Contagion via Policy Delays
In 2008, a global economy in disrepair and the tail risk of a depression and deflation prompted policy-makers all over the world to use everything they could in order to minimise the impact on their economies. Now, the global economy is in much better shape (barring Peripheral Europe) but policy options are far more restricted, to a significant degree in DM economies and to a lesser extent in the EM world. In the absence of the same tail risks and with some avenues of policy relatively inaccessible (e.g., credit growth for China, fiscal stimulus for India), EM policy-makers are unlikely to use the ‘nuclear option' this time round. Given the obvious restrictions on policy for the DM policy-makers, EM policy-makers should really be willing to act by more than they would have in tandem with significant DM easing. Since they are unlikely or unwilling to act aggressively, it becomes exigent that they at least act pre-emptively, in our view. In doing so, they would have to balance off inflation risks that have not yet fully dissipated - a tough balancing act.
Who Can Ease, and by How Much? Rewinding the Unwind
Thanks to the speed with which they recovered from the Great Recession, EM policy-makers were able to unwind some of the easing they had delivered during the financial crisis and the ensuing recession. If they wanted or needed to, they could rewind some of this unwind.
Plenty of Monetary Legroom
With a few notable exceptions, policy rates in all of the EM economies under our coverage have moved above their 2008-09 trough. The exceptions, Turkey (whose central bank cut its policy rate recently), and Mexico and the Czech Republic (whose central banks have not yet hiked), all have room to cut rates. In the case of the Czech Republic, our economist, Pasquale Diana, thinks that QE could be considered if rates at zero are not enough. In a nutshell, most economies have plenty of room to cut, certainly on an absolute basis but even relative to where policy rates went in 2008.
With EM currencies currently ‘soft pegged' to the US dollar (discussed further below), their monetary policy stance is decided partly at home and partly by DM central banks. Rather than discuss the constraints on DM central banks here, we direct interested readers to the options at the disposal of the Fed and the ECB discussed in The Global Monetary Analyst: Unconventional Unconventional Easing, August 10, 2011. The bottom line, however, is that both the Fed and the ECB have legroom, given unconventional measures and the ability to deepen and broaden these measures, perhaps even in unconventional ways.
Some Fiscal Legroom
Fiscal legroom is more limited, particularly for the likes of India, Poland and even Brazil. But the distance between the EM and the DM world is bullishly stark. The fiscal position in India, Brazil and Poland is already loose enough that it bothers policy-makers. Further easing as a first (or even second) option seems to be out of the question for at least these economies, in our view. The rest of the EM world, notably China (despite its off-balance sheet concerns), is in a much better position to ease should it want to.
How Would the EM Giants Ease?
Our EM teams have recently written comprehensively on how individual countries could deliver easing. Here we present a brief collection of their views:
China: With a massive increase in credit used in 2008, that channel now rightly will be less favoured. The stimulus is more likely to come from a fiscal package that could focus on social projects. On the margin, the faster appreciation of the RMB should give consumers more spending power, moving China along on its preferred rebalancing path. Monetary easing could mean liquidity easing and policy rate cuts too.
India: Like China, India used policy aggressively in 2008, via fiscal stimulus. One-off revenues aside, its deficit is still above 9% of GDP. Its best option would be to fast-track some key and visible investment projects that would likely generate a positive reaction from an industry that has done very little capex over the last two years. Monetary easing would likely involve cutting liquidity restrictions first, followed by rate cuts.
Brazil: Brazil has been very aggressive in raising rates against a backdrop of terms-of-trade shocks and currency strength that have boosted spending but stalled production. A slowing global economy would reverse these shocks and currency strength, bringing the Brazilian economy into better balance and allowing the central bank to roll back rate hikes.
Russia: Russia has plenty of scope for fiscal easing, given its fiscal surpluses. The more flexible currency regime would act as a buffer against a drop in the USD-denominated oil price. Finally, easing liquidity conditions and policy rate cuts could also be part of the package.
Turkey: The central bank's appetite for easing is some of the best news that markets could have received. A good fiscal position means that the room for fiscal easing also exists and could be used.
Poland: The fiscal situation is very tight for Poland, with debt close to the crucial 55% mark. However, given recent hikes, there is plenty of scope for monetary easing.
Some smaller EM economies are worth mentioning, given circumstances. Hungary, even if the central bank wanted to cut rates, might have to watch risk appetite. Any deterioration in risk could put the currency under pressure, keeping the central bank from cutting. Some relief could come from a postponing of fiscal austerity measures. The Czech Republic could similarly delay fiscal tightening. If rate cuts there aren't enough, there is a chance that it could consider QE-style policies.
