Irish GDP grows at average annual 5.5% in H1.

The available labour data shows that Irish employment continued to grow very strongly in the first quarter of the year (by an annual 3.5%) and the decline in the unemployment rate since implies that  pattern is still intact. One would expect GDP growth to be stronger, given normal productivity growth, and although the Irish quarterly GDP figures are extremely volatile, the picture from the National Accounts  is  broadly consistent with the employment data; annual GDP growth in q2 was 5.8%, following a 5.2% rise in q1, to give an average for the first half of the year of 5.5%.The figure for the full year is likely to be lower, given the surge in reported GDP in the latter part of 2016, and we expect around 4%.

On a quarterly basis GDP expanded by 1.4% following a revised 3.5% contraction in q1. The latter reflected a plunge in investment spending, mainly related to mulinational R&D , and that reversed in q2, duly accounting for most of the rise in GDP. Consumer spending actually fell, by 1.1%, and on the published national accounts consumer spending is now only 34% of GDP and only marginally ahead of capital spending- in most developed economies the former is well above 50%.

The CSO now publishes a separate figure , Modified Domestic Demand, to give a better picture of underlying spending and output in the Irish economy, as it strips out multinational flows into R&D and aircraft leasing . On that metric real demand grew by an annual 4.2% in q2 following a 5.8% rise in q1, so the average increase over H1 is  still a very healthy 5.2%, indicating that the underlying economic performance remains strong. One puzzle is  limp  consumer spending, averaging growth of  just 1.8%, which is modest given the strength of employment growth alongside 2% growth in pay. and zero inflation. Domestic investment spending is expanding at a robust pace, in contrast, with annual growth averaging 15% over the first half of the year, albeit hiding a mixed performance, with buoyant construction offsetting a  fall in domestic spending on machinery and equipment.

Overall, it would seem that the Irish economy continues to expand at a robust pace, if one discounts the extraordinary short-term volatility and adjusts for the distortions caused by the sheer scale of the multinational flows.

QE is fuelling Irish House Prices

Irish residential property prices have risen 60% since the lows of early 2013 but  this cycle is investor rather than credit driven. Gross mortgage lending for house purchase has picked but the average new loan has risen by just 28% over the past four years, implying a fall the average loan to value ratio, while data on transactions (recently revised up by the CSO) indicates that mortgage loans  still appear to be accounting for less than half of turnover in the market. New lending is also now constrained by the Central Bank’s mortgage controls.Moreover, net mortgage lending ( i.e new lending minus repayments) has been falling now for over seven years, although there are recent signs that it may finally be bottoming out.

Nothing here then to indicate that credit is playing a strong role in driving prices and it is curious that little attention has been paid to the impact of the ECB’s monetary policy  on the housing market, and, more specifically, its  non-standard measures including the asset purchase programme. The latter, QE, is designed to boost bond prices and hence lower yields so that ‘ investors may choose to take the funds they receive in exchange for assets sold to the ECB and invest them in other assets. By increasing demand for assets more broadly, this mechanism … pushes prices up and yields down, even for assets that are not directly targeted by the APP’.

QE is generally perceived as having a significant impact on equity markets and it would be odd if it did not therefore impact other  asset markets, including property, and we  can readily  see this at play in the Irish data on transactions. In 2011, investors (here defined as Buy to Let individuals  plus non-household buyers) accounted for 16% of residential transactions rising to 24% by 2012 and averaging a third of the market or more since 2014.

The yield on ‘risk-free’ assets , such as Government bonds, plays a big role in investment decisions and so the plunge in Irish Bond yields has been  a very significant backdrop for the Irish residential and indeed commercial property market : 10-year Irish yields peaked at double digit rates in mid 2011 but really started to fall sharply following Draghi’s ‘whatever it takes’ speech in 2012, and fell below 1% , where they still reside, following the commencement of QE in early 2015.

In contrast, the gross yield on residential property ( average rent/ house price) has not declined significantly in our rental model, and is still at 4.8%, having peaked at 5.4% in 2013. The rental yield fell to  a low of 2.75% during the last cycle, and is still well above the post EMU average (4.25%) and of course extraordinarily high relative to the ‘risk free’ rate available on Irish bonds, let alone Bunds.

