Fundamentals March 2015

MARCH 2015 ECONOMIC AND INVESTMENT COMMENTARY

Fair skies and tailwinds

Fundamentals:

INSIDE:

Market overview:Back to ‘normal’, higher volatility?

Snapshot:Dollar Drought? Emerging Markets, Oil and the Dollar

UK forecast: Lower for longer

In this edition of Fundamentals, LGIM economist Hetal Mehta discusses the improving near-term

growth picture for the euro area in light of the favourable developments in exchange rates and oil prices, as well as some of the structural imbalances plaguing the single currency zone.

OILING THE GROWTH ENGINESThe sharp plunge in oil prices was one of the most unexpected developments in 2014. When converted into euros, the oil price has fallen by around 50% since mid-2014 (figure 1).

Unlike the US, and to a lesser extent the UK, the euro area produces very little in terms of energy – less than ¼% of GDP – and so there is a negligible drag from reduced investment in oil production. Moreover, with the euro area being a large net importer of oil, it is one of the biggest beneficiaries of the decline; the fall in prices and ensuing lower inflation acts as a more powerful enhancement to economic growth.

While several other regions of the world have already made progress on the road to recovery, euro area growth has been anaemic for several years and inflation has been on a persistent downward trend. But with the dramatic fall in oil prices, a weaker exchange rate, and the European Central Bank (ECB) finally embarking on a programme of quantitative easing (QE), are we at a turning point?

Seven years from the onset of the global financial crisis and five years

since the euro area sovereign debt crisis started, many question the growth

outlook and whether the euro has what it takes to survive in the long run.

02MARCH 2015 ECONOMIC AND INVESTMENT COMMENTARY

Headline inflation in the euro area is likely to fall sharply into ‘technical’ deflation territory in the first half of 2015, giving a large boost to real incomes. In addition, the labour market is improving, employment gradually rising and, so far, wage growth is steady and firmly positive at around 1.7% in year-on-year terms, so nominal incomes are already rising at a modest pace. This implies a lift to real incomes that is large enough to take real disposable income growth back to pre-crisis peaks (see figure

2). While some of the income boost could be saved, a good proportion is likely to be spent, especially if oil prices remain permanently lower. Indeed, the countries experiencing the lowest inflation rates in the euro area in the past year have generally been those seeing the most buoyant consumer sentiment and strongest consumer spending. Naturally, there is also a risk that low headline inflation feeds into reduced wage settlements, which would undermine this positive real income dynamic. The fall in inflation expectations is a worrisome development and could presage a self-fulfilling slide into deflation. However, the ECB now seems alert to the danger and this was one of primary motivations for its decision to

launch full scale QE including sovereign bond purchases.

EX-CHANGING UP A GEAR

A further tailwind to the euro area economy has come in the form of sharp currency depreciation. Partly in response to interest rate cuts by the ECB in 2014, but largely in anticipation of the QE, the euro exchange rate has depreciated by 10% in trade-weighted terms. This boost to price competitiveness should support exports and subdue imports. This effect will take time to feed through, but LGIM estimates show that for every 10% fall in the effective exchange rate,

the boost to growth is around 0.5% in a year’s time.

Q.E.DONE

Aside from the impact on the exchange rate, the ECB’s actions to pump more than €1 trillion of liquidity into the economy should help boost asset prices in Europe and create a wealth effect. Furthermore, the signalling effect that the ECB has both the willingness to be a lender of last resort and potentially unlimited firepower to hit its inflation target, should significantly limit the tail risks (including deflation) and make it harder for the euro area to lapse into recession again in the coming few quarters. Indeed, QE could help dampen any contagion stemming from political instability.

CREDIT WHERE CREDIT IS DUE

One of the key aspects behind the lacklustre recovery to date has been the impaired transmission mechanism and blocked credit channels. After years of banks reporting that the supply of credit is restricted and/or that demand

Source: Reuters Ecowin

Figure 2. Real disposable incomes to hit pre-crisis peaks

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04 05 06 07 08 09 10 11 12 13 14 15 16

Source: Reuters EcoWin

Figure 1. Oil price in dollar and euro terms

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2010 2011 2012 2013 2014 2015

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Brent crude oil price

Brent crude (USD) Brent crude (EUR)

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CPI inflation Nominal disposable income Real disposable income

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Forecast


for credit was weak, this is now starting to improve. According to the most recent ECB bank lending survey, supply conditions are easing at a pace similar to that seen pre-crisis, and demand is now surging (figure 3), with the jump in corporate demand for credit for fixed investment purposes particularly notable. With the ECB’s asset quality review and stress tests now complete, it seems the path is clearer for banks to restart lending. Indeed, recent lending figures suggest that the deleveraging that had characterised the economic stagnation over the past three years is diminishing.

