Economic Outlook – October 2016

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Eurozone confidence has proved resilient so far despite mounting political uncertainties brought on by Brexit, Spain’s difficulties in forming a government, and Italy’s December 4th deadline for constitutional reform. After hovering around 53 since the beginning of the year, September’s Eurozone composite PMI index fell back from 52.9 to 52.6. Looking beyond the effects of monthly volatility, its average level over the third quarter is very similar to that of the second and is likely to continue, indicating an annualised growth rate in the region of 1.5%.

Growth figures have been volatile in recent months but remain healthy overall. Eurozone industrial production for August jumped 1.5% after a 0.5% fall in July with most countries enjoying better growth. Retail sales have stabilised after rising 0.3% last month, with the trend remaining positive against a backdrop of both continuing high consumer confidence and positive news on the job front.

Overall inflation is picking up pace, and after reaching a low of -0.2% (annualised) in April it stood at +0.4% in September, above August’s +0.2% reading. Underlying inflation, however, is struggling to rise and has stabilised at 0.8% year-on-year.

At the close of its September 8th meeting, the ECB decided to maintain the status quo, judging that additional measures were not yet justified but keeping the door open for additional loosening. Mario Draghi confirmed that the monthly asset purchases of €80 billion are intended to run until the end of March 2017, and beyond if necessary. He also announced that a working group is tasked with assessing the options available for ensuring the asset purchase programme runs smoothly: this announcement makes adjustments to the programme’s current framework a possibility.

In Spain, Socialist Party leader Pedro Sanchez’s resignation means that after nine months of deadlock because of the socialists’ refusal to back down, a minority government under Parti Populaire leader Mariano Rajoy is looking more likely. If no agreement between the various parties is reached before October 31st, then fresh legislative elections will be organised.

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Second quarter US growth disappointed with GDP growing at an annual rate of just 1.4% despite the 1.1% rise in the first quarter. Whilst household spending was very buoyant, growth was hit hard by two factors that have already weighed on growth in previous quarters, namely inventory drawdowns and, to a lesser extent, lower investment.

That said, monthly data suggest stronger growth in the third quarter. Household spending is falling back but non-residential investment is recovering judging by the increase in capital goods orders over the last two months, especially in the oil and mining sectors. In addition, because second-quarter inventory drawdowns were particularly sharp, this effect should now drag relatively less on third-quarter growth.

Following August’s sharp fall, the rebound in September’s ISM indices greatly calmed fears over a growth slump. The manufacturing index reversed some if its previous fall, moving back up from 49.4 to 51.5, and the non-manufacturing ISM rose from 51.4 to 57.1, a record high since October 2015.

Employment data are rather lacklustre. Private sector job creations remain healthy at 167,000 in September and total hours worked also rose. However, a rise in the participation rate meant that unemployment rose from 4.9% to 5.0% whilst hourly wages were disappointing at 0.2%.

During its September 20th-21st meeting, the Federal Reserve opted to maintain the status quo but opened the door even wider to a rates rise this year, whilst revising down the expected number of rises in 2017 from three to two. The FOMC minutes showed that several committee members who voted for the status quo had in fact found it difficult to decide and believe that a rates rise ‘relatively soon’ is becoming appropriate. Among the three who voted for a September rates rise, some underlined that the Fed risked damaging its credibility if it delayed too long. According to the markets, the odds that the Fed will raise rates at the November meeting, just five days before the presidential elections, are low at about one-in-five. By contrast, they give a two-out-of-three chance that rates will rise in December.

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Latest confidence surveys indicate a resilient UK economy despite the uncertainty stemming from the June 23rd referendum. Following a sharp fall in July, August’s composite PMI index rebounded and continued upwards in September to reach at 53.2, its highest level since January 2016, driven by a manufacturing sector that appears to be enjoying the benefits of a depreciating pound.

Nonetheless, at 51.3, the third-quarter composite PMI index average is one point lower than for the second quarter. NIESR September GDP estimates suggest a third-quarter slowdown rather than a collapse, with the annual rate moving from +2.7% in the second quarter to +1.6% in the third quarter.

Even if economic data have surprised to the upside since the referendum, the currency has given up almost 15% against both the euro and the dollar. After relative stability in the GBP/EUR exchange rate between July and September, the pound quickly fell at the start of October.

The harsher tone of Theresa May’s speech at the Conservative Party Conference, and ahead of negotiating the UK’s exit strategy from the European Union, clearly triggered sterling’s downturn. The Prime Minister stated that she wanted to ensure companies had maximum freedom to operate in Europe’s single market, whilst indicating that she would not compromise on her immigration policy. These two apparently contradictory goals raise the likelihood of a hard Brexit, whereby the UK exits the EU and also loses access to the single market. That said, the negotiations have not yet started and the UK’s exit from the EU is not to be expected before the first quarter of 2019. Theresa May has indicated that her government will trigger article 50 of the Lisbon Treaty, which formally activates the EU exit procedure and is expected to last a maximum of two years, before the end of March 2017. Whatever happens, sterling’s fall is doubtless far from over. In fact, despite its depreciation and according to the effective exchange rate index, sterling is not that much cheaper than in 2011-2013 and further falls will be needed to reduce the UK’s current account deficit, which remains very high at 5.7% of GDP for the 12-month period to the end of the second quarter of 2016.

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