Economics

Economic Insights – Week ahead 11/01/2016

Headlines:

  • First week hangover: don’t blame it all on China

  • Coming up: more slowdown evidence

  • L’Europe en danger! Et ses femmes!

  • Brexit is hard to do

  • Markets: sauve qui peut! Every stock for itself!

 

First week hangover

2016 has got off to what can only be described as a rather poor start but I am sticking to my headline last week that we may well all be ‘doomed but just not yet’.  China is currently getting most of the blame but, in fact, the real causes are problems carried over from last year:

  • The slowdown in growth is global and not only the fault of China’s manufacturing
  • The central bank with most clout remains the US Fed even if others are more deluded.
  • China has almost nothing to do with the Syrian crisis threatening Europe.
  • All markets have become fragile and exposed to stampedes

Alas, the hangover follows what was  not even that much of a party. Much of 2015 went by with the Fed’s signalling its desire to remove the proverbial punchbowl and finally doing so just as Santa was expected with his proverbial rally. So, it should really be no surprise that things look grim right now and, unfortunately, there appears to be no equivalent to PG Woodhouse’s ‘Jeeves famous hangover cure’. Hangovers are wretched but they do eventually fade and I remain convinced the major stock markets will end 2016 not so far away from where they started, albeit they are more likely to take a few nasty tumbles on the way and from which not all may recover fully by next December. Having said that, last week’s rout in equity markets included the worst ever start to the New Year in the US and has given new material to the soothsayers who routinely come out with such bonmots as ‘Santa Rallies’ and ‘Selling in May’. The latest sooth is ‘as the year starts, so it proceeds’ and this may well prolong the hangover for the more nervous. Why not take a look at Chart 1 and judge for yourself?

 Chart 1 S & P 500 in 2016?: Pick a number between -40% and +30%

1.png

Source: Pension Partners via Financial Orbit

Coming up: more slowdown evidence

Two charts from last week highlight the current challenges to the global economy and  provide a framework for assessing data to be published in the coming weeks. Chart 2 from Caixin/Markit came out on Wednesday showing China’s Manufacturing, Services and the combined Composite PMIs for December. These surveys are widely regarded to be as close to being independent as any data from China.The shock was that the Services PMI had for the first time ever fallen below the 50 level that delineates expansion and contraction.Taken to extremes, which inevitably it was (especially by the new archetype gung-ho investor, Mrs Wong), this could mean that the whole Chinese economy was contracting in December. So, forget the official GDP growth rate of 7% and the switch to Consumption! It is going to become increasingly difficult for the authorities to massage the next batches of data and so this week we can expect further softening in both Exports and Imports. Later in the month Retail Sales and Industrial Production in December may also be reported as softer but the authorities will probably try to tough it out with reporting 7% GDP growth in 2015 as a whole.

Chart 2 Caixin China Output PMI: Services pooping the Party

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In contrast, at first sight the December US Labor Market numbers seemed very encouraging when they first came out on Friday: 292K new hires in the month, previous months revised higher, another nudge higher in the Participation Rate and also in Average Hourly Earnings. However, the doomsters have since been busy deconstructing the data. Chart 3 tells a similar story to the UK in so far as almost all recent new hires are in the Services sector, where many jobs are lower paid, unskilled and less productive. Indeed, average hourly earnings did not increase month on month from November. Perhaps even more worrying is that of the 292K incease in the December Non-Farm Payrolls 281K represent an annual adjustment because of the Festive Season that may or may not be accurate. This week Industrial Production is almost certain to be soft again but there may be some cheer in Retail Sales, which are due for a good month after struggling over the last few months. In other words, whether the US is even close to growing at 2% per annum depends almost entirely on shopping.