The scale of investor interest in Irish property is therefore not surprising given the yield on offer and  is unlikely to disappear any time soon. Higher bond yields would make a difference, no doubt, and in that context the future of QE plays a part; the ECB will soon decide whether to scale back its asset purchases or indeed cease any additional buying. Yet it is likely to reinvest the proceeds of maturing bonds for a while at least, therefore maintaining the stock of QE, so absent an inflation shock bond yields may well stay low by historical standards. If so investor interest in Irish property will continue to be a big driver of the market.

Irish Mortgage Lending crimped by supply and competition from non-debt buyers.

The latest data from the BPFI on  Irish new mortgage lending shows that 6,781 loans  for house purchase were drawn down in the second quarter, with the annual increase at 17.6%, providing further evidence that the year as a whole is likely to see a substantial increase on the 2016 total of some 25,000. Yet the annual pace is slowing, following a 26% increase in q1, and on our seasonally adjusted model  lending actually fell on the quarter. What is more striking though is the unusually large divergence between mortgage approvals and actual drawdowns ; approvals for house purchase in the second quarter amounted to 10,250. Looking at the picture over the first six months, approvals stood at 18,576 against a drawdown total of 12,634 , which is a wide gap even allowing for the usual lags between approval and purchase.

Buyers with approval may delay purchase if they are nervous about the market but survey’s suggest that price expectations have risen of late so that would normally bring forward the timing of transactions. The alternative explanation is that buyers with approval are being squeezed by the limited supply of property for sale and the prevalence of would-be purchasers not reliant on debt finance. The ECB’s QE is compressing yields on financial assets, making residential property a more attractive alternative. Judging by the CSO figures on transactions (executions) in the first quarter, mortgage loans are still  only accounting for around 50% of the total ( the q2  transaction data have  yet to be published).

The BPFI data also reveals that the average mortgage for house purchase is now just under €214,000. 8.1% above the previous year and at levels last seen in early 2010. In cash terms mortgage lending for house purchase  in the quarter amounted to €1.45bn and overall lending rose to €1.65bn when top-ups and re-mortgaging is included, bringing the total for the half-year to some €3bn. Our forecast for the full year is currently €7.2bn but we are likely to revise that down, given the  slowing momentum in the numbers drawdown.

Nonetheless, new mortgage lending is growing and it now appears is finally close to offsetting repayments, with the latest Central Bank data on net lending showing  that the  monthly decline in that series is now extremely small. Irish household deleveraging started  in mid-2008 and one doubts if few or any thought it would last this long.

The Fed versus the Market

Central Banks set short term interest rates and can influence longer term rates  but the market is in control of the latter and determines financial conditions in general. At times, financial conditions can move in the opposite direction to the stance of monetary policy, and we have a good example of that playing out now in the US.

The Federal Reserve has tightened policy and has signalled  this process will continue; the Fed Funds rate target is currently 1% higher than it was eighteen months ago, following four rate increases,  and the FOMC expects conditions to evolve that will ‘ warrant gradual increases‘ over time. Furthermore, the Fed’s Balance sheet will start to shrink ‘relatively soon’, as the Central Bank stops reinvesting some of the bonds purchased under QE. Yet the market is currently giving a 60% probability to rates being unchanged by year end, and broader financial conditions are now looser than they were when the Fed started to tighten.

Indeed, financial conditions in the US have rarely been easier, according to The Chicago Fed’s Financial Conditions Index. This uses over 100 financial variables (including the exchange rate, equity market volatility, credit spreads and the yield curve) to derive a weekly snapshot of risk, liquidity and leverage in the US. It is clear that the Fed is therefore at odds with the market; the former believes it is time to tighen policy, albeit gradually, while the latter acts as if the economy does not need such medicine.Moreover, some FOMC members have voiced concern that loose financial conditions carry risks for financial stability and increase the chances of a sharp correction in asset prices.

Why is the market shrugging? Unemployment is very low and  is around what many think  of as full employment, but inflation remains stubbornly below the Fed’s 2% target, and has eased in recent months. The economy is growing but at a modest pace ( 0.9% over the first half of 2017) and the market may well believe that inflation will stay low for structural reasons, contrary to the Fed view of a gradual pick up to target.

