Equity markets are dipping as they digest important political news and face cross-currents from economic data. Our main scenario for growth, inflation and yields is relatively benign, but we think this is now widely discounted. While the tail risks are getting fatter, we think markets continue to focus on the more benign outcome. So our asset allocation remains cautious.
POLITICS BACK IN THE HEADLINES
The markets are busily discussing Brexit ahead of this week’s speech by UK Prime Minister May who is expected to outline the plans for the UK’s departure from the EU. Rumours are that she will argue for a hard Brexit, giving the UK full sovereign control over immigration, but also costing it access to the eurozone’s common market and freeing it from the jurisdiction of the European Court of Justice. The talk has mostly affected the British pound: it fell below 1.14 EUR per GBP and close to 1.20 USD per GBP. With the UK economy quite untouched by any fallout from the Brexit vote so far and the pound weakening, UK equities have surged to record highs. That may change in the case of a hard Brexit, but even today UK equities are down by less than other European markets.
US president-elect Trump has made stiff remarks about an obsolete NATO, a nuclear deal with Russia in exchange for lifting sanctions and tariffs on carmakers producing vehicles outside of the US. But he has yet to clarify his economic plans. Markets are clearly focusing on the positive proposals, such as cutting corporate taxes and a favourable treatment of repatriated company profits. The impact of the corporate tax cut is quite unclear at the moment since the actual average tax rate is much lower than the statutory rate for a number of companies due to many deductions and loopholes. Such a tax cut may benefit smaller, domestically oriented companies relatively more, which is why we currently overweight these.
We think repatriated foreign profits could be used to raise dividends or buy back shares, which should support US equities. We do not expect it to lead to a surge in business investment. Also, we do not see Trump’s meddling in individual companies’ decisions as positive from a macroeconomic perspective. It may support domestic growth for now, but would also raise costs and prices. With the proposed tax cuts and higher infrastructure spending hitting an economy close to full capacity, higher inflation, interest rates and yields are increasingly a risk.
In South Korea the corruption scandal that has haunted the prime minister has now also engulfed Samsung. The broad implications are unclear for now. The export sector had been improving recently. The domestic economy looks sluggish with some business sentiment indicators modest and consumer confidence and spending weak. The Bank of Korea left policy rates unchanged last week, but rate cuts should not be ruled out.
US: WILL HOPE DRIVE REALITY?
Confidence has surged in the US among consumers, producers and homebuilders and now also small business owners. Confidence among these owners had suffered in the run-up to the elections. But this has now been undone in just two months. Consumer confidence fell by a notch in January, but it is still at its post-recession high.
Will these hopes drive reality in the sense that real indicators will follow suit? It is hard to ignore such a strong signal from the leading indicators, but as we mentioned before, we find it difficult to see where a growth surge would come from. The surge in the NFIB index was driven less by indicators related to what small business owners are actually doing in terms of expanding their businesses. Retail sales have been mixed in nominal terms and weaker in real terms.
EUROZONE: STRONG INDUSTRIAL PRODUCTION FITS WITH GLOBAL TREND
In the eurozone industrial production came in strongly, in line with the positive tone in the manufacturing PMIs and with our constructive view on the region. This was driven by stronger production in Germany, France, Italy, the Netherlands and Spain. It also fits with a global improvement in manufacturing. Improvements in emerging markets were most noticeable in Latin America, where the annual growth rate is still negative, but much less so than before, and in Asia, although it is more in line with the growth rates of recent years.
We see two main drivers for the global manufacturing sector. One is the tech cycle in Asia and the other is the end of the inventory correction, mainly in the US.
CHINA AND EMERGING MARKETS: DIVERGENCIES
Credit data in China told the same old story: growth was much stronger than nominal GDP growth and actually too strong for comfort. But other indicators suggest that the economy may be slowing. Weaker bank lending to the government implies that government stimulus has peaked. This should clearly be watched to see if growth will actually decrease in 2017.
Chinese exports disappointed, partly due to currency developments. Improvements in recent months in exports and imports have been slower than normal at this time of the year. January and February data will be distorted by Chinese New Year celebrations, but so far it looks like trade will not pull the economy ahead.
In Brazil the central bank surprised markets with a more aggressive interest-rate cut than expected. The latest cut was just enough to undo the rise in the real Selic rate resulting from the drop in inflation from November to December. In other words, while the nominal Selic rate has been lowered, the actual stance of monetary policy leaves room for the central bank to act again in an economy with a negative credit and employment cycle. Lower inflation is supporting consumer spending power. It is also positive that the currency did not weaken after the rate cut.
Two countries with exchange rate troubles are Mexico and Turkey. The peso is clearly suffering from president-elect Trump’s rhetoric on producing goods in Mexico for the US markets and his threats of higher tariffs. Mexico is among the few countries where producers have become less optimistic recently. One implication may be that monetary policy will be tightened further.
In Turkey, a country highly dependent on external funding, domestic and regional political developments have pushed down the lira to record lows. Given the political pressure not to raise interest rates, it is not easy for the central bank to act to defend the currency. Tightening domestic financial conditions have stopped the currency rout for now, but we doubt this will be enough, especially with inflation jumping to 8.5% in December.
MARKETS TAKE A PAUSE
Although our indicators do not show an end to the risk-on mode, the equity advance has paused. This should not be a surprise given the strong rally in most markets recently and the political news that markets have had to digest.
In Japan a reversal of the weakening yen trend has weighed on equities. In China equities lost some ground when bond and money markets suffered unrest after authorities showed a willingness to step up the pace of initial public offerings amid doubts about the liquidity needed. In a broader context, this fits with our view that China is having problems funding its debt spree.
In the US the latest earnings reporting season has started in earnest with big banks reporting. In general earnings were better than expected, mainly driven by stronger income from trading in fixed income and currencies. Expectations for this earnings season are somewhat higher than for previous quarters, but low enough to allow for positive surprises. However, with the strong US dollar, valuations and the tail risks as headwinds, we do not think that earnings will drive US equities much higher in coming months. Hence our underweight in developed equities.
With the partial unwinding of ‘Trump trades’, based on the notion that higher growth and higher inflation are good for equities and commodities and bad for government bonds and emerging markets, emerging market risk spreads have narrowed. Risk spreads on corporate bonds have been more stable as they are already quite low. In government bonds we have closed our long US Treasuries versus eurozone government bonds position. While political risks remain in the eurozone, the Italian referendum is now behind us, while the ECB’s extension of its asset purchase programme to the end of the year mitigates risks. Given the inflation dynamics and massive short positioning in the US, we see limited further upside potential for US yields.
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