Written by Jim Welsh
Macro Tides Monthly Report 03 May 2018
Does a Slowing in Global Growth Portend a Recession?
Last year was only the sixth year in the 28 years since 1980 when all 46 countries followed by the OECD were growing: 1987, 2004, 2005, 2006, 2007, and 2017. In the U.S. the economy finished 2017 on a strong note with GDP up 2.9%. Growth in the European Union was 2.4% in 2017 and the strongest since 2007 when GDP was up 3.0%. The table was thus set for a continuation of better growth as 2018 began.
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With the bar set high for the first quarter it was easier for data to come in below estimates and it did in the U. S., European Union, and around the globe. The Citi Global Economic Surprise Index fell from a relatively high level at the end of 2017 to below zero in early April.
One of the sectors that weakened during the first quarter was manufacturing. Of the 29 countries in the Global Manufacturing Purchasing Managers Index (PMI), only six countries experienced an increase in their PMI’s in the first quarter. Although the softness in global PMI’s was widespread, the underlying strength is apparent since the PMI for 28 of the 29 countries are still above 50.0 and 20 are above 52.5. Despite the slowing in the first quarter, manufacturing in almost all of the countries is still expanding and in almost 70% the PMI is comfortably above 50.
Periods of slower growth during an expansion are not uncommon and in the past 22 years have occurred often without leading to a recession. This is the 13th time global growth has slowed since 1995 but a recession followed only three times. Since the current recovery began in June 2009 this is the sixth time the economy has down shifted. There are a number of reasons why the current slowdown in global growth will not precede a recession in coming months and will more likely be followed by a resumption of growth in the second and third quarters of 2018.
The one caveat is trade. One of the reasons growth slowed in the first quarter was due to concerns about the potential of a trade war or at least a disruption in trade. In recent weeks, the heated rhetoric regarding trade coming out of the U.S., E.U., and China has cooled, but the heavy lifting is yet to be done in the next 60 days. If a trade war develops in coming months, the risk of a recession will increase measurably.
Eurozone
Although manufacturing slowed in the European Union in the first quarter, the Markit PMI for Germany, France, and the E.U. as a whole remained quite strong. In April the PMI for Germany was 58.1, 57.4 in France, and 55.2 for the Eurozone Composite. In each case the actual figure exceeded the Survey estimate. From a low in the first quarter of 2016 manufacturing activity throughout the Eurozone rose persistently through the end of 2017 before taking a breather in the first quarter.
With orders for manufactured goods still strong, delivery times have slowed which also may have contributed to the slowdown in orders in the first quarter. The Delivery Time Index was 36 in April which is the slowest since 2000. Prior to the recessions in 2001, 2008, and the pronounced slowdown in 2011 due to the European sovereign debt crisis, the Delivery Time Index first fell below 40 and then rose above 45. The only head fake occurred in 2005. As long as the European PMI’s hold comfortably above 50 and the Delivery time Index does not rise above 45, the outlook for manufacturing in the E.U. will remain in growth mode.
On April 23 it was reported that the ifo Business Climate Index for Germany fell to 102.1 in April registering the third consecutive decline and raising concerns about the German economy. However, Assessments of the current business environment remained quite high and significantly higher than the trough in early 2016.
The decline was driven primarily by a large drop in expectations which fell to the lowest level since August 2016. The decline may be attributed in part to the escalation of trade tensions which curbed optimism for the future.
Even though lending is nowhere near the levels reached before the financial crisis, banks are increasing their loans to businesses and households, which should continue to support economic activity in coming months. The European Central Banks negative interest rate policy has brought home lending rates down from 5.5% in 2008 to below 2.0%. This has spurred housing activity and housing prices, which are now comfortably above their peak in 2008.
After the ECB’s Governing Council meeting on April 25, Mario Draghi acknowledged that the European economy had experienced a pullback from the exceptional growth at the end of 2017 but was not concerned:
“Overall growth is expected to remain solid and broad-based.”
Draghi did note that the threat of protectionism had become ‘more prominent’. In terms of inflation Draghi expressed confidence that inflation would rise toward its target of 2.0% and mentioned the ECB was monitoring the exchange rate of the Euro:
“The underlying strength of the euro area economy continues to support our confidence that inflation will converge towards our inflation aim of below, but close to 2 percent over the medium-term. The Governing Council will continue to monitor developments in the exchange rate and other financial conditions with regard to their possible implications for the inflation outlook.”
