In this week’s bulletin:
- Markets rise on the back of strong US job numbers and signs that the Chinese economy is gathering pace again, although Eurozone woes continue.
- With hours to go until the US presidential election, the looming ‘fiscal cliff’ faces whoever wins.
- As the Bank of England’s latest tranche of QE ends, improving UK growth prospects raise questions over future policy plans.
- Better economic data from China boosts investor sentiment
- US employment numbers better than expected as economy gains traction
- Stronger US$ hits gold and industrial commodity prices
“There are thus increasing signs of the Chinese economy gathering pace again – indeed, we believe it may already have bottomed out.”
Carsten Fritsch, analyst at Commerzbank
A mix of increasingly positive global economic news meant financial markets were divided last week. On the one hand, a clutch of encouraging economic data from the US and China gave a welcome boost to equities and the US dollar. Conversely, the dollar’s strength paved the way for further falls in the gold price, along with industrial commodities such as copper and oil. Gold was particularly in the spotlight with prices falling more than 2% as stronger-than-expected US employment data saw gold bulls heading for the exit as the precious metal hit an eight-week low, slipping below the $1,700 per troy ounce level. A trader at Mitsubishi, the Japanese trading house, neatly summed up the situation, saying, “There is a risk that there’s light at the end of the tunnel. What gold investors fear is a return to normality and interest rates rising.”
The ‘light at the end of the tunnel’ comment referred to the exceptionally robust US non-farm payrolls report, released on Friday, which registered an increase of 171,000 last month, together with upward revisions for the previous two months totalling a further 84,000 jobs. Wall Street had pencilled in an increase of around 120,000 new jobs. The US employment numbers reinforced the growing view that the American economy was still on track to achieve growth of 2% this year and complemented earlier data showing US consumer confidence had hit its highest level for four years and that the manufacturing sector had grown at a faster pace in September. However, the corollary of improving growth is that it reduces the chances of more ‘risk-friendly’ quantitative easing by the Federal Reserve; a view seemingly taken by investors last week, hence the rally in the dollar and falling commodity prices.
Away from the world’s largest economy, there was more positive news from China. In recent months, investors have become increasingly concerned that the Asian powerhouse was in danger of slowing too quickly and facing a potential ‘hard landing’, with all its ramifications for the global economy. But the latest data to be released by the Chinese authorities – its purchasing managers’ data – showed that manufacturing had expanded in October for the first time in three months. “There are thus increasing signs of the Chinese economy gathering pace again – indeed, we believe it may already have bottomed out,” was the view of Carsten Fritsch at Commerzbank.
For investors, though, there is still one cloud on the horizon: the eurozone. Whilst corporate earnings remain remarkably resilient, the economic news emanating from Europe is worsening. Spain’s economy contracted for a fifth successive quarter and eurozone-wide economic sentiment fell for the eighth consecutive month – unsurprising given that the region’s unemployment rate is around 15%. And for good measure, Greece was back on the agenda on news that, according to its 2013 Budget, it would overshoot its deficit and debt targets. Observers are becoming increasingly concerned that, even with Greek and EU policymakers trying to put a deal together, there is still a risk the latest bailout will collapse.
By the end of the week though the bulls won, enabling global equity markets to notch up some useful gains; with most major indices rising over 1% and Shanghai and Hong Kong leading the way, up 2.5%.
US Election Countdown
Whoever wins will have to face up to US ‘fiscal cliff’ challenge: Bush-era legacy of expiring tax cuts combined with budget cuts could send US into recession
With only hours to go, both America’s presidential hopefuls will be campaigning to the last minute as opinion polls show them neck-and-neck, albeit with Mr Obama seeming to have the edge in the key swing states. Against this backdrop, pundits are poring over their history books to gauge the probability of an incumbent president being usurped after one term. Stock market analysts are also trying to assess which party candidate is likely to be most welcomed by Wall Street. Recent experience appears to have debunked the theory that the stock market does better under Republicans than Democrats; the S&P 500 has risen almost two-thirds under Mr Obama’s administration, somewhat remarkable given the financial crisis and ensuing poor economic backdrop. Last week, investors appeared to be taking a pretty sanguine view of events, although some volatility is likely once the result is known after tomorrow’s election. The explanation for the stock market’s stoicism might actually not be that complicated. Whichever candidate wins, they will have to address one single, overriding issue – America’s so-called ‘fiscal cliff’ – and time will be against them.
