Macro Model Quarterly Forecast Update, April 2014

Economic indicators at the beginning of 2014 reaffirm the previous outlook of a slow but robust recovery in developed economies. China’s shift towards a growth rate of 6.0-7.5% over the coming decade is continuing. Events in Ukraine have led to a major downgrade in the outlook for Russia, which is now forecast to grow by 0.9% in 2014 and 2.0% in 2015 (see our Russia forecast update earlier in April ). Trade repercussions on global growth of any tightening of sanctions against Russia are likely to be small, and a cut off in natural gas supplies to Western Europe is at this stage highly unlikely. However, the negative effects on business and consumer confidence from the worsening political relations with Russia could contribute to a more significant slowdown in growth.

Forecast Summary

• We have updated our US GDP growth forecast to 2.7% in 2014 (2.6% in our previous forecast) and 2.9% in 2015 (unchanged from our previous forecast). The main risk on the downside (with roughly 20-25% probability) is for a moderate slowdown in the recovery, with GDP growth of 2.1% in 2014 and 2.5% in 2015. We also assign a 10% probability to a more significant downturn due to lower than expected global growth and reduced confidence in the strength of the recovery. This would lead to economic growth of 1.6% in 2014 and 1.9% in 2015. On the upside, we assign a 25% probability to a more optimistic scenario in which the recovery is faster than expected, with GDP growth of 3.1% in 2014 and 3.6% in 2015.
• Our Eurozone forecast has become more optimistic, with GDP expected to grow by 1% in 2014 (0.8% in our previous forecast) and 1.4% in 2015 (unchanged from our previous forecast). There is still a 15% probability of negative shocks pushing the Eurozone back into recession (see our February update on downside risks to the Eurozone). In our main Eurozone recession scenario (roughly 10% probability), Eurozone GDP would barely increase by 0.1% in 2014 and decline by 1% in 2015. In a crisis scenario (roughly 5% probability), Eurozone GDP would decline by 0.3% in 2014 and by 2.5% in 2015.

• For China, we have maintained annual GDP growth forecasts at 7.4% in 2014 and in 2015. However, risks are tilted to the downside. There is roughly a 20% probability of a worsening slowdown in the second quarter which would reduce growth to 6.6% in 2014 and 6.7% in 2015. Furthermore, China’s excessive debt levels make it vulnerable to a credit crunch which could see GDP growth drop below 5% in 2014. A major downturn due to tighter credit conditions would cause GDP growth to drop to 4.8% in 2014 and 5.3% in 2015 (10% probability). In a more extreme “hard landing” scenario GDP growth would fall to 4.8% in 2014 and 3.5% in 2015 (5% probability).
• Our GDP growth forecast for Japan in 2014 remains unchanged at 1.4%, while we have increased slightly the forecast for 2015 to 1.2%. However, the negative effects of the increase in sales tax starting in April could end up being stronger. We assign a 20% probability to a slowdown scenario in which GDP increases by only 0.6% in 2014 and 0.8% in 2015. A more significant downturn due to the sales tax and loss of confidence in Abenomics would lead to no growth in 2014, followed by 0.3% growth in 2015. We assign this more negative scenario a 10% probability.

