The World’s Economy Needs Serenity

A sharp move in US stocks, US Bonds and the US dollar yesterday signaled the beginning of the year-end rally

Yesterday’s soothing comments by the FED Chairman sent asset markets flying yesterday from extremely depressed sentiment levels.

Federal Reserve Chairman Jerome Powell opened the door for a potential pullback in projected interest- rate hikes for 2019 following a widely expected increase in December.

In what was seen as a shift in tone from remarks last month, Jeremy Powell said that the Fed’s series of rate increases had brought policy to “just below” the range of estimates of neutral, where it neither spurs nor restricts the economy.

He also noted that the economy had yet to feel the full impact of the hikes.

Powell’s comments sparked a surge in a stock market that had struggled of late and came in the wake of repeated criticism of the Fed’s rate increases by President Donald Trump.

Policy makers provisionally penciled in three quarter-percentage-point rate increases for next year, according to the median of forecasts released in September’s so-called dot plot.

The S&P 500 Index rose the most since March, while yields on two-year Treasuries fell 2 basis points, as traders dialed back their expectations for interest-rate hikes.

Next month’s expected quarter-point increase would lift the
central bank’s target for the federal funds rate to a range of
2.25 percent to 2.5 percent.

That would bring it in line with the current levels of inflation, making the monetary policy truly neutral.

2018’s jump in the US economic rate of growth was primarily driven by the one-off shot in the arm of the Trump tax cuts.

As we argued many times, delivering tax cuts at the peak of an economic cycle just exacerbates the trends in place and lay down the foundations of the next down urn.

This is exactly what happened in 2018 where the tax cuts boosted spending and investment power in an economy that was already running at the lowest unemployment rate seen in decades.

The net result was a jump in consumption and an increase in wage pressures.

Logically, the FED had to increase interest rates and normalize monetary policy so as to contain inflation while keeping the momentum going.

And this is exactly where we are at with interst rates matching inflation rates.

But, as always, rising interest rates have a tremendous impact on liquidity, valuations and corporate earnings. As a result, 2018 is for now one of the very few years where all asset classes fell and delivered negative performances apart from cash.

The key question is whether the world economy has peaked and is falling into the next recession.

Trade wars, falling stock markets and slumping corporate bonds have all added uncertainty to the economic outlook.

Trade Wars have put Investments on hold

Donald Trump’s crusade against China did a lot of damage to the world economy.

It slowed economic activity marginally in China and Asia, but created a lot of uncertainty with investments, as CEO’s from all sides has no longer a stable environment to make their decisions in.

The Tweeting Policy made people look for the next Tweets instead of focusing on their investment plans, withdrawing one source of support for the global economic momentum of the world.

Tariffs applied to US imports of Chinese goods added pressure on prices for the US consumers and on margins for US corporations, while painting a somber picture for their future presence in the largest consumer of the world.

But it also took its toll on global trade and consumption by creating a psychology of war in a world that was just started to feel slightly better.

Europe’s re-structuring needed strong consumption and strong exports.

Donald Trump’s Trade War slowed the appetite of both European and Asian consumers that all need each other to grow.

And this can be seen in the recent weakness of the three most industrialized exporting economies of Europe : Germany, Switzerland and Sweden.

In Germany, output shrank in the third quarter for the first time since 2015 as the automobile industry was hit by new emissions testing, and an unexpected fall in exports.

Exports from Germany exports declined 1.2 percent year-on-year to EUR 109.1 billion in September 2018, as sales to the EU contracted 0.4 percent to EUR 64.7 billion. But exports to countries outside the EU shrank 2.2 percent to EUR 44.4 billion..

Germany is primarily an industrial machinery and final goods exporter and the threats of Tariffs on German vehicles in the US and the scaling down of investments in Bothe the US and China took a significant toll on the German industry.

And the lack of momentum in German exports had nothing to do with the strength of the EUR which decelerated form 1.255 in April to 1.12 in October, it really had to do with a significant decrease in investment demand from the rest of the world.