Does this  divergence matter? After all, official rates may be higher but policy  remains accommodative  ( the real Fed Funds rate is still negative) and it may well be that financial conditions may indeed move if rates do rise steadily from here, as indicated by Fed projections. If not, the Fed may have to raise rates more aggressively if it wants to secure a tightening in financial conditions overall. An inflation shock would change things but for the moment at least  markets  simply do not believe that the Central Bank needs to tighten as much as the Fed itself thinks. One of them is wrong.

Irish economy contracts sharply in Q1 but annual growth still 6.1%

According to the CSO the Irish economy, as measured by real seasonally adjusted GDP, contracted by 2.6% in the first quarter of 2017. This still left the annual increase in GDP at 6.1%, however, following substantial revisions to the quarterly pattern in 2016, with growth of 3% in q3 and a bumper 5.8% in q4. The impact on  annual growth  for 2016 was only marginal ( now 5.1% from 5.2%) but the CSO revised up nominal GDP over recent years by significant amounts; the 2016 figure is now €275bn, a full €10bn above the previous estimate and a massive €100bn above GDP in 2012.

This is the denominator used to measure the various debt and deficit ratios incorporated into the Euro zone’s  fiscal rules, and means that Ireland’s debt ratio last year is now 72.8% as opposed to over 75%, with every likelihood of a 70% reading in 2017. Yet many have argued that a better measure of domestic economic activity is required, given the extraordinary influence on the national accounts of the mulitinational sector. Personal consumption is now only 35% of GDP, for example, and is only €9bn higher than Investment spending, 32% of GDP. To that end the CSO, for the first time, have published a modified national income figure. This takes GNP ( which is lower than GDP as it adjusts  for net  cross border income outflows such as profits and interest payments) and deducts the profits of domicilled multinationals as well as adjusting for R&D spending on imports. This gave a figure of €189bn in 2016, compared with a €275bn GDP reading, and a debt ratio of 106%. However, it is clear that the economy has still being growing strongly in nominal terms on the new measure , by 9.4% last year and by 42% since 2012.

Investment spending tends to be the most volatile component of GDP and this was indeed the case in the first quarter, declining by 38% and hence accounting for  the contraction in GDP. Building and Construction rose ( by 5.8%) but this was swamped by a 22% decline in machinery and equipment investment and a 56% plunge in intangibles ( the term for spending on R&D, patents, etc). Virtually all of the latter is imported so service imports also fell sharply ( by over 10%), with total imports down by over 12%. Exports were broadly flat and government consumption barely grew ( 0.3%) leaving consumer spending as the only GDP component showing any positive momemtum, rising by 1.2%. This is still soft relative to retail sales, implying much weaker spending on services, at least as estimated by the CSO. and this divergence has been a feature over recent years.

Where does this leave this year’s annual forecast for GDP growth? The Department of Finance  expect 4.3%  but  the base effects for the second half of the year are now much more negative, albeit against an  annual figure in q1 above 6%. Our own existing forecast is less than 4% and we will produce an update in the next week or so.

Government has €200m to fund tax cuts in 2018 Budget

The Irish Government has just published the Summer Economic Statement which sets out updated economic  and fiscal forecasts, with emphasis on the 2018 Budget, scheduled for delivery in October.  Economic growth this year is still expected to be 4.3%, slowing marginally to 3.7% next year,  while the main change in the fiscal outlook over the medium term is higher capital spending, which means that Ireland continues to run a modest deficit until 2020. The new Minister for Finance also reiterated that a ‘rainy day’ fund  would be initiated in 2019, although now at €500mn per annum instead of the €1bn indicated by his predecessor.

Most interest will no doubt centre on the outlook for the upcoming Budget and the resources or Fiscal Space available to the Government to fund new spending or tax reductions. Under the existing euro fiscal rules an Expenditure benchmark is set and it now appears that Ireland will breach  the 2017 limit by some €500mn or 0.2% of GDP, so the Government now intends to undershoot the 2018 benchmark, albeit modestly.

