There are weeks when sitting down to write this piece is tough because not much worthy of note has happened in the markets or the economy outside of the usual noise. This week, that was most definitely not the case. Thank God it is Friday – we all need a break.
New Market Highs and the Economy Gets Uglier
Thursday the S&P 500 closed at a new all-time high and is now above its 50-day, 100-day and 200-day moving averages. The
Stocks may be partying like it is 1999 (for those who remember that far back) but the yield on the 10-year closed at 2.01% Thursday. To put that in context, on June 9th when the 10-year was down to 2.09%, the Wall Street Journal ran an article asserting that, “Almost nobody saw the nosedive in bond yields coming, but a few players were positioned well enough to profit. Some think there is more room for yields to fall further,” along with this chart. To be clear, despite not one respondent predicting the yield on the 10-year would fall below 2.5% in 2019, none of these economists are idiots, but the thing is they all tend to read from the same playbook.
The stock market is giddy over its expectations for lower rates, yet the spread between the 3-month and the 10-year Treasury has been inverted for four weeks as of this writing, not exactly a ringing endorsement for economic growth prospects. Every time this curve has been inverted for 4 consecutive weeks, it has been followed by a recession (hat tip @Saxena_Puru) for this chart. Note that the chart uses 10-year versus 1-year until the 3-month became available in 1982. Much of the mainstream financial media and fin twit believe this time is different. Time will tell.
Then there is this, with a hat tip to Sven Henrich whose tweet with a chart from Fed went viral – that in and of itself says a lot.
Both US imports and exports have declined from double-digit growth in 3Q 2018 to essentially flat today. The recent CFO Outlook by Duke’s Fuqua School of Business found that optimism about the US and about their own companies amongst CFO’s had fallen from the prior year.
The shipments of goods being moved around the country have plummeted since the beginning of 2018, as shown by the Cass Freight Index.
The Morgan Stanley Business Conditions Index fell 32 points in June, the largest one-month decline in its history.
If all that doesn’t have your attention, consider that the New York Fed’s recession probability model puts the probability that we are in a recession by May 2020 at 30%. Note that going back to 1961, whenever the probability has risen to this level we have either already been in a recession or shortly entered one with the exception of 1967 – 7 out of 8 times.
But hey, the market is going great so no need to worry right? If that’s what you are thinking, skip this next chart from @OddStats.
Geopolitics – From Bad to Oh No, No No
Brinksmanship with Iran continues as in the early hours of Friday we learned that the US planned a military strike against Iran in response to the shooting down of an American reconnaissance drone. The mission was called off at the last minute after the President learned that an estimated 150 people would likely have been killed. Frankly, the official story sounds a bit off, but what we do know is that we are in dangerous territory and one can only hope that some cooler heads prevail, and the situation gets dialed back a whole heck of a lot.
Given we weren’t enjoying enough nail-biting out of the Middle East news, an independent United Nations human rights expert investigating the killing of Saudi journalist Jamal Khashoggi is in a 101-page report recommending an investigation into the possible role of the Saudi Crown Prince Mohammed bin Salam citing “credible evidence,” and while not specifically assigning blame to bin Salam, did assign responsibility to the Saudi government. This week the US Senate voted to block arms sales to Saudi Arabia, rebuking the President’s decision to use an emergency declaration to move the deal forward. This matters when it comes to investing because there are some seriously high-stakes games being played out that have the potential to suddenly rock markets without any warning.
Italy continues to struggle with its budget deficit outside the limits allowed by the European Union, leading to a battle between Rome and Brussels. Friday Deputy Prime Minister Matteo Salvini (head of the euro-skeptic Lega party) threatened to quit his position if he is not able to push through tax cuts for at least €10 billion. While the US has been laser-focused on the Fed (and the president’s tweets) the Italian situation is getting
Today, Italy’s per capita GDP is 2.8% BELOW where it was in 2000 while Germany is 24.8% higher. Even the beleaguered Greece has outperformed Italy. Italy’s debt level is material to the rest of the world, its economy is material to the European Union, its citizens are losing their patience and its leadership consists of a tenuous partnership between a far-right, fascist-leaning Lega and a far-left, communist(ish) 5 Star movement lead by folks that very few in the nation respect. So that’s going well.
