Posts tagged Global Economy
Any mention of the European Union in recent days is likely to elicit a bemused shake of the head at the inexplicable ineptness of the entire British government as it dithers over how to dig itself out of the hole its leaders dug for themselves three years ago in deciding to have a referendum on Brexit (we will take this opportunity to reaffirm the prediction we made back in the fall of last year: Brexit will get delayed, then delayed again, and eventually will get put to a referendum and not happen, which is also apparently what investors in the British pound sterling think). But while the world looks on at the impasse between the Continent and those on the other side of the Channel, there is something of potentially larger significance for the EU in the long term. That something is bubbling up in Italy.
On March 22 the Italian government intends to sign a memorandum of understanding with China to participate in the Belt and Road Initiative under the auspices of a package of loans from the Asian Infrastructure Development Bank (AIIB). The signing will take place in conjunction with the visit to Rome by Chinese president Xi Jinping, and it brings a whole slew of testy geopolitical issues right into the heart of the single currency union. Italy is technically in recession, with what is now the second-highest unemployment rate in Europe, and increasingly receptive to China’s attempts to insinuate itself into the nation’s economic and political system.
On the surface of it, things don’t look all that dire from a financial markets perspective. Investors have been pouring into Italy in the opening weeks of 2019. The chart below shows the spread between benchmark Italian 10-year bonds and their German Bund equivalents, which has come down considerably after spiking at several junctures in 2018.
Italian paper now trades at yields around 100 basis points less than last year’s peak. That is hardly a sign of investor confidence in Rome, however, and more a manifestation of this economic cycle’s longstanding obsession: chasing yield. That obsession turned stronger still with last week’s pivot by the European Central Bank back to stimulus mode. As we noted in our commentary last week, the ECB’s about-face is not good news for a regional economy where growth and productivity have flatlined (productivity, which is the key driver of economic growth, contracted in the Eurozone in both the third and fourth quarter last year by the widest margin since 2009). Italy’s domestic woes, headlined by that poor job market and a fall in industrial production, are at the vanguard of the region’s economic ills.
Follow the Money
The practical significance of Italy’s newfound dalliance with China and the AIIB may not be readily apparent for some time yet. The variables that alter the course of complex systems like the global economy don’t always make themselves known in understandable ways. But the Belt and Road Initiative is arguably the largest and most progressive infrastructure project going on anywhere in the world now. The AIIB – and remember that this is a multilateral financial organization aiming to encroach on the longstanding domain of the International Monetary Fund and the World Bank – makes a point of playing by international rules rather than the more secretive practices of, say, the China Development Bank or the Export-Import Bank of China. Its attraction for struggling countries – including those in both western and eastern Europe – is undeniable.
As Europe continues to wrestle with growth and support its own sources of growth financing, it will become ever harder to resist China’s siren song. And that has profound implications for maintaining unity and cohesion within the EU – more profound, perhaps, than even the sorry farce of Brexit.
How do you tell whether someone is a novice investor or a seasoned observer of the ways of the capital markets? Simply pose a question like the following: “Growth data show a marked slowdown in economic activity in key economic regions like China and the European Union. Good or bad for global equities?”
“Bad!” says the novice. “Low growth means a poor outlook for companies’ sales and earnings, and that should be bad for the stock price, right?”
To which the seasoned pro chortles a bit and ruefully shakes his head. “Let me tell you how the world really works, kiddo. That low growth number? That’s good news! It means the central banks are going to prime the pump again and flood the world with cheap money. Interest rates will go down, stocks will go up. Easy as ABC!”
Down Is Up
The logic of “bad news is good news” has been a constant feature of the current economic growth cycle since it began in 2009 (and, barring any surprises, will become the longest on record come July of this year). The key economic variable of this period has not been any of the usual macro headline numbers: real GDP growth, inflation or unemployment. It has been the historically unprecedented low level of interest rates.
Short term rates in the US were next to zero for much of this cycle, with persistent negative rates (a phenomenon which itself flies in the face of conventional economic theory) in Europe and Japan. Central banks argued that their unconventional policies were necessary to restore confidence in risk assets and stimulate credit creation for the benefit of consumer spending and business investment. The evidence would seem to support the bankers’ view, as growth started to creep back towards historical trend rates while labor markets firmed up in most areas. The Fed has drawn its share of criticism for the easy money policies of quantitative easing (QE) from 2009 to 2015 -- but the Bernanke-Yellen-Powell triumvirate will forever be associated with the phrase “longest economic recovery on record” when that July milestone is reached.
