Paulo's Econ Watch

Global industrial trends

Posted on October 1st, 2015

Main takeaways:

Global PMI continues trending down.
But there is a clear divergence between emerging and developed countries...
...that suggests convergence of growth between the regions is likely to continue...
...resulting in a slowdown in global industrial production growth compared to pre-crisis growth pace.

Global PMI continues trending down...

... with a clear divergence between developed and emerging markets happening in the last 6-7 months.

This suggests industrial production in developed economies should continue to grow at around 1%...

...while industrial production growth in EM economies should slowdown further in the coming months.

And within emerging countries, the slowdown in industrial activity is driven by Asia (China)

The EM and DM PMIs suggest a convergence of growth between the regions is likely to continue...

... and as a result global industrial production growth is likely to slowdown. The chart below shows that world industrial production is usually cyclical -- except in the unusual expansion period between Dec/2001 and Feb/2008 and in the last 4 years up to mid-2014.

The previous slowdown / contraction periods (Dec/94 to Dec/95, Oct/97 to Oct/98, Aug/2000 to Dec/01, Feb/08 to Mar/09) were all period of crisis (Mexico, Asia, Nasdaq, and the GFR) and lasted about one year.

US Personal Income and Outlays (Aug/15 chart pack)

Posted on September 28th, 2015

Main takeaways:

No sign of a slowdown on either income or spending in August - despite the tightening of financial conditions and drop in consumer confidence. However, it might be too early to gauge the full effect of financial conditions on economic activity.
Household consumption was up 0.4% in June and income rose 0.3%.
Nominal (real) disposable income trend growth in the last 12 months growing at 3.3% (3.0%) and consumption trend growth at 3.4% (3.0%).
Core nominal (real) consumption (ex food and energy) growing at 4.4% (3.3%) in the last 12 months.

Personal spending rose 0.4 in August and household income rose 0.3% in the month.

The charts below shows that consumption has catch up and seem to be back to its previous trend before the slowdown in the first quarter. Savings rate remained moved down a bit to 4.7% (from 4.8%) in the month (the average rate observed since 2013 is 5%).

Disposable income seems to be in a steady trend, while household consumption rebounded from the lows early in the year and is back to its previous trend growth.

Chart 1a) Income and expenditures, nominal, since 2007

The growth trend in the last 12 months for disposable income went up to 3.3% in August from 3.2% in July and 3.1% in June, while the growth trend for consumption moved up to 3.4% from 2.8% and 2.6%, respectively.

Cart 1b) Income and expenditures, nominal, last 2 years

Chart 2a) Income and expenditures, volume, since 2007

When looking at volumes (constant prices) the trend growth in real disposable income slowed to 3.% in the last two years (from 3.2%), while real consumption rose 3% (from 2.8%).

Chart 2b) Income and expenditures, volume, last 2 years

The chart below shows slightly different measures of income. The green line shows private sector wages have clearly slowed down in recent months (from above average growth) and are now more aligned with the broader concept of disposable income.

Chart 3a) Different measures / concepts of household income, since 2007

Chart 3b) Different measures / concepts of household income, last 2 years

The chart below shows that almost all the recent stagnation in consumption was due to 'energy' consumption.

Chart 4a) Household consumption, core vs total, nominal, since 2007

Chart 4b) Household consumption, core vs total, nominal, last 2 years

Chart 4c) Household consumption, core vs total, volumes, since 2007

Chart 4d) Household consumption, core vs total, volumes, last 2 years

Breaking household consumption into goods and services show that the recent soft patch was entirely due to goods consumption -- but take a look in the chart of volumes: it shows goods consumption growing even faster than its recent growth trend.

Chart 5a) Goods and services consumption, nominal, since 2007

Chart 5b) Goods and services consumption, volume, since 2007

Digging further into goods consumption it is evident that most of the hit happened in nondurable (which includes gasoline), but when adjusting for prices nondurable goods seem to be back to the previous growth trend.