Chart 3 US cumulative new jobs by sector: low skill, lw pay

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Here in the UK, Industrial Production may actually be better as the ONS seems to report good and bad numbers in alternate months but the year on year headline for Manufacturing Output is still set to show a deterioration. Also due for an uplift are British Retail Consortium sales in December (shopping again!). The MPC meets this week but the only question is whether Ian McCafferty will fall back in line with his colleagues and vote to hold Base Rates (probably not). The most interesting announcement will be the NIESR’s rolling 3-monthly GDP estimate (not a forecast) which will cover Q4. The previous two rolling estimates came out at +0.6% which suggests an estimate for Q4 of no worse than +0.5%, which sets up a potential clash with the ONS’s first cut when it is published later this month.  Chancellor Osborne will have to put up with the latter’s numbers but will not welcome any further downward revisions for previous quarters. His downbeat ‘poisonous cocktail’ speech last week, however, should be seen as a political rather than economic warning. Protocol prevents his giving hints to the MPC but Tory MPs need a wake-up call on Brexit risk and, of course, he must ensure that he gets none of the blame if his upbeat message of only one month ago turns out too optimistic. It should always be remembered that Mr Osborne is usually (but not always!) at least two moves ahead of everyone else.

Meanwhile in the EZ, mixed data suggests that although its economy is no longer getting worse significant recovery remains elusive. This week, with Italy and Spain taking centre stage, should add to this picture following last week’s Unemployment (slightly better), CPI (under pressure again), Industrial Production (stalling) and PMIs (slightly better).

L’Europe en danger! Et ses femmes!

One thing that can be said for the EZ elite is that they take holidays very seriously. Sadly, there has been no avoiding the shocking accounts of muggings and sexual assaults in parts of Germany but who would guess that all the major problems are still festering. Greece is not and, to be fair, probably cannot, comply with the bail-out conditions, Italy and France are trying to neutralise the Stability and Growth Pact, Germany is still trying to block the Single Bank Resolution, Portugal and Spain are without stable governments, Denmark wants no more integration, there is a North-South dispute over gas pipelines from Russia, the Bundesbank is trying to subvert the ECB’s monetary policies und zo weiter. The Brexit negotiation is a minor irritant by comparison.

 

However, there is no doubt the Syria crisis represents the greatest threat to Europe and it has already undermined the Schengen agreement on free movement and returned high wire fences to Eastern frontiers. Migration generally brings direct economic benefits to all concerned: more jobs, more public spending but tax receipts taking over from initial social benefit outlays but this time the problem is so many migrants’ arriving at once. This point is made in a most civilised way in the following extract from an article by Klaus Brinkbäumer, Editor in Chief of DER SPIEGE:

9:26 p.m. – 25 Dec 2015 · Details

No migrant leaves his or her home casually, frivolously or even with any kind of pleasure at all. It is a far-reaching decision and all who pull up roots know it, even those who are still in their formative years. The migrants who come to us merit empathy — and what choice do those people have who come from war-torn Syria? What would we do in their situation?

There is proof for everything — for almost every thesis as well as for its antithesis. Regions that have integrated many migrants in the past are prosperous today, but integration only works if the state doesn’t lose control, and Germany at present has lost control. Of course there is a basic human right to asylum, but without an upper limit — enforced, if necessary, with border controls — it will be almost impossible to find a way out of the crisis.

The political and social disruption is only just beginning and it is hard to be optimistic. Much is being made of the rise of extremist political parties but I would suggest that the most sinister long-term threat is to the status of women unless ‘multiculturalism’ is made more sympathetic to them.

Chart 4 Brexit voting intentions

4

Source: YouGov via The Times

Brexit is hard to do

Full disclosure: both my head and heart are in favour of the UK staying in the EU. Heart is easy to explain as my father was an immigrant, my wife and I between us have family and friends in 8 other EU countries and I spend up to 2 months every year in Italy and France. Head (from an economic stance) is slightly more difficult if the post-Brexit outcome is merely a ‘Swiss/Norway plus’ deal in a free-trade zone although I boggle at the logic of  still  being bound to most European Treaties without being able to participate in future decisions.  The extreme solution of joining some sort of ‘Anglo-Saxon’ English-speaking trade group (specifically with multiracial US, Canada, Australia and New Zealand) seems even more illogical as well as politically fanciful and economically reckless. At least our European partners value our trade!  Nevertheless, it may well be that fear of migrants from Syria, Somalia, Afghanistan and Pakistan rather than Europe itself will tilt the balance in favour of Brexit,  which would ironic in a number of ways, not least because we would need to increase trade with many such countries.

