Economic activity in the developed markets

Market participants and economists expect that there is an ongoing linkage between the buoyancy of risk asset valuations and pricing, and economic conditions, and with 2013 having provided strong returns, seemingly discounting strong economic recovery and growth in 2014, so there were no shortage of forecasters projecting a significant step up in economic activity. Such forecasts went arm in arm with the premise that there’d be gradual normalisation of bond markets and the Bloomberg consensus forecast as at end 2013 for the US Treasury 10 year bond yield at end 2014 was 3.44%. As the data now show, amongst the Developed Markets, the UK economy led the charge, growing by 1.6% in real terms over the first half of the year, with much of the expansion due to special factors, whilst Germany only managed 0.5% real growth, the US just 0.4%, whilst France experienced no growth, Italy’s economy contracted 0.3% and Japan also shrank 0.3%. Outside the key developed markets, China’s economic activity in the first half of 2014 seems to have been quite modest by its own standards, with annualised growth in Q1 perhaps down to 3.5%, and whilst the rebound in Q2 has not yet been confirmed, it was likely quite modest. Taking an overall view, on a weighted average basis, we can estimate that real GDP growth for the G7 in the first half of 2014 was around 0.4%, and after taking account of inflation, nominal GDP growth in US dollar terms at current exchange rates for the G7 was around 1.5%, although a chunk of that is down to exchange rate movements rather than actual growth.
In the context of this disappointing growth picture, US Treasury 10 year yields of 2.4% look reasonable if not attractive for investors with significant ‘real’ liabilities, and put simply, and contrary to the message offered by the ever buoyant, but increasingly statistically flawed PMIs, the global economy did not recover in the first half of 2014. As a consequence, investors who positioned portfolios to reflect the expectation that there would be no early rate hikes and no shift up in liquidity seem to have performed better than those that bet on a strong cyclical recovery.
Digging into the details, it’s arguable that the picture was even worse. Thus growth in Germany in the first quarter growth was helped by mild weather rather than by an ‘inflationary boom’, as was largely assumed by analysts and commentators, and policies designed to address structural challenges remain tricky – for example, with Italy, it would seem that renewed fiscal austerity overwhelmed the support received from the impact of resurgent capital inflows on the monetary system. Meanwhile Canada’s economy has been losing momentum of late as its housing boom has receded and although some of the weakness in the US during the first quarter can be explained by the weather, albeit that the bad weather did drive a very significant increase in energy production and consumption, the rebound in the second quarter was very modest, and excluding inventories, US real domestic demand growth in the first half of the year was only 0.5% annualised.
In the UK, mild weather may have helped GDP but the bulk of the improvement in domestic demand can be explained by the one-off benefits of substantial compensation payments made by banks directly to households. We can estimate that without these payments UK GDP growth would probably have come in at less than 1% annualised.
The aggregate picture for the major economies for the first half of the year turned out to be notable weakness relative to prior expectations and in absolute terms also. In seeking an explanation for the disappointing growth trends, the principal culprits would seem to be weak household income trends, particularly within economies facing ongoing austerity measures, combined with continued very weak rates of credit expansion within the real economies.
Looking forwards, whilst US household income growth has improved slightly, trends in Euroland remain very weak, they are soft in the UK, and disastrous in Japan. Therefore, whilst many commentators still forecast a rapid acceleration in growth in the second half of the year, in practice we may expect that whilst G7 growth should be better in the second half, any improvement will likely be quite modest.