Chart 6a) Goods consumption (durables and nondurables), nominal, since 2007

Chart 6b) Goods consumption (durables and nondurables), volume, since 2007

Chart below focus only on nondurable goods (volume) to better spot the trends.

Chart 6c) Goods consumption (nondurables), volume, since 2007

US 2Q15 GDP (third release): revised up to 3.9% (from 3.7%); real GDI revised up a tenth to 0.7% in the quarter

Posted on September 25th, 2015

Main takeaways:

GDP keeps running above potential.
But GDI has been running very weak in the last two quarters. It may only be a 'catch-down' since GDI was running above GDP, but it bears watching.
Inventories are close to the highs -- this could trigger a short-term GDP slowdown.
Investments (ex. oil) are picking up.
The value of goods and services purchased by US residents, "private" GDP, private domestic demand, are all growing at or slightly above 3%.

Second quarter GDP was revised up by 0.2pp, above market consensus of no change.

Note that the contribution from inventories went down by 0.2pp.

Chart pack

GDP is running roughly 1pp above potential...

The average of GDP and GDI is running a bit below GDP. GDI has slowed in the last two quarters -- the statistical discrepancy is shrinking, since GDI is higher than GDP, but it is worth watching how GDI evolves in the coming quarters.

GDP excluding inventories is growing at 2.5%...

The value of goods and services purchased by US residents (regardless of where goods and services were produced) excluding inventories is growing at a healthy 3% since mid-2014...

... a similar growth pace is obtained if one looks only at "private GDP" (i.e., GDP excluding government consumption and investment)...

...and private domestic demand is growing at 3.5%.

Looking only at business value added, the growth pictures is similar to the whole GDP. It was very strong in 2Q (5.1%) and growing at around 3% since mid-2014.

GDP breakdown: Consumption

Consumption rebounded in 2Q and is growing a bit above 3%.

Excluding energy and food, consumption growth is even higher.

GDP breakdown: Investment

Overall investment growth rebounded in the last few quarters but the annual pace of growth is slowing...

...but recall that there is a collapse in investment in the oil sector.

Excluding oil sector, overall investment picture is improving, with annual growth rates at 6.9%. Note that this is not far away from the pace of investment growth before the great recession.

Nonresidential investment in structures excluding the oil sector is "booming"...

...and investment in intellectual property (R&D) is also booming...

...but traditional equipment investment is lagging well behind.

Housing investment has recovered from the taper tantrum and is growing at a pace comparable to before the great recession.

US FOMC: The headwinds keep blowing...

Posted on September 18th, 2015

Main takeaways:

The 25bp cut in the median 'dot' is not compatible with the change in forecasts.
This is happening since Sept/14. Blame it on the 'headwinds'.
Interestingly, the headwinds have consistently failed to affect Fed's forecasts. They only make their way to the underlying path of equilibrium real rates.

Despite FOMC's dovish statement and remarks, the forecasts for 2016 and 2017 have not changed materially:

Nevertheless, the 'dots' moved down by 25bp across the board. Is it compatible with the forecast revisions?

In order to check this, I have used Yellen's preferred Taylor rule -- the one she mentioned in her speech on Normalizing Monetary Policy.

The chart below plugs Fed forecasts into Yellen's Taylor rule for December 2015. It shows the implied path for interest rates assuming zero real rates (the solid light gray line) and assuming real rates at the long run value forecast by the Fed.

The lines with markers show the median and the trimmed average 'dots'. One can see that the Fed's median forecasts for interest rates at the end of 2015 have been consistent with negative real rates since mid-2013. The average in the period from Jun/13 to Jun/15 was -35bp and the most recent median dot is compatible with real rates at -65bp.

When looking at 2016 forecasts, the picture changes materially. The updated forecasts suggest nothing has materially changed in the Taylor rule range, however the median dot for December 2016 has consistently moved down since September/14. The most recent median dot is compatible with equilibrium real interest rates at -35bp.

