Macro Weekly – A lot of negativity, but equities hold their ground

by: Han de Jong

  • Populist Italian government starting
  • Trade dispute getting ever more serious
  • US economy solid, Europe and Asia getting over soft patch
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What strikes me most about developments in recent trading days is that equities are holding their own reasonably well. It would not be so hard to make a list of reasons for investors to throw in the towel. The new Italian government will quickly engage in conflict, either with the European Commission and European partners, or amongst the two coalition partners, or both. In addition, the trade tensions have entered a new phase with the US refusing to give the EU (and the Nafta partners) another extension of the exemption of the steel and aluminium tariffs. In response, the EU has announced retaliatory measures. To keep things lively, the Americans have announced they will investigate whether European car companies are a threat to US national security. If deemed so, more tariffs will be on their way. Another factor that could worry market participants is the unexpected weakening of European, and Asian, business cycle. The sustained tightening of monetary policy by the Fed (rate hikes, plus gradual but sustained shortening of the size of the balance sheet) and the stronger dollar could also be a reason for market participants to become more cautious. Of course, risky assets haven’t exactly had their best time in recent weeks, but it seems to me that it could have been a lot worse.

What does that mean? Either, market participants are underestimating the risks and a significant correction will follow at some stage, or there are other reasons to hold on to risky assets. I go for the latter. Company profits are healthy and expected to grow. I also think that the uncertainties mentioned above will not lead to calamities and that the dust will ultimately settle. On the economic front, the US economy appears to be going from strength to strength, which is important to financial markets. Last, while central banks are tightening policy on balance, they are doing so gradually and in a measured and predictable way. Should economic and/or financial market developments take a big turn for the worse, central banks will not hesitate to reconsider their policies.

Italian politics

At the time of writing it looks like the impasse in Italian politics has been overcome. A new government is ready to govern. The M5S-Lega coalition is a somewhat strange coalition of left wing and right wing populists. Their economic plans look likely to push up the budget deficit beyond what will be acceptable in Brussels. If the new government carries out these policies, they will soon find objections from European partners and the European Commission on their way. A comparison with the Syriza government in Greece is sometimes made. The situation is, of course, very different. The economic situation is very different. Greece had a massive budget deficit (15% GDP) and balance-of-payments deficit (12%). Italy’s budget deficit is just over 2% GDP and it is running a surplus on the current account of the b.o.p.. Italy’s debt is also considerably lower than Greeces’s at that time. Also, Syriza may have been a new party with internal differences, they at least were all on one side of the ideological spectrum. We will have to wait and see how long the Italian government can stay alive. On the negative side, Greece was only a small economy and could be bullied by the rest of Europe. It will be harder to bully Italy.

The experience so far in Europe is that populist governments often start with aggressive, heterodox economic policies, but relatively quickly follow a more conventional route of some fiscal prudence. The M5S party is now making it clear it does not intend to take Italy out of the euro. So they are becoming more mainstream. Our base scenario is that calm will return after a while and that an Italian default or an exit from the euro are not on the horizon, the horizon being the next two years or so.

Trade conflict heating up

The American administration pushed ahead with its tariffs for steel and aluminium and did not allow the EU a further exemption. This is not good for world trade. There are accusations from both sides of unfair trade practices and the EU has announced retaliatory action. At the end of the day, steel and aluminium tariffs are a big thing for producers and buyers, but the macro impact is modest. However, the US have now announced it will determine a view on whether or not European cars are a threat o national security. That is ridiculous, but this strategy is followed by Washington as WTO rules allow protectionist measures if they are aimed at defending the national interest. Hopefully, negotiators will come to their senses and recognise that we all have a lot to lose here. The biggest losers of measures against European cars would be German car manufacturers.

More of the same on the economic front

Economic data releases of recent days confirm what we have seen recently: US data has been strong while Europe and Asia appear to be overcoming their soft patch.
Chinese PMI data for May was encouraging. The national manufacturing PMI rose from 51.4 in April to 51.9 while the non-manufacturing PMI only inched higher.

Other encouraging Asian data included South Korea’s trade data for May. As the data for the first 20 days of the month had indicated, export growth recovered from -1.5% in April to +13.5 in May. Korea’s PMI also improved in May (48.9, up from 49.4) the first improvement after four consecutive monthly declines. Korea also reported firm GDP growth in Q1: 1.0% yoy, and solid industrial production: +3.4% mom in April, and +0.9% yoy, versus -4.3% in the previous month.

Europe stabilsing

European economic data suggest that economic conditions are stabilising after cooling in the first couple of months this year. The European Commission’s gauge of ‘Economic Sentiment’ (combining business and consumer confidence) fell again in May, but only fractionally: 112.5, versus 112.7 in April. This is still a level suggesting the economy continues to grow at a healthy clip. A little worrying perhaps is that industrial confidence weakened further. This may suggest that the threat of US trade measures is weighing on sentiment.

Inflation picked up in May. The yoy rate rose to 1.9%, from 1.2% in April while the core rate accelerated from 0.7% to 1.1%. We have often argued that the April data was a little distorted (too low). The May data most likely is a correction and we have no fear that inflation in de eurozone is now on a clearly upward trajectory. Nevertheless, the May inflation data must be welcome to the ECB.

Solid US data

As we have seen recently, economic data in the US remains strong. Regional business confidence measures in Dallas and Chicago bounced strongly in May.
The consumer also remains enthusiastic. While personal income rose a nice but somewhat modest 0.3% mom in April, personal spending rose 0.6% mom, after 0.5% in April.

The personal income and spending report also includes the inflation gauge the Fed pays most attention to: PCE and core-PCE. The April CPI data released earlier had already suggested that inflation remains under control The PCE data confirmed that. Headline PCE rose 0.2% mom and the yoy rate was stable at 2.0%. The core PCE index also rose 0.2% mom as the you rate stabilised at 1.8% supporting the view there is certainly no need for the Fed to accelerate its pace of rate hikes.

Solid US growth combined with sustained modest inflation is a friendly backdrop for risky assets. This must be an important reason for investors not to give in to worries over the list of uncertainties mentioned above.