Draghi Speaks, Markets Balk
But to return to that conversation between our novice investor and seasoned stock pro: Does “bad news is good news” always work? Is there a point at which the magical elixir of monetary stimulus fails to counter the negative effects of a slowing economy? That is a question of particular interest this week. On Thursday, the European Central Bank (ECB) backed away from its attempt to wean markets off easy money when it reopened the Targeted Longer-Term Refinancing Operations, a stimulus program to provide cheap loans to banks, for the first time in three years. ECB chief Mario Draghi made it clear that the catalyst for this return to stimulus was the steadily worsening outlook for EU economic growth.
This time, though, markets failed to follow the “bad is good” script and reacted more the way our novice investor would think makes sense: selling off in the face of a likely persistence of economic weakness. Italy is already in recession, Germany is only barely in growth territory, and demand in the major export markets for leading EU businesses is weakening, most notably in China. That economy, the world’s second largest, has its own share of problems. A record drop in Chinese exports -- far worse than consensus expectations -- sent Chinese shares plunging overnight Thursday. Other Asian export powerhouses including South Korea and Japan are also experiencing persistent weakness in outbound activity.
Pivot to Fundamentals
In our annual outlook published back in January we noted that weakness in Europe and China was prominent among the X-factors that could throw a wrench into markets in 2019. For much of the time since then it has not seemed to be much of a factor. World equity markets bounced off their miserable December performance in a relief rally driven by the “bad is good” logic of a dovish pivot by central banks, underscored formally by the Fed in late January.
But the market’s underwhelming response to the ECB on Thursday, amid a vortex of troubled headline data points that now includes a tepid US February jobs report, suggests that real economic activity may be starting to matter again. In just a few weeks we will start to see corporate sales & earnings numbers for the first quarter, which consensus expectations suggest could be negative for the first time since 2016. Shortly after that will come Q1 real GDP growth, which analysts are figuring could be in the range of one percent. All this could suggest more of that volatility we predicted would be a primary characteristic of 2019 risk asset markets.
Our novice investor of that earlier conversation may not be schooled in the ways of markets, but she made one salient point. Low growth should mean a poor outlook for company sales and earnings. Those sales and earnings, in the long run, are all that really matters, because a share price is fundamentally nothing more and nothing less than a net present value expression of all that company’s future cash flows. Perhaps the time is at hand when this long-term truth will actually have an impact on the market’s near-term directional trends.
In May 2018 the US economy achieved a milestone of sorts, outlasting the growth cycle of 1961 to 1969 to become the second-longest expansion in the country’s history. In 2019 an even more auspicious accomplishment is in sight. If the economy does not experience a recession between January and July of this year it will become the longest-ever expansion, supplanting the decade of growth enjoyed between 1991 and 2001. From where we sit today, the odds appear rather strongly in favor of July arriving without a recession along the way. Indeed, for a recession to officially begin as early as July we would need to be experiencing nearly uninterrupted negative GDP growth between now and then – a possibility that would appear remote to the point of being negligible. Barring the catastrophically unexpected, this recovery looks set to claim the gold medal for longevity, if for nothing else.
What Have You Done For Me Lately?
Not that we should expect investment markets to be toasting the newly-minted longest-ever recovery with Champagne and noisemakers, though. Markets are forward-looking by nature, and they are already looking well past July in anticipation of when this economic cycle does turn. In some corners of the developed world outside the US, initial signs of the turn are already at hand. Five developed-market economies – Germany, Japan, Italy, Switzerland and Sweden – saw negative GDP growth in the third quarter of 2018. The IMF has lowered its outlook on global growth in 2019. At 3.7 percent the outlook is still relatively rosy, but the effects of slowing international trade, including the potential impact of a trade war yet to be actualized, give cause for concern. As the effects of fiscal stimulus in the US wear off, the persistent absence of meaningful growth in productivity – the one viable source of long-term growth – will come back into focus.
As the World Turns
There is a growing dissonance between markets and the economy based on deeper issues than headline macro data and other short-term sentiment drivers. There is a case to make that the world is in the early stages of a transition not unlike the unraveling of the Bretton Woods framework that guided the global economy’s first quarter century after the end of the Second World War. By the late 1960s the US was losing its grip as the great stabilizing force of the world economy. The waning of US preeminence was underscored when then-president Nixon took the US off the gold exchange standard in August 1971. What ensued for the next decade was a period of great uncertainty, including four recessions of varying degrees of intensity with persistently high unemployment accompanied by soaring inflation. Equities fell in and out of bear market territory, finishing this miserable stretch more or less where they began it – in nominal terms, that is. On an inflation-adjusted purchasing power basis, an investor in a basket of S&P 500 stocks was much worse off at the end of this cycle than he or she was at the beginning.
