September 2019: Market Viewpoints

By Manish Singh | Market Viewpoints

Sep 27

Summary

In further evidence of business morale plunging in Germany the factory activity in Germany shrank at the fastest pace in a decade. Furthermore, the weakness in Germany's huge industrial sector is spilling over into the rest of the economy and impacting the service sector. The Ifo Institute forecasts 2019 economic growth in Germany at +0.5%. It now seems Germany may struggle to record any economic growth this year. The manufacturing downturn has deepened and job creation has stalled, amid greater pessimism for the future. Bottom line: Germany is in recession. However, I am not entirely bearish on the prospects of the Euro area in the short term and this is largely due to policies announced recently by the European Central Bank (ECB) and a hint that the Euro area may finally be moving (albeit very gradually) to a more counter-cyclical fiscal stance. Highly indebted Euro area nations, particularly Italy will benefit the most from the latest ECB largesse.

Despite this week’s violent US Money Market jitters, the US Federal Reserve (Fed) looks to have a clear plan for managing monetary policy and liquidity conditions. The Fed is now considering growing its holdings of US Treasurys for the first time in five years. During the month of September, the US-China trade narrative has continued to evolve, in a positive light, as President Donald Trump has toned down his abrasive tone and sought reconciliation. While the two sides are still far from a final deal, the chances of a compromise are growing. No further escalation in the trade spat should be seen as a short term deal and one that will help risk assets rally further.

As for Brexit, with the Supreme Court wading into the debate via its unanimous judgement this week, in my view, an immediate General Election is the only way forward in order for the electorate to get back into the Brexit debate - which has become the property of vested interests, professional well-funded lobbies and lawyers.


UK: A General Election now!

The UK Supreme Court has spoken and it has ruled the prorogation of parliament by the government of Prime Minister Boris Johnson unlawful. The emboldened opposition is up in arms and wants Johnson gone. If only there were democratic means to get rid of Johnson. Oh wait, it’s called a General Election, and the opposition won't have it despite calling for it consistently over the last six months!

With the Supreme Court wading into the Brexit debate via its unanimous judgement this week, in my view, an immediate General Election is the only way forward in order for the electorate to get back into the Brexit debate - which has become the property of vested interests, professional well-funded lobbies and lawyers.

The state of UK politics is such, that in the House of Commons, we have Members of Parliament (MPs) who purport to represent the will of the people and who have changed parties - sometimes more than once - without doing their constituents the courtesy of asking them for their permission by standing in a by-election. We have Green, Labour and Liberal Democrat MPs demanding a second referendum, before the first one has been implemented, whilst declaring that they would reject the result of that second vote if it went against them. We have backbench MPs in charge of the most important foreign policy - Brexit deal/no Deal outcome. So much for upholding democracy and the will of the people!

We must have a General Election now. Maybe the people's 2016 choice to leave the European Union (EU) has truly changed. Maybe this Supreme Court ruling has produced serious doubts about the current government and the judgement of the Prime Minister. Let’s find out.

The British voters are slow to anger but when they are treated with the contempt shown by the politicians, as is the case now, watch out for their wrath and its various manifestations.

Germany is “in recession”

Earlier this month the influential Ifo Institute predicted that Germany would suffer its worst economic growth in six years, as production in German factories continued to slow down. It warned that the German economy would likely contract by -0.1% in the third quarter. This Monday, we received another set of data which has all but confirmed that Germany is in recession. Germany’s economy contracted by -0.1% in the second quarter. A recession is defined by a period of negative economic growth for two consecutive quarters.

In further evidence of business morale plunging in Germany, September’s Manufacturing PMI reading came in at a woeful 41.4 (MPMIDEMA in the chart below). A reading below 50 is a sign of economic contraction. Factory activity in Germany shrank at the fastest pace in a decade. Furthermore, the weakness in Germany's huge industrial sector is spilling over into the rest of the economy and impacting the service sector (MPMIDESA) which is also losing momentum fast. Germany also recorded its first Composite PMI (MPMIDECA) reading of less than 50 since 2013. The Ifo Institute has its forecast for Germany’s 2019 economic growth at +0.5%. It now seems Germany may struggle to record any economic growth this year. The manufacturing downturn has deepened and job creation has stalled amid greater pessimism for the future. All of this whilst enjoying the enormous benefit of the weak Euro exchange rate compared to if it had its own currency.