For more details, see Asia Pacific Economics: Implications from Sovereign Debt Issues in Eurozone and US, August 9, CEEMEA Economics: Back to 2008?..., August 9, and "The Risk to Abundance Returns", This Week in Latin America, August 8.
"If You Choose Not to Decide, You'll Still Have Made a Choice" (Rush, in Their Song Mission)
In a nutshell, restrictions on EM easing are limited, but so is the appetite to ease. By not opting to ease aggressively or pre-emptively, EM policy-makers may be choosing to act much more aggressively afterwards.
Some Encouraging Early Signs - EM ‘Soft Peg' to the Dollar Weakens
The recent sharp appreciation in the RMB against the USD is an encouraging sign if it is a harbinger of a more robust pace of appreciation against the dollar. For China, it shifts the burden of responsibility of keeping inflation under wraps to the exchange rate, freeing up space on the monetary side to ease as needed. Thus far, EM policy-makers have tried to keep their currencies competitive against the RMB. As it depreciated in trade-weighted terms thanks to USD weakness, but appreciated very slowly against the USD itself, EM currencies were ‘soft pegged' to the USD. If the RMB appreciates appreciably faster, then this peg weakens, giving EM central banks more legroom. Add to this the pre-emptive (and prescient?) rate cuts from the Central Bank of Turkey, and EM policy-makers have more room as well as precedent to follow. Whether they will use this space early enough is another question.
The Other Side of This Argument
What if DM growth is only going through a soft patch. The last payroll and retail sales numbers from the US were strong. Would pre-emptive easing by EM economies not be a mistake, given that they have just about won a battle with overheating and inflation? We have been proponents of the need to do more to win the war, not just a battle, with inflation. Having been on the wrong side of the growth argument thanks to a rather dramatic drop-off in growth, we believe that easing early has a better risk/return trade-off than waiting for developments. Overheating and inflation are issues that central banks are much more adept at dealing with than growth that is spiralling downwards when policy options are limited.
Economic and Market Contagion
Slowing DM growth will work its way through to EM economies via exports, external balance sheet vulnerability (including funding problems) and worsening risk sentiment, which can lead to portfolio outflows as investors move out of risk to protect their portfolios. EM external balance sheets are in much better shape than they have been in the past, but funding stress still puts EM economies at the mercy of the famously difficult to predict nature of financial markets. Exports remain a link against which few EM economies have built defences via domestic demand.
The CEEMEA region appears to be first in the line of fire in the EM world, given its close links to Europe, and due to the fact that it lagged the AXJ and LatAm regions in the recovery process, implying weaker economies relative to the rest of the EM world in general. AXJ economies are, unsurprisingly, vulnerable via their export links, but have strong external balance sheets and lots of policy options. LatAm economies are in better shape than they have been in the past to deal with a global slowdown, but this does not make them immune to a slowdown, in our view.
External Vulnerability - Far Lower than in the Past
Our analysis suggests that Turkey, India and Brazil remain vulnerable to external balance sheet constraints on an overall basis. Their long-term potential, however, suggests that the downside even for vulnerable economies in the EM domain is far more limited than it has been in the crises of the past.
From the perspective of relying on portfolio inflows (and hence on risk appetite), Poland, Turkey, South Africa, India and (to a lesser extent) Brazil run deficits in their current accounts as well as the ‘basic balance' (the part of the current account financed by long-term FDI inflows). Our Brazil economist, Arthur Carvalho, suggests that Brazil may be more vulnerable than numbers suggest since many portfolio flows may have entered the economy under the guise of FDI inflows in order to circumvent the impediments and costs on portfolio inflows.
Some economies do have short-term external funding requirements (as a percentage of total external debt) that are relatively high, but the holdings of excess reserves that these economies possess are so much higher that a temporary disruption in funding markets can be overcome without any dislocations to the domestic economy. Should such a condition arise, however, the concern in markets could rise to very high levels.
Despite strong balance sheets, funding markets could be the Achilles' heel of external vulnerability, as was the case to a large extent in 2008 when debt markets froze and trade and other types of financing requirements ground to a halt. This time around, markets are extremely liquid and policy-makers will likely work hard to keep them so. However, liquid markets can also see spreads and funding costs rise rapidly, which means taking immunity for granted appears to be unwise (see Channels of Financial Market Contagion - Funding Risks, August 11).
Contagion via Trade and Commodity Prices
If DM economies see a sharp slowdown in the months ahead, the primary source for economic contagion is likely to be via global trade and the effect on commodity prices. The obvious candidates for maximum exposure to trade are AXJ economies where trade is a fairly large percentage of GDP. However, CEEMEA and LatAm economies will likely suffer too. Commodity exporters dispersed within these regional classifications are also at risk, because a decline in global trade would almost certainly lead to a sharp drop in commodity prices, delivering a sudden and negative terms-of-trade shock.