As if the European Union didn’t have enough to worry about as its new parliament struggles to find any sort of direction or agreement on leadership, the parliamentary process for selecting the next Prime Minister of the UK is down to two finalists. Enthusiam is rampant.
A hard Brexit is looking more likely and that is not going to be smooth sailing for anyone.
The Bottom Line
All this is a lot to take in, but there is a bright light for the week. Anna Wintour, Vogue’s editor-in-chief and eternal trend-setter, has given flip-flops her seal of approval. So, we’ve got that going for us. If that didn’t put a little spring into your step, I suggest you check out this twitter feed from Paul
As someone famous (or infamous depending on your leanings) once said, “there are known knowns….there are known unknowns…but there are also unknown unknowns.”
We’ve got a whole lot of the second two going around these days and that is not good for growth. Life and investing requires dealing with uncertainty to be sure, but holy cow these days investors and businesses are facing a whole other level of who-the-hell-knows and that is a headwind to growth.
- The bumbling battle over Brexit
- China’s earnings recession
- Slowing in Europe
- Yield curve inversions
- Record levels of frustration with
- The Cost of Corporate Uncertainty
- The battle over the GDP pie
- Beware Reversion to the Mean
The United Kingdom, in or out? The mess that has become of Brexit is wholly unprecedented in modern history. As of March 29th, the day the UK was set to leave the EU, Brexit has never been more uncertain nor has the leadership of the UK in the coming months. This graphic pretty much sums it up.
Many Brits are unhappy with the state of their nation’s economy and are blaming those folks over in Brussels, as are many others in the western world – part of our Middle Class Squeeze investment theme.
Its economy is slowing, but just how bad it is and just how dire the debt situation in the nation is difficult to divine given the intentional opacity of the nation’s leadership. The ongoing trade negotiations with America run as hot and cold as Katy Perry depending on the day and when you last checked your Twitter feed.
Most recently China’s industrial profits fell 14% year-over-year in the January and February meaning we are witnessing an earnings recession in the world’s
Last week the markets ended in the red, driven in part by weaker than expected German manufacturing PMI from Markit with both output and new orders falling significantly – new orders were the weakest in February since the Financial Crisis.
It wasn’t just the Germans though as the French Markit Composite Index (Manufacturing and Services) dropped into contraction territory as well in February, coming in at 48.7 versus expectations for 50.7, (anything below 50 is in contraction). The French PMI output index is also in contraction territory.
This led to the largest one-day decline in the Citi Eurozone Economic Surprise Index in years, (hat tip TheDailyShot).
Yield Curve Inversion
This pushed the yield on the German 10-year Bund into negative territory for the first time since 2016 while in the US Treasury market, the 10-year to 3-month and 10-year to 1-year spreads went negative – an inverted yield curve which has been a fairly reliable predictor of US recessions. The 10-year 3-month inverted for the first time in 3,030 days – that is the longest period going back over 50 years. The Australian yield curve has also inverted at the short end.
No Love for Capital Hill
Americans’ view of their government is the worst on record – another manifestation of our Middle-Class Squeeze Investment theme. Gallup has been asking Americans what they felt was the most important problem facing the country since 1939 and has regularly compiled mentions of the government since 1964. Prior to 2001, the highest percentage mentioning government was 26% during the Watergate scandal. The current measure of 35% is the highest on record.
Few issues have every reached this level of importance to the American public: in October of 2001 46% mentioned terrorism; in February of 2007 38% mentioned the situation in Iraq, in November 2008 58% mentioned the economy and in September 2011 39% mentioned unemployment/jobs.
While America appears to be more and more polarized politically, the one thing that many agree upon, regardless of political leanings – government is the greatest problem.
It isn’t just the US that is having a tiff with its leaders. Last weekend over 1 million (yes, you read that right) people protested in London calling for a new Brexit referendum – likely the biggest demonstration in the UK’s history and then there are all the firey protests in France.
The Cost of Corporate Uncertainty
When companies face elevated levels of uncertainty, they scale back and defer growth plans and may choose to shore up the balance sheet and reduce overhead rather than invest in opportunities for growth. So how are companies feeling?
A recent Duke CFO Global Business Outlook Survey found that nearly have of the CFOs in the US believe that the nation will be in a recession by the end of this year and 82% believe a recession will have begun before the end of 2020.