The trend for 2017 is similar to 2016: the implied equilibrium real rate moved down by 100bp in the last year (but is currently compatible with equilibrium real rates at +50bp).

The bottom line is: no, the change in the 'dots' is not compatible with the change in forecasts (assuming the reaction function has not changed).

Therefore, the pattern of the last four FOMC dot-plots can only be compatible with the famous 'headwinds' (low oil and commodities, strong dollar, slower global growth) which, interestingly, have consistently failed to affect the forecasts. They only make their way to the underlying path of equilibrium real rates!

The chart below shows the implied Yellen Taylor rule assuming 1.5% real rate (red) and zero real rate (green). The blue dots are the median dot in the Fed's forecast and the chart shows also the fed fund futures the day before the meeting and as of September 18. Markets are skeptical the Fed will be able to follow its own plan (and markets have been right, so far).

US FOMC: Hinted at December liftoff, but within a very dovish framework

Posted on September 17th, 2015

Main takeaways:

FOMC hinted the most likely meeting for liftoff is December.
Yellen message was: FOMC has not "fundamentally altered its outlook", the risks remain balanced, but uncertainty increased; thus...
...FOMC wants more evidence to bolster its confidence inflation will return to 2%.
However, the message was conveyed in a very dovish framework that sounded like a departure from the previous reaction function.

The FOMC surprised with a clear "dovish hold". The question is, why?

The quick answer comes straight into the statement:

"Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term."

A more explicit link from global developments to domestic developments is provided in Yellen's prepared remarks at the press conference:

"My colleagues and I continue to expect that the effects of these factors on inflation will be transitory. However, the recent additional decline in oil prices and the further appreciation of the dollar mean that it will take a bit more time for these effects to fully dissipate."

In another passage of her prepared remarks, Yellen explained what has made FOMC to change stance: equity prices, stronger dollar and spreads.

Developments since our July meeting, including the drop in equity prices [-5%], the further appreciation of the dollar [2%], and a widening in risk spreads [20bp], have tightened overall financial conditions to some extent. These developments may restrain US economic activity somewhat and are likely to put further downward pressure on inflation in the near term."

Note: the numbers in [ ] were not mentioned by Yellen.

So should we just focus on financial conditions? Not so fast... the Fed claims it does not target financial conditions... during Q&A Yellen stated:

"The Fed should not be responding to the ups and downs of the markets and it is certainly not our policy to do so. But when there are significant financial developments, it's incumbent on us to ask ourselves what is causing them ... And so they have concerned us in part because they take us to the global outlook and how that will affect us."

Ok. Now I got it. The FOMC has changed its global outlook and therefore its US outlook. No...read a bit further:

"...these recent developments...have not fundamentally altered our outlook. The economy has been performing well, and we expect it to continue to do so."

And then she mentions that "to be clear":

"...our decision will not hinge on any particular data release or on day-to-day movements in financial markets. Instead, the decision will depend on a wide range of economic and financial indicators and our assessment of their cumulative implications for actual and expected progress toward our objectives."

Then she added:

"The recovery from the Great Recession has advanced sufficiently far, and domestic spending appears sufficiently robust, that an argument can be made for a rise in interest rates at this time. We discussed this possibility at our meeting."

Ok. Now it is clear !! The US economy is so close to a rise in interest rates that the Committee has decided to send a very dovish message...go figure.

To be fair, Yellen mentioned that the "Committee judged appropriate to wait for more evidence...to bolster its confidence that inflation will rise to 2 percent".

It seems, thus, that despite the dovish message, the FOMC just wants to wait a bit more to make sure the recent bout of volatility will indeed only have temporary effects on the economy.

That might be the case...but it wasn't the message that came across from the statement, from Yellen's prepared remarks and from the Q&A.

The emphasis on (previously disregarded) market-based inflation compensation, explicit concerns about Chinese growth, the impact of commodity prices on emerging market economies, the capital flight from EM, and even concerns about Canada "which is an important trading partner", all departed from the message conveyed in a similar bout of uncertainty earlier this year and sounded very dovish.