Eventually the fog of uncertainty lifted and the era of what former Fed chair Ben Bernanke termed the “Great Moderation” began. Neoliberal politics and relatively unfettered global capitalism – known as the “Washington Consensus” – flourished as the dominant model for the next quarter century. That model got its comeuppance with the 2008 market crash and deep recession. The institutions emblematic of the Washington Consensus have become increasingly strained. As in the early 1970s, there is a sense that what worked once is no longer working. And, likewise, a growing uncertainty about what comes next.
We believe heightened volatility will be the principal characteristic of asset markets in 2019. Volatility cuts both ways – up and down – meaning that predictions about market directional trends will be subject to high amounts of variability. Developments to which markets typically pay little heed – including political dysfunction and foreign policy crises – potentially will come under greater scrutiny. Outside the US, China and the EU may be sources of increased instability. Risk spreads are positioned to widen between benchmark government credit and various tiers of corporate, mortgage-backed and other debt types. The corporate debt market could be particularly tricky, and we will be paying close attention to trends in lower-investment grade paper. Central banks will be following these developments closely and may turn more dovish than expected in efforts to mitigate the impact on global markets. What central banks do – and do not do – will in turn influence investor sentiment back and forth between risk-on and risk-off. Currency and commodity markets will likely find themselves in the cross-winds of these sentiment shifts – again, volatile swings have the potential to impede the formation of durable directional trends.
Reasons (Maybe) to Smile
A prediction for heightened volatility does not necessarily translate into a doom-and-gloom outlook. For starters, we do not see compelling evidence of imminent financial risks on par with those that catalyzed the massive market sell-offs in 2000-02 (absurd asset valuations) or 2007-09 (overleveraged and intertwined credit markets). Valuations, in fact, are relatively attractive: the S&P 500 price-to-sales (P/S) ratio is currently below its 5-year average on both a twelve trailing months and forecasted basis. With the consensus forecast for FY 2019 sales still in the mid-high single digits, there are buying opportunities aplenty for investors willing to look past the short-term fury of the past two months.
Inflation – or rather its absence – could be another positive influence in the months ahead. The Core Personal Consumption Expenditures (PCE) index, which is the Fed’s preferred inflation gauge, has remained fairly closely tethered to the central bank’s two percent target in recent months, with little upward pressure thus far from continued tightness in the labor market. As long as inflation remains in check, the Fed will have flexibility to pause its monetary policy tightening in response to other potential developments, without increasing the risk of overheating the economy.
Finally, one wild-card boost to sentiment (though relatively limited in terms of real economic impact) could come between now and March if UK Prime Minister Theresa May’s government manages to either succeed in bringing about a second referendum on Brexit (i.e. with the potential to avoid Brexit altogether) or at least push the March deadline for Article 50 down the road. As things stand right now the only viable options on the table are a deal loved by precisely nobody, or a hard crash out of the EU with potentially dire economic and social consequences for Britain. Popular support for a second referendum has grown markedly, offering at least some hope that Britons may wake up, breathe a sigh of relief and say “it was all just a bad dream.”
The Big Unknown, Even Bigger
Any such positive X-factors as may emerge will, however, have to contend with plenty of negative possibilities. In our view the biggest of these resides at 1600 Pennsylvania Avenue. We say this with no regard whatsoever for ideological reasons or personal preferences, but simply as an assessment of the current power dynamics in Washington and sufficient existing evidence of a willing recklessness on the part of this administration with scant regard for consequences. Global trade, geopolitics and the independence of the Federal Reserve are examples of where and how what happens in Washington could matter to markets far more than is typically the case. Markets are used to political dysfunction as long as it stays within the sausage-making policy factory inside the Beltway. That assumption worked in 2017, but it has steadily unraveled since.
In conclusion: while the direction of risk assets in 2019 could plausibly end the year in either positive or negative territory, we believe the going will be bumpier than usual. If we truly are in the early stages of a tectonic shift in the socio-economic environment similar to what happened in the late 1960s, then there will potentially be an increased tendency to interpret new information through a glass-half-empty rather than half-full perspective. There will be opportunities, but it will be harder to capitalize on emergent trends in the presence of higher volatility – and this could well be equally true for equity, credit and alternative asset classes. In this environment we believe a more defensive position is warranted than one year ago, and that careful diversification among both riskier and low-risk portfolio segments can help buffer the impact of multiple cross-winds.
