Global Equity Markets Giving Mixed Signals by Bill O’Grady and Kaisa Stucke of Confluence Investment Management
Global equity markets are mixed this morning. The EuroStoxx 50 is up 0.2% from the last close. In Asia, the MSCI Asia Apex 50 was lower by 0.5% from the prior close. The Chinese markets fell, with the Shanghai composite down 3.5% and the Shenzhen index down 5.0% as well. U.S. equity futures are signaling a sideways opening from the previous close.
The major news overnight was that Chinese equities took another tumble. This occurred despite reports that the Xi government cranked up its fiscal spending by 26% last month, by $201 bn. To some extent, it appears that the government is using fiscal stimulus instead of monetary easing to boost growth. The problem with the latter is that if rates are cut, it pressures the CNY and leads to further capital flight. The trick with fiscal spending is figuring out how to get the best growth increase for the money spent. There are essentially two forms of fiscal stimulus—direct spending on goods and services (tanks, roads, dams, etc.) and transfers (tax cuts, rebates, transfer payments). The problem with the first form is the “bridge to nowhere” dilemma that Japan experienced in the 1990s into the turn of the century. Merely spending money on government investment that fails to generate a return is a form of malinvestment that eventually must be fixed (by tearing down a bridge no one uses, for example). Does China have room for further public investment that will pay off? It’s hard to say, but earning a positive return from public investment becomes harder over time as an economy develops. No one disputes the fact that the U.S. building the interstate highway system was a winner—but you can’t build it twice!
The other form of fiscal spending, which involves shifting funds to households, will only be as effective as the “marginal propensity to consume,” an old economic concept that measures how much a household spends out of each new currency unit provided. In other words, if you give a household a transfer payment, it probably doesn’t spend all of it but will save some as well. Unless the financial system can efficiently recycle that saving into additional consumption or investment, the transfer will have less impact than the money spent. In China, households are traditionally strong savers, mostly due to the lack of a government safety net. Think of it this way—Americans tend to have a higher marginal propensity to consume due to the existence of Social Security. Knowing there is help in retirement gives American households the confidence to spend transfers or tax cuts now rather than saving them for later.
China’s problem is that there is much evidence of wasted government investment (many of the “see-through” apartments are built with local government financing), and without a safety net transfers won’t generate much new consumption. China has no other choice but to tolerate slower growth as part of its restructuring. Until the Xi regime can adjust expectations, China will struggle to create a sustainable path forward. This leads to more capital flight and market turmoil.
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The migrant crisis in Europe is putting pressure on the EU in unexpected ways. Initially, Germany opened its borders and sought to show leadership on this issue. However, the flood overwhelmed its ability to process the newcomers, leading the Merkel government to “temporarily” close its borders. This, of course, led nations that are much less open to allowing migrants to close their borders as well. What is being undermined here is the EU concept of free movement of peoples, one of the building blocks of the European Union. Under EU rules, a citizen of any EU nation can freely move across any border; this creates a single labor market within the EU, a major goal for those pushing for European unity. When Germany moved forward to liberalize its treatment of refugees, it essentially created a crisis for the other EU states because once these refugees become German citizens they can move anywhere in the EU…unless the free movement is restricted. If borders return, it will be even harder for the Eurozone to survive. We note that German Interior Minister Thomas de Maiziere recommended today that nations that oppose taking their quota of refugees should face “pressure.” We would suspect he is hinting at economic sanctions; if Germany recommends this step, it is further evidence it is taking on the role of regional hegemon.
Finally, on the eve of the FOMC meeting, fed funds futures put the odds of tightening at 28%. Thus, we are vulnerable to a rate hike as the financial markets have not discounted this outcome. It is our position that the FOMC will move to raise rates on Thursday.
U.S. Economic Releases
Industrial production fell 0.4% in August, weaker than the 0.2% decline forecast. However, July’s numbers were revised higher to a 0.9% increase from the 0.6% increase previously reported. Manufacturing production fell 0.5% in August, with a 6.4% decline in motor vehicle production. Vehicle production can be volatile this time of year due to the moving nature of retooling downtime.
The chart above shows the industrial production index. Production fell in the beginning of the year due to port closures and other weather-related issues in addition to the rising dollar and weak emerging market demand. Production was relatively flat in June, rose in July and fell again in August. The strong dollar and weak international demand still remain headwinds for domestic production.
The chart above shows the capacity utilization. Capacity utilization fell to 77.6% from 78.0% in the prior month, weaker than the 77.8% forecast.
