Not counting chickens05 April 2016

After a sluggish start to the year, the first signs that industrial activity may be stabilising have

emerged as JP Morgan's global manufacturing PMI edged up to 50.5 in March, from 50.0 in

February. The improvement in the month was led by the output and new orders components,

which increased by 0.9 and 0.8 index points respectively, to 51.2; while the employment and export

orders components both remained in contractionary territory (see Chart 1). Declining employment

was likely a consequence of the lagged effects of earlier output weakness, together with the

natural reaction of industrial firms to weak earnings. Falling export orders in the presence of rising

output and new orders suggests that the lift in demand was primarily being satisfied by domestic

producers.

The pick-up in global manufacturing sentiment is encouraging, but it is too early to tell if a turning

point in activity has been reached. Sentiment can be volatile from month to month and does not

always reflect genuine changes in the underlying trend in activity. For example, China was one of

the biggest improvers in the month, which could reflect the benefits of recent policy stimulus but

may also be related to the timing of the Chinese New Year. Certainly, the rest of Asia was a mixed

bag; sentiment in Taiwan, Indonesia and Vietnam improved, but it deteriorated in South Korea,

Malaysia and Japan. The drop in Japanese activity was especially large and highlights growing

question marks over the future of Abenomics. Elsewhere, European manufacturing sentiment

picked up slightly, led by Ireland, the Netherlands, Italy and Germany. The weaker sentiment

readings recorded in Greece, France and the UK may be due to elevated political risk. Meanwhile,

it is hard to get an accurate read on the trend in US manufacturing sentiment. The Markit PMI

increased only slightly and remains close to a multi-year low, though it is still at a level consistent

with mild growth in production. The more widely-followed ISM Index increased more strongly, albeit

from a lower base, led by a surge in new orders. Although it will take time before it is clear which

is providing the more reliable signal, we are doubtful that elevated new orders can be sustained,

given the softness in manufacturing fundamentals.

Contributors

Authors:

Jeremy Lawson

Govinda Finn

James McCann

Alex Wolf

Editors:

James McCann

Stephanie Kelly

Chart Editors:

Carolina Martinez

Alessandro Amaro

Contact:

Jeremy Lawson,

Chief Economistjeremy_lawson@standardlife.com

Who's afraid of the external wolf?

After a soft Q4, in which the Bureau of Economic Analysis (BEA) now estimates that the economy grew at a 1.4% seasonally

adjusted annualised rate (saar), Q1 is likely to be even weaker. After a big drop in March, light vehicle sales were down in the

first quarter as a whole, leaving personal spending on track to grow just 1.5%; well down on last year’s pace and the

weakest outturn since Q1 2014 (see Chart 2). Sluggish consumption growth is a problem because there are few other drivers of

growth to be found. Net exports will weigh on growth again in Q1, while the trend in non-structures capex spending remains flat,

though investment in structures is growing at a healthy clip. March did see a healthy rise in the manufacturing ISM, led by a surge

in new orders, but the Markit PMI edged up more modestly and the combination of soft consumption, weak external demand and

elevated inventories suggest that new orders will drop back gain in the coming months. As has been the case for some time, the

healthiest economic signals are coming from the labour market. Nonfarm payrolls continued to increase at an above-200k pace in

March, while the upward trend in the employment-to-population rate was maintained, propelled by another increase in labour force

participation (see Chart 3). The only disappointment was that implied trend productivity growth remains anaemic.

Despite the continued strong performance of the labour market, Federal Reserve (Fed) chair Janet Yellen gave a wide-ranging

policy speech last week, which revealed that she has become more concerned about downside risks from the global

economy and financial markets, justifying a more accommodative path for interest rates. She also elaborated on the rationale for

the Fed’s cautious view on core inflation, observing that short-term developments can be volatile. With further pass-through from

earlier dollar appreciation likely and some measures of inflation expectations running low, medium-term inflation risks are tilted to

the downside. Yellen also chose not to push back against the market’s dovish expectations for Fed policy, instead pointing out

how lower market rates had helped shield the economy from recent shocks. She then went on to argue that the current stance

of monetary policy was sufficiently accommodative because the neutral real interest rate (that which is neither expansionary nor

contractionary) – which the Fed currently estimates is close to zero – remains above the actual real rate – which is -1.25% once core

PCE inflation is subtracted from the federal funds rate. This implies that the economy should continue to growth modestly above

potential, ensuring further progress on the Fed’s employment and inflation goals. Further out, her view is that that the neutral rate

will gradually rise over time to around 1%, allowing the Fed to lift rates while still maintaining a modestly accommodative stance. If

neutral real rates do not increase, the terminal fed funds rate will naturally be much lower.