The Lunar New Year in 2019 falls on February 5, a bit shy of two months from now. According to a New York Times article today, managers in some factories in China – where Lunar New Year is one of the big holiday events of the year – are letting their employees off for the holidays starting this week. Imagine if your boss came into the office one sunny October morning and said “Merry Christmas all, and I’ll see you in January!” Pretty weird. Such, apparently, is the extent to which the cadence of growth in the world’s second largest economy is slowing.
Tales From the Not-Yet-Trade War Front
A rather dour investor sentiment has been traveling across time zones from east to west this morning, cutting a swath of negative figures through the major equity indexes of Asia and Europe before showing up for another down day on Wall Street. The culprit appears to be another set of macro data releases from China coming in way below the already modest expectations of analysts. We show two of them below – retail sales and industrial production – along with the current state of things in China’s equity and currency markets.
Both these figures are notable in that they represent multiyear lows: in the case of retail sales, a 15-year low. Robust double-digit growth in sales has been the norm even through the 2008 financial crisis, but today’s read is just 8.1 percent year-on-year growth. The other point worth making is that these numbers have relatively little to do with the trade war. China’s exports have not turned down notably even after the implementation of successive waves of tariffs by the US. The problem appears to be domestic sentiment – households are turning down the volume on their spending habits and businesses are cutting production shifts accordingly (hence those extended “holiday breaks” noted above).
Old Habits Die Hard
We’ve been writing about the “China rebalancing project” seemingly forever. For literally the entirely of this decade to date, Beijing has loudly proclaimed its intention to move the economy beyond the old formula of massive spending on state-run infrastructure and development projects, towards a more consumer-oriented society closer to Western economies in terms of consumer spending as a percentage of GDP. By some measures it has succeeded – while official published figures from China are not necessarily reliable, consumption has grown as a GDP contributor over the past ten years. But the old fallback growth formula of debt-funded infrastructure has not abated. Indeed, fixed-asset investment, led by housing and infrastructure, hit a five-month high in the most recent data release. With debt levels already sky-high, though, there is a serious question about how many more times policymakers can go back to their old quick fixes for further growth.
Abroad and At Home
China’s slowing domestic economy is a major reason for the weakness in global energy and industrial commodities prices that has persisted over the past several months. That, in turn, seems to be having a positive impact on consumer spending here at home. With gas prices down a couple percent over the past month, US retail sales for the same period jumped by 0.9 percent month-over-month, exceeding analyst expectations (this refers to the so-called “control group” basket of retail goods and services that excludes volatile categories like automobiles, building materials and food services). November was a particularly bright month for big-ticket items like furniture and electronic goods.
US companies will be hoping that trend keeps up domestically. The average S&P 500 company earns around half of its total revenues from markets outside the US, notably China and the EU (which is having its own particular growth problems). Flagging demand in those markets will be a drag on the pace of sales and earnings growth, which in turn will put pressure on stock price valuations, which in turn could feed into prevailing negative sentiment towards risk assets generally, which in turn can spill over into spending plans by households and businesses, which eventually has the potential to lead to recession.
Protectionist and nationalist rhetoric may fill the political airwaves around the world, but it is still a globally interlinked economy, where the fates of consumers and business managers in China, the US, Europe and elsewhere are joined at the hip.
Be careful what you wish for, because it might come true. A couple weeks ago, bond investors were wishing upon their stars for a retreat in yields from the 3.25 percent the 10-year Treasury had just breached. Well, retreat it did, falling below 3.1 percent in early Friday morning trading. But these falling yields were clearly of the risk-off variety, dragging down everything else with them. The S&P 500 is flirting in and out of correction territory (a peak to trough decline of 10 percent or more) and may well have settled there by the end of the day, while the Nasdaq has already gone full correction.
As we noted in our commentary a couple weeks ago, corrections aren’t particularly rare events. We also noted the Tolstoyan flavor of these events – each one has its own unique story of dysfunction to narrate. “Okay, fine, so what’s the sad story accompanying the current situation?” is thus quite naturally a question that has come up in conversations with our clients this week. The narrative for the glass-half-empty crowd has indeed started to gel, but it is yet by no means clear that this will be the narrative that dominates for the remainder of the quarter (we will remain on record here as believing that it will not).
What we still have is a battle between two narratives, each looking at the same set of facts and drawing different conclusions, as if they were so many Rorschach inkblots. Let’s look first at the case for negativity.