FISCAL HEADWINDS ABATED

Austerity is another major headwind that has now finally largely eased. Back in 2011, euro area governments were on average tightening policy by around 2% of GDP. This drag faded to close to zero in 2014 and according to IMF estimates will remain at around 0.5% in the next few years.

A BUMPY RIDE?

While the underlying economic fundamentals for short-term growth are strong, politics remains a key risk to economic and financial stability in Europe this year. There’s a danger of contagion from the inherently unstable situation in Greece, with both Portugal and Spain holding elections in the

coming months and the latter in particular seeing increased ratings for anti-austerity parties.

The situation in Russia and Ukraine also poses major risks to the euro area. While in economic terms, Russia is still a relatively small trading partner – accounting for only 3% of exports – the financial linkages and impact on sentiment of a conflict so close to the euro area should not be underestimated.

STRUCTURAL WEAKNESS

Putting politics aside, with all of the tailwinds driving the euro area economy forward, could this serve as a catalyst for sustained growth? Looking at the euro area in aggregate one could be forgiven for thinking there are no major economic problems; the government deficit is less than 3% of GDP, government debt is less than 100% of GDP (very different to Japanese levels of nearly 250%

of GDP) and the region is running a current account surplus of nearly 3% of GDP. For sovereign nations, we do not make distinctions between the differing fiscal balances of one city versus another. The partial integration and absence of political union make this far more salient for the euro area. The imbalances within the euro area are where the problems really lie.

On an individual country basis, one area of major concern is the overhang of both public and private sector debt. As figure 4 shows, Greece had significantly higher public sector debt than the euro area average in 2013 (a total of 175%) while Germany and The Netherlands have 17% and 27% less than the average. While the days of harsh austerity are over, countries with high debt need to implement growth policies to reduce their debt ratios.

Household debt levels also remain a problem. Despite some deleveraging, household debt in Spain and Portugal remains high at close to 120% of income, while in Italy it is as low as 63%.

Another area of concern is the labour market. Not only are unemployment rates still painfully high in parts of the periphery, but they are at record lows in Germany. And more

Source: ECB

Figure 3. Euro Area Composite Indicators Average* - Normalised

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Jan-2003 Jan-2005 Jan-2007 Jan-2009 Jan-2011 Jan-2013 Jan-2015

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Availability Average* Demand Average*

*Average of NFCs, House purchases and consumer credit

Source: Macrobond

Figure 4. Government debt vs euro area average

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Greece Italy PortugalIreland Cyprus SpainFrance Germany Netherlands


structurally, a divergence in very long-term unemployment (defined as being out of work for 2 years or more) is also severe (see figure 5). Reforming vocational training schemes and improving job search facilities are needed to alleviate the problem.

Levels of competitiveness are also starkly different. Since 2000, euro area unit labour costs (wages adjusted for productivity) have risen by around 25%. In Germany they have risen by only 10% yet in Italy it is close to 38%. Higher wage growth in Germany will help bridge the gap, but countries such as Italy need to boost their productivity through higher levels of investment.

Access to credit appears to be improving gradually and borrowing rates across the region have fallen sharply, yet a large gap persists between borrowing

rates in the periphery countries and France and Germany (see figure 6). The move towards creating a capital markets union may be a slow process but should help reduce these imbalances in the future.

A WINDOW FOR REFORM

Overall, in the next few quarters the conditions are ripe for a decent cyclical recovery. But

this should not be confused with sustainable growth in the long run, nor can it mask the major imbalances that remain.

But while there is a long way to go, Europe’s problems are not insurmountable. The euro area is still young as an entity, and needs to mature into a fully-fledged fiscal and political union to make the euro area at least as resilient as other regions of the world and to foster further economic integration.

A determined effort to undertake major reforms – particularly of labour and product markets and to encourage investment – has the potential to boost long-term growth. But without these changes Europe will have to accept a lower cruising altitude, and with it the higher risk of economic turbulence.

Source: Macrobond

Figure 5. Variation in very long term unemployed

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Q3 2014

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Greece Spain PortugalItaly Ireland CyprusFrance Germany Netherlands

Source: Macrobond

Figure 6. SME borrowing rates

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Dec-2014

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Interest rates for Non-Financial Corporations vs Euro Area*, 1-5 Year Loans, Total, New Business

Greece Italy Portugal SpainNetherlands Germany France


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Dec 2013 Feb 2014 Apr 2014 May 2014 Jul 2014 Sep 2014 Oct 2014 Dec 2014 Feb 2015

S&P 500 Nikkei 225Eurostoxx 50 FTSE All-ShareMSCI Emerging markets

Volatility continued to increase in February, exceeding levels seen over the past few years. Could this be a sign that things are starting to get back to ‘normal’ after several years? Equity markets were strong over the past month, with US, UK and Japanese equities posting all-time or multi-year highs. Oil prices looked to be regaining their poise early in February only to later dip lower as Nigerian calls for OPEC intervention quelled the bounce. Greece was granted some breathing room on its debt timetable and a ceasefire in Ukraine was agreed. However, both situations are far from resolved and still pose a threat of further volatility ahead.