Unless laws are changed, tax cuts from the Bush era – themselves a direct result of the post-credit crisis stimulus plan – will expire at the end of December. Simultaneously, automatic federal budget cuts kick in, affecting whole swathes of government. The stakes are undeniably high. The Congressional Budget Office has estimated that this fiscal cliff could result in a drag of $600 billion next year, equivalent to 4% of America’s GDP. Whilst both sides agree that the laws need to be changed to avoid another US recession, details of any agreement seem very far off. Analysts are busy crunching the numbers given a selection of possible outcomes, such as a Democratic President but a Republican-controlled Congress. Either way, a deal needs to be struck and financial markets appear to believe that this will ultimately be the outcome; but in the interim it’s quite possible that Wall Street investors might, in the run-up, find their nerves being somewhat frayed.
The £375 Billion Question
- Bank of England’s latest tranche of QE ends this week
- Improving UK growth prospects pose question over future policy intentions
- One of BoE’s deputy governors believes QE losing its effectiveness
“The Bank could not countenance any suggestion that we cancel our holdings of gilts. The Bank must have the ability to reverse its policy… when that becomes necessary.”
Sir Mervyn King, Governor of the Bank of England
News that the US economy is doing better than expected has, as mentioned, reduced the possibility of new QE from the US Federal Reserve. The UK, according to some economists, is at the same crossroads following the recent news that the economy grew by 1.0% in the third quarter. But some experts argue that the issue goes somewhat further than the simple question of whether the Bank of England (BoE) should cease QE. Notwithstanding the end of the recession, the likes of the Confederation of British Industry (CBI) see the economy ending flat on the year and growth of 1.4% in 2013 rising to 2% the year after. The CBI’s Director-General John Cridland argues that it is unlikely Britain will return to the previous average growth rate of 3% pa, saying, “There’s a ‘new normal’ here and it’s leaner. If we can get organically driven 2% growth and get it sustainable in the UK, then I think we’ve got some sort of recovery.”
With most agreeing there may still be a need for the BoE to intervene – particularly if the eurozone sinks into a deeper recession – the issue is how and to what extent. One of the Bank’s own deputy governors, Charlie Bean, said last week that there was an “open question” over how much effect the lower interest rates generated by money printing were having, implying the Bank’s programme of QE was losing its kick. There is also the supplementary question around what the BoE should do with all the gilt-edged stock it owns as it matures. The Bank’s current QE programme will shortly expire and to date it owns around one-third of the gilts in issue.
Starting with the latter point, the BoE is due to receive its first repayment from the Treasury when £6.1 billion of gilts mature – the cash will go to the BoE’s Asset Purchase Facility. As redemptions gather pace, the amounts get larger – some £23.9 billion in 2015 alone – and the Bank has given no hint at what it intends to do, either with maturing bonds or the income it has received to date; a total of some £20 billion. One option would be to re-invest in new gilts, implying a continuation of QE for a long time. The other would be to cancel some of the existing gilts in the Bank’s portfolio rather than the Treasury repaying the Bank, in the hope that this would leave more cash to boost the economy. On this point, BoE Governor Sir Mervyn King has been unequivocal. “The Bank could not countenance any suggestion that we cancel our holdings of gilts. The Bank must have the ability to reverse its policy… when that becomes necessary.”
If growth does remain more subdued than hoped for and the existing policy is losing its impact, what other action could the BoE take? One of the BoE’s Monetary Policy Committee (MPC) external members, David Miles, believes the existing QE policy is working and that the alternatives involve far greater risks to inflation. One alternative might be for the MPC to embark on a policy of money-financed spending – sometimes known as a ‘helicopter drop’ of money. In simple terms the government might decide on a lump-sum temporary tax cut which it hopes households will spend (the US did this). The government issues new gilts to fund the cost and immediately the new bonds are bought by the BoE which then channels all the coupons (income payments) and redemptions back to the Treasury. The downside comes if inflation picks up: because with traditional QE the BoE is able to shrink its balance sheet by selling gilts which means yields rise, along with the cost of borrowing, thus suppressing excess demand. However, using the ‘helicopter drop’ approach is far riskier, says David Miles. As to the final outcome, the Bank is saying nothing at this juncture. So, no doubt, the markets will take an even closer interest going forward; but for now it remains business as usual.