Indeed, from late 2014 to earlier this year, the Fed watched a sell-off in EM currencies, a decline in oil and other commodity prices, a strengthening of the US dollar, a sharp drop in market-based measures of inflation compensation, a sharp slowdown in global trade, West Coast port slowdown, a contraction in first quarter GDP growth,..., and the message conveyed back then was more upbeat.

One thing that stood out was Yellen's remarks on inflation compensation:

"...the Committee has taken note of the recent declines in market-based measures of inflation compensation and will continue to monitor inflation developments carefully."

This was a complete departure from the line of thought of late 2014 and earlier this year!

Back then the FOMC decided to focus on survey-based measures of inflation expectations and disregarded market-based measures of inflation compensation. In February Semiannual Monetary Policy Report to Congress Yellen mentioned that inflation compensation "mainly reflects factors other than a reduction of longer-term inflation expectations". Fed staff even prepared a box in the Monetary Policy Report explaining the "challenges in interpreting measures of longer-term inflation expectations" from financial instruments.

To be fair, when speaking by herself (and not on behalf of the Committee), Yellen often seemed more concerned about inflation compensation than the full FOMC.

Allow me a digression to show how inflation extracted from the TIPS for the 5 year period from 2020 to 2025 is correlated with today's oil prices!!

(And, by the way, market-based measures of inflation compensation today are not far away from where they were back in February 2015 when Yellen spoke to the Congress.)

Returning to the main point, it is clear that the FOMC is worried about inflation and that something has changed.

One can clearly see that in their forecasts!!

Don't you think a tenth down change in median forecast and in the central tendency range for inflation reflect a material change? Well, you've got company. It is very hard to argue that a tenth move is not well within any forecast error margin...

But, what about the move in headline PCE down from 0.7% to 0.4%? Well, that's really a large shift, but note that the core PCE rose from 1.3% to 1.4%. Moreover, would the FOMC make today's monetary policy based on the forecast for the next 3 months? Even Yellen believes monetary policy has lags..."But there are lags in the impact of monetary policy on the economy" she answered in the Q&A.

So, if the FOMC has not materially changed the forecasts, has the dovish message resulted from a change in the balance of risks? The statement reads:

"The Committee continues to see the risks to the outlook for economic activity and labor market as nearly balanced but is monitoring developments abroad."

It seems the risks remain balanced but worth monitoring; so has uncertainty increased?

Yellen mentioned in the prepared remarks that "the outlook abroad appears to have become more uncertain of late, and heightened concerns about growth in China and other emerging market economies have led to notable volatility in financial markets".

So it seems that an increase in uncertainty was behind the change to a more dovish stance. But what is odd is that this uncertainty is not reflected in the forecasts. Look at GDP, unemployment and inflation forecast in the table above: forecast ranges have not changed materially from June -- this does not reflect an increase in uncertainty (or the Fed was not brave enough to change forecasts and acknowledge the worsening of the outlook and increased uncertainty).

So, the Fed has not materially changed the outlook, neither the balance of risks, but has acknowledged an increase in uncertainty. And if one is not willing to show this uncertainty in the forecasts, you show it by lowering the 'dots' when your forecasts suggest otherwise, and sounding dovish.

Would the markets really get surprised with a liftoff?

Posted on September 16th, 2015

No.
Fed fund futures imply less of 30% change of the first hike on Sept. 17.
Surveys (e.g., Bloomberg, FT) suggest the odds are closer to 50/50.
More interestingly, the term structure of the yield curve already has one hike fully priced!!

One of the key arguments against an increase in fed funds on September 17th is the fact that the Fed has not provided a 'heads-up' and therefore the market is not prepared for it. It would be too disruptive to move away from the ZLB without the markets being prepared for it, the argument goes.

So, would markets really get surprised in the event of a liftoff?