Overall, it was hard to detect any urgency in the speech about lifting interest rates. April is almost certainly off the table,

meaning that a rate rise will not come into play until at least June. For now, we maintain our view that two rate hikes are still possible,

but external and financial risks will need to dampen, alongside an improvement in domestic growth indicators. A healthier labour

market is clearly a necessary, but not sufficient, condition for tighter monetary policy.

Author: Jeremy Lawson 2 05 April 2016

Weekly Economic Briefing www.standardlifeinvestments.com

Getting defensive

The Office for National Statistics has, as usual, revised up GDP estimates. Growth is now believed to have risen 2.3% last year,

with household consumption contributing 1.7 percentage points (ppts) of this increase. Investment played a supporting role, adding

0.7 ppts to growth, although it seems likely that firms will be more cautious over coming months as political uncertainty around the

EU referendum builds. Indeed, the latest Deloitte CFO survey reported that the referendum is now seen as the biggest risk

to large companies. When we add broader economic and financial concerns, the share of CFOs who rate the uncertainty facing

their business as above normal has jumped to 83%. Unsurprisingly, this has weighed on risk appetite, with respondents favouring

more defensive balance sheet strategies, such as reducing costs and increasing cashflows (see Chart 4). We have to be a little

cautious interpreting these data. While large corporates are an important part of the economy, smaller companies account for a

larger aggregate share of economic activity. Moreover, SMEs might be less directly sensitive to the UK’s relationship with the EU.

However, it seems fair to assume that investment and hiring will be weaker over the first half of the year as the vote approaches.

Given the softness in global trade and attempts, albeit slightly watered down, to tighten the fiscal purse strings, the onus is even

more on household spending to support short-term growth. Thus far, the resilient UK consumer looks to be up to the job, helped

by a boost in incomes on account of low inflation. However, this does not provide a sustainable growth mix in the longer term. The

hope is that any pause in businesses investment proves temporary, in order to broaden an increasingly imbalanced upturn. This

imbalance is also being reflected in current account dynamics. These provided a nasty surprise at the end of last year, with

the current account deficit widening to a record 7% of GDP. This is being financed by huge capital inflows, particularly in the

form of portfolio investments. Political uncertainty has created concern that the market could be less willing to finance the current

account shortfall. Indeed, sterling has weakened by 7% in trade-weighted terms since the turn of the year and the cost of insurance

against a more pronounced depreciation has increased to levels above those seen during the financial crisis.

Policy setting is becoming increasingly difficult in the current environment. At home, we have seen signs of growth moderating

while the global backdrop remains rocky, illustrated by wild swings in financial markets. Meanwhile, inflation is running well below

target, albeit largely on account of weak commodity prices. While the Bank of England believes that spare capacity is almost

exhausted, this has yet to translate into material domestic inflationary pressure. Finally, there are tentative signs that credit growth

is starting to accelerate, creating concerns that financial imbalances may be building (see Chart 5). At present, the Bank is using

macroprudential tools to tackle concerns over financial stability. Last week, it announced an increase in the capital that banks

must hold relative to risk-weighted assets. This gives it the scope to allow monetary policy to help cushion some of the short-

term headwinds. However, questions remain over the efficacy of this dual policy approach over the longer term.

Author: James McCann 3 05 April 2016

Weekly Economic Briefing www.standardlifeinvestments.com

Staying cautious

The European Central Bank (ECB) has made its move. Last month, it announced a package of easing measures that comfortably

exceeded market expectations on most counts. Asset purchases will be broader and more aggressive, while the central bank

has redoubled its credit easing efforts. Markets were admittedly disappointed that President Draghi signalled a reluctance to cut

rates much further, although we were more relaxed with this reticence, given our scepticism over the efficacy of negative interest

rates. The central bank will now be keenly watching the data to see how large an impact the deteriorating global and

financial backdrop will have had on domestic activity. At first glance, the latest array of survey data might give it some heart.

