What trends are likely to be in H2?
· The rebound in global growth momentum (excluding China)
· European GDP growth continues to recover
· The reflation of the Japanese economy
· China growth continues to disappoint, as the leadership focuses on the quality of growth (rather than the quantity)
Market trends in H2
· Rising equities
· The bear market in bonds (if the ISM rises to 55, fair-value yield of 3.1% on the US 10-year bond)
· The bull market in the US-dollar trade-weighted index
· The bear market in commodities
- Global macro surprises, which tend to trough in line with global economic momentum, have rebounded strongly over the past month driven, in particular, by strength in Japan and the Euro-area
- US economy is ok on many fronts: exports, employment, corporate spending, housing
The NAHB index suggests residential investment as a % GDP should rise to c4.5% of GDP from 2.7% now
- Synthetic lead indicators has peaked up or steady: GLI, CSBMI, GlobalCycle, PMI new orders, US 10 Factor model, global M1 growth accelerating
- If three last years is a proxy – than we will acceleration in H2 seasonally
Reasons why global economic momentum could accelerate:
- The proactive monetary policy in Japan
- The removal of some of the brakes on Euro-area growth
- Falling commodity prices (each 10% off the oil prices adds c.0.2% to GDP growth and lower commodity prices generally keep headline inflation low, thus allowing central banks to be more dovish).
- Overshoot of bond yields
Q2 earnings preview
Q2 results likely to be choppy, but expectations are low. Global activity was mixed, but resilient in Q2
S&P 500 earnings reports by week: number of stocks and percent of equity capitalization
US earnings revisions
S&P500 -ve to +ve EPS pre-announcements ratio
Q2 vs Q1 S&P500 EPS seasonality
US jobless claims vs S&P500 EPS
Lead indicator points to improving domestic demand growth (back out from PMI new orders and PMI new export orders) in the Euro-area
Real M1 growth is consistent with GDP growth of around 1%
Economic momentum in the periphery is improving
The monetary transmission mechanism in the periphery is clearly blocked (nearly 70% of GDP in the periphery comes from SME, of which half have problems obtaining finance – and when they do, it is at rates nearly 2 percentage points above those charged to companies in the core). That said, a sensible funding-for-lending, ABS or TALF-type scheme could lead to another leg-up in Euro-area growth momentum.
European PMIs – current vs recent lows
· Policy is likely to remain proactive. BoJ is likely to miss its inflation target, which in turn is likely to prompt further policy action.
CS are forecasting underlying inflation next year of just 0.6%, and in their view, a ¥/$ of at least 150 is needed to hit the 2% inflation target (but could easily see ¥/$120 being required to hit 2% inflation)
· USDJPY is responding in line with history to historical BoJ action
· But further JPY weakness is crucial to BoJ raising inflation
· Either the JPY keeps weakening or BoJ adds more stimulus
Yen “normalization” stage one
The yen continues to track the mid-1990s’ depreciation
· Net foreign assets of 60% of GDP, a weakening of the yen effectively increases Japan’s wealth
· Credit Suisse expect a further supplementary budget of c.¥5trn (1% of GDP) to be announced in October. This in effect counters most of the fiscal contraction that is expected from the rise in the sale tax
- Japan is top of the macro momentum scorecard on the basis of relative PMIs, industrial output has increased in 5 of the 6 months in which Abe has been in office and cash wages have recently turned positive.
The main problem in China is that leverage is extreme—both in absolute terms (with total debt around 230% of GDP) and relative to trend (with private sector credit to GDP some 17 percentage points above its 25-year trend, on BIS data, with BIS research suggesting that deviations of more than 10 percentage points are a warning signal for future financial crises). Two thirds of new loans in the last year have come from the shadow banking system.
Concern in the medium term
- High leverage
- Reduced sensitivity of GDP growth to a change in leverage
- Housing looks like a bubble (the house price to wage ratio is triple London on IMF data, there is 20% oversupply and housing as a proportion of GDP is at the peak levels reached during the Irish and Spanish housing bubbles)
- Infrastructure investment is already running at 20% year-on-year (and thus cannot accelerate any further as it did last year),
- The investment share of GDP, at 48%, is extreme (and transitions from investment to consumer-led growth have in the past seen the GDP growth rate fall by between a third and a half),
- The labour force contracted last year (leading wage growth as proxied by minimum wages to accelerate)
- RmB has also appreciated strongly against all other emerging market currencies this year
- New government will likely pursue structural reform rather than attempt to stimulate growth
- Latest liquidity squeeze in the interbank market
- Risk of a policy misstep
Risk: Chinese trend GDP growth eased to 6%.
The new government wants
- A stable albeit slightly slower growth and a stable financial environment, not immediate deleveraging or major restructuring that could be destabilizing
- Moderate government debt level
- Higher domestic saving
The most likely outcome is the Chinese economy going through a period of sluggish growth and adjustment, restructuring some bad debt as well as overcapacity in the real economy.