Germany’s pain: Germany’s private sector is suffering from the worst downturn in over 7 years

Germany’s pain: Germany’s private sector is suffering from the worst downturn in over 7 years

Source: Bloomberg

If that were not enough, these are febrile days in East Germany. The right-wing Alternative for Germany (AfD) party, is firming up its support. After becoming the largest opposition party in the Federal Parliament two years ago, the AfD has now established itself as a dominant force in Germany’s former German Democratic Republic (GDR), home to about one fifth of the population. In the recently concluded elections in Brandenburg and Saxony, where more than 5 million people were eligible to vote, the AfD notched stellar numbers. In Brandenburg, the AfD nearly doubled its vote share from 12.2% to 23.6% and finished just 2.6% points behind the ruling centre-left Social Democrats (SPD) which has run the state since German reunification in 1990. In Saxony, the AfD tripled its share from for 9.7% to a whopping 27.8% and finished just 4.5% behind the ruling Christian Democrats (CDU). As Germany’s economic woes deepen, the East-West divide will only get worse. The Euro area economy is contracting and Germany is a proxy and lead indicator. The European Union (EU), which for years managed to follow protectionist policies and safeguard its manufacturing, now lies exposed as the cost of protection ratchets up

Germany, as the Eurozone’s largest economy, should be playing a pivotal role in combating the economic slowdown. Yet, it just drags its feet.

  • In 2018, Germany recorded a budget surplus of +1.7% of GDP which amounts to approximately €58 billion
  • Over the last five years, Germany has accumulated a budget surplus of €160 billion. In the same period, France, Italy and Spain have accumulated budget deficits of - €363 billion, - €212 billion and - €231 billion respectively

We hear rumours that Germany is getting ready to spend and steer away from running a balanced budget, as it has for the last five years. However, you can be sure that the politics in Germany will stifle any meaningful fiscal spending and, even if one comes, it will be spread over a long period instead of being front-loaded to provide immediate help to the European economy. German Chancellor Angela Merkel’s coalition is very fragile and an early election in Germany has been on the cards for some time. In such conditions, with opinion polls in Germany showing that fiscal prudence remains highly popular, it will take longer for German politicians to break free of the five years of budget surpluses.

Eurozone Net Government Interest Payments as a Percentage of GDP

Eurozone Net Government Interest Payments as a Percentage of GDP

Source: Bloomberg

However, I am not entirely bearish on the prospects of the Euro area in the short term and this is largely due to the policies recently announced by the European Central Bank (ECB) and the hint that the Euro area may finally be moving (albeit very gradually) to a more counter cyclical fiscal stance.

  • Next year the ECB will roll over maturing debt to the tune of an average €16bn a month on top of its €20bn in net new asset purchases. The presence of a persistent buyer in the form of the ECB means that the Eurozone sovereign bond yields will not rise for at least the next five years
  • The effective capping of yields means the interest costs are going to be considerably lower (if not disappear) over the next few years as Euro area governments refinance themselves at very low rates (and some at zero and negative rates)
  • Highly indebted Euro area nations, particularly Italy will benefit the most from this ECB largesse
  • The interest costs in the Euro area range on the low end, +0.45% of GDP in case of the Netherlands to the higher side, +3.6% of GDP in case of Italy (chart above). Italy has run a primary budget surplus – budget balance excluding the debt interest payments – for 17 of the last 20 years. It’s current primary budget surplus is +2% i.e. Italy’s structural deficit consists entirely of interest charges
  • Drastic reductions in interest cost, therefore, will have enormous implications for Italy and other similarly indebted Euro area economies. It will automatically free up considerable room for fiscal stimulus

A small wave of counter-cyclical fiscal policies could lift the Euro area boat and force even austere German politicians to accept the medicine given that Germany is now in a recession. Previous Quantitative Easing by the ECB has not met with the right fiscal response from Euro area governments. Let’s hope this time is different and the opportunity is not squandered.

Markets and the Economy:

There are many US recession predictor models out there, but the one I find most accurate is the one from the New York Federal Reserve (NY Fed). This simple NY Fed model (chart below) uses the difference between 10-year and 3-month Treasury rates to calculate the probability of a recession in the United States twelve months ahead. A negative spread between the two rates has preceded all post-war downturns, and this been negative since May. The NY Fed’s implied probability of a US recession, based on the yield curve, has increased to 38%. The measure has breached the 30% threshold before every recession since 1960. A reading of 40% is seen as a near guarantee that a recession will follow within next the next 12 months. So it seems we are almost there.

Markets and the Economy

Source: New York Federal Reserve

As the US-China trade war deteriorated and President Donald Trump imposed new tariffs, the ISM Manufacturing PMI in the US fell to 49.1 in August (from 51.2 the previous month) and registered the first month of contraction in the manufacturing sector since January 2016, as new orders and employment declined. As the chart below shows, both ISM manufacturing and non-manufacturing PMIs have been falling and if the trade war were to worsen, leading to less and less capital expenditure, then the transmission mechanism for growth slowdown is straight forward: Manufacturers see profitability falling and consequently reduce their service providers and the services PMI slumps – leading to a recession.

