The number of market-based signals indicative of a slowing global economy are mounting along with weak GDP data in a number of important countries. In the face of a strong dollar and weak foreign currency translations, I believe it is unlikely that US multinationals can navigate this period without a hit to earnings growth. Share buybacks can help mask the deterioration in earnings but eventually, by early to mid-2015 the weaknesses will become apparent. As a result, the present sell off in shares is warranted as is the rally in government bonds. Commentary for Credit Writedowns Pro subscribers below
Last month I did a country by country macro in two parts (see here and here). In that analysis, the United States and Great Britain stood out as two economies with decent or strengthening macro numbers, while emerging markets and China showed weak or declining numbers. A number of data points have been released since that review which suggest that the global economic weakness is both pervasive and enduring, and, therefore, will ‘infect’ the US and UK data, to the detriment of corporate profits and equity and high yield markets which depend on those profits.
Here are a few of the most salient data releases.
TIPS breakevens. Inflation expectations embedded in the TIPS market have been collapsing since early August. According to Reuters, following the Fed’s most recent meeting and an unexpected monthly drop in the US CPI in mid-September, downward momentum in breakevens has been “at its most intense since the financial crisis”. 10-year breakevens are now below 2%.
This is the most compelling data point that widespread disinflation has reached the US and is not just a European phenomenon. I have two takeaways here. First, the Fed may delay its rate hikes if inflation does not trend back toward 2%. Doves like Evans will increasingly win the battle inside the Fed in 2015, when Dick Fisher and Charles Plosser retire. Second, the lower breakevens foreshadow lower inflation, which means lower nominal GDP growth and hence lower earnings growth and lower bond yields and equity return. This is bullish for high quality and government bonds but negative for equities and for insurance, pension and investment portfolio returns.
European inflation. According to Ambrose Evans-Pritchard at the Telegraph, the 5-year/5-year forward swap rate in the Eurozone has plummeted beneath 1.77%.
(source: Telegraph)
The numbers are now breaking well below the range of trading established when the sovereign debt crisis began in late 2009. As with the TIPS signal, the forward swap rate is, therefore, sending a market signal that inflation expectations are collapsing in the Eurozone as they are in the US, in a way that is salient to forecasters and investors.
European bond yields. At the same time European government bond yields keep hitting new lows, despite recent downgrades of French and Finnish debt by S&P. 10-year German Bund yields have been at record lows below 0.90%.
And Belgium, which has long struggled with government debt, now has 10-year yields lower than the yield on French debt, both of which are also near record lows of 1.17% and 1.26% respectively.
This has occurred despite Standard and Poor’s cut of France’s credit outlook to ‘negative’, due to concerns about the economic recovery. Finland encapsulates the prospects for Europe as it lost its AAA rating from S&P, which explained the cut by writing that the “downgrade reflects our view of the risk that the Finnish economy could experience protracted stagnation because of its aging population and shrinking workforce, weakening external demand, loss of global market share… and relatively rigid labour market.”
Takeaway: Japanese-style low growth and demographics will keep inflation low and yields will also remain low. Note that Greek 10-year yields have been rising, showing that the decline in yields in core government bonds implies a backstop from the ECB. In Greece, default risk remains.
Commodity prices. The Bloomberg commodity index has trended down from the 280 level to below 240 today, reflecting widespread weakness in the commodities space. Now, arguably supply factors are at play in the oil market due to the shale oil boom in the US. However, oil is not the only market with weakness. Agricultural commodities are weak, as are precious metals. And this broad weakness likely then is a signal that demand growth and inflation will remain low, making commodities and hard assets relatively less attractive.
In Latin America in particular, this could be a problem as the economies there are heavily geared to commodities export. CEPAL, a Latin American economics group, reports that exports out of Latin America declined 0.2% in 2013 and are expected to rise a mere 0.8% this year. Brazil will see a 3.4% decline, while Columbia will see a drop of 4.4%.
There are many more data points which confirm this declining trend. For investors, the macro takeaways are manifold.
- First, the so-called emerging markets crisis is in its infancy. The hiccup we saw in early 2014 will be followed by more turbulence down the line as EM adjusts to a new less accommodating global growth environment.
- Second, in discussions I have had with EM specialists, it is not the balance of payments that is the problem. Rather it is the increasing leverage within EM, particularly EM corporates that presents a challenge. In the recent Geneva report, we saw that global deleveraging just hasn’t happened. And this is because of a massive EM leveraging in the wake of the original currency wars, post-US QE. Asia is particularly problematic here and the contingent liabilities for governments may become real when crisis returns
- Third, EM will underperform in this environment. And so, there is a better entry point into EM in the future. My contacts tell me EM local currency government debt, hedged via appropriate currency management is a potential option once the shakeout has played out.
- Fourth, demographics and growth will cause Europe to underperform and periphery debt, especially in Greece and potentially Portugal and Italy will come into question. Italy desperately needs growth and, as the 2nd largest government bond market in the world, the ECB backstop is important to maintain low yields as government debt to GDP heads toward 140%.
- Fifth, US earnings have got to come under pressure here. A lot of what we saw in the recovery has been multiple expansion predicated on a favourable economic backdrop. In a global growth slowdown, this backdrop becomes much les favourable.
- Sixth, the Fed will be caught between a rock and a hard place on monetary policy. If it decides to raise rates, expect growth to ease even more and for the yield curve to flatten appreciably. If the Fed stays on hold due to decelerating inflation expectations, government bonds will be less attractive but still relatively better than equities.