Since early 2017 the Core CPI rate dipped from 1.2% to 1.0% in April, despite much stronger economic growth in 2017. As I noted in the March Macro Tides a stronger Euro is working against the ECB:
“Since January 2017 the Euro has soared more than 20% versus the Dollar and is up nicely versus the currencies of other developed countries. The appreciation of the Euro is a double negative. It depresses import inflation which puts downward pressure on inflation, which means it is working against the ECB’s goal of higher inflation. The strength in the Euro makes European exports more expensive which has the potential to slow export growth and overall economic growth given the European Union’s dependence on exports.”
Exports represent 44% of GDP in the Eurozone, so the appreciation in the Euro is a big deal.
The ECB has indicated that it will continue to purchase $30 billion of sovereign and corporate bonds through the end of September. The ECB will need to communicate its plans well before the end of September to avoid an adverse reaction in the European bond market. My guess has been that they will likely 4 announce their plans in June or July.
Given the uncertainty surrounding trade and deceleration in growth in the first quarter, the ECB may choose to trim its purchases in the fourth quarter, rather than going cold turkey at the end of September. The ECB is at the stage where it is data dependent. Unless the EU economy displays definitive signs of firming in the second quarter, Mario & Co. will lean toward scaling its purchases down as a form of insurance.
The ECB launched its QE program in March 2015 and has expanded its balance sheet from $2.25 trillion to $5.6 trillion, an increase of 150% in three years. The ECB’s balance sheet is 33% of the European Union’s GDP. The ECB is beginning to run into some constraints after buying more than $3.3 trillion of sovereign and corporate bonds. Since launching its QE program in March 2015, the ECB has been buying 5 to 7 times the amount of annual issuance of debt by EU countries.
The ECB owns more than $2 trillion of European sovereign debt, which is extraordinary.
The ECB began purchasing corporate bonds in June 2016 in an attempt to lower borrowing costs for European companies. Citigroup estimates that by the end of September the ECB will have bought close to $250 billion of corporate bonds. The ECB has succeeded in lowering borrowing costs to pre-crisis levels.
Since the ECB launched it corporate buying program, it has routinely bought at least 80% of the monthly issuance of corporate bonds. The problem facing the ECB is that it is starting run out of sovereign and corporate bonds that meet its requirements for purchase, so winding down its QE program is almost a necessity. Furthermore, the ECB has to accept that it has squeezed about as much as it can in boosting economic growth and inflation already from its QE program, so the law of diminishing returns are already present.
Before the ECB announces its plans for curtailing its QE program, the ECB is likely to address the value of the Euro. The ECB is concerned that the Euro may strengthen further as it unwinds its bond buying. One way the ECB can prevent an additional increase in the Euro’s value is to openly discuss how the Euro’s strength is preventing inflation from moving toward its 2.0% target and weighing on economic growth by suppressing exports.
Sooner or later international currency traders will get the hint and begin to sell the Euro short knowing the ECB will not intervene. This is what Mario Draghi did in March 2014 when he complained that the strength of the Euro had shaved .4% off the EU’s inflation rate. The Euro peaked in early May 2014 near 1.40 before falling to 1.05 in March 2015. If the ECB wants to stimulate economic growth and push inflation higher, this may be the only option left. The acceleration in economic activity in the Eurozone clearly peaked at the end of 2017, but GDP should grow above 2.1% in 2018.
In anticipation of a decline in the Euro in coming months, I established a partial short position in the Euro inverse ETF (EUO) which is leveraged 2 to 1 on March 8 at $20.25. On April 23 the Euro traded below a prior low so I added to EUO position at $20.69. The Euro has the potential to fall to 1.160 – 1.1720 in coming months. On May 2 EUO closed at $21.65.
China
Since the end of 2008 China’s debt to GDP ratio has soared from 158% to over 300% at the end of 2017. According to the Bank of International Settlements, non-financial sector debt has risen from $6 trillion in 2007 to nearly $29 trillion. The property sector and related industries accounted for half of the new debt, with two-thirds of corporate debt owned by State Owned Enterprises (SOE). Many of SOE’s are directly or indirectly involved in the construction industry so any slowdown in residential and commercial real estate can negatively impact SOE’s and the banks that lend to them.