Following a weak run, the Eurozone manufacturing PMI rebounded a little to 51.6, supported by an improvement in most member

states. Similarly, the German IFO survey regained a little of its lost ground, helped by an improvement in current conditions and

expectations. However, these tentative improvements still left most survey data signalling weaker growth than that seen through

much of 2015. Therefore, while the ECB might take some encouragement from signs of stabilisation in global manufacturing, it will

want to see a much more marked reacceleration before it becomes more optimistic.

The central bank is likely to have reacted to the latest inflation data with a similar degree of caution. The closely-followed core

measure of price growth provided a rare upside surprise, rising to 1% year-on-year (y/y) in March from 0.8% y/y in February.

However, scratching beneath the surface, this increase looks to have been at least partly driven by seasonal effects. Services

inflation jumped to 1.3% y/y (previous: 1.1% y/y) with the early timing of the Easter holidays helping to push the volatile air fares

component sharply higher over the month. Accordingly, the ECB will closely watch how price growth evolves in April, with some

payback from this seasonal factor likely. More generally, the central bank will want to see signs that inflationary pressures

are increasing on a sustained basis over a number of months. Key to this will be the evolution of unit labour costs. While it is

positive that February saw a 13th consecutive decline in the Eurozone unemployment rate, there remains little evidence that slack

has been reduced sufficiently to bolster wage pressures (see Chart 6). The central bank will need to engineer a sustained period

of above-trend growth in order to meet this objective.

Above-trend growth will require a well-functioning financial sector. Perhaps the strongest signal that the ECB can take from the

recent data was the resilience of bank lending data in the wake of a sharp rise in financial stress. Indeed, loans to households

accelerated to 2.2% y/y in February and loans to non-financial firms were up to 0.6% y/y (see Chart 7). Draghi and co. will again

be slightly cautious when interpreting this improvement. There may be lags involved between building stress and tighter credit

conditions. However, if this is sustained, it provides an encouraging signal that the transmission of monetary policy to the real

economy is not being blocked. Moreover, with the ECB offering even more generous funding and incentives to lend under its new

TLTROs, the scope for the financial sector to support growth should increase further.

Author: James McCann 4 05 April 2016

Weekly Economic Briefing www.standardlifeinvestments.com

The mask slips

There is a growing perception that the best of Abenomics may be behind us. Not only has the domestic economy stalled but

overseas demand trends have turned sour. Industrial production slumped 6.2% month-on-month (m/m) in February, the weakest

reading since November 2011, with the deterioration in the inventory-to-shipment ratio firmly pointing to a contraction in industrial

output in the first quarter. The news from the BOJ’s flagship corporate survey provided little reassurance either. Japan’s export-

sensitive large manufacturers reported a significant deterioration in business conditions, with the headline index plunging to +6

from +12 in the previous quarter.

For a better assessment of domestic demand conditions, it is useful to look at the SME sector. Here, the news of late has been

less downbeat. The Shoko Chukin Index pointed to greater resilience in the smaller company sector, rising in March for a second

consecutive month to 48.8. The Tankan too pointed to a less severe downturn in business conditions among smaller companies,

with manufacturers and non-manufacturers experiencing a -4 and -1 point decline respectively. However, the more forward-looking

elements of the survey suggest that these companies may simply be lagging their larger peers. Small enterprises plan to reduce

capex by a disappointing 19.3% y/y in FY2016, while profit expectations fell into negative territory at -5.4% (see Chart 8). Firms

have a habit of revising these measures as the year progresses but, even factoring that in, the outcome is underwhelming. If the

breadth of disappointment in the BOJ’s Tankan Survey is upsetting, the timing is even more galling. We are three years

into to the BOJ’s unprecedented monetary stimulus and the desired virtuous circle has failed to materialise. Yes, both

basic wages and corporate profits have risen but risk-averse household and corporate sectors have saved, rather than spent, rising

incomes. This has raised justifiable concerns about whether monetary policy can dispel Japan’s deflationary mindset. We have

written extensively about the challenges to policy transmission, including weak wealth and credit effects, as well as the impact of

non-price competitiveness concerns on the currency channel. However, we still believe higher inflation remains the best hope

for Japan. Indeed, the fact that the BOJ Tankan shows that proxies of the output gap – such as the production capacity, diffusion

index, and employment conditions – have started treading water, augurs for a further monetary policy response (see Chart 9).

