Welcome back to Credit Writedowns!
Labor Day is behind us now and I intend to have a much more regular posting schedule going forward. But the lack of posts has given me some time to reflect on the global macro situation without the need to write about it on a daily basis. And this has given me some distance from the situation to reflect more objectively.
I think the key question here is whether the macro economy has enough wherewithal to power through minor or even major economic surprises. I believe the US economy is still above stall speed but the global economy is decelerating on multiple fronts even while political and military upheaval is increasing. To my mind, this means risks are now weighted to the downside in a way that favours an overweight position in safe haven currencies and asset classes. Some analysis follows below.
In mid-August I updated you on my Ten Surprises list. But a lot has happened since then. So let me start off with several updates to my Ten Surprises list based on the data that have come out in the last couple of weeks. Predictions are in bold. Afterwards I fill in some other data points before closing with commentary on what this means.
Brazil goes into recession. When I updated the list in August I said I thought that this one would be a miss because the urgency of the emerging markets crisis had receded and government spending was up 11% year-on-year. Unfortunately, however, my prediction has been borne out in the data released last week. Brazil is now in recession. Q2 2014 GDP fell 0.6% from Q1 2014, which itself was down 0.2% from Q4 2013. And this comes in spite of the election year stimulus campaign by government.
Industrial production was down 1.5% q-o-q and 3.4% y-o-y. Investment was down 5.3% in Q2, the worst showing since early 2009. Moreover, consumer confidence reached its lowest level since 2005 according to July data. I find all of this alarming because Brazil is a large emerging markets economy that was pulling out the stops to maintain growth and it still wasn’t able to do so. Argentina is imploding, with strikes, inflation and default all coming together. Chile also saw manufacturing production decline 4.1% y-o-y in July with retail sales now growing at the slowest pace in 5 years. So Brazil is not alone.
The year-on-year contraction for Brazil is 0.9% for Q2 2013 to Q2 2014. Brazil’s economy could contract outright in 2014.
Spanish GDP growth rebounds and outstrips German GDP growth. I still believe this is on course to occur. But now, the story is less about Spanish outperformance and more about German weakness. And that’s a less bullish story than the one I had been making. Now, we know about France and Italy but now it’s the Eurozone as a whole that is a problem. Eurozone manufacturing growth is at a 13-month low, with a PMI of 50.7 in August, down from 51.8 in July. New orders were below 50, signalling contraction. And Germany is at an 11-month low of 51.4 on the PMI.
And note that Eurozone inflation is at a 5-year low of 0.3% through August. That puts deflation on the doorstep.Mario Draghi was surprisingly blunt at Jackson Hole, calling for fiscal measures and calling attention to the fact that monetary policy alone wasn’t going to help Europe. I don’t think his pleas will have measurable impact. Europe, then, will face weak growth, a deflationary threat and the potential for more debt deflation if we see an economic shock.
Vladimir Putin knows this and is pressing his advantage in Ukraine, cognizant that Europe does not want to cut its own throat by sanctioning Russia. Where this conflict goes is anyone’s guess. But, the risk is weighted to the downside now and that goes for Spain as well as Germany.
US growth below 2%. They way I put this was for Q2 and Q3 to be sluggish. But what has actually happened is that Q1 was so poor that full year forecasts are actually coming in at around 1.5%, above stall speed but very weak nonetheless. Q2, now at 4.2% annualized growth, is officially the high water mark, surpassing Q3 2013, which I have touted as the high water mark. And while much of this was catch up growth, we cannot completely dismiss the vigour of the US economy, especially in comparison to Europe.
Here’s the thing though; even after Q2’s 4.2% growth, average growth in the first half of the year is still only 1%. Yes, that is better than Europe. But no, it is not robust and is close to stall speed. Even if the US is not directly affected by Russian sanctions, the interconnections globally could be negative for the US with Europe near contraction again.
10-year US Treasury yields fall below 2.25%. We touched as low as 2.34% last week and are just at 2.40%. The importance here is that since August we have broken below a yield trading range between 2.50% and 2.80% that had held since September of last year except when breaking out to the upside before the disastrous Q1 data. That is a worrying sign for me because it means that, despite rate hike worries, the market is essentially telling us these rates will be backed out down the line due to sluggish growth and recession over the coming years. The US economy is weaker than the data would suggest.
Abenomics ‘fails’ as Japanese GDP growth slips below 0.5%. This prediction was already fulfilled via Q2 data. If you take Q1 and Q2 data together you get a net contraction of 0.3% for the first half of the year. And that follows a Q4 2013 contraction of 0.2%. I would call that failure. Now there is some data out that shows year-on-year labour cash earnings rose by 2.6% in July. And that is important. But the long-term outlook is weak. Harry Sender at the FT writes, for example:
Japanese makers have lost their competitive edge. In June, industrial production fell 3.3 per cent, bringing it to 6.9 per cent below its January peak. Parse the numbers and the story is even more sobering. For example, information and communication machinery in June was 44 per cent below its 2010 average, while the production of flat-panel televisions and mobile phones were 97 per cent and 71 per cent below their 2010 averages, according to Masaaki Kanno, chief Japan economist for JPMorgan in Tokyo and a former Bank of Japan official.
The problem with relying on currency depreciation is that it gives producers an artificial and temporary boost. Meanwhile, as Mr Kanno notes, Japanese consumers are (finally!) losing their preference for Japan-made goods.
Without the third arrow of reform and consistent wage growth, Abenomics will be a bust. And I believe wealth confiscation schemes may make an appearance.
China’s growth slows in at least two quarters to a 6% annualized rate. I’m not sure about the numbers here yet because I haven’t parsed the data. However, I had thought the growth slowdown was behind us. Recent data point to more weakness ahead. The HSBC manufacturing PMI slowed to 50.2 with these notable bullet points:
- Weaker expansions of both output and new orders recorded
- Job shedding intensifies
- Input costs decline for the first time since May
Meanwhile the official PMI also slowed to 51.1 from 51.7. I see the housing slowdown as a major contributing factor here because it is so widespread, 64 of 70 cities in a recent survey. With Brazil and China slowing, we have two of three biggest EM countries slowing. Luckily India is seeing a rebound in growth, with growth at a 2 1/2-year high.
There are a few odds and ends I haven’t mentioned here like the slowing in tax receipts in Norway, South Korea showing weak export numbers, Switzerland lobbing in a no-growth quarter and the fall in Russia and Ukraine’s currencies. But all of these factors are ones that show global growth deceleration and economic weakness.
My overall impression of the data flow is that it shows the global economy weakening more quickly. The big developed economies collectively show below 1% growth, which is 1 to 2% below where it would be in a more robust and ‘normal’ economic environment.
If we combine the deceleration in growth, with the stall speed dynamics in Europe and Japan, the deflationary threat in Europe, and the slowing in China and Brazil, it says that economic turmoil could precipitate another global recession. The risks are to the downside globally and the US is not immune to these risks. I believe this means policy rates will remain low nearly everywhere. And to the degree the US raises rates, it will not flow through across the curve, causing the yield curve to flatten further. This is a government bond bullish scenario.