WILL US CONSUMPTION HOLD UP?
Retail sales rose strongly in June, leaving headline retail sales up by 5.9% QoQ annualised in the second quarter for the fastest gain since the second quarter of last year when consumer spending rebounded from a hit from severe winter weather. Stripping out sales of food, cars and building materials, the underlying gain was even 7.4%, which matches the increase in the second quarter of 2014. What does this mean for the contribution of consumption to GDP? In the second quarter of 2014, that growth number had surged by 4.6% QoQ annualised and it was by 3.9% in the second quarter of 2015. Second-quarter growth above 4% is on the cards.
It is clear to us that consumption growth was much stronger than growth in real disposable income in the latest quarter. We expect consumer spending to slow in the second half of the year given that consumer confidence fell for the second straight month in July, effectively moving sideways since late 2014. Similarly, employment growth has trended lower and the Fed’s Labour Market Conditions Index has remained in negative territory.
ELSEWHERE IN THE US ECONOMY
Industrial and manufacturing production came in stronger than expected in June. This was partly a rebound from the drop in May. Still, these sectors do not look strong. The first of the regional measures of producer confidence published for July slipped to just above zero, suggesting a virtual standstill in production growth.
While it is too early to extrapolate this to the national level, we think US manufacturing faces headwinds such as the lack of demand for capital goods, an inventory overhang and a strong US dollar. On a trade-weighted basis, the dollar had depreciated from January to May, but lately it has regained some strength. Currently, it is just 3% below January’s all-time high.
Confidence among homebuilders slipped in July. We do not foresee a downturn in the housing market: sales and prices have shown robust gains for new and existing homes; housing starts have actually slowed relative to new home sales and inventories of unsold homes are low.
CHINA: WEAKER THAN THE HEADLINE NUMBER
Chinese GDP growth was unchanged in the second quarter at 6.7% YoY. For many economies, this would be an impressive rate, but for China, it is the slowest pace since the second quarter of 2009. While the headline numbers are okay, the details reveal weaknesses. Massive monetary and fiscal stimulus has only led to stabilisation, which is a reason for concern, in our view, since it increases the imbalances already apparent in the economy.
Strong credit growth after monetary easing is aggravating the debt overhang. A surge in fiscal spending may increase the investment overhang and the problem of inefficient capital allocation. Private-sector investment has virtually stopped growing. Real estate construction activity and home sales have shown signs of topping and with house prices surging in the bigger cities; it looks like another bubble has developed. Given the weak labour market indicators, we think the support from the real estate market will not last.
EQUITY MARKET STRENGTH: WHY?
US equities have gained just over 2% from before the UK vote to leave the EU, while eurozone equities have largely recovered from the losses and UK equities have surged by 6%. Even Japanese equities, which struggled for longer due to the stronger yen, are back at pre-referendum levels. Emerging equities are at their highest since last November. Risk spreads on investment-grade, high-yield and ‘peripheral’ eurozone government bonds have tightened.
We see no justification for this strength in risky assets at this point. We acknowledge that with bond yields close to record lows, there may be no alternative to equities. The search for yield is reflected in the strong equity market performance itself, but also in the relative outperformance of defensive sectors. And yes, consumer spending and labour market data in the US has been robust, while the Fed appears to be in no rush to tighten policy. This could change.
As mentioned, we see the outlook for the US as more mixed, while the option of Fed rate hikes may be back on the table soon. In the Europe, the first signs of the economic impact of the Brexit vote have started to emerge. The outlook component of the German ZEW indicator is at its lowest level since late 2012. In the UK, house price gains moderated sharply in July.
It is still early days in the current US earnings reporting season, but so far, most companies are surprising positively, as usual. But global earnings revisions have turned negative again after a brief period in positive territory. We think it is unlikely that US revenues or productivity can grow more strongly without any wage cost pressure. In the eurozone, somewhat slower growth after the UK referendum and still low inflation make for a challenging environment for profit growth. And political risks only seemed to have increased. In Japan, the strengthening of the yen since the start of the year will likely hurt corporate profits and business investment.
We are also suspicious of the recent drop in credit spreads given the low growth and low inflation, the need for fiscal adjustment and the serious problems in the Italian banking sector. We see a risk that spreads on ‘peripheral’ eurozone government bonds will widen. We also believe the fundamentals do not justify the recent spread tightening on emerging market debt.
We have left our asset allocation unchanged. We are underweight global equities, underweight emerging market debt in hard currencies and underweight commodities. In government bonds as well as in investment-grade corporate bonds, we prefer the US over Europe.
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