The latest data continue to support an improving economic picture for the Eurozone. First-quarter growth numbers were revised upwards to an annualised +2.3% as compared with +1.8% previously. These, together with consistently high PMI index readings (56.8 for May), bode well for yet another quarter of strong growth. However, when the volatility of recent months is stripped out, underlying inflation remains weak (+0.9% year-on-year for May), despite mounting signs of recovery.
Against this backdrop, following the ECB meeting on June 8th, the central bank chose to maintain both interest rates and its asset purchase programme unchanged. Nonetheless, with economic conditions improving, the ECB is starting to adjust its guidance with a view to gradually normalising monetary policy.
In particular, it shifted guidance on the future path of interest rates by removing any reference to interest rate cuts. Going forward, the central bank intends to maintain key rates at their current levels well beyond the deadline fixed for its net asset purchases. The main refinancing rate, deposit rate, and marginal lending facility stand at 0.00%, -0.40%, and +0.25% respectively.
During the bank’s press conference, Mario Draghi signalled that this was in response to the extreme risk of deflation having dissipated. In parallel, the ECB has cut its inflation forecasts for 2017 and for the two subsequent years (from 1.7% to 1.5% for 2017, from 1.6% to 1.3% for 2018, and from 1.7% to 1.6% for 2019).
The ECB also altered the degree of risk it was attaching to Eurozone growth. It now sees risk as ‘broadly balanced’ whereas in April it tilted to the downside. The bank’s more positive commentary also revised March’s growth estimates upwards (+0.1% per year for 2017, 2018, and 2019 to +1.9%, +1.8%, and +1.7% respectively).
In terms of non-standard monetary policy measures, the ECB is maintaining an asymmetric bias via its asset purchase programme and is prepared to increase its volume and/or duration. Mario Draghi indicated that the Governing Council had not yet discussed scaling back the programme.
After a challenging start to the year, household spending has improved in recent months, pointing towards a better second quarter for US growth following quarter one’s disappointing number (+1.2% annualised).
Household spending slowed in January and February before rising by 0.5% in March and 0.2% in April. The slowdown at the start of the year could have been down to temporary factors such as unseasonably warm weather reducing energy expenditure, and late tax rebate payments.
Employment data remain healthy despite disappointing private sector job creations for May, which at 138,000 were nonetheless enough to lower the unemployment rate to its current 4.3%. Despite an ever-tightening labour market, hourly wage growth remains weak at +2.5% year-on-year.
After two unpleasant surprises in March and April, May’s inflation data disappointed once again with the headline rate reaching +1.9% year-on-year and the underlying rate excluding food and energy reaching +1.7%. The slowdown appears to be linked to temporary factors such as lower-priced mobile phone services and medical prescriptions. Given the tightening labour market, it is unlikely that these factors portend a fresh downward trend in prices.
The Federal Reserve appears to share this viewpoint as at the end of its June 13th/14th meeting and in a move that investors had been widely expecting, it raised its benchmark federal funds rate range by 25 bps to 1.00%-1.25%.
In its statement, the Fed indicated it would be closely monitoring the upcoming inflation data and that it continued to expect inflation to converge towards its 2.0% target in the medium term.
The central bank maintained its median forecast of one further 25 bps rate rise for 2017 with three more pencilled in for 2018. However, whilst the market’s expectations match the Fed’s scenario for 2017, it expects only one rate rise for 2018, leaving the bond market vulnerable to any sudden changes.
The Fed also indicated that it might start reducing its balance sheet as soon as this year by not reinvesting the full principal amounts of maturing securities.
The UK general election on June 8th resulted in a hung parliament. Theresa May’s Conservative Party won the election but lost the absolute majority it had previously enjoyed in the House of Commons. It won 318 seats out of a total of 650, 13 fewer than it had won in the 2015 election. Jeremy Corbyn’s Labour Party won its highest number of seats since 2001 (262, an additional 30 compared with 2005).
The result was a setback for the outgoing Prime Minister who had called the general election to bolster her legitimacy and widen her parliamentary majority ahead of the Brexit negotiations. The head of the Tory party has been weakened and her leadership is being challenged just when the months ahead are set to shape the UK’s future. Fresh elections are not out of the picture.
Given the lack of an overall majority, Theresa May is attempting to form a coalition government with the ten MPs from Northern Ireland’s unionist party, the Democratic Ulster Party (DUP), currently led by Arlene Foster. However, reaching an agreement is proving difficult. The DUP is particularly opposed to any hard border between Eire and Northern Ireland and is also standing firm on other ultraconservative societal issues.
For Theresa May to receive the DUP’s support, she will have to soften her position over Brexit, yet she also depends on support from the anti-EU wing of her own Conservative Party. The general election results have heightened uncertainty over the UK’s negotiating position in the run-up to the scheduled June 19th start to negotiations with Europe.
This rise in political uncertainty comes at a time when UK growth is starting to lose momentum following a resilient post-Brexit performance. Growth in the first quarter of 2017 slowed to an annualised +0.7% as compared with +2.7% for the previous quarter. The slowdown is primarily due to weaker household spending as a result of higher inflation stemming from a depreciating pound.
Inflation has been moving sharply higher with the headline rate reaching +2.9% year-on-year in May, and the underlying rate excluding food and energy reaching +2.7%. This is stifling UK household purchasing power because the rise in nominal wages (excluding bonuses) is not keeping pace (+1.8% year-on-year in April).
The opinion expressed above is dated June 2017 and is liable to change.
This document is not pre-contractual or contractual in nature. It is provided for information purposes. The analyses and descriptions contained in this document shall not be interpreted as being advice or recommendations on the part of Lazard Frères Gestion SAS. This document does not constitute an offer or invitation to purchase or sell, nor an encouragement to invest. This document is the intellectual property of Lazard Frères Gestion SAS.
-- PDF --