Table1: GDP Growth in Major Economies

Source: Euromonitor International Macro Model and national statistics

Table 2: Inflation in Major Economies

Source: Euromonitor International Macro Model and national statistics

The US

• According to the latest estimate GDP increased at an annualised rate of 2.6% in the fourth quarter of 2013, down from 4.1% in the third quarter. However, fourth quarter growth was actually stronger after excluding the unusual increase in inventory investment of the third quarter. Consumer expenditure increased at an annual rate of 3.3% (2% in the third quarter), while business investment increased by 5.7% (4.8% in the third quarter). Durable goods consumption growth decelerated to 2.8% from 7.9% in the third quarter. But the services sector rebounded strongly with a growth rate of 3.5%, following slow growth of 0.7% in the third quarter.
• Unusually severe winter weather reduced economic activity at the beginning of the year. Retail sales fell by 0.4% and factory output declined by 0.8% in January. Purchasing managers’ indices (PMIs) indicate that the manufacturing sector recovered in February and March and the service sector increased at a faster pace in March after a slowdown in February. The average composite Markit PMI for the first quarter was 55.3, indicating solid expansion. Meanwhile, consumer confidence indicators have given conflicting signals but overall still suggest improving sentiment. The University of Michigan consumer confidence index declined in March to the lowest level since November 2013, but the Conference Board’s index increased to the highest level in 6 years.
• The unemployment rate remained at 6.7% in March with employment rising by 192,000 (compared to a monthly average increase of 184,000 over the previous year). This has increased total employment close to the same level as in December 2007 when the unemployment rate was 5%. However, the employment to population rate at 58.9% is still significantly below its pre-recession rate (62.7% in December 2007). Most of this decline is due to lower labour force participation.
• A key question is to what degree the overall decline in the employment rate is due to negative demographic factors, and to what degree it reflects the effects of the financial crisis (for example due to discouraged long term unemployed who have stopped searching for jobs) . Population aging has no doubt been a factor, with the proportion of the 25-54 group (prime working age) declining from 54% at the end of 2007 to 50.3% in the beginning of 2014.  At the same time, even among this prime working age group the employment rate has declined from 79.7% at the end of 2007 to 76.6% in 2014. The shift in this age group probably has little to do with demographics. A recent study from the New York Fed using more sophisticated statistical methods finds that demographic changes account for up to 41.4% of the decline in the employment rate since 2007. The rest of the decline is likely to represent the persistent effects of the great recession on labour markets.
• In its March monetary policy meeting, the Federal Reserve maintained interest rates close to zero and reduced financial asset purchases by a further US$10 billion a month. With the unemployment rate at 6.7%, the Fed dropped its 6.5% unemployment rate threshold for interest rate increases. This gives the Fed more flexibility in maintaining interest rates close to zero even if unemployment declines further. Asset purchases by the Fed are likely to end in the autumn of 2014. Our current forecast is for the Fed to start increasing interest rates in the second quarter of 2015, with the federal funds rate close to 2% by the end of 2016.

Figure 1: 25-54 Year Old Employment Rate

Source: Euromonitor International from federal  reserve economic data (FRED)

The Eurozone

• Eurozone GDP increased by 0.3% during the last quarter of 2013 (compared to 0.1% in the third quarter). The French economy in particular rebounded with 0.3% growth after stagnating in the third quarter. Growth was 0.5% year-on-year (compared to -0.3% in the third quarter), but this positive growth hides significant dispersion across different countries. While the German economy grew by 1.4% year-on-year, Italy’s economy declined by 0.8%. Eurozone consumer expenditure growth in the fourth quarter was tepid at only 0.1%, but business investment started to pick up. Gross fixed capital formation increased by 1.1% during the fourth quarter (compared to 0.6% in the third quarter).
• Current and leading indicators of economic activity also suggest an ongoing recovery. The average composite Eurozone PMI for the first quarter of 2014 was 53.1, indicating the best business conditions since mid-2011.  Retail sales in February were up 0.8% on the previous year, and the European Commission’s consumer confidence index in March reached its highest level since July 2011.
• Labour markets in the Eurozone have been lagging the improvement in growth. The Eurozone’s unemployment rate was 11.9% in February 2014, virtually the same as in February 2013. French unemployment increased slightly over the year from 10.3% to 10.4%, while Italian unemployment increased from 11.8% to 13% over the year. On a more positive note, Spanish unemployment has declined from 26.6% to 25.6% year-on-year.
• Eurozone sovereign bond markets have improved significantly over the year to date. Italian and Spanish 10-year government bond yields have dropped to 3.16% and 3.12% respectively (compared to 1.53% for German 10-year government bonds). The yield spread relative to German government bonds has declined to the lowest level since June 2011 for Italy and to the lowest level since October 2010 for Spain. The Greek government has also returned to international debt markets for the first time in four years, issuing 5 year bonds at a 5% interest rate. Despite this improvement in the sovereign debt markets that were at the heart of the Eurozone crisis, private sector credit markets have yet to recover. Eurozone lending to non-financial corporations fell by 3.1% year-on-year in February, while lending to households only increased by 0.4% over the past year.
• In March, Eurozone finance ministers finally agreed on a European banking union deal, but the deal is quite limited in key dimensions. There will be no common European deposit insurance scheme, no joint Eurozone bailouts of troubled banks beyond a limited fund of €55 billion fund to be accumulated over the next eight years. Furthermore, the failed bank resolution mechanism is quite complex and may be too slow to respond in a financial crisis. As a result, the new deal is unlikely to significantly improve funding conditions for Eurozone banks.
• Low inflation continues to be the main concern in the Eurozone recovery. Year-on-year inflation in March was 0.5%, the lowest level since 2009. This partly reflects energy prices which fell by 2.1% year-on-year. But even excluding energy prices, year-on-year inflation of 0.8% is far from the ECB’s 2% target.
• In these circumstances, the ECB left its policy interest rates close to zero in its April meeting and reaffirmed that it would hold interest rates close to zero for an extended period.  In our baseline forecasts, the ECB starts to gradually increase its interest rates in the third quarter of 2015. ECB President Mario Draghi announced that the central bank would consider using quantitative easing measures, and the German Bundesbank also endorsed the use of such measures for the first time. This significantly increases the likelihood of more unconventional monetary policy measures being adopted in the upcoming ECB policy meetings.