There are some automatic stabilisers built into the system. A deterioration in oil prices would help net importers of oil. Re-exporters like the Central European economies and Mexico would see export prices fall but would see import prices fall as well. While these relative benefits would help, the overall impact of a global slowdown would be a negative one.
The breakdown of the exposure that EM economies have to the US, Germany and China shows CEEMEA economies exposed to Germany, and AXJ and LatAm economies exposed to both the US and China (with the latter accounting for a growing share of EM exports, particularly from AXJ and LatAm economies).
The plight of commodity exporters is perhaps best exemplified by the telling case of LatAm exports. The overwhelming role of commodities in their export profiles has created many complications for policy. A sharp drop in trade and commodity prices would hit LatAm economies twice over, creating yet another difficult proposition for policy-makers to deal with.
Summary
There are two sources of contagion for global growth shocks to affect EM economies, but only one of them is inevitable if there is a shock to global growth. The inevitable one is the link that has been forged through economic and market linkages. Specifically, the trade links between DM and EM economies and the implications for commodity prices will have a significant impact on EM growth if DM and global growth slows down, taking global trade and commodity prices lower. Contagion through external balance sheet vulnerabilities appears lower at this point, but funding market tension could hurt EM economies.
The evitable one is weakness in EM economies as a result of policy inaction or delayed action from EM policy-makers. As of now, they have far more options than DM policy-makers. Indeed, the very fact that DM policy-makers are constrained should prompt EM policy-makers to do more than they would otherwise have.
Absent the kind of tail risks that were present in the world in 2008, and having barely emerged from a battle with inflation and overheating, it is somewhat predictable that EM policy-makers don't want to use the nuclear option (at least at this stage). However, if they do not act aggressively, they need to at least act pre-emptively. Some action from the renminbi and the Central Bank of Turkey is encouraging, but lingering inflation risks could keep EM policy-makers from being pre-emptive. But if EM policy does not deliver an aggressive or a pre-emptive response, the risk of a DM shock moving us back to the dark days of 2008 should rise. By choosing not to act aggressively or pre-emptively, EM policy-makers may be choosing to act aggressively later.
An extremely volatile week across global markets ended with Treasuries showing sharp 7-year-led gains as concerns about the US economic outlook continued to rise, with worries about market turmoil and political and economic uncertainty further hitting consumer and business sentiment, the FOMC predicted no increase in rates before mid-2013 and the potential for resumed easing, and worries about the impact of the European debt crisis on growth and the banking sector remained high even as there was some notable improvement over the course of the week in key EMU government bond yield and CDS spreads. Risk markets swung wildly back and forth in response to these developments and the S&P downgrade, which was not taken seriously in the Treasury market, which also supported gains in rates markets. After a brutal start Monday, the S&P 500 ultimately closed down only 1.7% for the week - after daily changes of -6.7%, +4.7%, -4.4%, +4.6% and +0.5% - and the Euro Stoxx 50 index lost 2.9%. Hit relatively harder by rising worries about banks, credit did a lot worse, however, with the IG CDX index widening 12bp to 115bp and the iTraxx Europe index 14bp to 150bp. It was a light week for economic data, and mixed results - better-than-expected jobless claims figures that pointed to a solid August employment report, and upside in core retail sales that implied slightly better consumption growth in 2Q and 3Q, but a much wider-than-expected trade deficit that pointed to a significant downward revision to the net exports add to 2Q GDP growth and a drag on 3Q - had little market impact. Instead, market focus moved from the S&P downgrade Monday, to the FOMC meeting Tuesday, and then largely back to developments in Europe through the rest of the week.
The Fed did not take any new policy actions at Tuesday's meeting but did fire a warning shot by indicating that it discussed a range of options - which appear to go beyond mere balance sheet adjustments - and is prepared to act as necessary in response to a significantly downgraded economic outlook and rising downside risks. The FOMC statement also said "extended period" now means that the fed funds rate is expected to remain near current levels through at least mid-2013. There was no "pledge" in the statement not to move rates before then as some media incorrectly claimed, and the market was already effectively largely pricing in no rate hikes over that period before the meeting anyway. But this Fed guidance did lead to risk premia in eurodollar and fed funds futures of the possibility of earlier rate hikes being largely priced out - the July 2013 fed funds futures contract gained 36bp on the week to 0.175% and the June 2013 eurodollar futures contract 40bp to 0.535% - and supported the strong gains in the intermediate part of the Treasury curve and an even bigger rally in the MBS market. We are eager to hear details of the potential new easing measures that were discussed at the meeting. Just more Treasury buying or an extension of the duration of the current Fed holdings seem unlikely to have any significant market or economic benefit, with the 10-year real yield already now actually below zero. We think that a further cut in the interest rate the Fed pays banks on excess reserves (IOER) to zero or even negative territory could be a more impactful approach to trying to stimulate lending and lower extremely high liquidity preference.
