Strategy: Punctured healthcare initiative takes air out of reflation trade

Doubts grow about ambitious US stimulus plans

27 Mar 2017

  • PMIs fall in the US, but rise in eurozone
  • Real data is broadcasting mixed signals
  • US political developments dominate financial markets
  • Asset allocation: defensive stance justified

US domestic politics dominated markets this past week. The failure of the Trump administration to replace the Obamacare healthcare plan has raised doubts among investors about the government’s ability to attain its ambitious tax cutting, tax reform and infrastructure spending goals. After hopes for fiscal stimulus had run high in the markets, equities lost ground, while government bond yields fell as the replacement scheme for Obamacare stumbled.

MIXED SIGNALS FROM PMIs

The US manufacturing PMI hit its lowest level in five months and the services index fell to a six-month low. Obviously, the composite PMI also slipped. The positive news is that US PMIs are still comfortably above 50, pointing to growth. It is more disturbing that in general, confidence indicators have surged since the US election, but real indicators have lagged. The cheery leading indicators may be right, but we find it difficult to see a sharp acceleration in US economic growth. The business cycle is mature, fiscal stimulus is uncertain and the Federal Reserve is in the process of raising interest rates. So we may be heading into a period where leading indicators will come down to more realistic levels.

PMIs in the eurozone defied expectations for modest declines and surged to their highest since 2011 when the eurozone experienced an initial recovery from the financial crisis. France and Germany saw improvements in both the manufacturing and services sectors. As in the US, the PMIs in the eurozone may paint an overly rosy picture, but at least there is room to grow. GDP has only just surpassed its 2008 peak, pointing to a positive output gap. Business investment is low relative to GDP and unemployment is still high. We are more optimistic about growth in the eurozone than in the US. Our positive view on the eurozone was confirmed by the German Ifo index, which in March jumped to its highest since July 2011.

Japan has so far only published its manufacturing PMI. This slipped, but it is still higher than it was in most of the past 12 months. The Japanese economy has recently benefited from strong external demand, while domestically, the economy looks lacklustre.

REAL INDICATORS ALSO MIXED

The US housing market has shown some strength recently: sentiment among homebuilders jumped higher and price gains of new and existing homes accelerated. Housing should be supported by the robust labour market and deferred demand, but weather trends and the prospect of higher mortgage rates may be boosting demand in the short term. Investment data was somewhat less positive. Orders for durable goods have basically moved sideways in the past four years. Orders for capital goods excluding defence and aircraft orders have stalled for two months. If doubts emerge about fiscal reform and stimulus, investment may suffer anew.

Eurozone consumer confidence recovered from a small dip. Gradually falling unemployment and stable growth should be supportive of consumer sentiment and spending. Higher inflation and lower real incomes are a risk, but we think that more positive developments in business investment should keep the eurozone economy on a firm growth path. But even in the eurozone, not all indicators are positive. Growth in M3 broad money slipped for a second straight month. Bank lending is struggling to grow, growth in consumer credit has slowed and loans to the non-financial corporate sector are showing barely positive growth.

As said, in Japan, the external and domestic sectors are moving in drastically different directions. With exports growing much faster than imports, the economy can expect another boost from external trade in the first quarter. But consumer spending has been weak with nominal income hardly growing and inflation eating into consumer spending power. Moreover, the strong Japanese yen benefiting from a sell-off of risk assets should curtail exports.

MARKETS DOMINATED BY US POLITICS

While we believe economic developments are broadly neutral for equities at this point, markets were dominated by the failure of the Trump administration to find a majority in the House of Representatives for its repeal and replacement of Obamacare. Markets had anticipated the collapse of the initiative and were hit by a perfect storm of political uncertainty, falling oil prices and a drop in bond yields. Cyclical sectors such as energy, materials and industrials suffered, but bank stocks also sold off as yields fell. The VIX volatility index spiked and in option pricing, demand centred on downside protection. US markets calmed down as the news of political uncertainty was discounted, but the selling pressure continued in Asia and Europe.

We think that there are several indications that the equity rally is maturing and losing steam. Cyclical indicators may be as good as they get. Sector performance has rotated from cyclical to more defensive sectors. Small caps have underperformed large caps, especially in the US. Yields have stopped rising and the US dollar has weakened. Perhaps the drop in oil prices is specific to this commodity, but copper prices have also weakened lately, as well as iron ore.

ASSET ALLOCATION: UNCHANGED

We had gradually moved to a less cautious asset allocation in recent weeks given the strong performance of cyclical leading indicators, but with an underweight in developed equities, an underweight in US high-yield corporate bonds and an underweight in emerging market debt in hard currency, we are still defensively positioned. We think high market prices do not properly reflect the worsened fundamentals. For equities, high valuations are our main concern. For US high-yield, we are worried about weakened corporate balance sheets and for emerging market debt, we see the value of the US dollar, interest rates and protectionism as risks.

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