The latter is determined by the European Commission and dictates that Ireland must limit  spending  next year to  €71.2bn from €69.6bn in 2017, a rise of 2.4% ( the benchmark excludes certain items, notably debt interest and some capital spending).  That gives a Fiscal space of €1.6bn or €2.1bn given that Ireland does not index its tax system (i.e higher prices and wages would increase tax revenue by around €500mn). Some  €800mn of that will be eaten up by demographic pressures on spending and prior commitments on pay, leaving a net figure of €1.3bn, which the Government has chosen to limit to €1.2bn.

That would translate into €1.5bn in cash terms ( because not all of any additional capital spending is included in the  Benchmark) and the Statement indicates that €1.1bn of this will take the form of additional spending ( €0.6bn current and €0.5bn capital ) leaving €400mn for tax reductions. Further, the carry over effects of last year”s cuts will use up almost €200mn of this , leaving just €200mn on budget day to fund  net tax cuts ( leaving aside any refund of water charges)

Of course it is always open for the authorities to free up additional resources by cutting  some existing spending programmes or indeed  raising indirect taxes if it wants to pay for a reduction in income tax or USC. To that end it is noteworthy that the Department of Finance has drawn attention to the cost of the cut in VAT introduced in 2011 to support the tourism and hospitality sector ( from 13.5% to 9%) . The cost of accomodation has risen by over 20% since that move, and reports suggest that the lower rate is costing the Exchequer around €0.5bn. On the available arithmetic the Government will not be able to fund any meaningful direct tax cuts unless it finds money elsewhere.

ECB caught between strong growth and weak inflation

Longer term euro interest rates have moved higher over the past few weeks as the market starts to adjust to what it perceives as an imminent change in monetary policy from the ECB. 10-year German bond yields are trading at over 0.5%, which is still extraordinarly low but compares with a yield of only 0.25% at end-June, so the speed of the move has surprised. A  ‘reflation’ reference by Draghi was the initial  catalyst ( although later played down by the ECB)  and the pace of economic activity has  certainly picked up this year but the problem for the hawks in the Governing Council is that inflation remains stubbornly below target (1.3% in June), with the core rate still remarkably low (1.1%).

GDP in the Euro area  (EA) grew by 0.6% in the first quarter and  strong  survey readings  (the IFO in Germany is currently at  a record high) imply a similar if not stronger figure for q2. On that basis it now seems likely that annual growth in the  EA may emerge at 2.1% or 2.2% this year and hence above the 1.9%  projected in the June  ECB staff forecast. There have only been two previous tightening cycles by the Bank, and the IFO is currently well above the level that has previously triggered higher rates, but , to date, the pick up in economic activity has not put any material upward pressure on prices.

The persistence of low inflation , not just in the EA  but across  other developed economies, notably the US, has prompted a lot of analysis.What is striking is the behaviour of wages, as they have not responded to tightening labour markets in the expected way. That relationship is generally known as the Phillips curve, and the evidence shows that the curve is now much flatter than in the past i.e.  a given fall in unemployment has very little impact on wages. So, for example, EA unemployment has fallen from 12.1% to the current 9.3% but wage inflation in q1 was only 1.4% and averaged 1.5% in 2016.

A range of factors have been put forward for this limp growth is wages; low price inflation, the decline of trade unions, globalisation, the growth of self employment and changes in the structure of the jobs market. Many of these factors are structural and if so, the acceleration in wage inflation expected by the ECB over the next few years may not materialise, despite stronger GDP growth.

The ECB also now tends to emphasise core inflation more than it did under the previous President, but the inflation target is set in terms of the headline rate, and most research shows that to be strongly influenced in the shorter term by commodity prices and the exchange rate. Consequently, the recent fall in oil prices and the appreciation of the euro ( up 8% against the US dollar in the past three months), unless reversed, would normally prompt a further downward revision  in the the next ECB inflation forecast in September.The June forecast itself reduced the inflation projection over the next three years by a cumulative 0.6 percentage points, largely reflecting weaker oil prices. Another point worth noting is that credit growth, although stronger than last year, is still anaemic, a factor referred to in the latest ECB minutes.

