Taken together, the average of 149,000 jobs in two months is still below the five year average of 180,000 per month. We believe that the Federal Reserve (Fed) is likely to wait for more information before deciding to increase rates. If employment were to weaken further, it would be difficult to justify interest rate rises despite the fact that inflation continues to increase and the Fed remains keen to normalise rates ahead of the next recession. The Fed also runs the risk of stagflation, a period of low growth and high inflation, if it fails to take timely action. Leading indicators on the whole remain mixed. Industrial production and durable goods orders continue to fall, although retail sales have held up better. Over the quarter we have seen a scaling back of interest rate expectations following the UK referendum on EU membership. Whilst previously the Fed was focused mainly on domestic matters, notably inflation and employment, it is increasingly concerned by global developments.
It is likely that this has had a negative effect on economic activity, although in any case Gross Domestic Product (GDP) growth was slowing down beforehand. Recent survey data is consistent with GDP growth of only 0.2% in the second quarter. Whilst investors have focused on the referendum, there has been some positive economic data in recent weeks. Industrial production grew at the joint fastest rate in a year in April, although this was distorted by exceptional gains in energy and pharmaceuticals. The rate of unemployment fell to 5%, the lowest in over ten years. Wage growth also picked up, although that was partly down to the introduction of the Living Wage. Retail sales saw growth in value spent of 3.1% on the year, the highest rate of growth in 18 months. It is striking that growth has picked up at a time when unsecured lending hit its highest level in six years and the savings ratio is at an all-time low, suggesting it is unsustainable. House prices have also been under pressure with the May report showing the largest fall in the Royal Institution of Chartered Surveyors (RICS) survey balance in six years. The market has been hit by changes to tax and stamp duty at a time when affordability is looking stretched. In a bid to boost bank lending, the Bank of England introduced new easing measures.
The European Central Bank (ECB) expanded its Quantitative Easing (QE) programme to include corporate bonds for the first time during the quarter. Lower yields have forced investors to take on greater risk to meet income requirements, although the potential for capital losses remain high. Despite the central bank buying corporate and government bonds in order to push interest rates down, this has generally failed to stimulate borrowing activity outside Germany and France and inflation still remains negative. Trends in credit growth remain negative in Italy and Spain suggesting that the recovery is still not widespread. Recent survey data fell to a 17 month low, primarily due to weakness in services. On the positive side, there have been some gains in industrial production. Manufacturing, particularly in Germany, continues to outperform. Following the UK’s decision to leave the EU, political concerns have only intensified. There have been calls for other votes on independence, notably in France and Holland, and the future of the EU itself is in jeopardy.
It was boosted by strong consumption and government spending, although business investment declined. Despite the growth on the quarter, the annual rate of increase was only 0.1%. Strength in the yen, due to its status as a safe haven currency, has undermined the QE policy. It continued to hold back trade with the rate of contraction in exports accelerating to over 11% on the year in May, reflecting a wider slowdown in global trade. The government delayed a further increase to the consumption tax from 2017 to 2019, helping to improve sentiment and leading to marginal GDP upgrades. Despite the ongoing QE programme, inflation remains stubbornly negative, partly due to the strong yen.
There has been some suggestion of expanding the QE policy, maybe even introducing “helicopter money,” an outright money creation programme whereby citizens are given money. It would most likely provide much needed weakness to the yen and provide a short term boost to consumption and inflation, although it would be unlikely to solve the critical long term issues of an aging population and high levels of debt.
Growth in retail sales fell to a five year low and capital expenditure (defined as funds used by a company to acquire or upgrade physical assets such as property or equipment) slipped to the lowest growth rate since 2000. Chinese trade data has been poor this year. For the first half of the year, exports have fallen 7% in comparison to the previous year.
We have also seen poor trade data in Korea and Taiwan where exports have been declining sharply, reflecting challenges in the IT sector and weak global demand. Despite a clear slowdown in the real economy, Chinese property prices continue to rise, up 6.9% on the year in May, led by Beijing and Shanghai where prices appreciated by 19.5% and 27.7% respectively. In our view, the moves are not supported by fundamentals and likely indicate speculative activity. In response to Brexit, China stepped up its efforts to competitively devalue, sending the yuan to the lowest point in ten months. It is at the weakest level against the US dollar in over five years.
Over the quarter, Korea cut interest rates to 1.25%, a record low, also in a bid to devalue and boost exports. A close victory for the Conservative coalition in the Australian election highlights that the country has been slow to reform and undermined by weak commodities; has added to slower growth for the region.
As oil has stabilised, emerging markets have outperformed but concerns over default and currency remain. Nigeria, for example, saw its currency devalue by around 40% due to weak oil prices. Whilst we believe selective opportunities exist, equity performance at the moment does not generally reflect the state of the underlying economy. The equity market in Brazil has performed well this year, although the country remains in recession with GDP down over 5% on an annual basis in the first quarter as it struggles to adapt to lower global growth.
Unemployment rose to over 11%, the highest level since 2004. Russia also continues to struggle, although the ruble has strengthened this year in line with oil, helping to bring the inflation rate down from double digits.
India is still our preferred emerging market due to favourable demographics and continued progress on reforms, although there are some concerns over valuations. It has actually benefited from lower commodity prices and there is less reliance on dollar funding, an issue which may yet to return to hurt those countries which are overexposed.