In an effort to slow credit growth the Peoples Bank of China enacted new regulations to thwart the amount of high yielding bank wealthmanagement products that are in reality loans. In 2017 banks transferred $3.5 trillion of loans to brokerages and other ‘shadow’ bank lenders that subsequently repackaged them into investment products sold to investors. By moving the loans off their balance sheets, Chinese banks don’t have to set aside reserves for possible losses. The volume of wealth products sold tripled between 2014 and the end of 2016, but stalled in 2017 as regulators clamped down.
For the rest of this article click on any chart or graphic for larger image.
As the above source of funding slowed, Chinese banks resurrected the sale of Negotiable Certificates of Deposit (NCD). In March NCD sales were $335 billion and have a maturity of one month to 12 months. The dependence on short term funding, especially for small banks, can leave banks vulnerable to a liquidity squeeze and higher funding costs. The yield on NCD’s has climbed from 4.1% in January 2017 to over 4.8% in March, as banks competed for deposits by offering higher yields.
The yield on the Chinese 5- year government bond has jumped from less than 2.70% last fall to 3.90% in late 2017, before dipping to less than 3.70% in late April. Historically, a rise in the 5- year Chinese government bond yield has led to a fall in Chinese property prices with a lead time of 12 months. Since the 5-year yield peaked in December 2017, property prices in the largest 70 cities are likely to remain soft for at least another 6 months. Tighter monetary policy as measured by the slowing growth in M2 and total financing suggests China’s economic growth is likely to slow in the coming 6 months.
Monetary restraint is not the only headwind facing the Chinese economy. Two weeks ago President Trump tweeted that China was manipulating its currency lower to unfairly gain a trade advantage. This isn’t the first time that President Trump has accused China of devaluing its currency. One of Donald Trump’s campaign themes was calling China “The single greatest manipulator that’s ever been on this planet.”
I reviewed the history of the Chinese Yuan versus the Dollar in the January 2017 Macro Tides which was entitled, “Is China a Currency Manipulator?” In that I review I noted that
“The Chinese Yuan (CNY) increased 25.5% in value versus the Dollar (USD), between January 14, 2007 and July 27, 2015.”
Since December 30, 2016 the Yuan has appreciated by 9.60% versus the Dollar, and is up 2.60% in 2018 through April 27. Candidate Trump was wrong in 2016 and as President he is wrong again. The 9.60% increase in the value of the Yuan (Renminbi RMB) since the end of 2016 is going to slow China’s export growth in coming months.
China has forecast that GDP will grow 6.5% in 2018, and given China’s ability to always realize its forecasts, China’s GDP will grow at least statistically by 6.5% in 2018. But China’s leadership is obviously concerned that falling real estate prices, higher interest rates, and a stronger currency may force them to fudge the numbers more than usual.
The Peoples Bank of China took an aggressive step to ease monetary policy on April 17. The PBOC said it was lowering the Deposit Reserve Ratio for banks from 17.0% to 16.0%. This action is expected to free up $200 billion that banks have been holding in required reserves that will now be available for new lending and make it easier for small businesses to get loans. The bottom line is that China is not likely to add much to global GDP growth in 2018 and may prove a drag on growth, especially if trade negotiations with the U.S. falter or become disruptive.
Emerging Economies
According to the Bank of International Settlement (BIS) the total amount of Dollar denominated debt outside of the U.S. is near $11 trillion. After tripling since 2010 the amount of Dollar denominated debt in emerging market economies is now up to $3 trillion. After peaking in January 2017, the Dollar Index fell from 103.82 to 88.25 in February 2018, a decline of 15.0%. For emerging market companies that derive a large portion of their revenue in their local currency or other non Dollar currencies, the Dollar’s decline makes it much cheaper to repay Dollar denominated debt. The 15.0% decline in the Dollar has thus been a big tailwind for emerging market economies.
