Ready for the rollover?

Published on 13-03-2017 14:39:3313 March 2017

Despite buoyant global asset markets, we are seeing increasing evidence of slowing economic momentum. In the US, bank loan growth has slowed significantly since Q4 16 and the Atlanta Fed’s GDP nowcast is only indicating 1.2% US growth for the current quarter, compared to over 2.5% as recently as early February. In the UK, the services PMI peaked in January and is now declining while in Europe – a bright spot in terms of economic surprise – disappointing German factory orders cast some doubt on the durability of any recovery. China’s M2 money supply growth has also ebbed since Q1 16, suggesting an easing of basic materials prices, should prior correlations still hold.

Exhibit 1: Economic surprise indices

Although the recent run of economic data has certainly surprised to the upside, Exhibit 1, this is in part both seasonal (shown in Exhibit 2) and mean-reverting over a period of 3-6m. The seasonality may be relatively modest but it does appear that positive surprises have typically been concentrated at the start of each calendar year, with easing momentum over the following 6m. Based on the seasonality and the mean-reverting nature of economic surprise indices, we believe the recent momentum may ebb as we enter Q2 17.

Exhibit 2: Seasonality in US economic surprise – average by calendar month

Survey data in the UK has already softened in the most recent data releases, such as the services PMI index, Exhibit 3. The recent cautious outlook from supermarket chain Morrison’s reinforces the Bank of England’s current view that a meaningful squeeze on the consumer may be underway by H2 17 as consumer price inflation outstrips wage growth.

Exhibit 3: UK – Softening PMI survey data

We note in the US that core durable goods orders, in a similar manner to consensus US profits forecasts, have not shown nearly as much of an uptick as increasingly optimistic ISM survey data, Exhibit 4. In addition credit growth in the US appears to have stalled in recent weeks, Exhibit 5. There is certainly nothing like the acceleration shown in the US stock market evident in the real US economy; the Atlanta Fed’s GDP nowcast is only indicating 1.2% US growth for the current quarter, compared to over 2.5% as recently as early February. We continue to believe that Trump’s infrastructure spending plans and changes to the US corporate tax code are a 2018 earnings story at the earliest – and there remains significant uncertainty over the ultimate form and size of these fiscal measures.

Exhibit 5: US – core durable goods orders lagging ISM optimism

For Europe, a recent bright spot in terms of positive economic momentum, the question since 2012 has always been the durability of any recovery. In this regard, with optimism still strong we would highlight German industrial orders which showed a significant softening in January, Exhibit 6.

Exhibit 6: German industrial orders month-on-month

In China, the growth of the M2 money supply has historically been correlated with industrial metals prices, which have lagged the change in the money supply by 6m. We note a slowing of M2 since the rebound in Q2 16, Exhibit 7, even as for now China’s PMI indices remain in positive territory and iron ore prices are only a little lower than their highs for the year. We still maintain the view that the commodity and energy bounce was a 2016 phenomenon and from an oversold position rather than representing a new bull market. The recent correction in the oil price also raises further questions over near-term demand.

Exhibit 7: China – slowing M2 money supply growth and iron ore spot price

In our view, the data tentatively indicates that the gap which has arisen between optimistic survey data, actual economic performance and consensus earnings forecasts will be closed with an ebbing of optimism. For equity investors, the immediate future may become more difficult as slowing economic momentum is juxtaposed over rising US interest rates and significantly above-average equity market valuations.

Our cautious views on equity markets are coincident with those expressed in the FOMC meeting minutes and more recently the OECD interim economic outlook which refers to “disconnects between the positive assessment of economic prospects reflected in market valuations and forecasts for the real economy”. Based on the current outlook for profits growth, current equity market valuations highlight a further disconnect between financial market prices and the likely evolution of corporate profits. In addition, corporate credit risk premia also appear unusually compressed at present, a dramatic reversal from only 12 months ago.

The question remains as to how far investors are prepared to ‘look through’ this period. History suggests that if the Fed continues to tighten policy monotonically then equity markets would perform poorly. However, that is only one scenario; policymakers’ reaction to the softening incoming data is still an unknown. We believe that caution remains warranted in terms of equity allocations.

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