The Big Conversation
Episode 89: A slowdown is coming - should we care?
This week we look at the data which is starting to roll over and points to an economic soft patch ahead. There was a time that this would be a worry for stock markets, but in today’s world of intervention, a delay to taper or even an expectation of more QE would more than offset a slowdown in business activity. Most of the data remains very robust, but the momentum is starting to wane in the three largest economic regions. Central banks have shown they are far less tolerant of slow growth versus higher growth (and inflation) and could react with more accommodation if the data deteriorates.
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Roger [00:00:00] A slowdown is coming, but does it matter? Many key data sets have been disappointing compared to expectations, and that's reflected by the Citi Global Economic Surprise Index now dipping into negative territory. Policymakers had engineered a rapid rebound off last year's lows, but it was inevitable that this would run out of steam at some point. But is that a negative for financial markets or does it mean that additional QE is actually more likely than a taper from here? One of the biggest questions for the recovery is whether it will be sustainable without the efforts of extreme monetary and fiscal policy. The U.S. budget deficit had hit a record level outside of a war footing when it reached minus 20 percent of GDP in Q1 of this year. It has improved, but still remains extreme. The budget deficit in frugal countries such as Germany is also at record levels, although not at such an extreme. Most measures of government debt to GDP have soared over the last few months, although some of this has been offset by central banks buying back that debt and putting it onto their balance sheets. But right now, just at the point when investors are contemplating a taper announcement from the Fed, the macro data is starting to roll over, albeit from high levels, implying that more accommodation such as QE rather than a slowing of bond purchases may actually now be necessary. The market's response to Powell's Jackson Hole speech last week was underwhelming, to say the least. In fact, if he did announce a taper, yields may well fall from here, rather than follow the 2013 blueprint, where they surged higher because the decline in bond purchases today may take some of that inflationary expectation out of the market. Last week we saw that the 50-day moving average for the US 10-year yield was about to cross down through the 200-day moving average. In previous periods, that's generally, though not always, led to steep declines in bond yields. So what about the macro data today? The ISM manufacturing index remains strong, though it's hard to maintain these levels for long periods of time, and it's now given back that euphoric peak from earlier this year. If the ISM falls from here in subsequent months, but stays in the mid 50s, then the economy remains in strong territory, and of course, it's considered to be expanding if reading is anywhere above 50. A decline here would indicate a slowing of momentum rather than a slowing of the economy. The latest ISM data will be released shortly after we recorded the show. Now some of the regional surveys are starting to move significantly lower. The Richmond Fed Manufacturing Survey has dropped back to nine, whilst the Empire Survey missed expectations by a considerable margin. All however also remain in expansion territory. Over the last few months, manufacturing has been on a tear in order to satisfy that huge pent-up demand that had been created by the lockdowns and sluggish activity of the early pandemic era. But much of the inventory rebuild has now taken place. The inventory cycle is one of the most powerful elements of the business cycle. But U.S. business inventories have been replenished to pre-pandemic levels. They could still build further to regain the old trend, but the inventory cycle and all the demand that it represents is nearing completion. Durable goods had helped lead that charge with a surge in orders during the second quarter of 2021. But these lagging indicators are set to turn much lower because of the impact of higher prices on consumer sentiment. The University of Michigan Consumer Sentiment Index has fallen to a 10 year low because of the price of large-scale items such as housing and vehicles has exploded higher due to the problems with supply chains. Demand had been strong because household savings grew at a rapid pace through the pandemic period. But price, in many instances, has moved too quickly and is now destroying that demand. It's often said that the best thing to cure high prices is high prices, especially if the demand behind them is not sustainable in nature. If prices led demand, then demand will eventually decline, and furthermore, supplies will eventually overcome the bottlenecks to take advantage of the higher prices and then driving those prices lower. Investors will therefore be closely watching the new orders components of the ISM release. It has remained largely range-bound for the last few months. If there is a reading below 60, it would still be a historically robust number, but it would also indicate a change in momentum to the downside. If it was just the US that was seeing a change of data momentum, then we could have expected some regional asset allocations, even though the US market has tended to outperform under a variety of different economic conditions over the last year. The US market held its own versus the DAX, even when the reflation trade, which should have favoured the export-heavy German index, was in full swing. When the yield curve moved higher, Germany should have been outperforming. However, it's not just the US economy that appears to be losing momentum in the key macro data, Europe and Asia are seeing a similar change in trajectory too. The ZEW indicator of economic sentiment for the Eurozone has dropped significantly off its recent high. This could be a repeat of the reverse and rebound in the second half of 2020, but that was during a period of much greater economic uncertainty than today. Other data points around Europe that had also seen surges are now dropping right back to Earth. Like the year-on-year industrial production data for Germany, Europe's industrial powerhouse. More and more of the base effects, which had helped fuel those