Friday, 1st of November 2019
“Nothing is so permanent as a temporary government program.”
– Milton Friedman
This week investors were treated to a flurry of economic data which seems to justify a more optimistic outlook for global growth than is the current consensus. Japan was one region where most figures were noticeably better than expected. For example, it turns out that industrial production climbed +1.1% YoY in September (versus -4.1% expected and -4.7% for August) despite the major dislocation in US-China trade relations and the Chinese economic slowdown, both of which have taken a toll on manufacturing worldwide. Given the scale of flows between the US, Japan and China, and the contractionary 48.4 print for Japan’s manufacturing PMI, this news came as a surprise to many. Nevertheless, it is only one data point and should not be over-interpreted. The Bank of Japan may have kept rates on hold on Thursday, as it highlighted the limited domestic impact from escalating trade tensions, but it signalled a dovish bias going forward given the external risks to growth. Staying in Asia for now, China also released some positive PMI data this week as the preliminary but unofficial and more reliable Caixin manufacturing survey showed the sector pulling out of recession and reaching a two-year high of 51.7 in October. This conflicts with the less positive official surveys (which normally overstate China’s success but may have been used to smooth the official growth trajectory on this occasion). The Caixin data also shows a pick-up in export orders, evidence that global trade may have recovered somewhat as US-China tensions eased from early September.
Even in the Eurozone there were some green shoots. GDP grew at an almighty +0.2% clip in the three months to September, which represents an annual growth rate of +1.1%. Economists expected the block to register negative growth given the technical recession that Germany is believed to have entered during the quarter and with the risk of a disorderly Brexit haunting investors. However, France and Italy both grew at +0.3% in Q3 according to data released this week and, together with the fast-developing economies of Eastern Europe, this seems to have been enough to keep things on an even keel. The one area of concern is Eurozone inflation, with the headline rate sitting at just +0.7% YoY for October. The significant undershoot of the ECB’s 2% target was in part driven by falling energy prices. Indeed, core inflation came in at +1.1% which is markedly higher. However, with interest rates already far below zero and the QE taps flowing fast this level of inflation will worry policymakers going forward.
Also released this week was a host of US data, much of it after the Fed had been bullied by the market into a ‘hawkish cut’ to interest rates on Wednesday. The headline GDP reading of +1.9% for Q3 beat market expectations (even if it was below what Trump and his Administration would have wanted) and remains ahead of other developed markets in Europe and Asia. Support came from consumer spending, which grew at +2.2% QoQ. This is lower than in Q2, however it is stronger than expected thanks in part to rate cuts over the summer which reduced mortgage costs and buoyed the housing market, making owners feel richer and more confident to spend. Indeed, pending home sales were up +3.9% YoY in September having suffered earlier in the year before the Fed reversed course. Finally, Friday saw another strong number for US non-farm payrolls as the economy created a further 128k jobs. Still, not all US data was positive with the ISM manufacturing PMI coming in at 48.3. In today’s globalised world, export-focused sectors cannot simply hide onshore from trouble abroad even if the domestic economy proves resilient. Nevertheless, the positive data from the US and elsewhere gives us confidence that the market is too pessimistic on global growth. There are many tail risks today – from the US-China trade war to conflict with Iran – and it is important to protect against them using puts and other hedges. However, investors should not take as their base case the seventh circle of hell and need to keep that upside optionality in portfolios by staying invested.
On Monday, outgoing President Mario Draghi made his farewell speech at the helm of the ECB with a call for unity among Eurozone policymakers. Since he made an open-ended commitment to further QE in September, despite the misgivings of a full third of MPC members, Northern European bankers have regularly spoken out against the ultra-loose monetary policy that has come to define his tenure at the bank (and which new President Christine Lagarde has pledged to continue). The Bundesbank President has been particularly vocal about the impact of negative interest rates and QE on pension funds which are forced to buy the bulk of negative yielding government debt under current regulations. It is also hard to argue with his view that the Draghi’s ECB was in the business of financing government spending when you consider the scale of asset purchases under his tenure and their limited success in supporting growth and inflation through portfolio rebalancing (i.e., the programme’s stated purpose). Of course, the short-term market impact of extraordinary monetary policy has been positive. Who would say no to the free beta on offer when the ECB opens the liquidity floodgates? But no party lasts for ever. Moreover, in his speech on Monday, Draghi once more lambasted Northern European states for failing to follow his lead by adopting the loose fiscal policy that he believes is needed to support growth and aggregate demand in the block. In many ways this is a fair criticism, given the size of their trade deficits (and fiscal surpluses). However, should the unelected ECB President be railing in public against elected EU politicians in this reverse-Trumpian way? Is this the way to endear voters to the integrationist EU project? The bureaucratic activism is not set to improve under President Lagarde, who has already suggested privileging Green Bonds in QE. This would make a mockery of the market-neutrality principal enshrined in EU law. That it is even being considered is proof that (with monetary policy) once the cat is out of the bag it is hard to put back in. Investors should be wary of policy ‘innovations’ going forward.