The Empire manufacturing report came in much weaker than forecast for September, coming in at -14.7 compared to the forecast level of -0.5. This is only a slight improvement from the August level of -14.9. Conditions remain tough for New York state manufacturers in this environment of weak global demand and a strong dollar.
In fact, the Empire state data is somewhat troubling in that we have had two consecutive very negative readings that would be consistent with recession. This index has a relatively short history, but if the Philly Fed index confirms similar weakness it would raise the odds of recession. Again, the rest of our indicators are NOT signaling trouble.
Retail sales came in close to expectations for August, rising 0.2% from the month before compared to the 0.3% forecast. However, the prior month’s number was revised upward to 0.7% from 0.69%, so the two-month net change was on forecast. Sales excluding autos rose 0.1% compared to the 0.2% forecast, but again July’s numbers were revised higher. Sales excluding autos and gas rose 0.3% compared to the 0.4% forecast, and the prior month was revised much higher. Retail demand was especially strong in the healthcare, food/beverage and motor vehicle sectors, while weakness was seen in building materials and furniture sectors. Sales at gasoline stations were also weak due to lower gasoline prices.
The chart above shows the annual change in retail sales. Overall, the retail sales report indicates solid consumer recovery.
For the rest of the day, at 10:00 EDT, the July business inventories will be released, with a forecast monthly increase of 0.1%.
Foreign Economic News
We monitor numerous global economic indicators on a continuous basis. The most significant international news that was released overnight is outlined below. Not all releases are equally significant, thus we have created a star rating to convey to our readers the importance of the various indicators. The rating column below is a three-star scale of importance, with one star being the least important and three stars being the most important. We note that these ratings do change over time as economic circumstances change. Additionally, for ease of reading, we have also color-coded the market impact section, with red indicating a concerning development, yellow indicating an emerging trend that we are following closely for possible complications and green indicating neutral conditions. We will add a paragraph below if any development merits further explanation.
The table below highlights some of the indicators that we follow on a daily basis. Again, the color coding is similar to the foreign news description above. We will add a paragraph below if a certain move merits further explanation.
The commodity section below shows some of the commodity prices and their change from the prior trading day, with commentary on the cause of the change highlighted in the last column.
The 6-10 and 8-14 day forecasts call for warmer than normal conditions for the majority of the country. A low pressure area in the Gulf of Mexico is forecast to make landfall today and slow. Two low pressure areas have moved into the mid-Atlantic, both with medium chances of becoming cyclones over the next two days. We are still in the most active season for tropical activity, which usually peaks on September 10.
Weekly Asset Allocation Commentary
Confluence Investment Management offers various asset allocation products which are managed using “top down,” or macro, analysis. This year, we will start reporting asset allocation thoughts on a weekly basis, updating the piece every Friday. We hope you find this new addition useful.
September 11, 2015
Global foreign exchange reserves reached a record high earlier this summer but fell precipitously in August, mostly led by foreign reserve drawdowns by emerging market countries. Foreign exchange reserves are the assets held by central banks or other monetary authorities to back their liabilities and, in a fixed exchange rate economy, are often used to maintain the pegged currency rate. These assets are held in major currencies, most commonly the dollar. According to the IMF, about 65% of foreign reserves are dollar-denominated and 20% are euro-denominated, with the rest of the currencies representing single-digit proportions. Since most foreign reserves are dollar-denominated, they are often recycled back into U.S. Treasuries by the central banks. Did foreign reserve accumulation partially support the bull market in domestic bonds? If so, could the reduction in international foreign reserves put pressure on these same markets?
To understand how the decline in foreign reserves might affect the domestic bond market, let’s first look at the dynamics of the initial reserve accumulation. We will use China as an example as it is the largest emerging market foreign reserve holder, accounting for about one-third of all reserves held worldwide.
China’s growth policies since 2002 have been investment-focused and export-led. As China produced goods for international markets it exported goods and received payment in a foreign currency. The majority of these payments were dollar-denominated for two reasons. First, the U.S. was a major consumer of Chinese exports, and second, since the U.S. dollar is the global reserve currency, most international trade is dollar-based, even if it takes place between two non-dollar countries. Instead of holding all the reserves in dollars, the country recycled these dollars by purchasing U.S. Treasuries. The WSJ reports that about 40% of China’s foreign exchange reserves are held in Treasuries, which accounts for about $1.3 trillion.
