 per cent probability to a this month increase in US interest rates and a 60 per cent probability to an increase in December.
While the US domestic growth outlook is strong and, when viewed in isolation, is sufficient to justify increasing interest rates, international developments and conditions in financial markets recently have tilted the balance of probability towards a delay. A similar rationale was applied in March this year when the decision was taken to delay lifting rates.
Currency is becoming the economic weapon of choice amongst developed markets as national central banks allow competitive devaluation to stimulate domestic business activity.
The currencies of many major developed markets sit considerably lower against the US dollar than a year ago. For instance, the Australian dollar has lost almost 25 per cent and the Reserve Bank of Australia is hoping this trend can continue.
The euro and pound sterling have both fallen just over 12 per cent and the Canadian dollar, very much a commodity currency like the Australian dollar, has declined by almost 18 per cent. There is a reason this is a ’beggar thy neighbour’ policy; as the US dollar has appreciated, US products have become increasingly expensive for many markets and as a consequence, year-on-year US export growth has suffered. It turned negative in January this year and the trend of contraction has continued.
The currency picture across emerging markets is not so consistent and resembles more of a patchwork, depending on the path of domestic interest rates and the fundamentals of each economy. When economic times are tough, some currency depreciation can help deliver a competitive edge but, as we have seen in Russia, a wholesale deterioration in conditions can lead to a highly undesirable capital flight.
At one end of the emerging market spectrum sits Brazil, an economy that at the peak of the China-driven commodity boom posted a momentary current account surplus as its iron ore was hoovered up by a ravenous trading partner, has since deteriorated dramatically as slumping commodity prices have damaged export revenues and its budgetary position, leading to a rapid increase in debt levels.
The exodus of funds from Brazil as a result has seen the currency plunge almost 40 per cent in the past year and inflation is now running at 8.8 per cent.
At the other end of the spectrum is the Philippines. Its government continues to run a primary budget surplus and Macquarie is forecasting an annual average economic growth rate of 6.7 per cent and inflation of 1.7 per cent. Its current account also remains in surplus.
These fundamentals have protected the currency from capital flight and the peso now sits only slightly lower against the US dollar than 12 months ago.
The currency devaluation in China is hardly dramatic in the scheme of things. While it is expected that exporters benefit from a short term boost, it should also be viewed as measured policy implementation which is part of continuing financial reform in China and an opening of the country’s capital account. This latest move is designed to add weight to the argument for including the renminbi in the IMF’s special drawing rights basket of reserve assets. Allowing market forces to determine the exchange rate is a step along this road.