Whether other economies in the region also merit a more aggressive monetary response is a more controversial question.

In Korea, central bank Governor Lee Ju-yeol recently attacked claims from ruling party members that monetary policy should be

eased further to support growth, citing structurally higher inflation and growth. The robust defence is clearly aimed at defusing a

potentially explosive issue ahead of upcoming parliamentary elections. However, the more important consideration for the BOK will

be the composition of growth rather than the level. The Bank appears cautious about stoking further credit growth in the household

sector, fuelled by a strong property market. However, with industrial output growth remaining tepid, averaging just 0.3% m/m in the

first two months of the year, the Bank may be forced to act in the absence of a sustained acceleration in trade.

Author: Govinda Finn 5 05 April 2016

Weekly Economic Briefing www.standardlifeinvestments.com

March madness

Emerging markets assets have rallied over recent weeks as risk sentiment rebounds. However, the lack of economic improvement

in many economies leaves open the question as to whether the rally is sustainable and how long it can last. The rally has

been indiscriminate; markets have improved across regions and asset classes, Brazilian equites are up over 30% since January,

Chinese A and H shares are up 13% and 17% respectively, and EM currencies are up 6%. Economic data has been more mixed; on

a positive note EM PMIs generally improved in March to their highest level in a year, following a weak start to 2016. The improvement

was broad, with only Turkey and Russia seeing a decline among the major EM economies. However, other data points to sustained

weakness; industrial production is uniformly soft and trade continues to disappoint. Average industrial production growth rates

(y/y) in Latam, EMEA, and Asia are -4.2%, 1.1%, and 2.6% respectively – the weakest figures since the global financial crisis.

Furthermore, global trade has continued to deteriorate and does not yet appear to be bottoming out. Among the 30 largest EM

economies, only three have positive trade growth this year.

That said, factors other than economic fundamentals combined to boost EM risk sentiment. Dovish remarks by Fed Chair Janet

Yellen signaling gradual rate increases, combined with improving sentiment in China and rising commodity prices, have boosted

flows to EM funds. The Institute of International Finance reported that EM flows turned sharply positive in March, surging to a 21-

month high of $37 billion. Behind much of the improvement in EM is the view that China’s economy has stabilised, following recent

bouts of policy and economic instability. As such, a closer look at China’s data can determine how sustainable it may be. Since

the GFC, China’s economy has been heavily driven by the housing sector. Much of the rapid growth following the crisis was due

to construction activity and much of the weakness over the past two years was due to slowing property investment. Therefore, the

recent rise in property prices, construction, and manufacturing PMIs – after months of declines – were taken as a sign that the

economy is stabilising.

However, we believe it is likely still too early to call for stabilisation for three reasons: property inventories are still very

high, improved housing prices are highly concentrated in three regions, and much of the recent economic activity has been

driven by quasi-fiscal spending. China’s inventories began a healthy correction last year, as new starts continued to contract.

Policies to boost sales began to show dividends, as developers worked through excess supply. This process has largely stopped,

however, as new starts surged in February on the back of price increases. Inventories still have further to fall before reaching healthy

long-term levels. Additionally, price improvements have been highly concentrated in three regions: greater Beijing; Shanghai; and

Shenzhen (see Chart 10). When you strip out the cities that fall in those greater metropolitan areas, average prices are now just

beginning to rise but nowhere near the surge we are seeing in the overall average. Lastly, improved investment has been driven

by SOEs not private firms (see Chart 11), an inherently unsustainable surge considering the weakness among many SOEs. A

rebound based on property exuberance and quasi-fiscal stimulus means it might be more transient than the market wants

to believe.

Author: Alex Wolf 6 05 April 2016

Weekly Economic Briefing www.standardlifeinvestments.com

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