Since bottoming in February the Dollar Index has increased by 2.8%, while the J.P. Morgan Emerging Market Currency Index has declined 4.40%. The Dollar Index has the potential in coming months to rally an additional 3.0% based on its chart pattern, positioning in currency futures which shows the largest short position in the Dollar since 2011, and negative sentiment toward the Dollar. The cost of servicing Dollar denominated debt has already increased based on rally in the Dollar and decline in most Emerging Market currencies and would become more of a burden should the Dollar rally another 3.0%.
Since September the 10-year Treasury yield has increased from 2.034% to 3.035% in late April. The correlation between U.S. Treasury yields and yields in Emerging Market debt is pretty high. Yields for Emerging Market debt bottomed in August 2016 one month after Treasury yields recorded their low, and both posted a low in September 2017. The rising trend in EM Bonds was broken on February 2 after wage growth was reported to have increased 2.9% in January and Treasury yields spiked higher. Almost $400 billion of Emerging Market debt is expected to roll over in 2018 and it will be more expensive for issuers with rates up significantly from the yields some of the debt was initially issued.
On April 16, the International Monetary Fund estimated that Emerging and Developing countries will grow at around 4.9% over 2018-19, roughly the same pace as in 2017. Given the decline in EM currencies and increase in EM interest rates, the risk is the IMF’s forecast may prove a bit optimistic with growth falling short of 4.9% in 2018. Nonetheless it is noteworthy that these countries continue to account for over half of world growth.
U.S. Economy
In its first estimate of first quarter GDP, the Commerce Department reported the economy grew 2.3%, after growing 3.2% in the third quarter and 2.9% in the fourth quarter of 2017. The slowdown was led by a decline in consumer spending, which rose just 1.1% after spending jumped 4.0% in the fourth.
The slowing in consumer spending (Personal Consumption) was expected as discussed in the January Macro Tides:
“Most consumers may be surprised when their January paycheck doesn’t reflect lower tax rates since the IRS won’t have them ready until February. The combination of low savings, higher credit card debt, and the delay in receiving the increase in net pay can be expected to lower consumer spending in the first quarter.”
In January and February consumers reduced their credit card balances by $43 billion the most in 8 years. The saving rate rose from 2.4% in December to 3.1% in the first quarter. The full benefit of the tax cut didn’t fully kick in until March, so consumers will have more net pay than they did in January and much of February going forward.
Wage growth should increase in coming months as small employers pay more to keep good employees, and the strength of the labor market encourages more employees to move to new employers. According to the National Federation of Independent Businesses (NFIB), small companies have been increasing wages and plan to increase them more in coming months. Workers who have switched employers have received a nice bump in their wages. With confidence high in the economy, more experienced workers are likely to take advantage of the competition between companies looking for good workers. The NFIB notes that small businesses rank labor shortages as their number one concern for the first time since 2000.
Wage growth will help consumers pay down more credit card debt, increase savings, and spend more, which will help lift growth in the second and third quarter.
In 2015 and 2016 nonresidential investment grew a paltry 0.6%. Nonresidential investment is the term used to describe business investment. Since the beginning of 2017 (and after the election), business investment spurred by less regulation has grown on average by 6.3%. As a result of the Tax Cut and Jobs Act, investments can be fully written off in the year they are made during the next five years. This should help maintain the increase in business investment experienced during the last five quarters. Of the first 125 public companies that have reported their results for the first quarter, almost 70% of them were optimistic about growth and more than 20% were positive about increasing their Capex (business investment). More than 20 also expect wage costs to increase.
The economy will pick up speed in the second quarter as consumer spending revives and business investment remains healthy. However, there are a few headwinds that will dampen how robust the rebound is. The national average for gasoline prices ended April at $2.81 a gallon up 18.1% from a year ago. A motorist in California pays an average of $3.61, while gas prices in the northeast are closing in on $3.00 a gallon.
Those on the lower end of the income spectrum are receiving less of a benefit from the tax cut since most workers earning less than $40,000 pay no federal income taxes. The after tax increase for a worker in the lowest percentile will only rise by 0.4%, but spending on gas consumes about 8% of their income. The 18.1% increase in the cost of filling their gas tank will cost them 1.4% more of their income (18.1% X 8.0%) compared to a 0.4% net income rise. For taxpayers in the second lowest quintile, the tax cut only marginally exceeds the increase in gas prices. For almost 40% of working Americans, the increase in the cost of driving their car exceeds the increase in their net pay or neutralizes most of the benefit from the tax cut.