In Switzerland too there had been signs that the fast pace of growth seen earlier this year might not be sustained.

Economists had expected the country to expand in the period but the Swiss economy unexpectedly shrank 0.2 percent on quarter in the three months to September 2018, after a 0.7 percent growth in the previous period and missing market expectations of a 0.4 percent expansion.

It was the first quarterly contraction since the fourth quarter of 2016, as net trade contributed negatively to the GDP and investment in equipment slumped while household consumption was almost unchanged.

Swiss exports slumped in the third quarter only to recover in October 2018.

The only explanation to the slump in Swiss exports — they account for 46 % of the GDP, one of the highest in the world apart from the Oil producing countries — is the sudden lack of investment demand in the rest of the world

The Swedish economy also contracted unexpectedly by -0.2 % in the 3rd Quarter of 2018. The quarterly contraction is the nation’s first since 2013.

Although exports overall made a positive contribution, it was services exports that performed well, while goods’ exports unexpectedly decreased, confirmed Cathrine Danin, economist at Swedbank in Stockholm.

The Swedish is also a highly industrialized export-oriented economy.

The main industries include motor vehicles, telecommunications, pharmaceuticals, industrial machines, precision equipment, chemical goods, home goods and appliances, forestry, iron, and steel.

Sweden is renowned for its engineering, mining, steel, and pulp industries that are competitive internationally, as evidenced by companies like Ericsson, ASEA/ABB, SKF, Alfa Laval, AGA, and Dyno Nobel.

This sudden lack of investment demand is HIGHLY UNUSUAL in a world where economic growth is on the uptrend, consumption strong, corporate earnings at record highs and interest rates still very low.

The only explanation is a sharp deterioration in business sentiment and the best way to illustrate it is to take a look at the trends in Business confidence in the major economic zone of the world.

In the USA, the Institute for Supply Management’s Manufacturing PMI in the US fell to 57.7 in October of 2018 from 59.8 in September and below market expectations of 59.

The reading pointed to the slowest growth in factory activity in six months after reaching the highest since 2004 in August. New orders, production and employment eased and price pressures continued.

In China, the Official NBS Manufacturing PMI in China fell to 50.2 in October 2018 from 50.8 in the previous month and missing market consensus of 50.6.

The reading pointed to the weakest pace of expansion in the manufacturing sector since a contraction in July 2016, as output rose the least in eight months (52 vs 53 in September) and new order growth continued to slow (50.8 vs 52), with export sales falling for the fifth straight month (46.9 vs 48).

In Japan, the threats of tariffs on US imports of Japanese cars had an immediate effect on the auto industry and Business confidence started declining sharply as soon as Trade Wars took center stage.

There again, currency competitiveness was not the issue as the US dollar strengthen against the Japanese Yen over the same period, something that usually makes Japanese export oriented economy humming.

In Europe, the business climate indicator picked up to 1.09 in November 2018 from a 17-month low of 1.01 in October. There again, neither consumption, which has been clocking record highs after record highs in 2018, nor the exchange rate could be faulted as the Euro depreciated against the US dollar over the period.

The only valid explanation to the sudden and unusually loss of confidence of Businesses, and the corresponding slowdown in investments and fixed capital formation is the UNCERTAINTY created by Donald Trump’s Trade Wars.

A confirming indicator is the fall in exports of goods at the same time in all the major economic zones of the world while consumption remained strong.

CEOs are holding off and avoiding to commit to important investment plans.

Even more, in some countries such as the US themselves, the recent decision of GM to shut down factories and engage in cost cutting plans testifies of the emergence of the “B” plans :

Keep profits going up by cutting costs rather than by making new investments.

Stock market Blues

2018 has been a bumper year for corporate earnings with annual growth rates North of 20 % in the US, in the non-financial sector in China, in Japan and in most Emerging markets economies.