It isn’t just in the US as CFOs across the world believe their country will be in a recession by the end of this year – 86% in Canada, 67% in Europe, 54% in Asia and 42% in Latin America.
All that uncertainty is hitting the bottom line. Global earnings revision ratio has plunged while returns have managed to hold up so far.
It isn’t just the CFO that is getting nervous as CEOs are quiting at the highest rates since the financial crisis – getting out at the top?
The GDP Pie
To sum it up, lots of unknowns of both the known and unknown variety and folks are seriously displeased with their political leaders.
So what do we actually know?
We know that US corporate profits after tax as a percent of GDP (say that five times fast) are at seriously elevated levels today, (nearly 40% above the 70+ year average) and have been since the end of the financial crisis. No wonder so many people
Corporate profits have never before in modern history been able to command such a high portion of GDP. This is unlikely to continue both because of competition, which tends to push those numbers down and public-policy. If the corporate sector is going to command a bigger piece of GDP, that means either households or the government is going to have to settle for a smaller portion.
It isn’t just the corporate sector that has taken a bigger piece of the GDP pie. Federal government spending to GDP reached an all-time high of 25% in the aftermath of the financial crisis and has remained well above historical norms since then.
Given the level of dissatisfaction we discussed earlier concerning
That leaves the households with a smaller portion of the economic pie – evidence of which we can see in all the talk around how wage growth remains well below historical norms.
Reversion to the Mean
Given the current political climate, it is unlikely that government spending as a percent of GDP is going to decline in any material way, which leaves the battle between the corporate and household sector. Again, given the current political climate (hello congresswoman AOC) it is unlikely that the corporate sector is going to be able to maintain its current outsized share of GDP – the headlines abound with forces that are working to reduce corporate profit margins and as we’ve mentioned earlier, global earnings are being revised downward significantly. If the corporate sector’s portion of GDP falls to just its long-term average (recall today it is 40% above and has been above that average for about a decade), it would mean a significant decline in earnings.
The prices investors are willing to pay for those earnings are also well above historical norms.
Today the Cyclically Adjusted PE Ratio (CAPE) is 82% above the long-term mean and 93% above the long-term median. What is the likelihood that this premium pricing will continue indefinitely? My bets are it won’t.
The bottom line is that the level of both corporate profits and what investors are willing to pay for those profits are well outside historical norms. If just one of those factors moves towards their longer-term average, we will see a decline in prices. If both adjust towards historical norms, the fall will be quite profound
Looking at the moves in the stock market, one would likely think all is right with the world and the US economy is back on track after bobbing and weaving around 2 percent GDP for much of the last several years. That is until we got the most recent reading on the health of the economy.
Friday’s estimate for fourth quarter 2016 GDP came in below expectations at 1.9 percent quarter-over-quarter, seasonally adjusted, versus the consensus expectations for 2.2 percent and the Atlanta Fed’s GDPNow estimate for 2.8 percent. The Fed’s consistently excessive expectations never cease to impress. To put 2016 in context, going all the way back to 1950, only four other years were as weak and they were all recessionary (1954, 1958, 2008, 2009).
This reading was a material decline from the 3.5 percent posted in Q3, but then that was primarily driven by an increase in inventories and exports. The net export contribution in Q3 was the largest since late 2013 was due in large part, and we are seriously not making this up, to soybean exports to South America where the weather decimated their soybean crop, adding a full 0.9 percent to the Q3 GDP growth. Exports in Q4 dropped -4.3 percent with goods declining -6.9 percent, revealing the headwind presented by a strong and strengthening dollar as net exports overall subtracted 1.7 percent from the fourth quarter’s growth. We’ve heard comments from a growing number of companies about the impact of the dollar and foreign currency translation in the current earnings season, but to put it in context, Q4 was the largest trade-related drag on overall growth since Q2 2010.
The U.S. economy decelerated in the final three months of 2016, returning to a lackluster growth rate that President Donald Trump has set out to double in the face of challenging long-term trends.