Figure 2: Eurozone Main Economies Year-on-Year GDP Growth

Source: Euromonitor International Macro Model and national statistics

Notes: Forecast starts in Q1 2014

China

• The Chinese economy has continued to slow at the beginning of 2014. First quarter year-on-year GDP growth was estimated at 7.4%, down from 7.7% in the last quarter of 2013. Industrial production expanded by 8.7% year-on-year (compared to 9.7% in the last quarter of 2013), while retail sales increased by 10.9% (compared to 11.5% in the last quarter of 2013). Our baseline forecast is for growth to increase in the second quarter, with output 7.7% higher year-on-year.
• The average Markit composite PMI for the quarter was just under 50, indicating a slight contraction in economic activity relative to trend. Underlying the composite index, service sector activity was expanding above trend with an average PMI of 51.2, while manufacturing activity growth was below trend with an average PMI of 48.7 for the quarter. This pattern is likely to be common over the coming years as the Chinese economy rebalances from a heavy emphasis on manufacturing and investment towards a greater role for services and consumption. In 2013, the share of services in GDP at 46.1% was already higher than the share of manufacturing for the first time.
• The Chinese government has reaffirmed its GDP growth target for 2014 of 7.5%. It seems to have accepted the slower growth rates of 7-7.5% expected over the coming years without undertaking any large fiscal stimulus measures. Instead, the government announced modest measures such as an extension of the halving of corporate income tax on firms with sales below 60,000 Yuan (US$9667) to 2016, an increase in railway construction using a new fund of up to 300 billion Yuan (US$48.3 billion) and new infrastructure projects in areas ranging from information technology to clean energy.
• Year-on-year growth in Chinese M2, a broad measure of money supply, declined to 12.1% in March. This is the fifth consecutive month of decline and the slowest growth rate in a decade. Lending conditions have tightened, as banks have finally started responding to government pressure to reduce lending to sectors with significant excess capacity such as steel production. March saw China’s first corporate default when solar panel maker Chaori missed a bond payment. Small scale defaults are likely to become more frequent over the next few quarters.
• The government has made some progress on financial system reform. In March, Premier Li Keqiang announced a timetable for extending Basel III bank capital regulation to China’s shadow banking sector. China has launched a pilot scheme for new private banks. These would eventually compete with the large state banks and increase the access to credit of private firms, while being easier to regulate than trusts and other shadow banking entities. Stricter regulations on the financing of trusts have been adopted. Finally, the government has developed new guidelines for injecting private capital into state owned enterprises (SOES), a move which in the long run could lead to significant improvement in the productivity of these SOE’s.

Figure 3: Chinese Year-on-Year GDP Growth under Alternative Scenarios

Source: Euromonitor International Macro Model and national statistics

Notes: Forecast starts in Q2 2014

Japan

• Japan’s economy grew at an annualised rate of 0.7% in the last quarter of 2013, the slowest growth since the end of 2012. Domestic demand increased at a solid pace with consumption growing at an annualised rate of 1.6%, and non-residential investment growing at an annualised rate of 3%. The low GDP growth was due to a deteriorating trade balance, with imports increasing at an annualised rate of 14.9%.
• The composite PMI increased in March to 52.8 from 52.0 in February, indicating continuing expansion relative to trend. But the business sentiment component of the index declined to the lowest level since June 2012 due to concerns about the impact of the rise in sales tax. The Bank of Japan’s Tankan survey of business conditions also improved slightly in the first quarter, but respondents forecast a significant deterioration in business conditions in the second quarter.
• Year-on-year core inflation in Japan was 1.3% in February. But core-core inflation was only 0.8% year-on-year in February, suggesting slower progress on the Bank of Japan’s 2% inflation target (core-core inflation excludes more volatile and supply shock affected food and energy prices and is closer to the US definition of core inflation).