After getting off to a topsy-turvey start in November the markets’ spirits were lifted once again by the European Central Bank promising to roll out even more largesse to prop up asset markets.
Super Mario tells us he has more tricks up his sleeve
Things in Europe actually look pretty good, though it’s coming off a really low base. It’s like someone who’s been in a bad car crash; while the cuts and bruises have healed they’re still not back to how they used to be. GDP growth continues to creep up, approaching three year highs of 1.6% p.a. and unemployment has finally nudged below 11% – see the two charts below. So they’re both heading in the right direction.
Euro area annual GDP rate Euro area unemployment rate
Source: Trading Economics
The problem, as we’ve talked about before, is that inflation is running at 0.1% for the whole year, which Mario Draghi, who runs the European Central Bank, tells us is keeping him awake at night. He could of course do what some other central bankers do and focus on ‘core inflation’, which would exclude the 30% fall in the oil price since its half-hearted mid-year rally, which looks a lot healthier at 1.1% – see the charts below.
Euro area inflation Euro area core inflation
Source: Trading Economics
Instead Super Mario announced the ECB will undertake more stimulatory measures when it meets this Thursday, saying “If we decide that the current trajectory of our policy is not sufficient to achieve our objective, we will do what we must to raise inflation as quickly as possible.” So that got markets excited enough to lift them from the monthly lows, but there’s ample room for cynicism. The ECB’s cash rate is already a measly 0.05%, it’s in the throes of a €1.1tn quantitative easing program that has driven the 10 year bond yield to negative 0.2%, plus the last time Euro GDP growth was at this level the ECB actually hiked rates. So given the numbers appear to be heading in the right direction, why would he be rattling the cage now?
One answer may well be the ongoing currency war between the world’s central banks. The lower Super Mario can jawbone the Euro the better it is for the exporting powerhouses of the EU, like Germany. And what better time to talk about more monetary loosening than when the U.S. Federal Reserve is on the cusp of raising interest rates? As a result, the Euro has weakened to all-time lows against the U.S.$ – see the chart below.
Euro vs. U.S.$
Source: Trading Economics
The money trail
It’s been interesting to see the investment flows in and out of the various regions over the course of the year. These flows of course reflect investors indicating where they see the best potential returns. See the chart below.
Regional investment flows
Source: Deutsche Bank
It appears that investors believed the U.S. market would struggle to repeat the strong returns of the past couple of years and switched their funds into Europe and Japan. The Emerging Markets – see the chart below – also suffered significant outflows.
Emerging Markets investment flows
Source: Deutsche Bank
Since the U.S. Fed announced it would be first winding back its quantitative easing and second raising interest rates, markets have presumed the tsunami of yield-seeking liquidity that washed over the world from the U.S. into places like the emerging markets would be sucked back home. The natural presumption was that EM stock markets would suffer.
There is, however, an alternative explanation: money flows have followed central bank quantitative easing. The blue line in the chart below plots the Federal Reserve’s balance sheet, showing the steady rise as it bought trillions of dollars’ worth of bonds as part of its QE scheme. The red line is the S&P500. Now the correlation is not perfect and there would be plenty of people who would argue the point, but it sure looks like there’s a relationship there. Is it any coincidence that the stock market flattened out once the Fed wound back its QE? Likewise, is there any coincidence that the money is following the two central banks that are still conducting aggressive QE operations: the European Central Bank and the Bank of Japan?
The Federal Reserve’s balance sheet vs. S&P500
Source: St Louis Fed
Chinese accountants don’t need iron ore
It’s easy to think of China as the world’s factory, and to therefor presume its economy is just one giant production line, but that’s a very outdated view. The services sector now accounts for about 50% of the Chinese economy, while manufacturing is about 40% – that’s a reversal of what it was like only 10 years or so ago and it’s a change that could have profound consequences for China’s trading partners, like Australia.
We’ve written before how China’s economy appears likely to slow only marginally rather than fall in a big hole, but the problem for her trading partners is that the (call it) 6-7% growth in GDP over the past year was made up of 11.9% from the services sector and only 0.2% from the industrials. Services of course are far less reliant on imports of raw materials. In fact, the value of imports into China fell by 19% in the past 12 months – see the chart below.
China’s sectoral output and total value of imports
Source: San Francisco Fed
It makes sense: accountants and lawyers don’t need to import a whole lot of gear to provide their services, and that will have flow on effects to all those economies that have been reliant on supplying to China’s manufacturing boom over the past seven or eight years.
A bright spot for Australia though is the recent free trade agreement we signed with China opens the way for more services exports. While that sounds like an odd concept, Australian health, aged care and education companies are lining up to explore opportunities.
Australia – capex it is a changin’
With the commodities bubble now a distant economic memory, for some time the government has been waiting for the non-mining parts of the economy to step up to the plate and do their fair share of driving growth. During the month the new private capital expenditure numbers were published, these cover things like spending on buildings and equipment by the private sector, and the headlines screamed “20% drop in a year”.
As with so many things that appear in the media, if you stopped there you’d be forgiven for being pretty gloomy, but when you look a little deeper things aren’t nearly so bad. The capex numbers are published each quarter, and between the June and September quarters the estimate actually went up by 4%. And within that number, the services sector showed a 6.1% increase while mining also went up, by 2.3%.
According to the survey the services sector increased its planned spending on plant, machinery and equipment by a whopping 16.7%. But it’s also important to keep in mind that the survey doesn’t include a bunch of service sectors that account for about half of all the non-mining capital spending, like health care, training and education. Why would they miss out such important parts of the economy? No idea, but it means the survey dramatically overstates the importance of the mining sector.
During the month the Reserve Bank of Australia also lowered its growth forecast for 2015 to 2.25% and once again cut the inflation forecast as well. Ordinarily you’d have thought that was softening people up for another interest rate cut but alas Governor Stevens pooped everyone’s party despite the commercial banks hiking rates of their own volition and said that’s a trick they’d like to keep up their sleeve just for now. Part of that could be because the unemployment rate fell to 5.9%, which means we’re still seeing jobs being created.
The U.S.: it’s odds on this time
The U.S. Federal Reserve has been talking about raising interest rates in 2015 since the end of last year and we’re clearly running out of time. During the month the Fed President, Janet Yellen, all but said in that cryptic Fed-speak that it’s going to happen in December. We’ve said all year that raising rates by 0.25% is unlikely to do a whole lot to the real economy: it’s not when they raise, it’s how many times they do it and by how much.