We are seeing some recovery in fixed investment, with fixed investment in mining, shafts and well structures contributing to GDP for the first time since Q4 2014, thanks to rising oil prices. While this contribution was relatively small, the removal of the headwind of low oil prices in this sector had allowed it to start contributing to GDP. We remain cautious here as the number of rigs coming online is rising week after week (see today’s Monday Morning Kickoff for more), and we remain skeptical that the OPEC deal on production cuts will survive given all the, shall we call them, colorful relationships involved.
Real investment in industrial equipment is at an all-time high, totaling more than $200 billion in 2009 chained dollars and looks to be still rising. On the other hand, investment in manufacturing structures is slowing a bit, which isn’t shocking given that capacity utilization rates are at levels normally seen around a recession.
We have also now seen Consumer Spending decline over the past three consecutive quarters despite all the euphoric talk.
This brings full-year 2016 GDP growth to just 1.6 percent, putting the U.S. growth now in 2nd place within the G7 group with the U.K. delivering growth of 2 percent for the year. We are no longer the cleanest shirt in the laundry. This is the worst growth rate for the U.S. since 2011 and down from the 2.6 percent in 2015. America has now experienced a record eleven consecutive years without generating annual 3 percent GDP growth going all the way back to 1929. Is it any wonder there is a lot of frustration in the country?
Despite what we keep hearing from the Fed, this is not an economy that is accelerating. While over 80 percent of the survey data has come in above expectations, giving investors a sense of security, the actual hard data, rather than the more sentiment-oriented survey data, has seen over 50 percent come in below expectations.
With the recovery in oil prices and inventories back on the rise, two major headwinds have been removed, but the biggest and potentially most lethal remains – a rising dollar. The Fed still appears to be confident that it will raise rates three times this year which increases the dollars’ relative strength. Any trade barriers that result in fewer imports into the US, such as a 20 percent tax on fruits and vegetables from Mexico, would also serve to strengthen the dollar; the less we buy from the rest of the world, the fewer dollars are outside the country. That scarcity bids up the price of the dollar, particularly given the effectively massive short position in the dollar due to the over $10 trillion in dollar-denominated emerging market debt.
Mr. Trump has argued the U.S. can achieve stronger growth by overhauling the tax code, boosting infrastructure spending, rolling back federal regulations and cutting new trade deals that narrow the foreign-trade deficit.
The two big hopes that Wall Street has been relying on to boost the economy have been President Trump’s infrastructure plan and his tax cuts. This past week we saw signs that our concerns over when these would actually be enacted are warranted. Last week senior congressional aides revealed that the spring of 2018 is a more likely target for passage of tax reform legislation. According to Reuters, as the days passed at the annual policy retreat for Republicans last week in Philadelphia, leaders were also discussing that it could take until the end of 2017 or even later to pass fiscal spending legislation. Trump has taken office with the lowest approval rating in modern history and the level of controversy surrounding him isn’t declining, which will likely make passage of legislation he wants more challenging.
Putting it all together, despite the headlines over more sentiment-oriented reports, the economy does not look to be accelerating and the expectations around the timing of Trump’s infrastructure spend and tax reform plans are likely overly enthusiastic. Even the Wall Street Journal’s survey of over sixty economists projects GDP growth of 2.2 percent in the first quarter of 2017 and 2.4 percent in the second. We will continue to monitor the data to see how likely that consensus view becomes in the coming weeks. We believe the market is also incorrectly discounting the potential negative impact of a strengthening dollar and the degree to which this strengthening may occur.
We keep hearing, particularly from the Federal Reserve and those in DC, that the economy is improving. Hmmm, let’s look. With consumer spending responsible for roughly 70% of the economy, how about retail sales?
Ok, so maybe not there. How about employment? We keep hearing about how strong employment has become.
The percent of working-age people who are actually employed is back where it was over 30 years ago. That doesn’t look like a recovery to me.
What about new jobs? The level of job openings looks to be rolling over as well.
As for inflation concerns?
Not so much there.
But then it is tough to get inflation going when we have a heck of a lot more productive capacity than we need!
As for industrial production, that peaked way back in 2014.
As for that painfully weak GDP growth, if we strip out healthcare costs which have been on the rise as a percent of household spending in recent years, we get an economy that is nearing stall speed.
Bottom Line: The data is not painting a clear picture of an economy that is strengthening, but rather one that is rolling over, having never achieved even the typical average rate of growth. Keep this in mind when looking at equity markets sporting historically rich valuations.
