With all the news headlines currently surrounding the Federal Reserve and Bank of Japan, some broader perspective is required. We know that the majority of the world has an easing bias, and the threat of higher United States interest rates is creating a growing threat of a temper tantrum across equity markets.
However, outside of the United States and Japan, there has been no interest rate action from the last round of central bank meetings in the UK, Europe, South Korea, Switzerland, Canada, Australia, Brazil, Turkey or Indonesia – despite an easing bias in all nine countries.
In addition, there have been no further material updates on the economic forecasts of the World Bank, International Monetary Fund or OECD since the July downgrades. This means we can focus our attention sharply on the material underlying changes in key economies and some of the market expectations ahead.
Of particular note is the economic yo-yo of the United Kingdom, as the market continues to struggle with the impact of Brexit. Manufacturing PMI surveys, viewed as one of the most reliable precursors to the economic direction, are bouncing around almost uncontrollably with the last release showing a rise from a three-year low of 48.3 in July to 53.3 in August.
To illustrate the oddity of this yo-yo effect, the bounce of five points actually broke records on the biggest month-on-month change for the UK. While Brexit remains the key talking point of markets, along with the gradual rise in the Federal Reserve interest rate and the United States election, we should warn that we remain agnostic in forming a directional position on the UK as the picture is still not clear on the likely trigger date of Article 50 and whether the UK can be successful in its desire to remain in the single market.
This obviously has vast implications to the asset class backdrop and we would warn that anyone claiming an ability to gaze into a crystal ball is potentially making false claims.
There are other stand-out considerations though. A recent poll of investors showed the biggest market concerns are currently European contagion risks, a Republican election victory, a further Chinese currency depreciation and a United States inflation spike.
The European backdrop makes for an interesting case, especially in light of our valuation-implied return calculations. We have seen mildly positive changes across the economy, although weak enough to harbour hopes of further stimulus in the near-term. The European Central Bank will be disappointed to know unemployment has now halted at 10.1% for five-months in a row.
The economic progress of China will require a watchful eye, with general forecasts showing a hard-landing is perhaps not forthcoming in the near-term as the data has exceeded expectations since late 2015. However, concerns do remain over the transition from investment-led growth to consumption, and the rapid debt expansion this entailed. It firmly places China as the most indebted corporate sector in the world as a percentage of GDP, although much of this debt was from state-owned banks to state-controlled entities.
Regardless of the source, historical analysis shows that high debt comes with higher economic risk and slower future growth, therefore it appears prudent to assume a gradual slowdown is in order and to account for potential drawdown risks if a bad debt cycle presents itself. Offsetting this is the unique positioning of China’s foreign reserves, which appear to have halted around the $3.2 trillion mark for the seventh consecutive month, down from $4 trillion in June 2014, which is pleasing news given the continued speculation about a further currency depreciation.
Debt and Inflation
More broadly, the global composite leading index, a sign of short-term economic health, has increased for the fifth consecutive month led mostly by the emerging market recovery. We view the implications of these short-term series with some scepticism, as economic shocks are rarely predicted with any precision. We are also witnessing the rapid expansion of many central bank balance sheets, which could have economic consequences that are probably not adequately reflected in the economic projection analysis.
The other underlying factor everyone wants an answer to is inflation. A spike in the inflation rate is one of the only feasible ends to the negative interest rate saga, so everyone is trying to figure it out. The problem is that inflation is notoriously difficult to judge, and as Morningstar’s economist team view it, the inflation rate is an unpredictable data series caught between the gravitational forces of higher oil prices and a lower Chinese currency. The commensurate inflationary and deflationary impacts are causing a stalemate and the catalyst for a sustained increase is unclear.
