Strategy: Risky assets face headwinds from various directions

02 Jun 2016


  • Stronger US consumption, weak manufacturing – enough for a Fed rate rise?
  • Eurozone economy plodding along; more stimulus could come
  • Postponed VAT hike may allow Bank of Japan to stay on hold
  • Asset allocation: unchanged

The latest PMI data generally confirmed the soft spot in manufacturing. In the US, this was offset by stronger consumption growth, but this is not the case in many other countries. The US S&P 500 equity index has risen to within striking distance of its all-time high, showing that investors are confident that the economy is strong enough to cope with the next interest-rate rise by the Federal Reserve. However, the bond market appears to be less convinced. Emerging equity markets have been less buoyant as recent data does not point to a strong growth rebound in China. Moreover, the US dollar has risen again and the Chinese renminbi has depreciated. Crude oil prices have advanced further, but other commodities have been flat since the end of April. We still see a tough environment for risky assets.


Household consumption in the US grew solidly in the first quarter, but lagged the surge in real disposable income, expanding the pattern of recent quarters. The resulting increase in the savings rate is stronger than low interest rates and improvement in household net worth would suggest. This signals that consumers have become more cautious about spending.

On average, the financial health of households has improved a lot and taken together with the gap between the rises in income and consumption, one could argue for a bounce in consumption in the current quarter. Indeed, in April, consumption grew more quickly than real disposable income, setting the stage for an improvement this quarter. We would caution against too much enthusiasm, but we still believe the GDP rebound has started.

The manufacturing sector is looking less rosy. Regional business confidence and the national Markit manufacturing PMI have weakened. Durable goods orders have been in a sideways trend since mid-2013 and orders for non-defence capital goods excluding aircraft, a proxy for business investment, have now fallen for six straight months. The headwinds include high inventories, weak business sales and a higher US dollar. Furthermore, energy sector suppliers are still adjusting to lower oil production and a drop in energy investment.


The Fed has continued efforts to prepare the ground for a rate rise. Fed chair Yellen has said a hike could probably be appropriate in coming months, echoed by board member Powell who said another increase may be appropriate fairly soon. St. Louis Fed chair Bullard, also on the Federal Open Market Committee, thinks markets are now well-prepared.

So what could avert a rate rise? It is possible that the Fed may just want to have the option handy to tighten policy without causing too much market turmoil. However, not acting after such clear signals would make it even harder for the Fed to thwart market scepticism in the future. Of course, economic data could be too weak to justify higher rates. After all, the Fed has consistently said that policy moves depend on the incoming data. The May labour market report due this Friday is critical. If slower employment growth is accompanied by another drop in the unemployment rate, this might suffice for the Fed. Finally, there is the 23 June UK referendum on EU membership, which was mentioned explicitly as a risk in the minutes of the April FOMC meeting. Looking at all these developments, we think the Fed will raise US rates in June, although postponing a move until July is also a viable option.


Growth was strong in the first quarter, exceeding what we believe is sustainable. Last week, we mentioned the slightly disappointing manufacturing PMI for the region and this week we heard that the PMI for the eurozone services sector was unchanged, holding at a somewhat lower level than late last year. Overall, the PMI data left a slightly downbeat impression. So, the stronger-than-expected improvement in the Economic Sentiment Index was welcome. At the current level, the index signals above-trend growth on the back of an upturn in consumer confidence, which fits with our view of more domestically-driven growth.

It won’t be all plain sailing though. The upturn in the credit cycle has stalled lately. This is disappointing given the massive monetary policy stimulus, converging bank lending rates among eurozone member states and banks easing credit standards. Unemployment is in only a gentle downward trend. More worryingly, in Italy, the unemployment rate has essentially been unchanged since last July. Leading indicators are mixed. With modest growth, it will be difficult for Italy to address its fiscal deficit and high government debt ratio.


For now, we don’t expect any changes. The ECB is busy implementing its new asset purchase programme for corporate bonds and GDP growth looks strong enough on the whole. The new longer-term loan programme for banks, where under some circumstances banks can borrow from the ECB at negative interest rates, is also in the pipeline. But inflation remains too low for comfort, causing market concern that inflation expectations will decouple from the ECB’s 2% inflation goal. So, further down the road, more stimulus may come.


Recent data has unnerved financial markets. After overestimating the risk of a hard landing by the Chinese economy, markets have now in our view become too sanguine about a policy-driven recovery. The drop in the Markit manufacturing PMI and the official services PMI and the sideways move in the official manufacturing PMI do not point to a rebound.

In Japan, PMIs for the manufacturing and services sectors are below 50 and confidence among small business owners has fallen to close to the lowest level since ‘Abenomics’ started in early 2013. Headline inflation has fallen deeper into negative territory due to low oil prices and the appreciation of the Japanese yen, which has depressed import prices. Core inflation is still way below the Bank of Japan’s much-delayed 2% target.

This week, finance minister Aso reversed course, calling for a delay of the consumption tax hike which had been planned for April 2017. This would support growth next year. But if the government wants to achieve a primary fiscal surplus (currently in deficit at around 5% of GDP) in 2020, as stated, the necessary austerity measures will hold back growth anyway. For now, the delayed increase may allow the BoJ to stay on hold.


Modest growth and low inflation hardly justify the current valuations of equities and the risk spreads on some bonds, particularly emerging market bonds in hard currency. Also, low nominal growth makes it hard for corporate profits to grow. In the eurozone, Japan and emerging markets, profit estimates have been trimmed, while expectations have stabilised in the US. But there, margins could come under pressure from higher wage costs. Concerns about China could weigh on global and emerging equities. We expect growth to gradually slow further and a renewed drop in the Chinese renminbi could cause market volatility.

We also see monetary divergence as a risk. Equity markets are not fully convinced of a US rate rise this month. High profits and margins imply further downside potential, even after the recent declines. On the other hand, the Fed will likely raise rates only gradually. The bond market also has some doubts about the US central bank being on the right track.


One is that bond markets turn around and discount further tightening, driving up longer-term yields and possibly even leading to a steeper curve. In itself, this would be negative for equities, but if it is driven by strong data, the downside could be limited. Another scenario is that growth stays modest and the yield curve stays flat or flattens even further. If accompanied by weaker data, the beneficial impact on equities would be limited. Having said this, we would caution that large-scale quantitative easing has distorted investors’ ability to read much into the shape of many government bond markets. Yields in many markets are artificially low due to substantial asset purchase programmes.

We did not change our asset allocation. We have kept our overweight in US and Japanese equities versus Europe. This trade has moved in our advantage recently amid increased political risk, which is one of the reasons for our European underweight. We also question the sustainability of dividends in Europe and regard the US equity market as a more defensive market. We are overweight Japanese equities since the BoJ may announce more stimulus. As this would weaken the yen, we have hedged the currency risk.

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