Posts tagged Global Economy
Remember last Friday? Investors were in the sunniest of moods, with another month of robust job numbers on top of a better than expected first quarter GDP reading. Even productivity was improved, as we mentioned in our commentary last week (not that anyone was paying attention to the single most important economic growth measure). It was shaping up to be a merry, merry month of May…until late into the weekend when the Twitterverse called investors away from their barbeques to inform them that the trade war was back on the table. Uproar and consternation! Chinese markets, which were already open, quickly went pear-shaped and financial media outlets set up the talking points for the week.
Trade war? Wasn’t this as close to a done deal as these things get? The presumed cessation of hostilities between the US and China on trade was widely accepted by market participants as one of the two primary tailwinds for the 2019 rally in risk assets (the other being the Fed’s pivot on interest rates). By the time the S&P 500 hit a handful of new record highs in late April, a successful outcome to the long-festering trade dispute was conventional wisdom. The Chinese delegation, led by Vice-Premier Liu He, was due to arrive in Washington on May 9 for a round of talks which, if not necessarily definitive, were at least supposed to affirm the intention of both sides to reduce tensions and maintain support for global trade (through bland platitudes if not much else). Instead, those tweets by Trump late in the day on Sunday put new tariff threats back on the table and upended the conventional wisdom.
Jittery Algos, Jaded Humans
Two years into this administration, most cognitively-endowed human beings have learned a thing or two about digesting news from Twitter, particularly that which emanates from one particular account on Pennsylvania Avenue. The performance art of grandiose pronouncements which eventually dissolve into nothingness has become routine. This wasn’t entirely clear when the trade war first started to spook markets in early 2018. But the absence of tangible actions to match the rhetoric of the tweets, along with this administration’s obsession with where the Dow is on any given day, eventually made it clear to anyone paying attention that there wasn’t much in the way of bite behind the bark.
Algorithms, bereft of those cognitive abilities, are not so sanguine, which partly explains this week’s pullback (a natural pause following an extended bull run also being in the mix). The quantitative models powered by these algorithms make up the bulk of intraday trading volume. Many of them are wired to respond to –yes, really – stuff that comes out on Twitter. So the Sunday tweets begat the Monday blues. But even algorithms have a natural stopping point. As we write this on Thursday morning, the S&P 500 is around three percent off its recent high. That’s not much, especially considering that the blue chip index had racked up gains of almost 20 percent when it set the most recent high on April 30.
It’s much less, in fact, than would be the case if the collective wisdom of human and bot traders alike determined that an honest to goodness trade war was the most likely outcome of the current state of play. Fortunately, the evidence against that outcome remains compelling. It’s performance art, and as long as neither US nor Chinese negotiators want to explain to their constituencies (and, in our case, voters) why the economy collapsed on their watch it will likely remain thus.
There is a predictable visual theme that accompanies articles covering the quarterly release of China’s GDP growth statistics. Pictures of vast, creepily empty real estate development projects festoon the pages of analytical pieces by the likes of the Financial Times and the New York Times, introducing readers to little-known place names like Luoyang and Tianjin. The imagery helps underscore the central importance of the property sector to China (by some accounts 30 percent of its total economy), as well as the increasingly clear evidence that in this sector supply has vastly exceeded demand.
Feed the Beast
And that trend won’t be changing any time soon. In 2018 China’s growth started to slow noticeably. The stock market fell, fears of the effects of a trade war increased, and consumer activity flagged. As sure as night follows day, Beijing flooded the economy with stimulus, in the form of some $180 billion worth of local government bonds. The effects of that stimulus are evident in the chart below, showing the fixed investment trend over the past five years.
The dramatic uptick in the first three months of 2019 (the crimson trendline) is all about state-owned enterprises, through which that stimulus largesse was funneled. The vast majority of the largesse went right into infrastructure and property projects. There will be plenty more of those sprawling ghost cities for journalists to attach to their future reports.
The spree of property project-bound regional bonds was not the only form of stimulus; there was also a major tax cut aimed at small and midsized businesses to encourage them to invest in their markets. That seems to have had some effect on real economic activity (by which we mean things other than property projects in Nowheresville). Retail sales ticked up slightly in the first quarter after the pace of growth fell dramatically in 2018. This trend is shown in the chart below.
China’s economic authorities for years have been trying to rebalance the economy away from the old infrastructure/property schemata to a more consumer-oriented model. The problem is that every time growth starts to slow, the old playbook comes right back out. Notice in that earlier fixed investment chart the timing of the previous surge in state-owned investment spending: 2015 and 2016, when major parts of the economy seemed headed for a dramatic reversal of fortune. Each time this happens, it expands a credit bubble already of historic proportions. China’s debt to GDP ratio was 162 percent in 2008; it grew to 266 percent by last year. Waiting for the rebalancing is like waiting for Godot, while the debt piles up.