So what is the market expecting? It would be difficult for the ECB to claim that there are upside risks to inflation but having stated that the risks of deflation have effectively disappeared the Bank may tweak it guidance on asset purchases, which currently states that ‘we stand  ready to increase our asset purchase programme in terms of size and/or duration‘. In reality, the scope to increase QE is anyway constrained, as in a number of cases the Bank is at or close to the 33% issuer  limit in government bonds. However, the market does not expect an immediate halt to buying by the end of the year, rather a  gradual tapering of the monthly total into 2018.

Yet the ECB would find itself in a difficult situation if inflation fell further over the next few months, as it has argued that QE has been instrumental in boosting the price level and that ‘ a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term’. The Fed  also faces low inflation but can point to its dual mandate ( stable prices and full employment ) to justify tightening,  but the ECB does not have that luxury.

UK housing market ; short term blip or steeper fall in prospect?

The UK economy defied the consensus expectation of a slowdown last year following the Brexit vote, and fears for the housing market were not realised.  The last few months have reignited concerns about both, however, and the news that the Bank of England is  now split on whether to raise interest rates ( a 5-3 vote to maintain the status quo)  won’t help.

House prices have certainly cooled. The Nationwide index for May showed annual house price inflation at 2.1%, the softest pace in four years, with a clear slowing trend; the index has now fallen for three consecutive months, by a total of 0.9%. The picture from the Halifax index is similar, with annual inflation slowing to 3.3% in May, from 6.5% in December. Both indices are based on mortgage lending and the Office for National Statistics (ONS) publishes a broader  but less timely measure, based on Land Registry transactions,  which shows an annual rise of 5.6% for April, albeit also pointing to a slowing trend.  The RICS data, based on a survey of chartered surveyers operating in the residential market.  also reveals a softer market. with a net 17% of respondents in May expecting prices to rise, the weakest reading since the summer of 2016. Buyer and seller inquiries were also seen to have cooled.

Are UK  house prices excessive? The average price in the UK is now £209,000 according to the Nationwide, or 48% above the cycle low in early 2009. Prices are also now well above the previous peak ( £186,000) and are 5.3 times the income of  First Time Buyers (FTB) against  a  long run average of 3.6.  However, interest rates are unusually low; the standard variable rate is over 4% but the effective rate on new mortgages is around 2% according to the BoE, reflecting discounts and lower fixed rates. Consequently , affordability measures do not suggest prices are overvalued; the Nationwide data, for example, shows mortgage payments at 33% of FTB income, bang in line with the long run average. Indeed, for most of the UK regions affordability is much better than the norm, the exception being London, although non-resident purchasers are  more significant in that market.

The supply of housing in the UK is widely thought to be persistently short of the demographic requirement, but completions also fell sharply after the crash, declining to 107,000 in England ( which has the most timely data)  from 170,000 in 2007. Completions have picked up again, in response to higher prices, rising to over 140,000 in England in 2016, and  the  housing starts data points to a higher total again this year. Yet few argue that supply is  still anywhere near demand.

Net mortgage lending  has been growing, in contrast to Ireland, although at a modest pace  relative to historical exerience, but  now also appears to be slowing, with annual growth at 2.8% in April against over 3% for most of the past year. Mortgage approvals for house purchase, a more forward looking indicator,  fell below 65,000 for the first time in six months in April.

This all may relate to uncertainty about Brexit and the short term economic outlook, with the election result also likely to weigh on sentiment. In our view the likelihood  of a more prolonged and sustained period of weakness depends upon the labour market, which to date has held up remarkably well;  the employment ratio is at an all-time high, while unemployment  is still making new cycle lows.  One suspects that UK  lenders and the Government  would only become seriously concerned about the housing market if cracks started to appear in employment.

What to do with the €3bn?

The Government has decided to proceed with the sale of 25% of AIB, and has indicated that it expects to raise around €3bn from the transaction. What to do with the money has been the source of some political debate, although the constraints imposed by the EU’s fiscal rules may leave the authorities with little room to manoeuvre.