The immediate answer is yes -- just look at the fed fund futures and you'll see that the probability of leaving the zero bound is as low as 30%. The Fed only moved in the last 20 years when the implied probability is north of 70%, Larry Summers recently said.

But looking at economist surveys, one gets a different picture. A Bloomberg survey shows that 51 out of 113 economists / strategists expect the Fed to move 25bp on Sept. 17th and 3 expect a move half this size. A similar survey by the FT shows 47% of 30 economists expect a move.

One may quickly dismiss surveys and argue that market prices provide a more accurate picture.

So, let's take a closer look at market prices other than Fed funds futures.

The term structure of the yield curve provides valuable information. From 1985 to 2007, 99% of the variance of the term structure of the yield curve can be explained by two factors (the first 2 PCA).

The chart below shows that using the common information provided in the 6m, 1y, 2y, 3y, 5y, 7y, 10y, 20y, and 30y constant maturity treasuries one can closely replicate the actual Fed funds rate. Note that the PCA calculated does not include the FF.

So it is clear that the term structure contains information on the fed funds rate. Note also how the blue line (FF compatible with the term structure) often (but not always) anticipates the move in the actual fed funds.

What if we use the model coefficients estimated up to 2007 (to avoid including the period of the crisis) to forecast where the fed funds rate should have settled, based only on the actual path of the yield curve term structure? (again, not using the actual fed funds).

The chart below shows that the estimated fed funds would have been negative for most of the ZLB period. Except for the last few months!

Zooming into the ZLB period, one can see that the term structure of the yield curve is compatible with a fed funds rate which has increased since Jan/2014 and matched the actual fed funds by November 2014.

The most recent data shows that the term structure is compatible with fed funds at about 35bp, exactly where the market expects the FF to trade after the first hike!

Bottom line: the term structure of the yield curve already embeds one hike.

US Inflation chart pack - are we there yet? (Aug/2015)

Posted on September 16th, 2015

Fed's criteria for raising rates:

"The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term."

So Fed needs to be reasonably confident inflation will move back to 2%. Are we there yet?

Consumer inflation is not there yet, but inflation momentum (3-month annualized inflation) is hovering around 2.0% in the last three months to August, a bit lower than in the previous months (note: there's a 0.5pp gap between CPI an the target PCE inflation).

The minutes of July's FOMC meeting (FOMC: moving closer, but with no conviction) showed an increasing concern with downside risks to inflation -- and this was before a further drop in oil and commodity prices and further strengthening of the dollar. Late last year, when oil prices were collapsing, the Fed (Yellen, Fischer) made the case that low inflation was not a big concern -- it is a lagging indicator, so the focus should be on labor market slack. More recently, the Fed appears to get cold feet about moving off the ZLB and inflation concerns are making a comeback. Moreover, headwinds (e.g. stronger dollar) could strength the doves' case.

See the chart pack below.

Core inflation momentum moved from 1.5% in Jan to 2.4% in June and down to 2.0% in August.

Trimmed-mean CPI -- mentioned in the minutes -- moved from 1.2% to 2.1% and then to 1.9% in the same comparison.

The chart below looks at the average of the three measures of core inflation over a longer time span. Despite all the talks of deflation / lowflation, annual core inflation has barely moved since late 2011.

Core CPI at 1.8% and CPI ex energy also at 1.8% (unchanged from July)

It's all about energy...

...and goods. Services inflation running at a healthy 2.6%

Oil prices are spilling over to core. Core inflation excluding airfares is a bit higher.

Gasoline prices down again

Sticky-Price CPI growth remains stable -- a sign of anchored expectations

The Atlanta Fed produces a breakdown between 'sticky' vs 'flexible' prices and they argue 'sticky' prices (which is a weighted basket of items that change prices relatively slowly) "appear to incorporate expectations about future inflation to a greater degree than flexible prices".

The chart below shows that 'sticky' prices remain...well, sticky at around the 2% level annually. Moreover, sticky prices inflation is down but is running very close to 2%. This is in clear contrast to the 2009 to 2011 period which clearly showed concerns about future inflation.

