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Weekly Economic Commentary • Principal Global Investors

Covering the week ended August 8, 2014 — Published on August 15, 2014

Revising up U.S. growth

Could second-quarter U.S. growth surpass the initial 4.0% print? Yes; the plunge in the June trade deficit suggests another 0.2%, as real exports rose 0.3% and import volume sank 1.7%. Other data also show positive momentum: the employment index from The Conference Board hit its best level since January 2008; July light vehicle sales ticked down but to a still robust 16.4 million annual rate; the fourquarter total of bankruptcy filings fell to the lowest in six years; surveys of service-sector purchasing managers are shining with the ISM index the highest since December 2005; factory orders and shipments for June were good and past reports were revised higher; jobless claims near record lows say companies are laying off fewer workers; small business optimism is rising; productivity rebounded smartly in the second quarter; and banks are loosening mortgage lending standards while seeing greater loan demand.

Profits are the key to U.S. growth. They determine whether companies feel comfortable expanding plants, equipment, and hiring. Profits are the source of productivity growth, wage hikes, new jobs, and capital spending. Without profits, the country stagnates, with or without monetary pump-priming or fiscal largesse. In simplistic terms, nominal GDP, a proxy for company revenues, rose 6% in the second quarter, but employee compensation jumped 6.1%, suggesting that economy-wide profits calculated by the Bureau of Economic Analysis (BEA) could have been flat after a large decline in the first quarter, i.e., no big rebound. Profit growth should pick up but last week’s report is a cautionary tale.

Recessionistas Back to the Eurozone?

Yes, at least in Italy, after its first report of a second straight quarter of economic contraction. Italy is an economic laggard in the Eurozone, perhaps accompanied by France, and the target of critical comments by European Central Bank (ECB) President Draghi at this week’s ECB meeting (see below). The Eurozone recovery appeared to stall mid-second quarter as momentum fell and data was weaker than expected. But, there were positives: business surveys perked up in July back near the highs of the cycle; the composite Purchasing Managers Index (PMI) rose to 53.8; retail sales have grown for three straight months and are up 2.4% over the prior year in June; and while historically very low, auto sales in the four largest countries are up nearly 8.0% from the low. The demand side of the economy is recovering faster than the supply side, as industrial production is very weak. The United Kingdom is a beacon of prosperity as business surveys, house prices, and new auto registrations are very strong. Clearly, the geopolitical problems in Ukraine and expanded sanctions are hurting economies across the Eurozone, especially Finland.

The Future of Mexico Is from Its History

With U.S. growth picking up and fast rising wages making China much less competitive, the future is turning brighter for Mexico. For decades, the story was about unrealized potential. A large, young population, an increasingly skilled labor force, and access to the huge U.S. consumer market have been negated by structural problems and political inefficiencies. Now, current President Enrique Peña Nieto is trying to change that by embarking on an extensive and comprehensive program of economic reform.

Since assuming power, Mr. Peña Nieto has had to contend with tough issues: an uncertain economic outlook, inefficient public sector, opaque bureaucracy and police, outdated political and voting institutions, an ineffective national school system, and widespread corruption. Many of these problems came from decisions of his own political party over the years, as the Institutional Revolutionary Party (PRI) has governed the country for decades and have created many of the current inefficiencies and bureaucratic processes. The President must now force special interests to make uncomfortable sacrifices to create a solid foundation for future growth. The reforms he has announced are widespread and encompass many aspects of the economy: education, criminal justice, political transparency, and agriculture, among others. However, there are three vital areas for reform—energy, public finances, and communications—that will have a profound and beneficial impact on the country and its future.

ECB: Treading Water, Wanting a Weaker Euro

At this week’s meeting, the ECB’s governing council did what was expected: nothing. It left its main refinancing rate at 0.15% and the deposit rate and marginal lending rate at -0.1% and 0.4%, respectively. The historic easing steps taken at the June meeting were deemed sufficient despite the Ukrainian headwinds facing the Eurozone recovery. ECB President Draghi did say that external shocks that endanger the inflation outlook could trigger more activist policy such as broad-based asset purchases. “The Governing Council is unanimous in its commitment to use unconventional policy measures like ABS purchases, like QE, if our medium-term outlook were to change. We will closely monitor the possible repercussions of heightened geopolitical risks and exchange rate developments,” said Draghi.

Geopolitical risks have risen. The United States and the Eurozone implemented stiffer economic sanctions against Russia after the Malaysia Airlines tragedy. In response, Russia placed import bans on a broad array of food items from the United States, Europe, and other countries. Draghi, however, said that the “interconnections” between the Eurozone, Russia, and Ukraine were of a “very limited” nature, though, he did admit “it’s hard to assess the impact at the beginning of these crises.” What is not difficult to assess is the fact that recent Euro area economic data has been weak, pointing toward an increasingly fragile recovery. Italy already revealed a -0.2% contraction in secondquarter GDP; and Germany announced a 3.2% drop in June factory orders from May, the sharpest dip since September 2011, suggesting a very weak second quarter. The German Economic Ministry cited geopolitical tensions depressing the outlook. Consumer prices in the Eurozone advanced just 0.4% in July over the prior year, down from 0.5% in June.

Emphasize the Euro

This is likely why Draghi is embracing a weaker euro as a policy tool. The euro is down about 5.0% against the U.S. dollar over the past three months, but Draghi is cheering for a further slide to boost inflation and juice growth via exports. While he didn’t express his sentiments that openly, he did state at the press conference that the “fundamentals for a weaker exchange rate are today better than they were two or three months ago.” These fundamentals include sharply lower Eurozone interest rates; narrower trade surplus; reduced capital flows; safe haven purchases of bonds of countries with stronger currencies; and the growing divergence between ECB policy and the Fed or the Bank of England; both appear poised to raise rates far in advance of the ECB. Of course, the ECB has yet to implement further aggressive policy of large purchases of public and private assets. That would likely put significantly greater downward pressure on the euro. Draghi’s remarkably clear comments about exchange rates highlight a level of concern about the challenges facing the ECB as it seeks to enhance growth and bring inflation back toward its target.



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The commentary represents the opinions of Principal Global Investors* and may not come to pass.

*Principal Global Investors and its affiliates are sub-advisors of many of the Principal Funds.

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