Europe and China and Rates, Oh My
Several strands of thought weave together the bears’ case. In last week’s commentary we had an extensive discussion about the malaise in Europe, first with the Italian budget standoff that has sent yield spreads on sovereign debt soaring, and second with the spread of political unrest from the continent’s periphery to its dead center. Germany will have another round of regional elections this weekend, this time in Hesse (the region that includes financial capital Frankfurt as well as a delightful-sounding tart apple wine called Ebbelwei). The establishment center-left party, the SPD, is expected to fare poorly as they did two weeks ago in Bavaria. A really bad drubbing for the SPD could lead to the party’s exit from being the junior partner in Angela Merkel’s national grand coalition. That in turn could ratchet up the growing uncertainty about Merkel herself at a time when steady leadership from the EU’s strongest member is of critical importance.
China forms the second strand of the pessimist case. The national currency, the renminbi, is at its lowest level in a decade and poised to break through a major technical resistance level at RMB 7 to the dollar. After China’s GDP growth numbers last week came in slightly below expectations (6.5 percent versus the 6.7 percent consensus) Beijing economic officials coordinated a set of emphatic verbal assurances to investors that renewed growth measures were in place. That was enough to give beleaguered Chinese stocks an upward jolt for one day, but the lack of any specificity in the officials’ assurances didn’t hold up for a rally of more extended duration, and shares resumed their downward trend.
With the rest of the world looking particularly unappetizing, attention then turns back to the domestic environment, specifically the prospects for continued monetary tightening by the Fed and concerns that the run of news for corporate financial performance – capped off by earnings growth expected to top 20 percent for 2018 – is about as good as it’s going to get. Higher rates will tamp down the currently rambunctious confidence among consumers and small businesses, while widening spreads will also spell trouble for the corporate debt market at a time when S&P 500 companies have record levels of debt on their books. Margins will be under pressure from upward creep in wages and input costs, and weaker economies around the globe will have a negative effect on overall demand for their products and services. Faltering leadership from high-profile tech and consumer discretionary shares is the canary in the coal mine, portending a more protracted period of market weakness.
It’s not a weak case, to be sure. But there is a strong argument on the other side as well, with opportunists scouring an expensive stock market for bargains made available in a 10 – 15 percent correction environment. This is the “song remains the same” crowd.
The Big Picture Hasn’t Changed
The glass-half-full argument always starts from the same point: the unrelenting sameness of US macroeconomic data month in and month out. The latest of these is fresh off the presses of the Bureau of Economic Analysis as of this morning: a Q3 real GDP growth reading of 3.5 percent, which translates to a 3.0 percent year-on-year trajectory. Same old, same old – healthy labor market with unemployment at decades-low levels, prices modestly but not dangerously above the Fed’s 2 percent target, zippy consumer spending and continued growth in business investment.
On the subject of corporate earnings, the optimists will point out that top-line sales expectations for 2019 are actually increasing. Yes – the tax cut sugar high will lapse once December comes and goes, so bottom-line earnings won’t repeat their 20 percent gains of ’18. But if sales continue to grow at a 6-7 percent clip it underscores the ongoing health in consumer demand, here as well as abroad. And yes – to that point about weakness in China, the adverse effects of the trade war have yet to show up in actual data. China’s exports grew at a 14 percent clip in September, and the $34.1 billion trade surplus it recorded with the US for the same month was an all-time record.
The Fed is likely to continue raising rates. The reason for that, as Fed officials themselves repeat time and again, is because the economy is growing well and (in their view) cans sustain growth while interest rates rise gradually to more normal levels. It’s worth remembering that yields on the 10-year Treasury averaged over 6 percent during the growth market of the mid-late 1990s, and around 4.5 percent during the mid-2000s. There is no particular reason (despite many reports to the contrary) that money managers “have to” rotate out of equities into bonds at some notional 10-year yield threshold (3.7 percent being the number bandied about in a recent Merrill Lynch / Bank of America survey).
To be sure, there are plenty of X-factors out there with the potential to add fuel to the present nervousness in risk asset markets. There are plenty of others that could accelerate a pronounced recovery of nerve heading into the peak retail season that begins next month.
It is also possible that we are seeing the first early hints of the next real downturn – much like those occasional days in August where there’s enough crispness in the air to suggest a seasonal change, even while knowing that autumn is still many weeks away. Just remember that while the timing of seasonal equinoxes is predictable, market transitions do not operate on any fixed calendar.