Macro Weekly – Here we go again

by: Han de Jong

  • Equity markets sharply lower. Was it on Fed, rates, trade conflict, profit taking, EM trouble?
  • US September inflation data is very benign
  • Chinese trade data remains robust
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Equity markets have moved sharply lower. It is never easy to determine what causes such a sharp move. The drop may be aggregated by programme trading, but the extent to which is also unclear. The big question is whether this is just another 5-10% correction in a bull market (as far as the US is concerned) or the beginning of a sustained move lower. Note that European and EM equities were already down year-to-date before the rout began. Various factors will have contributed to the recent slide in equity prices: US interest rates, the Fed, the trade conflict, profit taking, problems in some emerging economies etc.

US interest rates and the hawkish Fed

The most obvious culprit for the recent downturn is US interest rates and the communication by the Fed. The yield on 10-yr Treasuries had moved in a 2.8-3.0 range for most of the year, but broke out of that range in the second half of September, albeit only by a handful of basis points. Yields then suddenly rose to 3.25% early October. Meanwhile, several previously dovish FOMC members made more hawkish statements and Fed chairman Jerome Powell indicated that the economy is booming, that the current monetary policy stance is still loose and that the Fed may have to move rates up quite a bit yet. Market participants took that as a sign that they had to adjust their expectations for future monetary policy. This all happened against a backdrop of a (very) modest increase in the pace of wage gains and inflation creeping higher.

President Trump threw in his tuppence worth of observations. With just a couple of weeks to go to the midterm elections he needed to find a guilty party and anybody would do. Fed chair Powell was an easy victim to blame. The president proved to be reasonably sensible in this case as he pointed out that while the Fed was ‘out of control’ he wasn’t going to sack Powell. Luckily, the president realised that market volatility would only get worse, much worse even, if he were to sack Powell, which actually would not be so easy for a president to do anyway. My conclusion on this point is that Trump’s tuppence worth of analysis wasn’t even worth tuppence.

Expectations have adjusted enough

It looks to me as though market expectations have adjusted sufficiently. I note that while some FOMC members have sounded more hawkish lately, that hawkishness was not reflected in the most recent ‘dot plot’, the chart in their information material indicating the rate expectations of the individual members. Going by this dot plot, the FOMC members’ expectations of where Fed funds will be at the end of 2019 didn’t change between their 13 June and the 26 September meeting. Their estimate for the longer run, presumably the current estimate for the equilibrium rate, stayed at 3.0%. A bond yield of 3.25% looks reasonable against such assessments. Perhaps it has the potential to go a little higher, but it would seem to me that most of the rise in the bond yield is behind us, at least for now.

The Fed is clearly data dependent. One of the big surprises of recent years has been how subdued inflation has remained. Most traditional models would have predicted higher inflation by now given the strength of economic growth and the tightness of the labour market. I attended a meeting in New York in July where a Fed economist argued that their models had been overestimating inflation up till then, but that he was confident inflation would rise more strongly soon. I think he wasn’t the only one. And my guess is that fear of a sudden acceleration of inflation has made some FOMC members more hawkish in their statements. It has most likely also spooked financial market participants. When it comes to monetary policy in 2019, we are assuming that economic growth will weaken in the second half of the year as the effects of fiscal stimulus abate. By then economic growth will not provide a reason for the Fed to continue raising rates. It all depends on inflation then

Where is US inflation?

The most recent US inflation data must have come as a great relief against that background. Headline and core inflation amounted to 0.1% mom in September. The headline yoy rate fell back to 2.3%, from 2.7% in August. The yoy core rate was unchanged at 2.2%. Shelter remains the biggest driver of inflation. Shelter costs have a weight of almost 33% in the overall basket and almost 42% of the core basket. They were up 3.3% yoy in September. This implies that outside of shelter, food and energy, inflation was a mere 1.4% yoy. I realise that people have to pay for shelter, food and energy. But shelter cost inflation has its own dynamics. To assess the underlying inflation dynamics in the economy at large, it is justifiable, in my humble opinion, to look at inflation outside these areas. The bottom line for me is that the most recent inflation report provides no evidence whatsoever of accelerating inflation, let alone materially accelerating inflation. The Fed and the markets will inevitably take that on board. That is why I don’t think that an equity market sell-off on the back concern over accelerating inflation and tighter than expected monetary policy will be sustained.

Other worries

Of course, there are plenty of other factors people can worry over. The trade conflict is one of them. President Trump does not look like he is going to go soft on China any time soon. However, he hasn’t been targeting Europe for some time and he has done a deal with Mexico and Canada. If bilateral trade flows between China and the US are the only trade flows affected, the effects for the world economy at large will not be negligible, but neither will they be huge.