Chart 4 from pollsters YouGov shows referendum voting intentions to be very finely balanced with a narrow split between both men and women. The party political differences are as one might expect, which means people in London, the North and Scotland want to stay while those in the English shires want to leave. There is a more fundamental polarisation between those educated to ‘A’ Level and above (stay in) and those below (out) and also those aged under 30 (stay in) and over 50 (out). There is less polarisation by social class: AB and CI would prefer to stay while C2 DE want to leave. As with most referenda the onus will be on those who want a change and xenophobia as opposed to lofty superiority traditionally does not go down well in the UK. A sub-plot may well develop in which it becomes a matter of confidence in David Cameron personally, which should stay the hand of many Tory Eurosceptics. I would like to think the pointlessness of Brexit might swing the balance.

Markets: Sauve qui peut. Every stock for itself

OK, let’s get China and last week’s 10% belly flop out the way first. Foreigners are still not allowed to get much involved directly via the domestic stock exchanges and most are too smart to want to. With major shareholders subject to restrictive lock-in regulations, the wild swings are all about ‘Mrs Wong’ and the authorities clearly do not know what to do about her, given the absolute priority of keeping the Communist Party in power. The international repercussions are to undermine confidence in global growth and corporate earnings while the clumsy devaluation of the renminbi is more of an issue for China’s trading partners amongst the Developing Economies. It is all very unsettling but investors will just have to get used to it while Mr Xi decides how much he wants to ‘embrace the markets’ as The Economist mischievously put it back in July or, as now seems more likely, prop them up!

Chart 5. Xi ha!

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Source: Bloomberg

Some Emerging Markets are easier to get into than others but none look attractive right now and this highlights the problem of investing in broad asset classes and geographical markets. Where to get a positive return is proving increasingly hazardous for Japanese investors who are inclined to repatriate when risk is in the air but the resulting boost to the yen is counterproductive, especially for exports to China and other Developing Economies. European equities were fashionable last year but neither exports nor domestic demand are growing fast enough to encourage hopes for much further progress, albeit earnings multiples are still relatively modest compared to the US. In the UK the FTSE 100 looks a rather unhappy cocktail of beaten-up overseas resources companies and UK standard bearers in sectors facing margin squeezes and/or enforced structural change. The FTSE 250 has so far proved to be a more solid representative of UK plc and the wider economy but even it failed to escape last week’s sell-off.

Chart 6: M & A to the rescue?

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Inevitably, one has to look to the US for investment ideas but even this is not clear-cut. Valuations are historically very high especially when considering the prospects for future growth. After two soild years earnings of S & P 500 companies probably fell by at least 4% in 2015 and the outlook is still not encouraging. Share buy-backs no longer look so attractive to corporate executives nor does holding on to their stock options. There may be a silver lining in the form of M & A deals although even these may involve significant equity swap elements. It is only once one starts digging deeper that slightly more hopeful signs appear. If one strips out the energy and materials sectors, average corporate earnings turn positive with Consumer Dicretionary, Healthcare and IT topping the bill. This is yet another reason not to invest only in asset-classes and market indices.

Even better is to seek out individual companies that have a new story to tell and/or are temporarily off many investors’ radar screen. These stocks should be able to move independently of the general market or their sector but also be sufficiently liquid to enable short-term trades. This approach is applicable elsewhere but the US and the UK offer the most accessible opportunities. This ‘stockpicking plus’ strategy is the principle on which we recently launced our DAN-Trade equity product. Of course, there will always be great companies to buy and hold for the long-term but that too is becoming increasingly subjective-and risky!- in the current skittish markets.

Meanwhile some investors will continue, when all else fails, to rely on the Fed to bail us all out. Plus ça change …….

