First Quarter U.S. Slowdown Casts a Temporary Global Shadow
The decline in U.S. economic activity during the first quarter was more than earlier estimates, and appears to have weakened business sentiment in other parts of the world. Most of the fall in U.S. aggregate output was due to temporary factors such as adverse weather and port disruptions that led to delayed export shipments. The stronger dollar also reduced the earnings growth of large U.S. corporations with a global footprint. While U.S. economic growth is widely expected to recover in the coming months, investors were also disappointed by the slower than expected consumer response to lower fuel prices. It appears that most households have been cautious in increasing their spending, despite the savings from cheaper fuel. However, this could change if fuel prices remain at current levels and the labor market gains further. U.S. consumer sentiment in May was brighter when compared to the previous months, and should help retail sales growth.
In the Euro-zone, labor markets in several countries continue to improve and should have a positive impact on consumer spending. Retail sales growth data for the month of April was above expectations, sustaining the positive trends from earlier months. Credit to households is now expanding at a moderate pace while the volume of business lending is no longer declining. More positively for the European Central Bank, there are signs of core inflation picking up.
Global equity markets were mostly unchanged in May as gains in the U.S. and Japan were offset by declines in select European and Asian developed markets, as well as most emerging markets. Manufacturing activity growth moderated across most major regions, except the Euro-zone, while the global services sector continued to see robust growth.
International Equity Prices Witness Moderate Correction
International equity prices saw a moderate correction in May, giving up part of the gains from the first two months of the year. The weaker than expected U.S. economic output during the first quarter dampened investor sentiment, as slower U.S. growth could restrict the pace of expansion in several other economies as well. The recovery in oil prices also forced investors to reduce expectations about consumer spending growth across the world. In Europe, negotiations to provide additional financial support to Greece to avoid default dragged on without a result. Though it is widely expected that the European Union will make some concessions to end the stalemate, warnings from the IMF and the U.S. government about the potential fallout of a deeper crisis in Greece unnerved the markets. Among the developed markets, most major markets in Europe, Canada, Australia, and Singapore declined during the month. Emerging markets underperformed during the month as markets in Latin America and Europe corrected after the previous month’s gains.
Global manufacturing output expanded at a faster pace in May when compared to the previous month, helped by gains in the U.S., Japan, as well as select European countries such as Spain, and Italy. Among the developing countries, manufacturing growth accelerated in India and select Eastern European countries. China continued to report subdued factory output while Russia, Brazil, and Korea reported declines. New order flows continued to improve for the manufacturing sector, which should help sustain the growth momentum in the coming months. Global services growth also continued to expand in May, though the pace of growth was slower when compared to the previous month.
International Equity Near-Term Outlook
Global economic growth appears to be gradually emerging out of the relatively soft start to the year. The decline in U.S. economic output, due to a wider than expected trade deficit, was the biggest drag on global growth during the first quarter. However, continuing labor market gains and healthy consumer confidence should lift U.S. growth during the current quarter as well as for the second half of the year. The Federal Reserve is not expected to increase interest rates until the last quarter of this year. Most Fed officials appear to be in favor of very gradual increases after the first rate hike. This should keep borrowing costs low in the U.S. for a longer period and support consumer demand. Stronger U.S. demand should benefit the rest of the world, especially exporters of manufactured goods from Asia and Latin America.
The growth outlook for the Euro-zone remains healthy as the European Central Bank’s monetary measures have helped revive business and consumer confidence. The ECB now expects the common currency region to expand 1.5 percent this year and 1.9 percent in 2016. The risk of deflation that worried investors and policymakers in the Euro-zone for the last few years has faded as core inflation moved close to 1 percent in May. To lift inflation closer to the target of 2 percent, the ECB believes the current quantitative easing measures need to be sustained through the third quarter of 2016.
The Japanese economy grew at a healthy 2.4 percent annualized during the first quarter, providing early vindication of the policies followed by the central bank and the government. Household spending has recovered from last year’s steep fall while the Japanese are also turning more positive on housing. Low interest rates and rising wages are likely to support housing demand this year.
Emerging Markets Equities Correct as Latin America and Europe Retreat
Emerging markets corrected in May, as markets in Latin America and Europe retreated again after the previous month’s rebound. Brazil declined the most among the large emerging markets on concerns that inflation risks and political uncertainties could limit economic activity in the near future. Mexico continued to outperform among Latin American markets on expectations that healthier U.S. consumer demand could lift exports from the country. Markets across Europe, except Turkey, gave up part of their gains from previous months. Among Asian markets, China, Korea, and Malaysia declined the most while India and Indonesia saw moderate recoveries from previous months’ losses. South Africa also underperformed as the country’s GDP growth slowed during the first quarter.
Manufacturing activity weakened across most large Asian emerging economies during the month of April. In China, an official index of factory activity was almost unchanged while the HSBC China Manufacturing PMI index declined for the first time this year. Output also declined in Korea and Indonesia, while India remained a bright spot and reported one of the fastest monthly gains so far this year. In Europe, manufacturing activity increased at a marginal pace in Turkey while Russia continued to decline at nearly the same rate as the previous month. Output continued to decline in Brazil where the manufacturing sector also saw larger losses. In contrast, factories in Mexico added more jobs and output growth remained strong, though the pace moderated from the previous month. Services activity increased at a steady pace in China and the stronger than expected increase in new orders suggest that the gains could continue in the coming months. India also reported further gains in services sector activity, though the pace was lower compared to the previous month.
