Strategy: Eurozone leading indicators too good to be true?

14 Jan 2016

SUMMARY

  • Concerns about Chinese currency and capital (out)flows
  • Developed equity markets weather Chinese sell-off
  • Mild winter weather can distort data
  • European growth to partly follow buoyant leading indicators
  • Time for a short duration stance in bond-heavy portfolios

Financial markets have remained jittery, but so far, last week’s large losses have not been repeated this week. Encouragingly, developed equities held up well after another large sell-off in China despite investor concerns regarding the rapid fall of the Chinese currency and capital outflows. Data on the large trade surplus, low net foreign direct investment and sharply falling foreign exchange reserves point to such outflows of capital in November and December. Chinese data on trade in December was, however, strong, although there are caveats. December data on the US labour market was solid, which was welcome after earlier disappointments.

MILD WINTER

Mild winter temperatures can impact economic data such as industrial production or construction activity. So the question is: was this the driver behind the strong US labour report? There are no obvious signs. Construction jobs increased more strongly than in previous years, but it is important to remember that the housing market is still recovering. So even when taking some seasonality into account, this solid report should damp any concerns after the generally disappointing PMI data.

A large influx of workers gave the participation rate an encouraging boost. This reservoir of labour may explain why wage growth has remained so tame despite falling unemployment. However, there are signs of labour market tightness. The NFIB’s small business optimism index rose in December and a growing number of owners are planning to raise compensation.

Mild winter weather can also cool economic data. In the US, industrial production has been weaker than manufacturing production (which excludes the seasonally less busy utilities) for several months. In France, there is a similar pattern, but less so in Germany where the overall weakness was driven mainly by a drop in capital goods production.

EUROZONE LEADING INDICATORS TOO GOOD TO BE TRUE?

Leading indices including the composite PMI, the Economic Sentiment Index and consumer confidence, are pointing not only to above-trend growth, but also to an acceleration of the growth rate. This would be welcome since growth had slowed in recent quarters.

Judging just by these leading indicators, Italy should be booming: the Economic Sentiment Index there was recently higher than in the other major economies and Italian consumers are more optimistic than in any month since 2001. The reality? Quarterly GDP growth has decelerated through 2015 (as was the case in the eurozone), industrial production is well below the levels seen before the financial crisis and unemployment is higher. But the main point is that even if the leading indicators are only partly correct, growth should stop falling.

For the eurozone, retail sales have been weak, but industrial production has rebounded and employment growth is pushing down the unemployment rate. A report from the German Ifo institute, the French INSEE and the Italian Istat forecast 0.4% quarter-on-quarter GDP growth in the final quarter of 2015 as well as in the first two quarters of 2016. All in all, we tend to go with the leading indicators, expecting fourth-quarter growth in the eurozone to have been stronger than in the third.

ALLOCATION: TAKING PROFITS ON LONG EUROPEAN SMALL CAPS vs. LARGE CAPS

With emerging equities at their lowest since July 2009, we took profits on our underweight, but for an outright overweight, we would need more clarity on the outlook for Chinese growth and financial markets, better trade data or a halt of the commodity rout. Whether looking at trade in US dollars, in local currency or in volumes, there is just no upturn visible.

For global equities, we think the sell-off may have run its course for the most part. US valuations in particular still demand caution, but short positioning among investors is picking up once more. For now, we are neutral.

We took profits on our overweight in European small caps versus European large caps. This removes half of our overweight in European small caps since we are also overweight versus US real estate. The rationales for the small caps versus large caps trade are still largely in place, including more mergers and acquisitions and strong momentum. However, small-cap valuations have become more stretched, causing us to shift our stance.

TIME FOR A SHORT DURATION STANCE IN BOND-HEAVY PORTFOLIOS

While equity markets sold off, bond markets hardly provided a haven. A risk-off environment is thus not a guarantee that bonds will gain, but a eurozone economy that looks relatively resilient should gradually ease any investor fears of deflation and some pull might come from higher yields in the US. However, our conviction is not strong enough to implement a short duration in all our portfolios. For now, we only do this in bond-heavy portfolios.

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Please note that this article can contain technical language. For this reason, it is not recommended to readers without professional investment experience.

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