China’s total debt ratio
China’s private sector credit to GDP is some 17 percentage points above its 25-year trend
Global macro surprises are rebounding, but continue to fall in China
China manufacturing PMIs are weakening
Technical reasons to be optimistic about equities
The gap between the actual and warranted equity risk premium remains abnormally high
The earnings yield continues to be high relative to the corporate junk bond yield
Equity weightings of US pension funds remain well below average
Still a large amount of excess liquidity, with OECD excess liquidity (measured by M1 relative to global nominal GDP) still rising at 6% p.a., which is consistent with an on-going re-rating of equities. Developed market central bank balance sheets are set to expand by around 20% by the end of next year. The equity market peaked after, not before, the end of Q1 and Q2. The problem period for markets is typically the period surrounding the first rate rise (February 1994) or a change in language by the Fed (as in late January 2004).
- Commodities (commodity-exporting economies account for 40% of GEM market cap, compared to 10% for developed market market cap. Similarly, resource-related sectors account for 30% of overall GEM earnings, but only 17% of developed market earnings. Consequently, GEM tends to perform weakly when commodities do and we continue to be bearish on commodity prices)
- US real rates: emerging markets tend to outperform when developed market real rates fall, as falling rates incentivise investors to push funds into higher-yielding (i.e. emerging market) currencies. Over the past four years, GEM currencies have seen some $700bn of net portfolio inflows, or 3% of GDP. However, the recent sharp rise in US 10-year real bond yields has led to a sharp underperformance in GEM equities. This has also led to a sharp weakening in GEM currencies. The problem is that capital outflows from GEM tend to feed through to contracting money supply and falling multiples.
- Slowing relative GEM growth momentum: after a rebound in GEM lead indicators relative to developed market lead indicators between 2011 and late 2012, relative economic momentum has recently softened, most likely partly as a function of weak commodity prices, with relative GEM composite PMI new orders dropping into negative territory for the first time since 2011
- Strong dollar is a problem for GEM
GEM markets have underperformed in line with the strengthening of the dollar TWI
When GEM currencies appreciate against the dollar, GEM equities have outperformed in general
Change in ’13e consensus EM real GDP growth estimates
Reasons to be positive for GEM:
Emerging markets are trading on a 20% P/B discount – the lowest since 2005
· A rebound in global growth momentum:
· The outlook for US real rates
· EMBI spreads
US bond model suggests the fair-value level on the 10-year bond yield is 2.7%. If we assume 3% GDP growth (i.e. ISM new orders of 55), then this rises to 3.1% (though this does not take into consideration the effect the quantitative easing)
CS simple fair value model for bonds signals 2.7%
10-year TIPS yields have now overshot: the extraordinary event in the recent sell-off in rates is the fact that inflation expectations fell sharply, even as nominal rates rose, leading to a rise in real rates that was even sharper than that in nominal yields. US index-linked bonds yield have risen from minus 70bps in March to positive 65bps at the end of June (though they have fallen back to 50bps since). This has been driven not only by the reduced demand for ‘safe haven’ assets, but also by a better-than-expected US fiscal outlook (the CBO has revised down its forecast for the 2013 US primary budget deficit from 4% of GDP to 2.8% of GDP in May), a strong labour market (with the Fed linking its guidance to the unemployment rate), hawkish Fed rhetoric and falling inflation rates. However, we calculate that to stabilise US government debt to GDP and unemployment, even given the lower CBO numbers, requires for US real bond yields to be at 10bps. This suggests to us that TIPS yields have overshot
US 10-year TIPS yields have risen from minus 70bps to positive 50bps
CS estimate that the US requires a real bond yield of 0.1% to stabilize government debt to GDP
Technically 10 years oversold
Mining and oil companies’ capex has increased considerably over the last two years, which is beginning to have a meaningful impact on supply
The most commodity-intensive phase of Chinese growth (i.e. that which is led by investment) is coming to an end, which will reduce commodity demand.
Commodity prices have been driven up over the past decade by strong Chinese growth and, in particular, the boom in Chinese investment. However, at 48% of GDP, the investment share of GDP is 10 percentage points above the highest levels reached by any other industrialising country (in the cases of Japan in the early 1970s and Korea in the 1990s, the investment share of GDP peaked at below 40%).
Official policy appears increasingly aimed at boosting the consumer share of GDP. This should not only slow growth, but also make it less commodity-intensive. The new Chinese Premier, Li Keqiang, has stated his focus is on the quality of growth rather than the quantity.
A study by the IMF (China’s Impact on World Commodity Markets, May 2012) estimated that as a percentage of global production, China’s commodity consumption during 2010 accounted for c.20% of non-renewable energy resources, c.23% of major agricultural crops, and c.40% of base metals. A decline in China’s commodity demand would therefore have a significant impact on global demand.
If, for example, Chinese GDP growth were to slow to 6% and the investment share of GDP fall to 40% by 2020, investment growth would slow to 4% p.a., from an average of 19% over the last decade.
At the trough of the cycle, prices often fall to cash costs levels. Cuts in capex have a two to three year delayed impact on pricing. If there is a situation of oversupply, then prices often have to fall to levels at which a third of production is below the cash cost. The clearest example of this would be the oil price in the late 1990s and, today, the aluminium price (where 15% of non-Chinese producers operate at a cash loss, with the proportion in China closer to 30%).
Despite the recent falls, real industrial commodity prices are still only in line with their 100- year average
Real industrial commodities are in line with their long-run average