earlier gains, are now working in reverse. And Europe never saw the benefits of the reflation trade because most of it was confined to the US economy. And within the Asia region, the key economy of China also continues to consolidate. China's retail sales are falling back to trend, a trend which was gently downward sloping for most of the last decade. High single-digit growth is still impressive, but with the Delta variant of COVID leading to a new wave of localised lockdowns, plus the regulation on many consumer companies, the growth in retail sales will fall further. China's key manufacturing PMI narrowly drifted into contraction territory in August, although the current reading of 49.6 was a regular occurrence between 2018 and 2019. So this is not exactly an unusual event, but this once again reflects the stated aim of China's policymakers that they're trying to realign the economy away from growth at any cost. And that's one of the reasons why emerging markets continue to underperform many developed markets, despite a reflation narrative that was all-pervading during the first half of this year. China has shifted away from the fixed asset investment mantra of the last 20 years, they're trying to rein in the excessive of credit. M2 money growth, after the emergency surge to deal with a COVID pandemic has now returned to the lows of 2018 and 19, which is the time period where the economic changes started to take shape. And to reiterate this point, we can also see that this is the time period where the growth in the shadow banking system, which is the off-balance-sheet growth in social financing, well that turned negative. The government is still providing the economy with supportive credit at the headline level, but it has been turning the screws on the leveraged private sector. And this change in direction is being projected onto the global landscape in the shape of slower demand for many reflationary assets. Therefore, due to a combination of supply chain issues exacerbated by COVID, high prices impacting consumer demand and policymakers that are contemplating tighter policy, we should expect the macro data points to weaken further from here. But does that matter for financial markets in the broadest sense? For much of the last decade and certainly most of the last five years, U.S. asset prices have loved an environment of weak economic growth and the ongoing threat of more central bank intervention. US markets wobbled between 2014 and 2016, threatening to break down after the second mini devaluation from China at the beginning of 2016. But once the risks of a stronger dollar had been neutralised, which in turn stabilised the global industrial and commodity sectors, equities were again able to push higher, driven by the tailwind of European and Japanese QE. Outside of the US, the major factor for economies and asset prices has been the willingness of China to continue its credit-fueled growth, which they were willing to do at the beginning of 2016. But as discussed earlier, China changed tack a few years ago and no longer favours this credit-fueled growth policy. The global reflation trade never materialised this time around, apart from a few commodities reacting to a weaker dollar or to severe bottlenecks within supply chains. Emerging markets have continued to underperform. For the US, where there has been an improvement in growth expectations, the higher bond yields have actually been destabilising as they were at the beginning and end of 2018. Today's broad-based US equities have effectively switched away from price-earnings momentum towards pricing in liquidity momentum. And given the levels of debt, US risk assets remain very sensitive to higher yields, which in turn has a knock-on effect into global markets. As a result, policymakers are very wary of higher bond yields. But there's still quite a lot of breathing room anyway, with current yields around one point three percent still well short of the year's highs of one point seven five percent. Therefore, if weaker data means that the Fed becomes increasingly reluctant to commit to a taper, then an economic slowdown should be good for broad-based U.S. equities. If it comes with lower yields, then it should be particularly good for the tech sector, which have become duration assets. Value stocks will fare less well and banks should lose some of their lustre if long-dated yields fall and yield curves start to flatten again. The US bank index relative to the S&P has moved in lockstep with the US 10-year yield for the last decade. So the first opportunity for the Fed to announce a taper is the FOMC on the 22nd of September. Now we've got the ISM today and the payroll's later this week. The payrolls data remains too volatile for sensible comparisons with prior periods. But if the direction of the data momentum is down for now, we should expect the Fed to stall for time. They can announce a framework for tapering this month, but investors are not going to jump into any trades if the start date of a potential taper is open-ended. And we have to remember that from 2014 to 2016, the Fed were happy to regularly step back from any commitments to a tightening of policy. That said, many would argue that the taper of 2013 was itself a misstep and then the rate hike at the end of 2013 was a miscalculation that they quickly tried to rectify. They currently seem reluctant to take any bold steps towards tightening, given how they're happy to let inflation measures surge. The point is that weak economic data used to be bad for risk assets, but not anymore. If the last recession saw US equities quickly make new all-time highs, then a slight slowdown should also be beneficial today. If the threat of a slowdown drives long- dated yields lower, or the threat of a taper takes some of the inflationary pressures out of the market, then both these scenarios should be beneficial for stocks. Now long periods of higher equity markets and declining volatility does increase the risk of downside air pockets. But so far the data is heading in the direction of more policy accommodation being required rather than a beginning of tapering. And of course, if you've got any questions about this episode or any other episodes or the broad-based economy or financial markets, please do put them in the comments section or send them to an email address, which is TBC@Refinitiv.com, and we'll be happy to answer them. Thanks very much.