Additionally, the relatively high growth of China’s economy over the past decade attracted increasing amounts of foreign capital into China, pressuring the yuan higher. To supplement the export-led policies, China maintained an artificially low exchange rate. This meant that when capital flows into the country increased, the demand for Chinese yuan rose. To maintain the pegged exchange rate, the PBOC purchased the incoming dollars in exchange for yuan, which led to foreign reserve accumulation and thus increased Chinese demand for Treasuries. Additionally, as Chinese export trade increased, the PBOC purchased increasing amounts of dollars, basically injecting yuan into the economy, which led to rising money supply and stimulated the economy. The chart below shows the amount of China’s foreign reserves from 2009 to the present.
This historical pattern has reversed recently. As Chinese growth has slowed, international capital has flowed out of the country and slower international growth has also meant less demand for China’s exports. Because the yuan is pegged to the dollar and the dollar is appreciating, the Chinese yuan is no longer undervalued but is actually slightly overvalued against the euro. Also, as global growth has slowed and demand for Chinese exports has decreased, the PBOC has less capital inflows to exchange. In August, in the midst of rising market volatility, China supported its currency by selling Treasuries and dollars, leading to lower foreign reserves. While stocks sold off sharply at the end of August, bonds usually would have traded up as investors sought the safety of Treasuries. However, bonds remained under pressure alongside stocks, which is highly unusual by historical standards. There could be several reasons for this and all of them bear close watching to determine the magnitude of each factor. It is likely that the selling of Treasuries by China, caused by the currency intervention, pressured bonds lower. However, the likelihood of the Fed rate hike has also increased over the same time period, which could have led to rising yields.
Since Chinese data and political intentions are notoriously opaque, it is hard to determine the PBOC’s objectives. For markets, however, less reserve accumulation, by itself, should mean higher bond yields and a rising dollar against rivals, including the euro and yen. However, there are several other factors currently affecting Treasuries. The Fed rate hike is becoming increasingly discounted into the market and would also lead to higher yields. Historically, Treasury yields, especially in the short end, have been highly positively correlated with the fed funds rate. At the same time, weakening global growth and the stronger dollar environment usually increase the demand for Treasuries, which would lead to lower yields.
Given the crosscurrents currently affecting the Treasuries market, we are monitoring conditions closely. Although we generally have a favorable stance toward duration, we continually watch market developments and will adjust if necessary.
Past performance is no guarantee of future results. Information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice or a recommendation. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Opinions expressed are current as of the date shown and are subject to change.
U.S. Equity Markets – (as of 9/14/2015 close)
These S&P 500 and sector return charts are designed to provide the reader with an easy overview of the year-to-date and prior trading day total return. The sectors are ranked by total return, with green indicating positive and red indicating negative return, along with the overall S&P 500 in black.
Asset Class Performance – (as of 9/14/2015 close)
This chart shows the year-to-date returns for various asset classes, updated daily. The asset classes are ranked by total return (including dividends), with green indicating positive and red indicating negative returns from the beginning of the year, as of prior close.
Asset classes are defined as follows: Large Cap (S&P 500 Index), Mid Cap (S&P 400 Index), Small Cap (Russell 2000 Index), Foreign Developed (MSCI EAFE (USD and local currency) Index), Real Estate (FTSE NAREIT Index), Emerging Markets (MSCI Emerging Markets (USD and local currency) Index), Cash (iShares Short Treasury Bond ETF), U.S. Corporate Bond (iShares iBoxx $ Investment Grade Corporate Bond ETF), U.S. Government Bond (iShares 7-10 Year Treasury Bond ETF), U.S. High Yield (iShares iBoxx $ High Yield Corporate Bond ETF), Commodities (Dow Jones-UBS Commodity Index).
September 10, 2015
The above chart offers a running snapshot of the S&P 500 P/E in a long-term historical context. We are using a specific measurement process, similar to Value Line, which combines earnings estimates and actual data. We use an adjusted operating earnings number going back to 1870 (we adjust as-reported earnings to operating earnings through a regression process until 1988), and actual operating earnings after 1988. For the current and last quarter, we use the I/B/E/S estimates which are updated regularly throughout the quarter; currently, the four-quarter earnings sum includes two actual (Q4 and Q1) and two estimates (Q2 and Q3). We take the S&P average for the quarter and divide by the rolling four-quarter sum of earnings to calculate the P/E. This methodology isn’t perfect (it will tend to inflate the P/E on a trailing basis and deflate it on a forward basis), but it will also smooth the data and avoid P/E volatility caused by unusual market activity (through the average price process). Why this process? Given the constraints of the long-term data series, this is the best way to create a very long-term dataset for P/E ratios.
Based on our methodology, the current P/E is 19.0x, down 0.1x from last week. The drop was entirely due to the drop in equity prices this week as the level of earnings fell modestly. The P/E remains very elevated on a historical basis.