Macro Weekly – Shock adjustment

by: Han de Jong

Financial markets have shown violent moves during the last two weeks or so. And these moves have, to a large extent, been in tandem. Bond yields have risen sharply, particularly in Europe, the euro has strengthened and equities have sold off (especially in Europe). To be frank, I did not see this coming, so I can offer only post-mortem commentary. Such dramatic moves demand a verdict. Is this just a temporary correction or is it the beginning of a much longer and bigger move in markets? Taking economic fundamentals as my lead, I conclude that it is most likely temporary, although that does not necessarily mean that we will see a rebound in all markets concerned in the near future. Meanwhile, interpreting economic data is also becoming something of a challenge. How, for example, do disappointing US growth numbers and a steadily strengthening labour market add up? Well, they don’t, really.



Economics first

The European Commission updated its forecasts for the eurozone economy last week and did what most others have done in the recent past. They raised the forecast for the current year. GDP is now expected to grow by 1.5% this year while the Commission was previously forecasting 1.3%. They left their 2016 forecast for growth unchanged at 1.9%. These numbers, obviously, do not sound particularly impressive. We must bear in mind, though, that potential growth is even lower. The Commission currently estimates that trend growth is only 0.8%. As a result, unemployment is projected to continue its downward sloping trajectory. In fact, unemployment started to come down in Q2 of 2013 and has continued its gentle decline. As we now expect the eurozone to produce better growth numbers, the pace of decline in unemployment should accelerate.


European economic data has consistently beaten expectations in recent months, but that pattern is now disappearing. Perhaps expectations have adjusted upwards a little and maybe we are actually starting to see slightly more mixed data. I am not sure what is behind it. We have long highlighted the three major tailwinds for the eurozone economy: the euro, the oil price and borrowing costs. The first two have reversed somewhat in recent months and perhaps that has had an immediate impact. More likely, this is noise.

Last week’s data on German industrial production was soft as output fell 0.5% mom in March. Eurozone retail sales were also weak in March, falling 0.8% mom. There is, however, always volatility in numbers of this nature, and recent trends have been favourable. In addition, March data on industrial output in Spain and Italy surprised on the upside last week.

Our overall assessment of the eurozone economy does not change. Growth has picked up and is currently above trend. That is not going to alter any time soon.

US more of a puzzle

According to the GDP data, the US economy expanded at a snail’s pace in Q1. More recent data makes it likely that the number will be revised down into negative territory. Yet, the labour market appears to be completely ignoring this development and decent employment growth is continuing. This is an odd combination that cannot last. Either GDP growth will pick up, or employment growth will weaken. The combination of weak GDP growth and continued improvement in the labour market led to an annualised increase in unit labour costs in Q1 of 5.0%. This is the sort of number that freaks people out as they think it points to rising inflation pressures and downward pressure on corporate earnings. The truth is that unit labour costs is a very volatile series. Over the last five years it has ranged from +12% to -12%. The Q1 result was a mere 1.1% up on a yoy basis. The 5.0% annualised qoq does show that corporate profits were struggling but tells us what we already knew: either GDP growth will accelerate or jobs growth will slow.

It is possible that the GDP data is actually wrong. Some commentators argue that there may be something wrong with how the statisticians calculate GDP in the first part of the year as it seems to be consistently weak that time of the year.

If, on the other hand, there is nothing wrong with GDP numbers and they continue to disappoint, then we must, at some stage, see a sharp deterioration of the labour market as the labour market then adjusts to ‘economic reality’.

Mind the gap

One interesting development is the gap that is opening up between the ISM manufacturing and the ISM non-manufacturing. This gap suggests that weakness is concentrated in manufacturing and that growth momentum in the (more domestically oriented) services sector is holding up very well.

We have repeatedly argued that cyclical weakness in the US is largely due to temporary factors: adverse weather, strikes, the dollar and the initial effect of lower oil prices. The weather and the strikes are behind us. The effects from the strong dollar are likely to drag on for some time yet. The same is true for the effects of the oil price. Oil companies have aggressively slashed investment spending and the consumer has not yet spent his windfall. The savings rate has recently gone up as a result. Experience suggests that one can rely on US consumers to spend this money, although some argue that households will use the money to strengthen their balance sheets and, thus, keep the savings rate permanently at a higher level.


Weakness induced by dollar strength and the low oil price is consistent with the gap between business confidence in manufacturing and the services sector.

So where do we go from here? I think the question as to what has caused the slowdown is a typical case of ‘a bit of both’. Part of the slowdown in the US is caused by temporary factors that are behind us and part by factors that may ultimately also be temporary, but that are certainly not behind us yet. The most likely result then is that US growth will gain some momentum in the period ahead, but not hugely.


I think this is actually an excellent scenario. Stronger growth will boost employment and allow companies to grow their profits while it is unlikely to cause significant inflation risks and should keep the Fed moving cautiously. This is what we used to call the Goldilocks scenario.

No Goldilocks

Market participants do not see Goldilocks. As mentioned in the introduction above, recent weeks have seen violent moves: a sharp rise in European, and to a lesser extent US bond yields (10yr Bund yields rose some 50bps in just over a fortnight) and a painful correction on the equity markets (the Dax lost 8.5% over a three-week period). The reversal of oil prices (up some 40% from the January low) and the euro (up 7% from its March low) have lasted a little longer.

It is hard to assess what has caused these sharp moves. Some argue that is the market’s sudden realisation that deflation fears in the eurozone are overblown. It is true that inflation expectations have risen, but they are strongly linked to the oil price. In addition, it must have been obvious for longer than the last two or three weeks that painful deflation is not likely in the near term in Europe.

It seems to me that we are more likely looking at corrections that are driven by technicals and positioning. In addition, as yields in Europe were increasingly in negative territory, investors probably decided that there is little point holding them. And speculative investors who had tried to front-run the ECB had little better to do than to sell their positions as yields had no more further downside.

Something similar can perhaps be said about equities. Over the same period when the Dax lost 8.5%, the S&P500 lost less than 1%, although the euro gained 6%. This means that in a common currency the performance of both equity markets is much closer. Nevertheless, recent trends in corporate earnings news in Europe has been much more favourable than in the US. So it seems a little odd that European stock markets should underperform so suddenly and significantly. Profit taking on the prior rally and outperformance seems a more compelling explanation than a fundamental shift in underlying conditions.

As a result, I think the most likely explanation for the recent dramatic market moves is that they represent technical factors, profit taking etc. They do not seem caused by shifts in economic fundamentals to me. As a result, I would expect them to be temporary. That does not necessarily mean that bond yields will quickly fall again to previous lows, or that the euro will quickly move back towards parity and equity markets will rally strongly from here. The most likely of these actually seems a recovery of equities to me as I think that the Goldilocks scenario described above is conducive to favourable trends on equity markets.