Data points to further eurozone strength, US rebound, emerging market breather

Strategy: now overweight emerging market local currency debt

08 May 2017

  • Eurozone leading indicators: overly optimistic?
  • PMIs indicate slowdown in China
  • Don’t extrapolate strong earnings

Market reaction to the results of the second round of the French presidential election was quite muted. But there is more to consider. While US macroeconomic data has generally stopped offering up positive surprises, the latest labour market report was strong. Robust eurozone growth could have implications for monetary policy. The latest PMIs were mixed, but US and European company earnings have been strong. Amid such cross currents, we have maintained most of our positions, but we have gone overweight emerging market debt in local currency.

MARKETS NEUTRAL AFTER MACRON WIN

The final result of the French presidential election was as predicted by the polls: Emmanuel Macron won the run-off against Marine Le Pen by a decisive margin. This should be put into perspective. Le Pen, of the far-right Front National party, won record support in the second round, although less than the polls predicted. Around a quarter of the electorate abstained and another tenth cast blank or invalid ballots, indicating that neither candidate appealed to them.

The focus now shifts to the elections for the currently socialist-dominated National Assembly in mid-June. Markets will closely follow the polls to see whether Macron’s En Marche movement, started only last spring, can actually get close to a majority. Polls last month showed that En Marche could end up becoming the largest party. Alternatively, Macron will have to work with more established parties on domestic reforms, including less government spending.

The outcome of the presidential election also has broader implications. Markets will now look to the ECB for policy clues. We expect it to drop existing guidance about the need for possibly lower interest rates, which should be followed in September by announcements on the tapering of the ECB’s asset purchase programme. We believe the election result has made this course of events more likely. This partly explains the market reaction: ECB tapering would mean less buying support for bonds and may lead to higher risk spreads on ‘peripheral’ bonds.

ROBUST GROWTH IN THE EUROZONE

Leading indicators have gone from strength to strength. The Economic Sentiment Index (ESI) jumped to its strongest post-financial crisis reading. The PMI was at its strongest level in six years. Both suggest much faster growth than the 0.5% in the first quarter. Judging by historical relationships, the ESI and the PMI suggest the annual growth rate should be at least 100bp higher. Still, growth at the current pace should be sufficient to close the output gap, so, as ECB president Mario Draghi put it recently, ‘things are going better’.

The disconnect between survey data and actual growth and inflation numbers is also evident in the UK. The PMI services sector index has hit its highest since December 2016, while the manufacturing survey showed production expanding at the fastest pace in three months. The surveys provided further evidence of inflationary pressures. GDP growth, however, slowed in the first quarter. A further slowdown looks likely: consumer confidence has trended lower, consumer credit looks toppish and retail sales and industrial production growth have slowed.

US: REBOUND FROM ANOTHER WEAK FIRST QUARTER?

GDP growth slowed again in the first quarter, as it did in 2014, 2015 and 2016. This may be due to faulty seasonal adjustment, but possibly not for private consumption. Consumption grew modestly despite surging consumer confidence after rising inflation dented US consumers’ spending power. Business and residential investment were strong, though, while net trade was broadly neutral for growth. A slowdown in inventory accumulations was negative.

Looking ahead, a rebound in growth looks likely. The negative impact of rising energy prices on incomes should fade and the labour market is robust. The first-quarter strength in business investment may not be repeated. Capacity utilisation is relatively low, domestic business profits have fallen relative to GDP and the manufacturing PMI has slipped. Thus, in our view, we do not foresee the start of a period with much stronger growth than the trend of recent years.

PMIs SLIPPING IN EMERGING MARKETS

Our global GDP-weighted manufacturing PMI fell by a notch in April. Both in manufacturing and services, the average PMI rose in developed economies, but it slipped in emerging markets. In manufacturing, the China PMI barely held above 50, but it was also weak in Mexico and Russia. Especially in Russia, the manufacturing PMI has been trending down, which may be related to falling commodity prices. In services, there were slowdowns in China and India.

In developed economies, the US manufacturing PMI has now fallen for three straight months. The eurozone and Japan are holding up much better. Services PMIs in the US have increased.

From all this data, our concerns centre on China, where growth has stabilised and even accelerated recently, but only with substantial monetary and fiscal stimulus. Both are fading at the moment. With PMIs now falling, we are closely watching for any impact of monetary tightening on China, and by extension on commodity-producing emerging markets.

STRONG EARNINGS SEASONS IN US AND EUROPE

After a good start, the number of US companies that surprised positively on net profit has moderated, but remains above average. On revenues, while more companies are reporting surprisingly good figures, the extent of the overshoot has been modest. We are seeing a similar pattern in earnings expectations: more analysts are revising their estimates upwards, but the improvements they expect are more modest. And US equities have actually been rising faster than earnings growth would justify.

In Europe, the percentage of companies surprising positively on revenues is quite impressive. Earnings look strong too: 67% of companies that have reported so far exceeded expectations for net income. The actual earnings growth rate is a massive 40.7% YoY.

We would not extrapolate these numbers. There are favourable base effects and the strength is concentrated in a limited number of sectors. In the US, mostly in energy and basic materials, financials and information technology; in the eurozone, in energy and even more so in financials.

Developed equities look overvalued, most obviously in the US, followed by Europe, and less so in Japan and the UK. However, we think UK earnings expectations are too high and should come down. We look more positively on Europe, where equities are not cheap, but improving earnings expectations are reasonable. We regard the economic cycle and monetary policy as more favourable, as well as earnings revisions, earnings momentum and actual market momentum. Japan scores favourably on the earnings outlook, earnings momentum and monetary policy, but in recent weeks, Japanese equity prices have not fallen on yen strength. So we have not changed our underweight in developed equities.

NOW OVERWEIGHT EMERGING MARKET DEBT IN LOCAL CURRENCY

While we have doubts about the fundamental strength of emerging markets, as expressed in our underweight in hard currency debt versus US Treasuries, we also see positive developments. The US Federal Reserve should increase its policy rates only gradually, while the US dollar has retreated somewhat, removing some risks for emerging currencies, which we on average also see as undervalued. In large part, this – and relatively high real interest rates in a number of the emerging markets – justifies the overweight in local currency debt versus US Treasuries. We see monetary policy as broadly supportive, mostly so in Brazil and Russia, where falling inflation should enable the central bank to cut interest rates.

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