Friday we saw a great jobs number but… were the knock-it-out-of the ballpark numbers really indicative of a (finally) robust economy? Hmmmm, methinks there is more to it all. You’re shocked right?
I spoke with Matt Ray yesterday on America’s Morning news about the jobs report and how I thought the data could be misleading. You can listen to our chat by clicking here. Today, after seeing the NFIB report, I decided the topic deserved a thorough analysis, so I’ve added a lot here to what we discussed.
To start with, this number can be quite volatile, so if we look at a three-month rolling average, the current gain is still 26,000 less than the average during the first six months of the year. We did like to see a 0.4% rise in average hourly earnings last month, bringing the annual rate up to 2.5%, which is the strongest in the past six years. That bodes well for holiday spending, which ought to have companies like Amazon pleased as punch. If we look at the labor-force participation rate however, that remained unchanged at 62.4%, which is 0.5 lower than in January. This data point is one that causes yours truly much angst. Think of this as a measure of what percentage of the population is rowing the economic row boat. The more that row, the faster we can go. Today we have roughly the same portion we had in the late 1970s, not exactly a robust growth period for the nation!
The news of the strong jobs report sent the markets into a tizzy as the probability of the Fed kicking off the first interest rate hike in more than nine years at their next meeting in December soared to 68%, which is almost double the odds of such a hike just one month ago. One of the arguments for such an increase is that it would provide some assistance to savers, who have been struggling to earn much of anything on their savings. Hmmmm, if the Fed raises rates, and yours truly still considers that unlikely given the bigger picture of the US economy and slowing global growth, it will likely only raise rates initially by 0.25%. Over perhaps the following year it could theoretically get to 1%, which would in reality still do very little to help savers. The true beneficiaries would be those providers of money market funds that have been forced to eat the cost of overhead to give investors in such funds even the tiniest of yields. This led to soaring share prices of companies like Charles Schwab, E*Trade Financial and TD Ameritrade Holdings on the jobs news Friday.
In contrast to Friday’s robust report, today’s report from the National Federation of Independent Businesses revealed that job creation came to halt in October, with owners adding a net 0.0 workers per firm in recent months. 55% reported hiring or trying to hire, which was up 2%, but 48% reported few or no qualified applications for the positions they wanted to fill.
If we look at other economic indicators, we see that things really aren’t as rosy as Friday’s job report would lead one to believe.
Last week started with the weakest headline ISM (Institute of Supply Management) Manufacturing report since December 2012 at 50.1, however many economists were expected a reading below 50, (which is a contraction) so this was actually better than expected. Whoop, whoop! But, a painful portion of the grim report came from ISM Manufacturing employment, which is now at its lowest reading since August 2009 – good times! Thankfully manufacturing is a relatively small share of the total US economy, but we’d prefer to see more upbeat data. Overall manufacturing just looks awful, with everything but customer inventories lower year-over-year, as this next chart illustrates.
If that didn’t drive it home, this next chart on US Industrial Production ought. The Industrial Production index shown below is an indicator that measures real output for all facilities located in the United States manufacturing, mining, and electric, and gas utilities. This index is generated using 312 individual data series. The chart below shows how its longer-term upward trend from the depths of the financial crisis stalled towards the end of last year and is now trending downwards.
In fact, on a global level, manufacturing has been under pressure with the Global Manufacturing Purchasing Manager’s Index, (an indicator of the economic health of the manufacturing sector based on new orders, inventory levels, production, supplier deliveries and the employment environment) down to 51.4 from 52.2 a year ago. Remember that anything below 50 is a contraction. On the bright side, the number is a seven-month high. In the US, the Manufacturing Purchasing Manager’s Index is down to 54.1 from 55.9 a year ago, but up from 53.1 last month.
Speaking of inventories… this next chart almost speaks for itself. The wholesale inventory-to-sales ratio is at a level not seen out of a recession in decades, but I’m sure that’s nothing to be concerned over! Looking back at history, keep in mind the strides made in inventory management in order to keep inventories as low as possible to maximize returns. In a perfect world, the second a business gets an item into inventory, a customer grabs it right off the shelf. The longer items sit on the shelf, the more money the business has sitting idle. It is best to look at inventories relative to sales, as if sales double, it would be reasonable for a business to need to keep more inventory on hand. When we see inventories relative to sales rise dramatically though, that means that businesses are having more items sit on the shelves for longer, which is never a good sign.