Market-based inflation compensation is falling...this moves with oil prices and FOMC decided to downplay this by move late 2014.

Will they or won't they -- headwinds for the FOMC

Posted on September 16th, 2015

The overall economic data released since Fed's latest meeting suggests the criteria for liftoff has been met.
However, headwinds from the recent developments abroad and tightening of financial conditions in the US will likely postpone the first hike.
The Fed has not elaborated upon the way it sees the balance of risks -- so we're flying blind.
The key rational for believing a hike will be delayed is that the Fed has not provided any 'heads-up'.
Charts below: dollar, commodities, financial conditions.

Charts

US trade-weighted dollar is higher than earlier in the year, when Fed warned about its negative consequences to the economy

Oil prices are also back to the lows of earlier this year

Retail gasoline prices are not at the lows but have trended down since July

Commodity prices have just made new lows

US equities are 7% down since mid August

Equity vol off the highs but still elevated

US 10y Treasuries

Baa spreads widened materially vs Aaa

Market-based inflation compensation sharply down, but this could just be oil prices

Financial conditions, as measured by GS, have already tightened sharply in 2015...

...but broadening the definition to include oil prices show a more benign picture

Financial conditions, as measured by the Chicago Fed, also show a tightening, but overall levels remain in the accommodative range

Adjusting for the business cycle, Chicago Fed index suggest that financial conditions moved to tight since the beginning of 2015

Below, some additional financial conditions and financial stress indices

US Industrial Production: still weak (Aug/2015)

Posted on September 15th, 2015

Main takeaways:

August industrial and manufacturing production gave back part of July's gains.
Core IP is still moving sideways. Employment in the manufacturing sector is also moving sideways.
Renewed weakness in oil sector could again spillover to other manufacturing sectors.
Indeed, ISM survey and Conference Board leading indicator both weakened recently, suggesting there's no upside for industry in the near term.

August industrial and manufacturing production gave back part of July's gains. Core IP is still moving sideways.

Employment in manufacturing and core manufacturing in August gave back all of July's gains. Jobs in the manufacturing sector moved sideways so far this year.

Both the ISM and Markit PMI surveys weakened recently, suggesting there's no upside for IP in the near term.

The Conference Board leading indicators are also catching down with weak industrial activity.

Renewed weakness in oil sector could again spillover to other manufacturing sectors.

US Retail Sales -- good; two in a row (Aug/2015)

Posted on September 15th, 2015

Main takeaways:

August: another good retail sales report -- two in a row after the latest FOMC meeting.
Small revisions to the previous two months were positive.
Growth resumed after the winter lull:
- 12-month growth of total retail sales ex gasoline stations increased from 4.0% to 4.2%.
- 12-month growth of the 'control group' increased from 2.4% to 3.1%.
- Both are very close to the 4-year growth pace: a resilient consumer!
Inventory-to-sales ratio remained stable.

Another good retail sales report. Excluding sales at gas stations one can barely see the consumption growth scare that took place earlier in the year: total retail sales ex gas stations increased 4.2% in the last year compared to 4.5% in the last 4 years.

The chart below compares total retail sales with retail excluding gasoline sales. It is clear that most of the slowdown in retail sales earlier in the year was due to falling gasoline prices.

Looking at the "control group" (total retail excluding auto dealers, bldg materials, gas stations) a similar growth picture emerges: 3.1% growth in the last year and 3.0% in the last 4 years.

Revisions to the previous two months were positive.

Inventories: stable if one excludes gasoline sales (latest: July)

Extra charts

The charts below show retail and food services by kind of business. The red line is an index in log (averages zero in the period) so that a number 10 in the scale means sales are 10% higher than the period average. The red dashed line is the trend in the last 12 months and the blue bars (right scale) are the monthly percentage change. The headline is how the slope of the red dashed line has changed compared to last two months.

Last 12 months trend moved from 6.1% to 6.0% to 6.1%