Macro Weekly – No change in fundamentals, but what does that mean?

by: Han de Jong

  • Equity market drop not justified by economic outlook
  • US inflation outlook not as bad as the market correction appears to suggest
  • But factors were in place for sizeable correction at some stage
  • Services sector confidence strengthens in various economies
  • Spectacular Chinese import growth is a distortion
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The equity market is a forward-looking entity. When equities fall sharply as they have since the peak on 26 January (in the US; the peak in the eurozone was a few days earlier) investors must ask themselves what the market is saying. Is there an important message about the future course of the economy? If that were the case, the equity market’s move might be the start of a new downturn, not just a correction.

We think there isn’t sufficient reason to think that the economic outlook, either as regards economic growth or inflation has changed. Therefore, we see this market correction as a typical bull-market phenomenon that is not driven by economic fundamentals and, more importantly, will not lead to economic fundamentals ultimately justifying falling stock prices. That does not mean, of course, that a correction isn’t painful. Market participants had perhaps forgotten what corrections feel like as a 10% correction had not happened in more or less two years. It is a mug’s game to try and play these corrections. Perhaps a way to try and assess how deep and long a correction might be is to look at the following issues. First, the market had had a great run, serious corrections had not happened for some time and volatility was exceptionally low. This increases the potential size of a correction. Second, while there are many different views on valuation, most people would subscribe to the view that equities were not cheap and on several measures actually very expensive. The more expensive investors believe equities were, the larger the potential correction. And third, how many investors would run scared during a correction? Talking to many investors in recent months, I have got the distinct impression that sentiment was extremely positive. This suggests that many investors were complacent and they may cut their positions during a correction. This very bullish mood is a negative sign from a contrarian point of view and also suggests that a correction could be relatively large.

From the peak on 26 January the US S&P500 index lost some 10% until the time of writing while the EuroStoxx50 has shed some 9%. Year-to-date loses are much less significant, 2-3%, while the year-on-year gain is still some 13% for the S&P, though the gain for the EuroStoxx50 is a much more modest 3%.

What can we read in the economic tea leaves?

Recent economic indicators do not suggest that a material deterioration of the cyclical or inflation trajectory for key economies is around the corner. Economic data in the eurozone were particularly encouraging during the last couple of days. The industrial sector continues to do well. German factory orders were up 3.8% mom in December and 7.2% yoy. Industrial production was less impressive, falling 0.6% mom, though this followed a monthly increase of 3.1% in November. The yoy rate of increase of German industrial output accelerated to 6.5% in December. Output growth in other eurozone countries was solid too in December: Netherlands up 5.2% yoy, Italy 4.9% and France 4.5%. Another interesting development was the rise in business confidence in the services sector. The Markit services PMI rose to 58.0 in January, up sharply from December.

US data was few and far between in recent days. The Markit services PMI was weak in January, falling to 53.3, its fifth consecutive monthly decline, but the rival ISM non-manufacturing business confidence index rose sharply in January: 59.9, up from 56.0, and the highest since 2005.

A strong increase was also registered in the Caixin services sector PMI in China: 54.7 in January versus 53.9 in December.

If these improvements in services sector business confidence in these economies are all part of the same bigger picture, one must expect the cyclical upturn to get an even more solid basis in the months ahead.

Chinese statisticians also published the important trade statistics for January. I am particularly interested in Chinese import growth, as many other countries depend on exporting stuff to China. Chinese imports grew at a yoy rate of no less than 36.9% in January, up sharply from December’s 4.5%. Before getting euphoric, we must bear in mind that the timing of Chinese New Year may have distorted the data. Chinese New Year in on 16 February this year, while it was on 28 January last year. As the Chinese economy more or less closes down for business for a week during this period, January 2018 had 3 working days more than January 2017. Nevertheless, better to have strong distorted data than weak data.

All this does not suggest that the world economy will experience a material slowdown any time soon.

Is it inflation?

Perhaps markets are more concerned about inflation than about growth. Indeed, the so-called Fed’s five-year forward breakeven inflation rate started moving higher in December having been stable close to 1.8% since early July. In December and January, this rate moved to around 2% and has moved another 20bp since the US equity market peak on 26 January. However, we see little evidence of inflation moving materially higher. It is true that average hourly earnings in the US have accelerated recently, but the pace of wage increases remains relatively subdued. The international backdrop is also not likely to push US inflation up. Inflation expectations in the eurozone have risen also, but less than in the US while, for example, Chinese inflation eased in January as did inflation in Taiwan.

On balance

On balance, therefore, we believe the outlook for the economic fundamentals does not justify a sustained downturn in equity markets. That does not necessarily mean that the rising trend of equity markets will be restored soon. The timing of such market fluctuations remains a tricky game.