On a more upbeat note, the ISM non-manufacturing beat expectations mightily, coming in at 59.1 versus expectations for 56.5, down from last month’s 56.9. So the manufacturing sector is continuing to weaken while the services sector strengthens. The good news is the service sector counts for a larger portion of the economy, however the fly in the ointment is that these two tend to move along much closer together and are now diverging to a point not seen since late 2000/early 2001. This is cause for concern as we have every reason to believe the two will return to their historical relationship. Given the global picture, at the moment it looks more like services will move towards manufacturing than the reverse.
If we look at construction, it is also struggling. Residential construction spending rose 61 basis points in September, driven primarily by gains in private residential spending, without which, the spending number would have actually declined month-over-month.
Recently the Federal Reserve released its Senior Loan Officer Survey reported that for the first time since early 2012, a net 7.3% of bankers reported tightening standards for large and mid-size firms based on a less certain economic outlook. Most banks also reported weakening demand for most categories of mortgages since the second quarter while seeing credit card credit demand increase. In response, banks reported having eased lending standards on loans eligible for purchase by Fannie Mae and Freddie Mac. Tightening credit conditions are a headwind to economic growth, of which Chairperson Yellen and her team are highly aware. We’re quite sure they are watching this data very closely.
Looking at the Global Economy…
Monday morning the OECD, (Organization for Economic Cooperation and Development) lowered its global growth forecasts for 2015 and 2016 to 2.9% and 3.3% versus 3.0% and 3.6% previously. This comes just a few weeks after the International Monetary Fund predicted that the world economy would, in 2015, grow at its slowest pace since the financial crisis. We are particularly concerned with global exports as world trade has long been a strong indicator of global growth and so far in 2015, trade levels have been at levels typically associated with a global recession. To further drive home our concerns on global trade, we looked at the reports coming from the largest shipping company in the world, A.P. Moeller-Maersk, which handles about 15% of all consumer goods transported by sea. The CEO of A.P. Moeller-Maersk recently stated that, “The world economy is growing at a slower pace than the International Monetary Fund and other large forecasters are predicting.” Err, wait, what?! They just reported trade levels that are typically seen during a global recession and this guy thinks it is even worse? Argh! The company reported recently a 61% drop in third quarter profit as demand for ships to transport goods across the world hardly grew from a year earlier.
China, the world’s second largest economy, reported that its exports declined 6.9% year-over-year versus expectations for 3.8% and marked the fourth consecutive month of declines. In India, exports of the top five sectors including engineering and petroleum fell by about 31% in September on a year-over-year basis. Keeping a wary eye out here!
To put the chart below in perspective, world trade grew by 13% in 2010, but has been slowing considerably since then. The WTO (World Trade Organization) lowered its forecast in volumes to 2.8% from 3.5%, which is well below the 7% average for the 20 years leading up to 2007.
Bottom Line: We are seeing diverging data coming out on the domestic economy and continue to be concerned with the weakness we see in global commodities, transports and particularly in global exports as they typically lead global GDP trends. The combination of new trade barriers being introduced faster than existing ones are being removed coupled with cyclical problems that include falling commodity prices and debt overhang are acting as headwinds to global trade, which harms economies all over the world. While the US is the largest economy and is driven to a large degree by internal demand, it is not immune to the fates of the global economy. As is such, the US manufacturing sector is teetering on the brink of a recession. Whether the service sector, which is typically correlated with the manufacturing sector, can remain strong is yet to be seen.
P.S.: It isn’t only global trade that is suffering from too much government intervention. Today The National Federation of Independent Businesses released its Small Business Economic Trends Report which revealed that the single most important problem facing small businesses is (1) Government Regulation and Red Tape followed by (2) Taxes. The government could do a lot to stimulate the economy, by getting the hell of out it!
