Global Economic Overview and Equity Commentaries: August 2014

Significant Regional Divergence Continues

Economic data from the developed world continue to show significant divergence among the major countries. Growth appears to be accelerating in the U.S., while data from the Euro-zone and Japan have disappointed yet again and the central banks are likely to step in with additional monetary stimulus. Despite the lower than expected job gains in August, U.S. consumer sentiment continues to trend higher and should help sustain the recent expansion in retail sales growth. In the Euro-zone, most indicators have turned weaker as domestic demand is yet to see any meaningful recovery while the relatively strong Euro has limited export growth so far. Inflation slipped further in August, and remains far below the central bank’s 2% target. In response, the European Central Bank has again cut its policy rates and has announced a bond purchase program before the end of this year.

The Japanese economy contracted more than expected during the second quarter, yet again making the growth forecasts for the current year seem optimistic. Nevertheless, the government and the central bank are hopeful that a weaker yen will help Japanese exporters to add to their recent gains. The Japanese central bank has so far resisted calls for additional monetary stimulus, but could do so next year if growth remains anemic. Among the emerging markets, second quarter economic growth was healthy in select Asian countries such as India while most Latin American countries led by Brazil saw slower growth. Global manufacturing output expanded further in August, helped by further gains in the U.S. and the U.K. China’s manufacturing output growth was subdued in August but services activity showed improvement from the previous month. Oil prices have corrected, despite elevated geopolitical risks, and should help consumer spending in most developed countries in the coming months.

International Equity Commentary

European Stimulus Expectations Help Offset Geopolitical Risks

International equity prices saw modest gains in August as expectations about expanded monetary stimulus from the European Central Bank (ECB) largely offset persistent geopolitical tensions in Ukraine and the Middle East. Economic signals from the Euro-zone deteriorated further and inflation slipped again. Most major economies in the region saw weaker economic activity during the second quarter, including Germany that had been the growth engine for the region in recent years. In response, the ECB lowered its benchmark rate and has announced plans to start purchasing asset-backed securities in the near future. Meanwhile, U.S. Federal Reserve officials tried to allay market fears of an early rate hike by suggesting that the country’s labor market has not recovered enough to withstand higher interest rates.

The Japanese economy contracted more than expected during the second quarter on lower consumer spending after taxes were increased in April. In the U.K., GDP growth continued to exceed expectations during the second quarter and the country is likely to see the fastest growth among major developed economies this year. Among the emerging markets, India saw faster growth during the April – June quarter while output growth remained weak in Brazil. Global manufacturing and services activity continued to expand in August, helped by gains in the U.S. and the U.K. China’s manufacturing output growth was softer during the month, but the services sector saw acceleration.

International Equity Near-Term Outlook

The ECB’s marginal interest rate cut and asset purchase program announcement were largely unexpected, and have been well received by the markets. However, by delaying quantitative easing this long, there are concerns that the ECB has possibly made it less effective. The Euro-zone economy has been in a recession for a while now, and it is uncertain if additional monetary stimulus measures can make a significant contribution to reviving growth. The negative deposit rates are likely to encourage banks to step up lending to consumers and businesses. Nevertheless, the bond purchase program as announced is limited to select assets. As such, the scale of the program as proposed could be restricted by the availability of qualified assets. If economic growth remains subdued and deflationary risks worsen, it is likely that the ECB could expand the program further in the future. In any case, the recent decline of the Euro against other currencies in anticipation of ECB action could help exporters in the region to regain some of their price competitiveness.

The larger than expected decline of the Japanese economy in the second quarter has yet again revived concerns about the success of reform measures collectively known as ‘Abenomics.’ Consumer and business sentiment surveys suggested a recovery in May and June, but the trends have become less positive in August. The government announced its long anticipated fiscal reform measures recently, but they need to be implemented without further delay. On the positive side, exports picked up in July after the weak trends during the previous two months. The ongoing revival in global demand and the yen’s recent decline should help Japanese exports in the coming months. The Bank of Japan is yet to scale up its monetary stimulus measures, as the bank remains confident of meeting its inflation targets next year.

Emerging Markets Equity Commentary

Export Demand Revival and Cheaper Oil Could Help Emerging Economies

Emerging market equity prices saw further gains in August and continued to outperform most developed markets for the third month in a row. Markets in Latin America bounced back strongly from recent declines, helped by expectations of political change in some countries in the region as well as a revival in global demand for industrial commodities. Brazil, which is holding presidential elections this October, was the biggest gainer for the month, followed by Mexico where the government has stepped up its reform efforts. In Asia, Thailand advanced on expectations of improved political stability while equity prices in India sustained the uptrend on signs of economic growth picking up speed. Emerging markets in Europe remained weak, despite signs of a possible ceasefire in Ukraine. Russia declined the most after reports of stronger economic sanctions against the country by the European Union and the U.S.

