The U.S. Economy
The U.S. Federal Reserve at its September meeting once again did not raise the Federal funds rate. Stronger economic data earlier in the summer increased expectations for a Fed move, but data for August that was released before the meeting painted a less optimistic picture of the U.S. economy and likely contributed to the Fed's decision. December is now the focus for when the Fed might next raise its policy interest rate.
There were weaker data for both manufacturing and services in August. The Institute for Supply Management's manufacturing purchasing managers' index (PMI) fell into contraction in August, reversing the trend of stronger readings in recent months. The non-manufacturing PMI fell as well, dropping to a six-year low (but remaining in expansion territory). We remain of the view that the U.S. economy will move along at a slow and subdued pace, and that the Fed will follow a shallow and gradual pace of interest rate normalization, continuing to heed external risks to growth just as much as their dual mandate of stable prices and maximum employment.
In terms of inflation, the difference between the core readings of the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) deflator has expanded during the last couple of years. Currently, the year-over-year difference is largely due to the way in which each measure calculates medical care prices. CPI incorporates only the out-of-pocket health spending of households, and it indicates that medical care prices have risen sharply recently. The PCE deflator includes spending by Medicare, Medicaid, and private insurers. This calculation of expenses reflects more subdued medical care inflation.
This is interesting to consider in the context of overall inflation and the factors the Fed considers as it evaluates whether to raise interest rates, but it also could be noteworthy in terms of consumer spending. As a result of the Affordable Care Act, there have been changes to the way Americans pay for health care. There is the possibility that the U.S. consumer might not be as strong as recent data suggest, since mandatory spending (e.g., out-of-pocket medical care expenses) could be driving consumption and crowding out discretionary spending.
Regarding the labor market, the nonfarm payroll report released at the beginning of September showed that the economy created 151,000 jobs in August, a decline from an average of 273,000 in June and July. The growth of average hourly earnings fell to 2.4% year over year, the lowest rate since March, and average weekly hours worked declined as well. Nevertheless, the unemployment rate was unchanged at 4.9%.
Like the U.S. Federal Reserve, the European Central Bank (ECB) left monetary policy unchanged in September, although President Mario Draghi emphasized that rates would remain at current levels or lower for an extended period. He also mentioned that the ECB is exploring a redesign of its quantitative-easing program, which currently is set to expire in March.
We believe quantitative easing - where central banks create money by buying securities from banks with funds that did not previously exist - will probably continue beyond March since inflation and inflation expectations remain far below the ECB's target of 2%. Underlying growth and inflation conditions in Europe are unlikely to change soon, as the headwinds are structural.
The Bank of Japan (BoJ) bucked the trend and did make policy changes in September. The BoJ announced a commitment to allow inflation to overshoot the current 2% target. The central bank also said it would seek to control yields across different maturities of government debt, and specifically mentioned setting a floor for 10-year bonds at around a zero yield. This is due in part to the fact that the yield on 10-year government bonds has fallen below zero this year following the BoJ's move to institute negative short-term interest rates.
The BoJ acknowledged that while its policies have been designed to lower long-term borrowing costs in the hope of boosting the economy, those policies might now be generating negative side effects that could damage the financial system. The difference between short and long-term borrowing costs in Japan has largely disappeared, meaning it has become challenging for banks to make money.
We think it will be very difficult for Japan to escape its current deflationary and zero growth environment without the government pursuing structural reform or ramping up fiscal policy. The question is whether the government is now more willing than it has been to make the changes necessary to boost growth and achieve inflation targets.
In China, debt has continued to accumulate because of government efforts to prop up the slowing economy. Data from the Bank for International Settlements, which monitors the activity of central banks, estimates that China's total credit outstanding was 255% of gross domestic product (GDP) as of the end of March. Although this was lower than the aggregate ratio for all advanced economies (279%), the eurozone (271%), the United Kingdom (266%), and Japan (394%), there is concern about how quickly China's debt has risen. It has increased from 147% of GDP in 2008, which could be worrisome given that China is a developing economy and its financial system might not be sophisticated enough to hold that much debt sustainably.
We believe it is unlikely that China will experience a crisis from this growth in debt because the government controls the country's banking system and it has a low level of foreign held debt. Nevertheless, we see many sectors in China becoming increasingly less attractive investment options because market forces are not the primary driver for the economy anymore.
Source: FactSet. Analysis: Manning & Napier Advisors, LLC (Manning & Napier).