Chart 7 When you wish upon a star…….

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Source: WSJ Survey of Economists via WSJ

 

Central bankers at the helm?

The term ‘secular stagnation’ suggests a prolonged period of low growth, low inflation and high unemployment but it is quite tempting to opt for a less formal definition along the lines of an economic condition during which official monetary fails to stimulate growth.

In the US, the FOMC seems increasingly divided over when to start raising interest rates but somehow still unanimous in denying that ZIRP and QE2 and 3 have all been largely futile. This denial has put Committee members in a bind. On the one hand, they are concerned about asset price bubbles but on the other are also are worried that raising interest rates could cause a stock market crash and drive businesses and households into crisis. In this rarefied world they are joined by investors who know what FOMC members think and even know that they know they know and vice versa! There are similar worlds occupied by the ECB, BoJ and PBoC. On this basis, it is possible to assume that money will remain cheap indefinitely, asset prices will keep rising and that central bankers, while nominally at the helm are unwilling and unable to steer in a new direction. This is not attractive to your typical central banker!

So what’s do be done? Almost certainly, follow the Bank of England in doing nothing for an indefinite period while opening up new lines of research on macroeconomic and monetary policy. This could well lead to the conclusion that private debt is just as relevant to growth as public debt and that it is the commercial banks that separately and cumulatively determine aggregate credit. In fact, the Bank has issued research notes that suggest it is half way there already. This is a subject for much future discussion but in the short-term it suggests that rates should not be raised until both growth and inflation look to be firmly established. In the meantime, it is probably best to let equity markets correct (the UK market does not look outrageously expensive anyway) and speculation in gilts burn itself out. More controversially, it might be worthwhile to regulate more precisely lending for speculative investment.

Selling off now assets acquired under QE programmes would represent premature tightening but allowing some to run-off without replacement might reduce ongoing distortions to market rates. Again more controversially, such a run-off might create some space for the central bank to fund directly public investment. Such controversial policies would be more fiscal and, therefore, political than monetary and would throw into question the need for an independent central bank. Don’t hold your breath!

Wakey wakey!

It is definitely time investors for investors to wake up to the unreality of the world they share with central bankers. Writing in the Financial Times George Magnus put it well:

Speculative euphoria, even when encouraged by central banks, is defined by the way it ends — not with a whimper but with a bang….. Investors are still chasing low or negative yields in bond markets, fairly or fully valued equity markets, and rising property markets. Yet, it seems increasingly that, long-term investors aside, they are playing a greater fool game.

Investors often get their timing wrong often disastrously and the following chart shows that we may be at or close to another turning point where there will not be a greater fool waiting to buy.

 1 jun 5

Source: Streetalklive.com

Sovereign bond markets have become the gaming tables of speculators as who else could justify buying assets with negative yields to sell on to an even greater fool?

1 June 6

Turning again to George Magnus:

……the persistence of low real interest rates implies an environment of low real investment returns. So any euphoric returns today will be counterbalanced as night follows day. Central banks may be going boldly to the outer limits of monetary policy to encourage investors to buy risk, but it is difficult to reconcile the appetite for risk with what those policy actions actually imply.

Should investors throw in the towel? It is a conundrum. Institutions are still buying European debt on negative yields. Investors who have missed the doubling of the Chinese stock market since mid-2014 wonder if they can afford to stay out.

At least the penny appears to be beginning to drop amongst some people as shown in a recent BofA/Merrill Lynch survey of fund managers. Increasing one’s cash holding seems a smart move even if one is too superior to go for all that ‘sell in May’ stuff.

 

1 june 7

Regular readers will be aware that I advocated in March last year selective selling of equities and avoiding sovereign bonds. This may have cost money but it has also saved many sleepless nights. It is still not too late to do so now. However, I remain as convinced as ever that some individual stocks will ride though any storm provided one is willing to see them drop by up to 20% before recovering again. I also believe that returns as low as 4-6% through fixed rate coupons dividends or even capital appreciation are worth considering during a period of low growth and low inflation.