Even in Europe which is lagging behind in the cycle, corporate earnings growth has been strong helped by strong consumption, low interest rates and strong exports until Q2 2018.

As is always the case, higher stock prices and higher real estate prices also contributed to global growth through the “wealth effect” whereby consumers seeing their asset base growing feel more confident and willing to consume and borrow more.

Nevertheless, higher interest rates, higher labor costs and uncertainty about exports put an end to the valuation expansion phenomenon that had propelled global stock markets into the longest period of appreciation in history.

Global equity markets peaked in January 2018 and US equity markets peaked in September 2018, and, even more telling is the end of the technology sector lead, the one sector that has fueled the entire 2009–2018 bull market.

The October sharp correction was a stark reminder of what happens when psychology turns at extremes of overvaluations.

The Wealth effect goes into reverse and consumers suddenly retract.

In Europe, where stock markets peaked earlier in the year, Consumer confidence collapsed from June onwards.

The consumer confidence indicator in the Euro Area came in at -3.9 in November 2018, sharply below October’s final figure of -2.7.

It was the weakest reading since March 2017 due to a deterioration of all its components, i.e. consumers’ unemployment and savings expectations and their views on their future financial situation and the future general economic situation.

In the European Union as a whole, the consumer sentiment index was also confirmed at a 20-month low of -3.7 in November.

The question that begs to be asked is how can that happen when unemployment is at the lowest in a decade and interest rates are at zero.

In China, the correlation is even more striking with Consumer confidence falling sharply as of March after a massive improvement since 2016, just as Donald trump launched his Trade War and the Chinese stock markets started falling.

There again, nothing in the traditional macro-economics metrics of China justified such as fall, as real estate prices kept on going up, monetary policy remains accommodative, consumer credit keeps on growing and disposable income continues to grow substantially.

In China, the correlation between consumer confidence and the stock market is unusually high as can be seen from the falls in 2009, 2013 and 2016, when stock markets fell there in the previous quarters.

In the US, where equities kept on going until September, it is extremely likely to see the same phenomenon happening in the coming months, unless the stock market stabilizes.

Falling stock markets are bound to have a significant effect on consumption in the months to come.

Global uncertainty ended up Killing the Corporate Bond Market

In less than a month, the world credit markets went into a tail spin.

We had been warning for years now that fixed income bonds and credit markets were mispriced and kept artificially expensive by the abnormal monetary policies pursued by the world’s three largest Central Banks.

In the process, chap credit led to another binge of consumer and public borrowing and the world’s aggregate stock of debt is now at much higher levels than at anytime in history including the 2007 excesses.

The World total global debt reached $230 trillion in the last quarter or 313 % of the World GDP, and contrary to what some seems to think the largest increase does not come from China but from the US.

The Chart below from the Federal reserve shows the increase of US total debt and how the debt contraction of 2009–2010 was just a blip in what is truly an addiction to debt.

To put this into perspective the 2008 US meltdown occurred when household debt reached about 120 percent total debt to annual GDP.

The only way to keep payments current is with a low rate environment.

But the sudden cracks in equity markets translated into a sharp repricing of risk and BBB corporate debt suddenly breached the 8 % and 12 % thresholds in US dollar terms.

The effects of sharply higher interest rates for both corporations and individuals will have tremendously negative effects on corporate earnings, investments and consumption, eventually leading to the next recession.

In a nutshell, the unexpected UNCERTAINTIES created by Donald Trump’s Trade wars — and to a much lesser extent BREXIT and Europe’s Government debt — have dealt a massive blow to the World economy and are now creating a chain reaction in investments, asset markets and consumption

Whatever strategic or political motives Mr. Trump has been pursuing, he may have unleashed a highly destructive economic dynamic for the world economy.

Only a QUICK RESOLUTION OF THE TRADE WARS will restore global confidence.


and the US economy more than any other considering its high leverage and high reliance on a highly indebted consumer.

Originally published at Mechelany Advisors.