By Zac Tate, Hottinger Investment Management
Optimism rises that the world economy will escape further deceleration
For the last few months, we have taken the view that the all-important US economy is ‘late-cycle’ with growth decelerating and a recession looming. The latest slew of data might appear to challenge this view.
The Bloomberg Economic Surprise Index has reached an 11-month high after four indicators released last Thursday, including existing home sales and jobless claims, each surpassed expectations. The gauge swung to positive from negative last week for the first time this year. The data also pushed a similar measure produced by Citigroup to the highest level since April 2018.
Last week, the Fed highlighted the US economy’s strength even as it moved forward with another interest rate cut to guard against elevated risks to the expansion. Risk-on investors are growing more confident too, lifting U.S. equity benchmarks back near to records this month; meanwhile, over the last four weeks US Treasuries have sold off. It appears that investors are starting to buy the Fed’s talk of mid-cycle adjustment.
The US data follow reports from both Europe and Japan that sentiment has surprised on the upside.
But let’s be clear, while imminent recession risks are receding, we argue that the environment is still most plausibly late cycle. US firms are still reluctant to ramp up capital investment against a backdrop of trade policy uncertainty and tepid global demand. It is unlikely – absent a pre-election fiscal boost from the Trump Administration – that US GDP will return to the 3%+ rates it enjoyed last year. Indeed, despite the release of the latest hard data, the Atlanta Federal Reserve continues to predict an annualised expansion for Q3 of closer to 2%, the same level it forecast for that period at the end of July, when bonds were still well and truly rallying. That would represent a clear deceleration.
Meanwhile, manufacturing and industrials continue to act as drags on the economies of Europe and South East Asia. The euro area’s industrial output contracted 0.4 per cent in July over the previous month, according to official data from Eurostat. Compared to the same month last year, factory output in the 19 eurozone countries was down 2%, worse than the 1.3% fall expected by economists polled by Reuters. There’s still a risk that central banks will not move quickly enough to re-loosen policy sufficiently to keep the global cycle going further. The Fed has of course cut rates and the ECB has announced an innovative subsidy scheme for large banks by raising the deposit rate on excess reserves above those at which banks can borrow from the ECB. But it may still be too little to reverse the slowdown in global growth.
Signs of stress in dollar financing markets also remain – even if last week’s spike in repo funding costs was due to technical reasons rather than a symptom of seizure in financial markets. As we discussed recently, dollar shortage is pushing up trade financing costs, which will only ever be an impediment to business.
But perhaps by focusing so obsessively on the US and the Federal Reserve, we have missed the Chinese story. Have China’s policy actions in the face of trade headwinds turned around its economy and, in the process, improved conditions globally? It is too early to say conclusively but we can certainly point to signs.
The Chinese authorities have not been sitting on their hands this year. Since the turn of the year they have been responding to political hostilities by allowing their currency to depreciate, cutting taxes on incomes and consumption, and expanding loan availability to private firms that have been shut out by the clampdown on shadow banking operations in the country.
If we see a repeat of late 2015 with a rapidly rising Chinese credit impulse, the effect of that could far outstrip the real economy consequences of a 25bps cut in US interest rates. This would reflect the fact that the centre of the global manufacturing economy is now in Asia generally and China specifically. For that reason, we should keep a closer eye on policy developments in China.
What matters globally right now is the manufacturing and industrial picture. Until we see a reversal in fortunes in this space – and that will require both a resolution to the trade standoff and looser monetary conditions – we must still assume that recession risk globally is elevated, with Europe leading the way and the US not immune.