POSITIVE SIGNALS FROM LEADING INDICATORS
Leading indicators are pointing to solid growth in the short term. In the eurozone the manufacturing and services PMIs improved again in November, taking the composite index to its highest since August 2015. While purchasing managers’ indices for German and French manufacturing declined, they nevertheless remained in growth territory and the weakness was amply compensated for by higher confidence numbers in the services sectors. Germany’s Ifo index broadly held at its elevated October level. So, the outlook for the eurozone looks solid.
GDP growth in Germany disappointed slightly in the third quarter as net external trade was a drag on growth and fixed investment was flat. However, a tight labour market supported robust consumption growth, which represents a solid base. GDP growth in the UK held up well in the third quarter due to strong consumption, a positive contribution from net trade as imports fell and surprisingly positive growth in business investment. Thus, the consequences of the Brexit vote have not become visible yet, but we think that higher inflation due to the weak British pound and high uncertainty will leave marks going forward.
In the US the Markit manufacturing PMI improved further in November, while the services sector PMI only retreated by a notch, leaving the composite PMI solidly in positive growth territory and at its highest since last November. Durable goods orders jumped after a surge in extremely volatile aircraft orders. Orders for non-defence capital goods excluding aircraft – a better proxy for business investment in equipment – rose modestly. Orders and shipments of core capital goods seem to have bottomed after sliding from September 2015 to July this year.
Consumer confidence jumped in the US in November, making up October’s pre-elections loss. Eurozone consumer confidence also picked up, indicating that consumers are reacting to the positive tone in financial markets since the US elections amid hopes of stronger growth.
SUSTAINABLE IMPROVEMENT IN CHINESE PROFITS?
One of the most positive developments in the Chinese economy in recent months has been the improvement in producer prices, ending a spell of deflation from March 2012 through August this year. Recent gains in commodities are driving producer prices higher. While this may overstate the pricing power of Chinese companies to some extent, higher prices have led to a profit recovery. This should make the stabilisation in the Chinese economy more sustainable.
There is a caveat. The improvement in profits and activity in general has been largely driven by the infrastructure, real estate and the automotive sectors, which have all benefited from government stimulus. We will watch closely for signs of the impact of the stimulus fading and for any reaction by the authorities.
ASSET ALLOCATION: TAKING PROFITS ON INFLATION-LINKED BONDS
When we opened this trade in July, we felt that discounted inflation was extremely low. We saw this position as a hedge against the negatively tilted risk exposure of our overall asset allocation. In other words, if the global economy was stronger than we envisaged, inflation-linked bonds could benefit, compensating partly for our underweights in equities, emerging market debt and commodities. Since July, inflation break-evens have risen by roughly 25bp in France, Germany and Italy amid the stabilisation in commodity prices, a still mostly dovish ECB and more recently by hopes for fiscal stimulus. Since we have not seen any improvement in wage dynamics, we decided to gradually take profits on the strategy.
In equity markets, there are some clear risks ahead, which is why we maintained a reduced underweight in equities. Polls ahead of the Italian referendum on 4 December almost universally point to a rejection of the reform proposal, which would have uncertain political implications. On 8 December the ECB’s governing council may decide to slow the bank’s monthly asset purchases since the eurozone economy is doing okay. This may well keep the discussion about the timing and pace of the ECB tapering its quantitative easing alive. Given these uncertainties we did not want to close our underweight, which is concentrated in Europe.
The discussion on the possible tapering of the ECB’s asset purchases, as well as the diverging prospects for growth and inflation, led US and German government bond markets to decouple. While US yields have held at recent peaks, German yields have retreated, taking yield differentials to their highest since the late 1980s. Due to spread widening in the eurozone’s periphery, particularly in Italy, the impact on our long US government bonds versus EMU government bonds is smaller than the recent market moves suggest.
We have kept our underweight in emerging market debt in hard currency and in commodities. Emerging debt spreads have widened and local currency yield curves have steepened due to expectations of higher growth, higher inflation and weaker currencies, although the increase in risk spreads has been modest given the sharp rise in US government bond yields. Looking purely at the spread level and ignoring the carry, we are close to neutral in this strategy. But given the uncertainties for emerging markets from higher US yields, a stronger US dollar and possible protectionism, we have not closed the position.