One of the reasons GDP rose 2.3% in the first quarter, compared to the estimate of 1.8%, was an increase in inventories which added 0.43%. First quarter GDP would have been weaker had companies not added to their inventories. This suggests that companies will need to add less to their inventories in the second quarter, which will lower GDP in the second quarter. As discussed last month, the 90-day London Inter Bank Offered Rate (LIBOR) has risen from 0.30% in December 2015 to 2.36% on April 27. This is significant since there are upwards of $3 trillion of adjustable rate consumer loans and almost $4 trillion of corporate bonds tied to LIBOR. Consumers who have mortgages, credit cards, and student loans based on LIBOR will progressively feel the pinch from the rise in LIBOR in coming months, as will corporate borrowers.
The U.S. economy will strengthen in the second and third quarter but the rebound may not exceed 3.0% as forecast. The wild card is the upcoming trade negotiations. While a revised NAFTA deal is likely, China is likely to be a much more difficult and protracted process and may include at least one bump in the road.
Federal Reserve
As expected the Federal Reserve left the federal funds rate unchanged at its May 2 meeting, and reiterated its commitment to further gradual adjustments in the stance of monetary policy, i.e. additional rate increases. The FOMC statement also acknowledged that core inflation has moved closer to its 2.0% inflation target:
“On a 12-month basis, both overall inflation and inflation for items other than food and energy have moved close to 2 percent.”
After the March 2018 meeting the FOMC published its estimates for GDP, PCE inflation, and the unemployment rate. The FOMC’s preferred inflation measure is the Personal Consumption Expenditure Index (PCE) which was projected to reach 1.9% at the end of 2018 and 2.0% in 2019. The core PCE rate was estimated to rise to 1.9% in 2018 and 2.1% in 2019.
In April the PCE reached 2.0% and the core PCE rose to 1.9%, at least 8 months ahead of the Fed’s schedule. This prompted the FOMC to add the following comment to its statement:
“Inflation on a 12-month basis is expected to run near the Committee’s symmetric 2 percent objective over the medium term.”
A number of months ago I noted that the Fed would tolerate inflation above 2.0% after spending 6 years below 2.0%. Their target of 2.0% is not a ceiling but more like a zip code. By including the word symmetric, the FOMC was telegraphing that it would not over react if the PCE inflation measures ran above 2.0% in coming months.
There is a good chance that the PCE inflation measures will exceed 2.0% in coming months. The New York Federal Reserve’s Underlying Inflation Gauge (UIG) is rising at a steep slope and reached 3.14% in March. The 6 month rate of change for the core CPI was above 2.5% in March. The 3 and 6 month rate of change for the PCE were up to 2.6% and 2.25% in March. The acceleration in these indexes indicates that inflation pressures have been building up in recent months.
The Fed’s willingness to tolerate a PCE inflation rate modestly above 2.0% should help the bond market not overreact. The Fed will have a problem if PCE inflation rises to 2.2% and inflation pressures suggest it is going higher. This risk would be lowered if the economy’s rebound has less steam and fails to grow at 3.0%.
Treasury Bonds
In early January the yield on the 10-year Treasury bond was less than 2.50%. I didn’t think it would stay there as I discussed in the January Macro Tides:
“At a minimum, I expect the yield on the 10-year Treasury bond to rise to 3.0%, which was the high in December 2013. If this occurs the yield on the 30- year Treasury bond will at least test its 2017 high of 3.20%. If Treasury bond yields reach the targets I’ve discussed, it could spur a small reallocation out of stocks and into bonds. The odds of a 10% correction in the stock market will increase as interest rates rise during 2018.”
On April 25 the 10-year Treasury yield reached 3.035% and the 30-year Treasury yield rose to 3.219%. 11 In my April 2 Weekly Technical Review I recommended shorting Treasury bonds by buying either the 1 to 1 short bond ETF (TBF) or the 2 to 1 short bond ETF (TBT). On April 3, TBF opened at $22.77 and TBT at $36.45. I provide investment ideas and advice to a number of advisory groups and on April 25 I called every one and suggested that it was time to sell TBF and TBT. TBF was trading between $23.62 and $23.65 and TBT was trading above $39.20.
