By Economic Strategist, Hottinger Investment Management
The last few weeks have seen a slew of promising news about the world economy. In the UK, first quarter GDP growth, at 0.5% (or approximately 2% annualised), surprised on the upside. The US confounded analysts by putting in another quarter of more than 3% annualised growth. Italy exited technical recession and Germany returned growth of 0.4% during Q1.
In Europe, output has recovered on the back of resilience within the domestic-facing sectors of the economy, as retail sales and services take up the slack from a manufacturing sector that has struggled to deal with a challenging global environment over the last six months. Wage growth has exceeded inflation and unemployment – by European standards – remains low.
As Figure 1 shows, China has been leading the global economic cycle for the last seven years. Movements in important leading indicators of output – such as overseas orders, steel production and consumer confidence – have tended to run ahead of their US and European counterparts.
During 2018, Chinese manufacturers ran down inventories of raw materials, a signal of softening demand. With China now the focal point for global manufacturing, this had a knock-on effect for the world trade in goods; global shipping volumes most likely collapsed for this reason during the second half of 2018 (see Figure 3) and have since partly recovered. The likely cause of this slowdown was the earlier attempts by the Chinese government and the People’s Bank of China to tighten financial conditions in response to concerns over high levels of debt in state-owned enterprises and local governments. They had also sought to clamp down on a shadow banking sector that was proving hard to control, yet it was an increasingly important source of finance for private firms.
In China there have been signs that stimulus has come through. The central bank cut reserve requirements for commercial banks by 350 basis points – equivalent to over 5 trillion yuan (or over $700bn) of capacity for new lending – since April 2018 and the effects have been passing through. Whereas in the past the Chinese authorities have preferred stimulus measures that raise investment spending, this time they have focused on domestic measures that raise consumption, including tax cuts amounting to $300bn. Value-added tax (VAT) for transportation and construction sectors will be cut from 10% to 9%, and VAT for manufacturers will fall from 16% to 13%.
The euro area appears to be particularly sensitive to China’s industrial cycle, as Figure 2 illustrates. European producers will therefore welcome the fact that Chinese export orders have been rising in recent weeks, which should boost the demand for European exports of capital goods and semi-finished goods.
The Eurozone consumer economy nevertheless remains strong. German retail sales growth has averaged 3.5% per annum since 2015; and for the euro area as a whole, the figure is 2.5% per annum. By Eurozone standards, unemployment across the region is relatively low. Wage growth has been rising modestly towards 2.5% per annum. At the same time, headline inflation has come down to closer to 1.5% on the back of lower oil prices. It is no surprise, therefore, that in Europe there is a divergence between the services PMIs and the manufacturing PMIs, although the hard industrial data in Germany has not matched the gloomy mood of factory managers (Figure 4). Domestic activity and consumption, on the back of rising wages, have driven a moderate turnaround in Europe. More favourable global tailwinds resulting from Chinese stimulus could boost the external sector and raise European growth in the coming months.
Q1 US GDP figures came in strongly at 3.2% (annualized), but they obscured signs of underlying weakness. Contributions to GDP from consumption and non-residential investment declined markedly last quarter, with a collapse in imports and a rise in inventories artificially raising the GDP figure. Forecasts for Q2 GDP growth issued by the Federal Reserve Bank of Atlanta indicate a slowdown to around 1-2% annualised growth – see Figure 5. This is largely on the back of weakening manufacturing sentiment and softer retail trade and auto sales reflecting stricter financing conditions for buyers.
Core US inflation has fallen from its 2% target. We think lower inflation has been largely imported through the low producer price inflation in China that has passed through to US imports. This could, however, be reversed as firms pass on the effect of US tariffs on Chinese imports onto consumers and there are signs that this is already happening. If overall inflation remains low, that would give cover to the Fed to maintain its dovish stance, lowering the chance that it delivers a surprise interest rate hike during the year. Financial market participants have now priced in 80% probability of a rate cut by the end of the year, and it will prove hard for Fed Chair Jay Powell to reign in these expectations without causing trauma in the markets.
There are signs of a stabilising world economy. Stimulus in China is coming through; Europe’s domestic economy is holding up while the slowdown in the US could simply be a reversion to a sustainable trend after a year of stellar performance. Nevertheless, the risks are still there. Corporate debt is high and rising in the US, Europe and China. Collateralised loan obligations continue to be popular. US equity markets appear to have reversed out of late-cycle behaviour in the perhaps misguided belief that the Federal Reserve will keep credit cheap. Then there is the unresolved trade standoff between the US and China. There are plenty of reasons not to be complacent with this favourable turn in global economic events.
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