Meanwhile, S&P's downgrade of the US sovereign rating spooked the stock market Monday and added to already extremely negative public views of the competency of government economic policies. Indeed, the University of Michigan survey reported that a record high 61% of respondents in the first part of August rated government economic policy as poor and a record low 6% as good. S&P's decision and reasoning - altered to focus on politics after the Treasury Department indentified a major error in its previously debt- and deficit-focused report - was not taken seriously by the Treasury or CDS markets (the US 5-year CDS spread actually tightened 5bp on the week to 50bp). And after the initial market reaction Monday, the main impact of the S&P move shifted towards the impact it had on worries about the sustainability of France's AAA rating, given its higher current and expected government debt/GDP ratio than the US over the next decade. There was a much better tone in European sovereign CDS Thursday and Friday, but through mid-week this was offsetting the positive impact of the ECB's decision to expand SMP buying to Spain and Italy after disappointing markets at its last meeting by initially only buying Irish and Portuguese bonds. After ending the prior week at 145bp (after rising 40bp in two weeks), France's 5-year CDS spread widened to a record 175bp close on Wednesday, before rebounding to end the week 11bp wider at 156bp. Italy and Spain also widened significantly on Tuesday and Wednesday and then tightened back Thursday and Friday, but they were starting from a stronger level after a substantial positive response Monday to the ECB's weekend SMP buying decision, so for the week Italy's 5-year CDS spread tightened 30bp to 355bp and Spain 55bp to 355bp. Along with the solid late week improvement in CDS, government bonds in France, Italy and Spain improved substantially, tightening significantly against rallying German Bunds (in 10-year spreads by 16bp on the week to 65bp for France, 105bp to 268bp for Italy, and 103bp to 266bp for Spain).
While this better tone was developing, however, the focus of investor worries about the impact of the European debt crisis appeared to be shifting to banks from governments. This was reflected in the relatively weak performance of corporate credit markets and significant upward pressure on interbank dollar rates and spreads over overnight funding costs on indications of insufficient dollar availability for European banks. 3-month Libor fixed Friday at 0.290%, up 2bp for the week and 3.5bp in the past two weeks. The market is pricing further upside in the months ahead, with the Dec 11 eurodollar futures contract selling of 11bp to 0.53%. This boosted the December forward Libor/OIS spread by 11bp to 43bp compared to the current spot spread of 19bp and more normal levels near 12bp seen in June. This upward pressure came as the implied 3-month dollar lending rate in EUR/USD FX forwards markets rose 30bp on the week and 60bp in the past three weeks to near 1.05%. Investors are increasingly wondering how strained dollar interbank lending conditions might need to become before the ECB would decide to tap its FX swaps line with the Fed to lend dollars in European markets. For now, upward pressure on Libor is representing some mild tightening in financial conditions, though importantly, repo markets are functioning fine after some short-term disturbances ahead of the resolution of the debt ceiling fight.
On the week, benchmark Treasury yields fell 11-38bp, with the intermediate part of the curve leading and the front end lagging as it pretty much ran out of room for further gains after no change in short rates for the next couple years and minimal term premium was priced in. The 2-year yield fell 11bp to 0.18%, old 3-year 19bp to 0.30%, 5-year 31bp to 0.94%, 7-year 38bp to 1.54%, 10-year 35bp to 2.19% and 30-year 15bp to 3.67%. Except at the short end where inflation expectations fell significantly in response to some softness in oil prices, all of the week's gains reflected lower real yields, with inflation breakevens in the 10-year and 30-year sectors rising on the week. The 5-year TIPS yield fell 28bp to -0.95%, 10-year 36bp to -0.04% and 30-year 22bp to 1.01%. The 5-year/5-year forward inflation breakeven based on the Fed's constant maturity yields figures rose 6bp to 2.76%, in the upper end of the historical range since 2003. Markets appear to be reflecting an expectation that easy Fed policy will keep inflation from slowing much but won't do much to help growth. The MBS market had a great week, as the prospect for a further long period of near zero short rates and expectations for muted volatility in this environment encouraged carry trades. Current coupon MBS yields fell about 40bp on the week to near 3.25%. Current coupon mortgages currently have an estimated option-adjusted duration of near six years, close to the 7-year Treasury currently yielding 1.54%, so in relative terms the yield pick-up from shifting into MBS is still quite large. Primary mortgage rates have been somewhat sticky as MBS yields have plunged in recent days, with some of the major originators facing capacity constraints. If the recent gains are sustained, however, it should eventually drive 30-year mortgage rates towards record lows near 4% after a decline last week to an average of 4.32% in Freddie Mac's survey.