The proceeds of the sale will not affect the General Government balance , as under Eurostat rules it is classed as a financial transaction , merely  exchanging one type of asset within general government for another, in this case cash. However, the €3bn inflow will impact the Exchequer Borrowing Requirement (EBR), the  deficit on a cash flow basis. The 2017 Budget made no allowance for  any sale proceeds and projected a €2bn EBR  so on the face of it the Exchequer may now emerge with a €1bn surplus at end-year, assuming the initial underlying target is achieved .

The Budget also indicated that the NTMA would  over-fund in 2017 (i.e issue more debt than required to finance the EBR and to cover redemptions)  so in sum gross Government debt was projected to rise by around €4bn, to  €204.6bn or 72.9% of forecast GDP. Adding in the AIB proceeds would therefore reduce the forecast debt level to €201.6bn, or 71.9%.

The limited impact on the debt ratio ( just 1 percentage point) has prompted some to question whether the money might be better utilised to fund capital or even current spending, with most of the argument centred on the former. Whether this would be wise given that the economy is operating at or even above potential is one consideration, albeit not an argument one often hears from politicians, but there is a more significant constraint; Ireland is subject to the budgetary rules of the EU’s Preventive Arm, designed to reduce the risk of utilising one-off receipts, like the AIB monies, to fund increases in spending.

To that end an Expenditure Benchmark is in place setting a limit on the level of General Government spending ( Fiscal Space) allowed, net of any taxation changes, and the AIB  proceeds are not classed as General Government revenue. Capital spending, it could be argued, differs from current spending in that an asset for the State is created, but total capital spending is not exempt from the spending rule, only any increase relative to a 4-year average. For example, if the Government announced it intended to spend €6bn next year and the 4-year average was €4bn, a net €2bn would be exempt from the Expenditure Benchmark, However, the €6bn would obviously boost the  Budget deficit, which is also subject to EU rules, in this case a requirement to reduce it by at least 0.5% of GDP when adjusted for the economic cycle.

Putting the money aside or into a special fund would make no difference in terms of the above constraints. Ireland could simply ignore the rules, of course, and de facto there seems little prospect of any State being fined for a breach, but one doubts if there would be any appetite from the current Administration for such a move, as it risks alienating  key European partners amid Brexit negotiations .

Stronger euro and weaker oil bad news for ECB hawks

Last December the euro briefly traded below 1.04 against the US dollar and few forecasters envisaged a short term recovery, with a number calling for parity against the greenback. In the event the euro has appreciated, with the past two months seeing a notable rally, taking the single currency above $1.12. The consensus has also shifted, with many abandoning bearish calls in favour of further euro appreciation. Speculative positioning  has also tilted decisively, with the market now running modestly long the euro/dollar for the first time in over three years.

One factor driving the euro is the economic data, which has generally surprised to the upside,  in turn prompting analysts to revise up their GDP projections. As a consequence many now expect the ECB to shift its policy stance, moving initially towards less dovish rhetoric before changing its forward guidance, although a rise in the deposit rate is not fully priced in until the latter part of 2018. In contrast, the US data has tended to surprise to the downside and the market, which was effectively pricing in two further rate hikes in the US this year, is now much less confident about the second ( although  a rise this month is still seen as highly likely)

In its  Staff forecast in March the ECB projected inflation at 1.7% in 2019, predicated on a euro/dollar rate of $1.07 over the forecast horizon. The exchange rate is seen to have a significant impact on prices in the EA and if the next forecast ( due later this week) used a rate of $1.12 that , all else equal, may push the inflation forecast for 2019 down by as much as 0.2 percentage points.

Moreover, the March forecast assumed an oil price around $56 over the next few years, and that now looks too high, given developments of late , with  Brent crude prices falling to around $50 on market concerns that the OPEC cuts have not been sufficient to make an appreciable dent in the unusually high level of crude stocks. Again, a lower oil price projection, say around $50, would shave up to another 0.2 percentage points off the inflation projection.

Of course the Staff may revise up some other components ( wage growth for example) to avoid having to lower the inflation outlook, and one sometimes wonders if the forecast drives ECB policy or the other way round, but on the face of it the combination of weaker oil and a stronger currency should have a disinflationary impact.