Market overview:

Back to ‘normal’, higher volatility?

Figure 1. Global equity markets

Source: Bloomberg L.P. chart shows price index performance in local currency terms

UK

Stronger GDP

US

Yellen appeal

In 2014 UK growth was at its strongest since the financial crisis, with Q4 2014 GDP growth coming out at 2.6%. The UK as a whole has fared relatively well since the last edition of Fundamentals with equities higher, unemployment lower and sterling strengthening. The UK is one of many countries across Europe with a general election coming up this year, potentially quelling the likelihood of radical rate reform before May as the political policy exhibitionism heats up. For now, UK investors are enjoying seeing domestic indices climb to new highs with the FTSE 100 finally eclipsing the previous high set in December 1999. Valuations are considerably less stretched than during the heady days of the tech bubble, with aggregate earnings double what they were in 1999.

Once again, US Fed chairwoman Janet Yellen has managed to appease both the doves and hawks. For the latter, she confirmed that the end of record-low rates is nigh as labour market improvements approached equilibrium. For the doves, the rate hike will only occur when confidence grows that inflation will move up towards 2%. US treasury market yields increased over the period, with the 10-year benchmark bond some 50bps above lows hit in early February. US equity markets pushed through to new all-time highs and the US dollar weakened slightly. Expectations around rate hikes – and therefore a focus on Federal Reserve rhetoric – remain firmly in the driving seat of market performance.


Figure 2. 10-year government bond yields

Source: Bloomberg L.P.

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Dec 2013 Feb 2014 Apr 2014 Jun 2014 Aug 2014 Oct 2014 Dec 2014 Feb 2015

Germany US UK Italy Spain Portugal

FIXED INCOME

Bond volatility

Almost a year after Russia annexed Ukraine’s Crimea peninsula, Putin finally agreed to a ceasefire in Ukraine. It got off to a bumpy start with reports that fighting hadn’t actually stopped but, publically at least, Putin is supportive of the agreement. Russian equity markets have managed to recover slightly on the agreement as the prospect of further international sanctions against Russia have (at least temporarily) been taken off the table. It was a relatively quiet period in China as markets shut for extended New Year celebrations. On reopening, markets were softer, despite a better-than-expected manufacturing performance indicator release.

Ceasefire

ASIA PACIFIC/EMEA

Despite central banks across the globe cutting rates, government bond yields in most developed markets were higher month-on-month (in the opposite direction to prices), with the moves particularly pronounced at the long end of the curve. After Yellen’s announcement, US treasury market yields initially moved higher, but ended the period by rallying lower. As rate brinkmanship continues, further volatility in the government bond market is likely. Indeed, closing the gap between market expectations and the Federal Reserve’s expected rate path could prove painful. Corporate bond markets have once again managed to grind out gains, with European credit particularly benefitting from the European Central Bank action.

JAPAN

TOPIX hits 14-year high

Japanese equities reached the highs last seen in May 2000 this month. Importantly, the growth in equities was not only down to a weaker yen as the Bank of Japan declined to add further to its monetary easing policy. It is still too early to call it a trend, but there are signs that Japanese growth is picking up and that weaker data in the second part of 2014 was due to the increased sales tax.

European finance ministers gave Greece’s newly elected Syriza party some much needed breathing room by extending the €172bn bailout for another four months. However, the final reforms and the overall situation remain far from resolved and further volatility can be expected ahead. However, it’s not all bad news in Europe: sentiment and performance indicators are at the highest levels in many years, and equity markets have performed well over the past month. Part of the boost can be attributed to the European Central Bank’s quantitative easing measures but there are also some encouraging green shoots of better economic growth too.

EUROPE

Greek reforms approved


Snapshot:

Dollar Drought? Emerging Markets, Oil and the Dollar

Weaker commodity prices, a stronger dollar and an approaching hike in US interest rates pose some hefty challenges for emerging markets (EM). Current account balances have deteriorated since the global financial crisis and a big share of these deficits has been funded by international credit flows. The fear is that capital flows could fall back as US interest rates rise, as ‘carry-trade’ flows – previously attracted by prospects of emerging market currency appreciation – unwind and as the growth outlook in commodity producing countries deteriorates. There have been particularly strong flows into EM corporate bonds and a large share of these have gone to companies in the oil sector. At the same time, lower commodity prices are reducing the dollar export earnings of many developing countries and hence their capacity to service foreign debts.