The importance of China for global growth must not be underestimated. So a dent in that country’s exports on account of the trade conflict will have an impact. But we must not exaggerate either. China’s exports to the US make up less than a handful of percentage points of China’s economy. And the effects of tariffs have already been partly compensated by the depreciation of the yuan. Bear in mind that his depreciation not only makes Chinese exports to the US cheaper, but applies to all Chinese exports. In addition, Chinese policymakers have already taken a number of measures to boost domestic economic activity. This was perhaps not pro-actively to cope with trade disruptions and also in response to weaker growth resulting from their efforts to engineer some deleveraging in their economy. It seems to me that the message is that preventing too sharp a deceleration of growth, be it resulting from deleveraging or the trade conflict, now is the top priority. With this in mind it is difficult to get very gloomy over China’s growth prospects between now and, say, the end of next year. Whether or not the Chinese growth model can be sustained in the longer term is a different matter, but that is too far out for financial markets to fret about now.

Digging into Asian trade flows

I always find it insightful to monitor trade flows in Asia to assess economic conditions in that part of the global economy. It is like taking the pulse of the region’s economy. South Korea and Taiwan are large, export oriented economies doing a lot of trade with China. So their trade numbers are high on my list of important economic indicators. Taiwan reported trade data for September recently. Export growth was weak on a yoy basis: +2.6%. Nevertheless, the data was greeted with enthusiasm as they were better than expected. And the yoy growth rate actually improved a little from August’s 1.9%. But the enthusiasm about the numbers stem mainly from the improvement measured by the mom change. September’s export values were up 4.7% mom. That is impressive even if these month-to-month changes are volatile.

Korea’s September trade numbers were released early October. They had shown a massive 8.2% yoy drop of exports. However, this was affected by a period of public holidays which fell in October in 2017. If that is the correct explanation for September’s apparent weakness, the October data must come in very strong. We must wait and see if that is going to be the case.

So looking at the export data for Taiwan and Korea, one must conclude that export growth has weakened. But that is only an assessment at first sight. The most recent data appears to have been negatively affected by special factors. The graph showing Korean and Taiwanese export growth and China’s import growth, shows that an unusual gap has opened up. Given the intense trade relations between these economies, such a gap cannot last. So the question is how convergence will take place: at the higher level of growth of Chinese imports, at the lower level of Taiwanese and Korean exports or somewhere in the middle.

China’s trade numbers for September were also released recently and they were strong as can be seen in the graph. Import growth decelerated from August’s 19.9% yoy growth, but at 14.3% it was not showing any sign of weakness. The caveat here is that importers may have tried to be ahead of import tariffs which may have boosted the numbers. As that would apply to imports from the US only, perhaps imports from the US surged, which could explain the gap in the graph between Chinese import growth on the one hand and Korean and Taiwanese export growth on the other. The detailed data does not support that hypothesis in my view. While overall Chinese imports were up 14.3% yoy, imports from the US were actually down 1.2% yoy. For the numbers for 2018 year-to-date, overall import growth stands at 20.0% and imports from the US are up a more modest 9.4%. It thus does not look like importers are trying or successful at front running the tariffs on US goods on a large scale. Of course, we must wait and see. But on this basis, I am hopeful that convergence of Chinese import data and Korean and Taiwanese export data will be at the higher level.

Chinese export growth to the US stood at 14.0% yoy in September. As that is in line, even marginally below the 14.5% yoy growth rate of overall export growth, it does not look like efforts to front-run tariffs has boosted Chinese exports hugely either. But, I must repeat this, we will have to wait and see.

Bottom line

Markets can sell off for no apparent reason. And perhaps market participants simply wanted to take profit and reduce risk for whatever reason. Perhaps the majority of investors felt that equities were too expensive. Who knows? But looking at the two most obvious culprits for the sell-off, I say that neither of them justifies a sustained sell-off. US inflation does not look like it is taking off materially. As a result, the Fed has little reason to speed up its tightening process. Nor do I see any good reason for the Fed to tighten much more than indicated in their own dot plot. And that is more or less what is now priced in by markets.

As for China and the trade conflict, it simply does not look like China’s economic growth is decelerating materially. Even if it is or does in the period ahead, policymakers will do what they can to prevent a significant slowing.

So if US interest rates and Fed policy, and the trade war and the prospects for China’s growth are the main causes of the recent equity downturn, it should be a temporary correction.