Economic data from the major emerging economies showed further improvement in aggregate growth, though select countries continue to face challenges. Among the Asian countries, India, Malaysia, and The Philippines reported faster than expected growth for the second quarter while Thailand saw a modest expansion and avoided a technical recession. Second quarter growth in Turkey was lower than expected, but the upward revision of first quarter data has helped the country maintain a healthy pace of expansion for the first half of this year. In contrast, the Brazilian economy remained weak during the second quarter and forecasts for the current year have been lowered. Rating agency Moody’s has lowered its outlook for Brazil, citing weak economic growth and fiscal challenges. Manufacturing sector output growth remained largely positive for the major emerging countries in August. Select emerging market currencies have weakened recently on concerns that the U.S. Federal Reserve may hike interest rates earlier than expected.

Emerging Market Equity Near-Term Outlook

Recent export trends from select Asian countries suggest that the recovery in export demand is gaining momentum. Export gains for China and Taiwan for the month of August were larger than expected, while India has seen moderate export growth in recent months through July. Though shipments from Korea declined marginally in August, it was mostly due to subdued domestic demand in China. The positive trends were largely driven by the demand recovery in the U.S., where the economy expanded more than expected during the second quarter. U.S. consumer sentiment remains largely positive, helped by the sustained improvement in labor market conditions. This should help most Asian countries as well as select Latin American countries such as Mexico to maintain healthy export gains in the coming months. However, weak economic conditions in the Euro-zone limit the potential for further acceleration in export growth for the emerging countries.

International oil prices have declined recently, though geopolitical risks remain high in major oil producing regions such as the Middle East and Russia. If the current price levels are sustained, it could bring down inflation risks in large emerging countries such as China and India. This would allow more monetary and fiscal policy flexibility in several emerging countries, especially in India where the central bank is trying to lower headline inflation. In addition, lower fuel prices could help consumer spending in the developed countries and boost export demand for several countries in Asia and Latin America. In contrast, the economic outlook for countries that are more reliant on exports of energy and other commodities are likely to remain subdued.

GLOBAL INDUSTRY SPOTLIGHT FOR THE MONTH: BANKING

Before fully recovering from the after effects of the global financial crisis, the banking industry is likely to face the new challenge of divergent monetary policy approaches in the major developed countries. This could potentially create unpredictable changes in capital flows and liquidity, as markets and businesses calibrate their expectations of future policy actions. In addition, regulators in most countries remain cautious of market risk and are tightening rules for the banking industry even further.

The aggressive monetary policy easing by the world’s central banks in the aftermath of the global financial crisis was perhaps the most significant factor that stabilized the financial markets and subsequently facilitated the banking recovery. Central bank actions helped restore confidence in the banking system and substantially improved liquidity, giving banks enough breathing room and time to rebuild their damaged balance sheets. Monetary policy in most advanced economies has remained highly accommodative over the last five years.

That policy consensus appears set to change by next year, when the healthy economic recovery is likely to force the U.S. Federal Reserve to start hiking interest rates. While U.S. interest rates are likely to remain below historic averages even after that, the beginning of a rate hiking cycle after a prolonged period of exceptionally low borrowing costs could create significant uncertainties. Banks in the U.S. have enjoyed excellent earnings growth in recent years, even after the heavy regulatory fines for some of their lending practices before the crisis. For them to sustain their net interest margins, credit demand has to grow faster than the current pace.

However, mortgage lending in the U.S. has slowed this year as a good number of potential buyers are priced out of the housing market and the refinancing cycle has matured. Nevertheless, the large U.S. banks have mostly settled the regulatory proceedings against them, thus improving earnings visibility. In addition, they are also benefiting from higher fee income as demand for investment banking and other intermediary services remain buoyant. The U.S. Federal Reserve has indicated the possibility of increasing capital requirements for large banks above Basel III norms, but most banks are in a position to raise additional capital if the financial markets continue to be healthy.

In contrast, the European Central Bank is trying harder to encourage banks to increase their lending to consumers and businesses. The central bank has provided sufficient medium-term liquidity to banks in the past and has recently made it costly for banks to accumulate reserves. However, the high unemployment rate and weak consumer demand continue to make European banks cautious of potential loan loss risks and are hence reluctant to ease lending standards. Sustained recovery in domestic consumer sentiment, possibly boosted by additional government spending on infrastructure and other fiscal measures, could lift credit demand in Europe over the medium term.

Geopolitical changes pose a short- to medium-term challenge for the banking industry in some regions. The potential redrawing of national borders, mostly in Europe, could force banks in these regions to shift their operations, which could involve considerable cost and time commitments. Two large banks currently domiciled in Scotland have already indicated that they would be forced to relocate if the region decides to break away from the U.K. A breakup of the U.K. could also encourage sovereign aspirations of select regions in Spain, Italy, and elsewhere in Europe.

Rapid changes in technology and growing internet access over cellular phones are even more significant challenges for the banking industry in the long term. As consumers become more familiar with financial transactions over the internet, some of the services currently offered by banks could be provided more cost effectively by others. Money transfers over cellular phones have grown rapidly in Africa, and telecom service companies are looking to expand these features in other regions. The latest cellular handset models have the ability to enable financial transactions through virtual credit cards. As these services become more popular, the banking industry would be forced to share transaction fees with telecom service providers or even denied such revenues altogether. Most large banks seem to be aware of this risk, and are significantly expanding their online services and offering lower transaction costs to consumers.

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