There seems little doubt that EM vulnerability to external shocks has increased since 2008. Wider current account deficits make domestic spending levels more reliant on capital inflows and increase depreciation pressures on exchange rates, limiting monetary policy flexibility. External debt has risen faster than both GDP and export receipts in many of the major EMs. This not only increases the external debt service burden but also elevates balance sheet exposures to currency depreciation.

Source: National central banks, Datastream

Figure 1. Net External Debt as % Exports

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Brazil Indonesia India Turkey South Africa Korea Thailand Poland Russia Mexico

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However, it is hard to see a generalised EM crisis emanating from these external shocks. First, commodity exposures are highly varied across the major countries with most of Asia, Turkey, South Africa and Poland all set to benefit from lower oil prices as net oil importers. Likewise current account and external debt burdens diverge markedly. Moreover, the rise in external debt overstates the increase in EM borrowers’ foreign currency (FX) exposures as a large chunk of capital inflows have been into local currency denominated EM government securities. Most importantly, external liquidity buffers – official FX reserves relative to short term external funding requirements – still look much stronger today than in the 1990s.

Nevertheless, the current external environment does look problematic for a number of large EMs: Brazil has seen a marked deterioration in external debt ratios; Russia’s net oil exports are 12% of GDP and capital inflows have been adversely impacted by sanctions; and Turkey has seen very large capital inflows but maintains low FX reserve buffers and very low real policy interest rates. At the other end of the risk spectrum, most of Asia – including, China and, now, India – looks better placed to ride out these shocks.


Lower for longerUK forecast:

Source: Bloomberg L.P. and LGIM estimates*Forecasts are for end of Q2 2016

**Forecast for end of 2016

UK economy Price inflation(CPI)

GDP(growth)

10-yeargilt yields

Base rates $/£ £/€

Market participants’ forecasts 2015%

2016%

2015%

2016%

2015%

2016*%

2015%

2016*%

2015 2016* 2015 2016*

High 1.80 2.40 3.20 3.00 2.90 3.10 1.25 1.50 1.65 1.69 0.79 0.81

Low -0.10 0.90 2.20 1.50 0.90 1.80 0.50 0.75 1.38 1.32 0.63 0.66

Median 0.50 1.70 2.60 2.40 2.15 2.38 0.75 1.00 1.51 1.53 0.73 0.73

Last month median 1.00 1.85 2.10 2.40 2.52 2.75 0.75 1.00 1.50 1.52 0.75 0.74

Legal & General Investment Management 0.20 1.70 2.80 2.50 2.40 3.00** 0.50 1.00 n/a n/a n/a n/a

There was a flurry of excitement recently after Bank of England Governor Carney suggested that persistently low inflation could prompt rate cuts or even further quantitative easing. On the face of it, this isn’t such a shock – just two months into 2015 and we’ve already seen 20 central banks either cut rates or announce QE (no prizes if you know them, but you can test your central bank knowledge at the end).

But looking at the Bank’s February Quarterly Inflation Report, the risks of entrenched deflation were downplayed. Furthermore, although we expect inflation to continue to fall from here – with the potential for a headline-grabbing negative inflation number before the summer – this is largely due to factors such as the large fall in the oil price and sterling’s rise last year. These effects will start to fall out of the top line inflation numbers from later this year.

We think that the labour market holds the key. Unemployment in the three months to December was 5.7%, not far above the level the Bank considers to be ‘equilibrium’. We’ve been highlighting recruitment difficulties for some months – the concept that there are vacancies still to be filled but companies are finding it harder to get the right person into the right job.

This leaves us with two opposing forces. On one side, employers faced with tighter labour markets have to increase wages to attract and retain their staff. On the other, as we mentioned last month, consumer expectations of future inflation have been falling. At the same time, productivity gains – which would also support higher wages – have been sparse at best and may even have fallen in the latter part of 2014.

Where does this leave the MPC? Unless we see a clear increase in pay packets, it’s difficult to see a rate rise in the near future. It may even be as far away as 2016. Although recent votes have been unanimous in favour of leaving rates unchanged, the February minutes stated that for two members, the decision was “finely balanced”. We therefore wouldn’t be surprised to see a return to a split vote before long, but think that the Committee as a whole will be looking to strike a balance between pro-actively raising rates before the economy overheats, and holding back to prevent endangering the recovery.

And those easing central banks? The ECB – acting on behalf of its 19 member nations, but also: Uzbekistan, Romania, Switzerland, India, Egypt, Peru, Turkey, Canada, Pakistan, Russia, Australia, Singapore, Albania, China, Denmark, Sweden, Indonesia, Botswana and Israel.

The forecasts above are taken from Bloomberg L.P. and represent the views of between 20–40 different market participants (depending on the economic variable). The ‘high’ and ‘low’ figures shown above represent the highest/lowest single forecast from the sample. The median number takes the middle estimate from the entire sample.

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Fundamentals March 2015