GLOBAL TRADE: IS THE RECOVERY ALREADY OVER?
At the depth of the trade slowdown last year and early this year, exports from developed and emerging economies fell markedly, largely due to currencies weakening versus the US dollar. In local currency terms, the declines were less severe. By the spring and into the summer of this year, trade started to recover. In August developed economies’ exports turned positive in annual growth terms, both in US dollars and in local currency. Emerging market exports were still marginally negative in US dollars, but positive in local currency. However, these improvements came to a halt in September. China’s exports and imports disappointed strongly. Excluding the Chinese numbers, trade looks better, but the average annual growth rate of other early-reporting countries (Brazil, Chile, South Korea, Taiwan and India) still slipped back to become negative in September.
Structural factors such as muted global growth, weak investment growth, slower globalisation and a slower pace of new trade deals are still weighing heavily on global trade, which implies that the halt to the improvement in September was more than just a hiccup. The weakness in the first part of the year was probably due to a global manufacturing inventory-correction cycle, which should have largely run its course. We do not foresee a vigorous recovery in global trade from here.
Related to the trade cycle is a possible onset of inflationary pressure in Asia. Chinese producer price inflation turned positive in September for the first time in almost five years. However, we do not think that inflationary pressures are building in China or elsewhere in Asia. The higher producer price inflation in China is strongly correlated with higher commodity prices and the weakness in the trade-weighted renminbi, both of which are effects that should soon fade. Moreover, the price gains in September were concentrated in some heavy industry sectors and do not look sustainable. With house-building set to slow, investment still quite weak and the overall economy slowing, we expect Chinese producer prices to return to mild deflation. Elsewhere in Asia, producer prices in Japan and South Korean export prices were still firmly deflating in September.
US CONSUMER CONFIDENCE AND SPENDING SLIP
Constituting almost 70% of GDP, household consumption is the bedrock of the US economy. So, the sudden decline in consumer confidence apparent in a University of Michigan survey should not be ignored. This gauge of consumer confidence is traditionally sensitive to car fuel prices, but we do not think that recent rise in gasoline prices justifies the drop in confidence to its lowest level in a year. The impending US election appears a better explanatory factor. Overall we do not think the drop in September is in itself a reason for great concern at this time.
September’s increase in US retail sales looked strong at first sight. But removing the skew from stronger-than-headline car dealer sales as well as fuel and building materials sales, the monthly gain was a modest 0.1%. The annual retail sales growth rate fell to its slowest pace since February 2014. We think that downward pressure on corporate profitability is a risk for household income and employment and thus for household spending. Slower momentum at the end of the third quarter would also raise the bar for a rebound in the fourth.
Would this have implications for the Fed? The minutes of the September FOMC meeting showed that even for some of those voting to keep rates on hold, the decision to do so instead of hiking was a close call. In our view this shows how data and market-dependent the Fed is currently. In the wake of some weak economic data – especially the ISM manufacturing and non-manufacturing indices – the Fed did not want to hike. With the ISM indices bouncing back in September and expectations much higher for a hike in December, we think the Fed will pull the trigger. The Fed’s Labor Market Conditions Index remained negative in September. But we find it difficult to square the weakness in this index with the actual data. That momentum in the labour market may be slowing is something to watch, but our view is that it makes a stronger case for a very gradual hiking path than for the Fed staying on hold in December.
A POSITIVE SURPRISE IN THE EUROZONE?
We believe the eurozone economy is on a steady growth path. The composite PMI dropped a little recently, but the Economic Sentiment Index improved. The strong gains in industrial production in several eurozone member states were later confirmed by the number for the whole bloc. This suggests that the industrial sector should flip from being a drag on growth in the second quarter to being a positive contributor in the third. However, while exports bounced back in August from a July decline, the gain in exports in the first two months of the quarter was slower than the gain in imports. Thus, trade may flip from supportive in the second quarter to a drag in the third. And with retail sales growth slowing throughout the quarter, a positive growth surprise in the third quarter cannot be taken for granted.
ASSET ALLOCATION: HIGHER VOLATILITY
Volatility in US equities has recently become more pronounced while staying flat in the eurozone. Obviously the presidential election is looming large for US financial markets. No matter who wins, there will be uncertainties around the cooperation between the new president and Congress, as well as about global trade and regulation.
Another source of uncertainty relates to bond yields. Yields have increased in the US and in Germany, but in the US the uptrend looks stronger while we still expect the ECB to deliver more monetary easing in December. In any case, German yields are capped by the ECB’s asset purchase programme. Obviously, if bond yields rise further this will have implications for equities as it will impact the rate at which future profits are discounted and thus affect the price-earnings ratio. However, this impact may be small, or even positive. At low bond yields the correlation between yields and P/E ratios tends to be positive, probably as higher yields would point to less economic uncertainty. But higher yields would also hit corporate borrowing and corporate debt service ratios, especially after the aggressive re-leveraging in the US corporate sector in recent years.
In this uncertain environment we have left our cautious asset allocation unchanged, with underweights in global equities (with a preference for an underweight in Europe), in emerging market debt in hard currency and in commodities. We have hedged upside risks to risky assets through an overweight in US small caps versus large caps. If risky assets go up, we think small caps will outperform. But they should also benefit from the M&A cycle in the US. We have also hedged the upside in the US through an attractive options structure.
Last week we mentioned the sharp moves in the British pound and the Mexican peso. After having taken profit on our British pound versus the US dollar position earlier, we were not inclined to step back in. But regarding the peso we have taken a position versus the US dollar through options where we receive the premium as long as the peso does not weaken further.
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