Institute of Supply Management (ISM) Purchasing Managers Index (PMI) for the US (2013-2019)

Source: Bloomberg

US-China trade tensions escalated last month and talks broke down after Beijing said it would retaliate against the US, if the tariffs on China’s exports to the US set for September 1 went ahead. Trump lashed out on August 23 in a series of tweets, and the same day his administration announced a plan to raise all tariffs on China by 5% as of October 1. Over the month of September however the US-China trade narrative has continued to evolve, in a positive light, as Trump has toned down his abrasive tone and sought reconciliation.

Trump’s August 23 tweet where he “hereby ordered” the US firms operating in China to look for an exit and bring business and investment back to the US, seems a distant memory now. Following the deputy-level US-China meetings in Washington last week, Trump remarked that the trade war with China was “a little spat” that he would work to find a solution to and reiterated his respect for China’s President Xi Jinping. China has in-turn offered to make agricultural purchases if the US cancelled the October 1 tariff increase and eased up on the restrictions on Huawei. The first round of negotiations last week, post the breakdown in talks in August, seems to have gone well.

As reported by the Wall Street Journal this week, the de-escalation may also have come about due to the important phone call Trump had with the billionaire casino magnate, Sheldon Adelson, a major donor to the Republican Party, who warned the President about the conflict’s impact on the US economy and Trump’s re-election prospects.

Whatever the reason, it seems Trump is willing to make a deal. It is very likely he may wind up delaying the October 1 tariff as well as delaying the December 15 one. Both actions will be bullish for risk assets. While the two sides are still far from a final deal, the chances of a compromise are growing. No further escalation in the trade spat should be seen as a short term deal, and if, Washington and Beijing are actually about to strike a full and final deal (not my base case), the S&P 500 (SPX) Index could easily attempt a jump to 3100 or higher in October. I continue to be bullish on the SPX, as it is amply clear by now, that Trump will put getting re-elected over everything else and China is not keen to continue sparring either.

So the big question now is whether we are heading into a recession or is growth about to rebound? I believe the latter is more likely as the impact of lower interest rates is beginning to flow through to rate-sensitive sectors such as housing, durable goods and personal consumption. The rest of the economy should soon follow. I do not see a recession in the US in the next 6 months.

The equity markets, after a terrible December last year, have had a brilliant run all this year, as the data below indicates. With help for the Eurozone in the works and a de-escalation in the US-China trade war, I see more upside to global equities.

Benchmark Equity Index Performance (Year-to-Date)

Despite this week’s violent US Money Market jitters, where the overnight lending rates spiked from 2% to 10%, the US Federal Reserve (Fed) looks to have a clear plan for managing monetary policy and liquidity conditions. The Fed is now considering growing its holdings of US Treasurys for the first time in five years, putting a decision on the agenda for its October 29-30 meeting. “It is certainly possible that we will need to resume the organic growth of the balance sheet earlier than we thought. We’ll be looking at this carefully in coming days and taking it up at the next meeting,” Fed Chairman Jerome Powell said. The Fed stopped buying bonds in 2014 and began slowly shrinking its balance sheet in 2017. This drained reserves from the system. Reserves have fallen by over -50% to $1.3 trillion from a high of $2.8 trillion in 2014. The Quantitative Tightening (QT) ended on August 1 last year, when the Fed chose to keep the size of its balance sheet stable. However, it seems the Fed may have overdone it. As the economy has grown (the amount of currency in circulation has grown to $1.7 trillion from less than $800 billion in 2007), the Fed’s balance sheet should have kept pace to keep up with the demand for liquidity.

Whether we get another rate cut in the US later this year or not, monetary policy will remain on the easy path and the Fed will not raise rates anytime soon. Therefore, I feel very comfortable holding on to long US equity positions. If growth in China and the Eurozone trends up, helped by a stimulus in their respective economies, then there is little (if any) concern of a market sell-off in Q4 of this year.

I like to be long the cyclical sectors at this stage – Financials (XLF), Consumer Discretionary (XLP), Energy (XLE) and Industrials (XLI) in particular. Cyclical stocks have been outperforming since the end of the May sell-off and are still a good bet. Individual stocks in the Technology (XLK), Communication Services (XLC) and Materials (XLB) sectors also offer good upside. For specific stock recommendations, please do not hesitate to get in touch.

S&P 500 banks index/SPX index ratio

Source: Bloomberg

As you can see from the chart above, I believe being long US banks looks like a very good trade. Banks are ready to break out. Short term rates are getting lower, as the Fed continues to cut rates, and the US 10 Year Bond is trending higher i.e. the curve is steepening.

Best wishes,
Manish Singh, CFA

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