Emerging Markets Equities Near-Term Outlook
The recent moderation in emerging markets manufacturing output growth is likely the result of businesses reacting more cautiously to the larger than expected first quarter economic decline in the U.S. In addition, factory activity in the large resource exporting countries such as Brazil and Russia remains weak as low energy and commodity prices have limited domestic demand and investments. However, the U.S. economy is expected to see a healthy rebound during the second half of this year, led by consumer demand. U.S. labor markets continue to strengthen and wages gained further in May. Higher incomes are likely to buoy U.S. consumer sentiment in the coming months and lift demand for manufactured goods exported from Asia and Latin America. Though oil prices have recovered from the lows seen earlier this year, retail fuel remains cheaper than last year and should help household budgets. In addition, higher demand from Europe could also benefit emerging market exporters as recent growth trends from the Euro-zone have been better than expected.
Concerns about lower liquidity flows to emerging markets are also anticipated to ease in the coming months as the U.S. Federal Reserve is unlikely to increase interest rates before the last quarter of this year. While the U.S. economy is expected to rebound quickly from the first quarter decline, the Fed has been cautious about global risks in its recent policy statements. The International Monetary Fund has also urged the U.S. Fed to delay the first rate hike to next year to avoid risks to growth. Quantitative easing by the European Central Bank and the Bank of Japan should continue to ease global liquidity even after the Fed hikes rates. In addition, the successful conclusion of the negotiations to extend financial support to Greece could reduce the risk of lower capital flows into emerging markets.
GLOBAL INDUSTRY SPOTLIGHT FOR THE MONTH: MATERIALS
After the steep fall over the last two years, prices of industrial materials have recovered some ground in recent months. The price of iron ore has rebounded more than 35 percent since April of this year while copper prices have gained close to 15 percent since January. Reports of lower inventories, concerns about reduced supplies, as well as expectations of healthier global demand have driven the recovery. Nevertheless, prices of both metals remain below last year’s average and substantially lower than the record highs seen before 2008 when the commodity super-cycle started unravelling. Moreover, the meaningful discount for futures contracts relative to spot prices for iron ore suggest that the recent advances are led by short-term factors.
Demand for industrial materials such as iron ore, copper and nickel is considered to be a good barometer for the health of the global economy. During periods of vigorous industrial growth, higher demand and prices of these minerals typically boost investments into the mining industry. This was certainly the case before the 2008 global financial crisis, when emerging economies led by China expanded at an unprecedented pace and scale. Equity market valuations of miners and metal producers soared to record levels as these companies enjoyed strong earnings growth. The healthy cash flows and easy access to capital led to a significant capacity expansion, with several mega projects in the pipeline that would have increased capacity consistently for several years.
After the first wave of massive fiscal stimulus measures to recover from the global recession, China and other emerging countries have scaled down their spending on infrastructure projects. In addition, industrial demand for metals in Europe remained anemic for several years as the region struggled with a deep fiscal crisis. In the U.S., few industries have invested in capacity additions in recent years as they have focused on efficiency gains instead. Constrained by budget deficits, governments in most developed countries have also reduced their outlays for infrastructure. All these trends combined to pressure the prices of industrial metals lower. The last two years saw sustained falls in iron ore and copper prices as it became more evident that the Chinese government is less inclined to scale up infrastructure spending to boost economic growth.
From this perspective, it seems unlikely that the recent recovery in prices will sustain over the medium to long term. None of the large emerging countries are likely to step up infrastructure investments to match the levels seen in China before 2008. The Chinese government has clearly articulated that the country will gradually shift from a growth model dependent on exports and investments to a model driven by domestic consumer demand. While growth in consumer demand for housing, automobiles and other durables should lift metal consumption, the expansion from current levels is likely to be more gradual. Hence, it is unlikely that Chinese demand for industrial metals will see sharp surges as in the past.
The demand outlook for the developed countries is also restrained, and is unlikely to offset the slack in emerging markets demand. While Europe is now seeing sure signs of a moderate recovery, most governments are still constrained by slow growth in tax revenues and commitment to austere fiscal plans. It is difficult to see them embarking on a meaningfully large upgrade of their infrastructure in the near term. Sectors such as automobiles that are among the largest users of metals are seeing healthy demand growth more recently, even in Europe. Nevertheless, it could take a few years of sustained demand expansion before the metal producers bring down their current capacity surpluses.
Finally, despite the weaker prices, the supply of metals has not declined. Some of the projects, which were being implemented when the financial crisis hit, came on stream in subsequent years. For instance, global copper output has continued to expand in recent years even as prices fell from nearly $10,000 per ton in 2011 to $6,000 per ton last year. Similarly, after a moderate dip in 2009, global steel production has consistently increased in subsequent years. The leading mining groups and metal producers formed after industry consolidation now enjoy significant scale and cost advantages that allow them to maintain production levels even when lower prices push out smaller players. Unless some of the larger producers are forced out, it is unlikely that the metal producers could regain pricing power in the near future.
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