China isn’t the only country slowing, as we are sure you’ve all been hearing, the global economy is slowing to a level that ought to make everyone pay attention. Earlier this month the International Monetary Fund (IMF) cut forecasts for 2015 yet again, projecting 3.1% versus its prediction in July for 3.3% and its April prediction for 3.5%. This means that this year, despite the unprecedented level of monetary stimulus injected all over the world by government desperate to get things moving… the world economy will grow at its slowest pace since the global financial crisis.
Last week, Citibank cut its global growth forecast for 2016 for the fifth consecutive month, predicting 2.8% versus the previous forecast of 2.9%. Keep in mind that Citibank’s chief economist William Buiter has stated previously that global growth below 3% coupled with a significant output gap effectively represents a global recession. Now that’s just one person’s opinion, but it conveys the importance of these numbers.
If we take a brief tour around the globe, we’ll see that the Eurozone in 2014 finally posted positive growth of 0.9%, after having contracted in 2012 and 2013. The first quarter’s growth rate came in at 0.5% with the second quarter slowing slightly to 0.4%, giving the economy about 1.2% growth year-over-year.
In mid-November, we’ll get the first estimate for the third quarter, which so far is likely to be at around the same pace as the second. On Friday, we got some good news when the Eurozone Markit Composite PMI (Purchasing Manager’s Index) came in at 54 (above 50 is expansionary). The data for services came in nicely at 54.2 with manufacturing unchanged from the prior month at 52. So there is some growth in the region, though from a historical perspective it is still relatively weak. So let’s dig into the details.
If we dig a bit deeper, we see that the Eurozone’s largest economy, Germany, is suffering from the slowing in China and Russia, two major export partners with its 2nd quarter GDP coming in at 0.4%. Consumer confidence has been falling since the first quarter, but it still maintains an enviable unemployment rate of less than 5%, with a youth unemployment rate of 7%, which bodes well for the nation’s productivity in the future.
France, the Eurozone’s second largest economy, on the other hand experienced no growth in the second quarter, versus expectations for a 0.2% increase with an unemployment rate of just under 11% and a youth unemployment rate of nearly 25%.
Italy, the Eurozone’s third biggest economy experienced just 0.2% growth versus 0.3% expected. Unemployment has remained stubbornly high at nearly 12% with youth unemployment over 40%, which is a devastating number for the future of the country. However, Prime Minister Matteo Renzi has made a lot of progress in reforming the government, so despite those rather dour numbers, consumer confidence is higher today than it has been over the past 12 years! Directions are important – we can’t just look at the numbers in isolation.
So things aren’t great in Europe, but they aren’t horrible either… however, significant growth seems perpetually illusive with rising concerns that the slowing in China and the emerging markets could be a tipping point for the area, which is likely why the head of the European Central Bank, Mario Draghi, hinted last Thursday that the ECB (Europe’s version of the Fed) is willing and ready to inject more quantitative easing into Europe’s economy. More QE, the now omnipresent heroin of the stock market was promised and equity indices all over soared!
So what about China? How bad it is there? Truth is, no one really knows. The country is based on an ideology that requires opacity at all levels of government, so accurate data or even an honest attempt at accurate data is something we are unlikely to ever get from official sources.
Those sources recently reported that China’s growth in Q2 was 6.9%, close enough to the official target of 7.0%, but being below, it provides a wee bit of cover for some stimulus. And wouldn’t you just know it! The People’s Bank of China, essentially their Fed, just lowered lending rates…a coincidence we’re sure!
Taking a step back, China has cut their 1-year interest rate 6 times since November of 2014, lowering the rate from 5.6% to 4.35%… but we’re sure everyone there is quite calm! The Required Deposit Reserve Ratio for Major Banks has been lowered 4 times since February, from 19.50% to 17.50%. This ratio determines how much leverage banks can have, which translates into loans. The lower the ratio, the greater the leverage which means more loans… more of nothing to see here folks? We don’t think so.
Here are a few more interesting data points:
- China’s export trade has fallen -8.8% year to date.
- China import trade is down 17.6% year to date.
- Railway freight volume is down 17.34% year over year.
- China hot rolled steel price index is down 35.5% year to date
- Fixed asset investment is up 10.3% sounds great? (averaged +23% 2009-2014)
- Retail sales are up 10.9%, the slowest growth in 11 years
- China Containerized Freight Index, which reflects the contractual and spot market rates to ship containers from China to 14 destinations around the world, has just hit its lowest level in history, now 30% below where it was in February and 25% below where it was at its inception 17 years ago.