Retail sales gained 0.5% in July, with auto sales (+0.4%) up much less than implied by the surge in unit sales and gas stations (+1.6%) seeing a solid price-related gain. The key retail control gauge - sales ex autos, gas stations and building materials - rose 0.3% on top of an upwardly revised 0.4% (versus +0.1%) gain in June. July upside was led by grocery (+0.5%), electronics and appliances (+1.4%), furniture (+0.5%) and clothing (+0.5%) stores, while the revision in June was boosted by a upward revision in clothing (+1.2% versus +0.5%) that left it more in line with strong chain store sales reports. The better June sales numbers point to an upward revision to 2Q real consumption to +0.3% from +0.1%. We now see 3Q on pace for an acceleration to +2.3%, a bit better than our prior +2.0% estimate, to a significant extent reflecting a sharp expected rebound in auto sales as recovering production boosts dealer inventories.
The trade deficit widened $3.2 billion in June to $53.1 billion, a high since 2008, with exports down 2.3% on top of a 0.5% decline in May and imports falling 0.8%. Export weakness reflected sizeable and broadly based declines in food, industrial materials and capital goods. Autos were flat and consumer goods up significantly, but only because of unusual surges in gems and jewelry. The drop in imports was mostly accounted for by a price-driven drop in oil. Other major import categories were little changed, including, surprisingly, autos. The widening in the deficit in real terms was larger, with real goods exports down 3.3% and imports down 0.2%. This pointed to a smaller add to GDP growth in 2Q from net exports and the likelihood of a drag in 3Q of about 0.5pp.
The upside in core retail sales and previously reported strength in business construction spending point to upward revisions to consumption and investment in 2Q, but the trade deficit surprise and monthly inventory reports in the past couple weeks point to more-than-offsetting downward adjustments. At this point, we see 2Q GDP growth being revised down to +0.9% from +1.3%, with the trade contribution lowered to +0.2pp from +0.6pp, inventory contribution lowered to -0.1pp from +0.2pp, and final domestic demand (GDP excluding trade and inventories) revised up to +0.9% from +0.5%. At this early point, we see 3Q GDP growth tracking near +3.0%. About half of this expected gain reflects the sharp rebound in motor vehicle production from the 2Q supply chain disruptions, which should be apparent in the July industrial production report on Tuesday. On the spending side of the national accounts, the pick-up to +2.3% consumption growth we expect should largely reflect much stronger auto sales, some rebuilding of auto inventories after a steep drop in 2Q accounts for most of the 0.8pp inventory contribution we project in 2Q, and a pick-up in business purchases of motor vehicles should add a bit to investment. Beyond the significant near-term boost to growth from the big auto sector rebound, recent economic, political and market developments - with the collapse in public confidence in government economic policy particularly striking - are pointing to a sustained period of more sluggish growth, as it seems increasingly likely that the damage done to business and consumer sentiment will lead to slower growth in spending and rising precautionary savings instead. With consumer balance sheet repair well advanced, business balance sheets in excellent shape, and economy-wide inventory levels low, a recession doesn't appear likely though to us.
The economic data calendar is busy in the coming week. The CPI report on Thursday is the most important release, and while it is likely to show a further acceleration in core inflation, the FOMC statement suggested that this is less of a bar to further easing than the Fed had previously been indicating as priority seems to have shifted towards the full employment half of the dual mandate. Initial expectations for the key upcoming August employment and ISM reports will be guided by the initial regional manufacturing surveys - Empire State Monday and Philly Fed Thursday - and weekly jobless claims. Jobless claims this week will cover the survey period for the August employment report. Claims have continued trending lower from the May highs in recent weeks, pointing to a solid August employment report on top of the improved July results. We expect the 4-week average of initial claims to fall to 399,500 this week, down from 422,250 in the survey week for the July employment report, 426,250 in June and 440,250 in May. A significant rise in business cautiousness driven by recent market turbulence and rising economic and political uncertainty might lead to softening in job growth in the months ahead, but the August employment report will probably be pretty solid. Data releases due out this week include housing starts and industrial production Tuesday, PPI Wednesday and CPI, existing home sales and leading indicators Thursday:
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