Melting fudge

The Greek government sent last night for approval by the ‘ex-Troikasent’ a list of measures, as with Mr Varoufakis’s first bid to the Eurogroup of finance ministers, sound long on pious intentions and short on costed detail. It is very possible, therefore, that this second bid will not be immediately accepted today but a new fudge is surely likely before the real deadline of February 28th, when a €7.2bn tranche of IMF loans is due to be handed over under the existing bailout programme. A deal will happen simply because Greece is desperately in need not only of the IMF money but also further significant support from the ECB in the coming days and weeks. The treasury is emptying rapidly as taxpayers have been taking advantage of the political uncertainty to delay paying their dues while the banks are similarly running out money due to the massive outflow of funds out of the country. Rumours are still swirling about capital controls becoming necessary whether or not the country stays in the EZ. This why the Syriza government had to surrender on Friday and faces further humiliations.

Here are two contrasting figures on Greece, which can be used by the Prosecution and the Defence. While they should not be taken too literally they do help to explain the prejudices of the various protagonists. Figure 2 shows Greece at the top of a list of miscreants since its independence in 1832. However, Figure 3 also shows Greece to be top, this time of the OECD pops since 2007 on reforms promoting economic growth. No wonder Greece tried to replace the evil Troika with those nice folks at the OECD!

Defaults and Rescheduling, 1800-2010

Default

OECD reform ranking 2007-14

OECD

Probably too much has been written already on Friday’s deal but it is interesting to note how the verdict seems to have changed. At first it was widely held that the Greeks had done quite well, thanks to the brazen support of the EU Commission, the ECB, IMF and the French and Italian governments with Mrs Merkel stepping in to over-rule Mr Schäuble. This is certainly the view of all those who believe that the EMU is truly irreversible and think it time Germany stepped up to do its duty and open its wallet. For what it is worth, here is my alternative view:

  1. The Germans, including Mrs Merkel and even the SPD, are in no mood to take prisoners and if that means Grexit, so be it! It is still not sufficiently understood that they have the legal obstacle that any form of financial transfers are contrary to the Maastricht Treaty and would probably be challenged successfully at the Constitutional Court in Karlsruhe. The only flexibility is on timing, some detailed conditions and interest rates. Unless Greece agrees and observes the extension of the current bailout programme, the Germans seem prepared to accept Grexit and the losses that it would entail. It is all or nothing and not just to kick the can down the road. That, of course, does not mean that the usual EMU games will not be played of sticking the blame on the other side for any failures.
  2. A wider German purpose is to beat up Greece ‘pour encourager les autres’ in the EMU. To be fair, some of ‘les autres’ (Spain especially but also Portugal and Ireland) have for their own reasons elected to support Germany as have the Netherlands, Finland, Austria and Slovakia. The message is clear to France, Italy and their federalist supporters at the EU commission and ECB: stick to the rules and also that German money is not available in any circumstance. German resolve is being stiffened by the surge of popular support for the anti-austerity Podemos Party in Spain and the battles over even minor reforms that the French government is having with its deputies in parliament. Moreover, the Germans are still fuming over the preliminary European Court of Justice opinion on Mr Draghi’s sovereign debt support scheme and also over the proposed QE programme.
  3. Even wider German purposes, which is where Mrs Merkel comes into her own, seem to be to preserve the EU as a buttress against both EMU federalists (in Brussels and at the ECB) as well as Russian aggression. Both require the UK, Sweden, Denmark and the Czech Republic to stay onside.

Now, that’s what I call strategic thinking! It is up to the Greeks to choose between European money and national sovereignty. It was not what Syriza promised to voters and it is hard to believe that they will not try to buy time to wriggle, obfuscate and hoodwink. As Mr Schäuble cruelly observed: “The Greeks certainly will have a difficult time to explain the deal to their voters.

Any fudge this week will surely melt long before the end of the four months’ extension. After Grexit the next question will be whether France can put up with German intransigence or Germany with French recalcitrance.