You get the point. It is slowing and we suspect it is slowing a lot more than the official GDP numbers would indicate.
Why should those of us outside China care? Because China has been a major supporter of global growth since the financial crisis. When all hell broke loose in 2007 & 2008, China put its infrastructure spending into high gear. That meant that those economies that supply commodities had a backup buyer for their exports when everyone else was crashing, which put a vital floor under the global economy.
But China couldn’t keep it up indefinitely, and we are seeing the consequences of that nation’s shift from a primarily export driven, massive infrastructure-building economy to a more domestic demand-driven economy with a lot less infrastructure spending.
China has been Germany’s fourth-largest export partner, with Russia not that far behind. Falling oil prices and sanctions have crippled Russia’s economy, so it also isn’t buying much from Germany. If Germany sells less, it’ll buy less from other nations… and keep in mind that all those Eurozone countries are just barely eking out positive growth, so small changes will have an impact.
Onto those emerging economies, many of which were benefiting from China’s infrastructure spend as they are primarily commodity exporters. If we look at what has happened to commodity prices over the past twelve months, you can get an appreciation for just how painful this has been for many of these countries. Keep in mind that 45% of global GDP comes from commodity export nations – commodity prices crater and these nations can buy less stuff from other nations – more headwinds to growth.
In fact, 2015 will be the fifth consecutive year that average growth in emerging economies has declined. This is a serious drag on the advanced economies, which on the other end of the spectrum, will likely post their best growth since 2010 – albeit growth that isn’t all that spectacular.
Japan… well it’s still stuck between barely growing and contracting, regardless of how much the Bank of Japan tries to kick start the economy. Japan’s industrial output unexpectedly fell in September, raising concerns that the nation may be slipping back into another recession. Production declined 0.5% in August following a 0.8% decline in July versus economists’ expectations for a 1% gain. Inventories rose 0.4% in August over July, and expanded in five of eight months this year, which is a hindrance to future growth as with rising stockpiles of unsold goods, companies are less likely to expand output in the future.
As for Latin America, Argentina is still a mess and Brazil is in a recession, with many of the other countries doing alright. Chile is expected to be around 2.5% for 2015. Colombia 2.8%… like we said, ok, not great.
In the US, things aren’t awful, but not exactly robust, which is why I had been predicting for months that the Fed would not hike rates in September.
- For example, the Industrial production index came in with another decline of -0.4% in September versus expectations of -0.2%, which makes it the 5th decline out of 8 reported figures in 2015.
- Capacity utilization, which measures to what degree the economy is taking advantage of its ability to make stuff, was expected to drop from 78% to 77.8%. Instead, it fell further to 77.6%, for the 7th decline out of 8 readings in 2015. This means the U.S. continues to use less and less of its capacity to make stuff – hardly shocking given the wide misses in manufacturing data reported by regional Federal Reserve banks for August.
- September retail sales came in below expectations, rising a seasonally adjusted 0.1% from August versus expectations for 0.2%. The good news is the increase came from a 1.8% month-over-month increase in auto sales. Overall retail sales, when we exclude autos and gasoline, have not grown since January.
- U.S. producer prices in September posted their biggest decline in eight months, at a drop of -0.5%, as energy costs fell for the third month in a row. This means that the Producer Price Index is now down 1.1% year-over-year as of the end of September.
- U.S. total business sales also declined in September, down -0.58% month-over-month and down -3.09% year-over-year as of August.
Going forward, I still remain very skeptical that the Fed will raise rates. The fact that China is continuing to loosen its monetary policy and comments out of the ECB concerning it likely embarking on further easing only add to our skepticism as the moves by China and the ECB will already put upward pressure on the dollar, harming U.S. exports. A rate hike would only exacerbate the dollar strengthening against other currencies.
Fed tightening has been a trigger in nine of the last eleven recessions, so you can see yet another reason for the Fed to be cautious.
The tough thing now is that with a Fed that can’t seem to make up its mind, investors are left wondering what to do, so they end up selling the good and the bad when they get nervous. This will make for increased volatility, but that also means more opportunities for those that keep focused on the goal and don’t get distracted by shorter-term market dramatics.