It Matters for Markets
The principal headline in this week’s data release was that the overall rate of GDP growth was somewhat better than expected, at 6.4 percent. The reaction among much of the world’s investor class appeared to take this at face value and chalk up one more reason to keep feeding funds into the great market melt-up of 2019. But those same analytical pieces featuring Luoyang’s empty towers point out that, as much of the economic stimulus was front-loaded in the first quarter, a double dip may well be in store. That may matter for markets at whatever time the equity rally takes a pause from its blistering year-to-date pace. Not everything matters for markets, but the performance of the world’s second largest economy is one of the more reliable attention-getters, at different times for better and for worse. The durability of the current stabilization will be something to watch heading into the year’s second half.
It’s quite a world, this one we inhabit. Today is Brexit Day! Article 50 goes into effect at 11 pm Greenwich Mean Time…except, of course, that it doesn’t, because our esteemed and honourable Members of Parliament are still having an existential debate regarding what Brexit is all about (real time update: the debate is over, again, with no agreement, again). The Monty Python sketch about Silly Upper Class Twits comes to mind. But no matter! We have nothing more to say about Brexit other than commiserations for the 48 percent of the citizenry of the Isles who never wanted this farce in the first place. We are here to talk about one of the other surreal features of our present day Planet Earth. Negative interest rates are back, and they are back with a vengeance. Here’s a snapshot of the yield trend for the German 10-year Bund, the go-to safe haven asset for the European Union.
What Don’t We Know?
The German Bund’s fall back into negative rate Wonderland is, of course, just one part of a massive global rally in bonds. Last week we talked about the inversion of the US yield curve and what that may mean for fixed income and equity investors in the weeks and months ahead. Elsewhere in the world the same trend is playing out. Take, for example, New Zealand. The 10-year Kiwi, as the country’s government bonds are known, hit record low yields this week. Not “52 week low” or even “five year low” but actual record low. The Kiwi’s 10-year journey towards Wonderland (it has not yet gone through the looking glass to negative rates) is shown in the chart below.
The sharp rally in Kiwi prices (bond prices move inversely to their yields) has much to do with the effects of a China slowdown on economies in the Asia Pacific Region. It’s not the directional trend as much as the speed of this global bond rally that is surprising, however. After all, we have known for many months now that growth in China was slowing and that further potential negative risks lurked in the form of a worsening US-China trade environment. We knew this in September and December of last year, when the Fed pronounced a robust bill of health on the economy enabling future rate hikes. What was it, starting in January this year and snowballing through the first quarter, that caused first the Fed, then the ECB, and then pretty much everyone else to out-dove themselves? What do they know that we don’t?
Data Not There Yet
The right answer to that last question may well be…nothing. After all, the central banks aren’t directly responsible for the pace of this bond market rally. Traders are…and by traders we mean, of course, algorithm-driven bots primed to move whatever way the mass consciousness of the digital world seems to be going. Trading by Twitter. It is entirely possible that this rally is already overbought, with bond yields potentially set to return to less gloom-and-doom territory.
After all, the global economy is not in recession and the data still do not suggest it is heading towards one in the coming months. Here in the US we have one month of lousy job numbers and inflation still struggling to maintain a two percent range (the latest Core Personal Consumption Expenditure rate, released today, is 1.8 percent). Q1 GDP is expected to come in below two percent, but weak first quarters are not unusual. Not great, but not too bad. The IMF’s latest projection for real global GDP growth for 2019 is 3.5 percent – down from earlier projections but, again, still comfortably north of zero.
Postmodern Financial Theory
Yes, but what about the inverted yield curve we talked about last week? That hasn’t gone away, and it remains the most prescient harbinger of forthcoming recessions, based on past instances. Is there something different about fixed income markets now that possibly makes this indicator less useful than it once was? Well, yes actually. In no past recession, ever, was there the presence of unconventional monetary policy all around the world. No negative interest rates. These aren’t even supposed to exist according to the conventions of modern financial theory. A dollar today is worth more than a dollar tomorrow, and the rate of interest that expresses a future value in present value terms is positive – that’s why it is called the discount rate.
But we have negative interest rates today, in many parts of the world, and they have the effect of flattening curves in markets where rates are still positive (like the US). The real (inflation-adjusted) rate of return on a 10-year US Treasury note may be barely positive (as is the case today) but it is still a whole lot more attractive than actually paying the German government for the “privilege” of holding its 10-year debt in your portfolio. This is not normal – and it may well suggest that we should not be reading too many recessionary warnings into these tea leaves.
What to do, then? Well, this is Wonderland. Whatever emergent properties bubble out of the current soup of variables at play could go one way, and they could go the other way. Anyone who tells you they know which way that is, well, they probably also have a bridge to sell you. A little caution, without an undue reduction of exposure to growth, is how we have been positioning the portfolios under our discretion. That course of action still seems reasonable to us.
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.