Although Treasury yields may spike above the April 25 highs if the employment report on May 4 shows that Average Hourly Earnings rose by 2.9%, Treasury yields are nearing a peak. Technically, the recent increase appears to have completed a 5 wave advance in yields since the low in September, and positioning in Treasury bond futures show that Large Speculators have a record short position. If the rebound has less zip in the second quarter, trade negotiations prove problematic, or a geopolitical event in the Middle East or North Korea occurs, Treasury yields are poised to decline during the second quarter.
Stocks
More than half of the companies in the S&P 500 have reported earnings and overall they have been stellar, along with strong growth in revenue that has averaged 8.0%. To date 80% of companies that have reported first quarter earnings have beaten their estimate, the highest rate dating back to 1999. The average is 64%. Almost 60% of the companies have cited the weakness in the Dollar as a tailwind. If the Dollar rallies as expected the tailwind may become a small headwind by the third quarter. Despite great earnings many stocks have initially rallied only to quickly succumb to selling pressure. I discussed this possibility in the April Macro Tides
“While first quarter corporate earnings are expected to be very good, it is certainly possible that investors will use the good news to sell. This could affect technology stocks since they have become over owned and investors may choose to lower their exposure after the recent bout of weakness.”
Since peaking on January 26 at 2873 the S&P 500 has been briefly down more than 10% and is still -8.25% below the high in January as of May 2.
If stocks can’t rally on good news, it suggests it won’t take much bad news to push stock prices lower. The odds still favor the S&P 500 falling below the February 9 low of 2532 in coming months. A close below 2580 could lead to a waterfall decline. In my Weekly Technical Reviews during March, I recommended that if the S&P 500 traded above 2789 and 2730,
“investors should: 1) hedge your portfolios, 2) do some selling, or 3) go short using a stop above 2840″.
The S&P 500 traded above 2789 on March 13 and 2730 on March 21. The stop should be lowered to 2740 on a closing basis, just in case the S&P 500 breaks out of the triangle to the upside.
Dollar
In the April 2 Weekly Technical Review I suggested establishing a partial position (up to 50%) in the Dollar ETF (UUP). On April 3 UUP opened at $23.64. On April 23 the Dollar broke out and I recommended adding to the position. On April 24 UUP opened at $23.86. In coming months, the Dollar index has the potential to rise to 94.50 – 95.00 and lift UUP to $24.50 to $24.70. Sell 1/3 of the position if UUP trades above $24.50 and use a stop of $23.89. On May 2 UUP closed at $24.40.
Emerging Markets
The combination of higher interest rates in the U.S. and a stronger Dollar could prove a heavy burden on EM debt denominated in Dollars between now and Labor Day. A retest of the February low near $45.00 on the Emerging Market ETF (EEM) would represent a buying opportunity for at least a partial position of no more than 33%. If the S&P 500 does drop below 2532, EEM could fall below $42.50.
Euro
On February 16 I established a partial short position in the Euro inverse ETF (EUO) which is leveraged 2 to 1 at $19.89. After Trump announced his decision to proceed with tariffs on March 1, I sold my position in the Euro inverse ETF EUO at $20.38. I reestablished the EUO position on March 8 at $20.25. The breakout in the Dollar Index was confirmed on April 23 as the Euro fell below its low of 1.2215 on April 6. With the breakdown in the Euro on April 23, I added to EUO at $20.69. The Euro has the potential to fall to 1.160 – 1.1720 in coming months. On May 2 EUO closed at $21.65.
Gold
If the Dollar moves toward 94.50 in coming weeks/months, Gold has the potential to close below $1306 and decline to $1275 and potentially $1250. If Gold does breakdown below $1300 it will likely set up a great buying opportunity, since I still expect Gold to rally above $1450 before a more significant top occurs. If Gold doesn’t breakdown, go long if Gold does close above $1368.00, with a stop on a close below $1356. I think a good trade will set up in Gold soon which will be discussed in the Weekly Technical Review.
Gold Stocks
If Gold drops below $1300, the Gold Stock ETF (GDX) has the potential to decline to below $21.50. Given the volatility inherent with Gold stocks I can only try to manage the risk through the Weekly Technical Review which allows for timely updates.
