Buy not sell in May and go away?

It seems to have become a tradition that the majority of the world’s economic forecasters begin each year in an optimistic frame of mind.

Friday, March 14th 2014, 9:35AM

by Andrew Hunt

Certainly this has been the case for the last five years and this year was once again expected by the consensus to witness not only a long-awaited surge in capital expenditure in the US but also an economic recovery in Europe, a rebalancing of China’s economy towards more consumption-led growth and Japan’s emergence from its lost decades.

These are the types of high hopes that have been dashed before but on this occasion forecasters were able to take heart from a slew of seemingly very buoyant confidence indices, such as the US and European Purchasing Managers’ Surveys.

Unfortunately, we believe that the message that emanates from these types of essentially subjective surveys has been heavily influenced by an unfortunate level of distortion within the seasonal adjustment processes that take place within the compilation of these series.

Specifically, the exact timing of the Global Financial Crisis in 2008 had the effect of “cancelling Christmas” for many companies and this Grinch-like phenomenon distorted the seasonal adjustment systems to such an extent that even today many of these models now implicitly assume that Christmas has been cancelled indefinitely, with the result that they tend to portray the customary year-end surge in consumer spending (in Europe, some 40% of annual retail spending occurs in the run-up to Christmas) as a change in the economy’s underlying trend
rather than merely a regular, seasonal event. Hence much of the survey data has been biased upwards and many forecasters both in the public and private sectors have therefore set their sights perhaps too high.

In fact, if we examine the more recent and objective economic data points for the US, we find that last year’s rapid growth in the transportation sector is cooling rapidly and that the housing market data has begun to look a little more equivocal. Crucially, we also find that household disposable incomes are falling in nominal terms despite the ongoing rise in total employment, while much of the recent increase in the volume of total consumer expenditure has been the result of rising energy consumption associated with the very cold weather.

As most people in the real world know only too well, having to pay more simply to keep warm generally reduces the amount of money that you have left over for more discretionary spending in the future, particularly within a weak income growth environment...

In Japan, while it is true that nominal wages have started to increase for the first time in almost a decade, unfortunately the forthcoming hike in the rate of GST will imply that consumer prices will rise by even more, with the result that real wages will decline by some 4% this year. Meanwhile, outside of a few specific areas of the service sector, such as warehousing, we find that corporate expenditure trends remain essentially weak and we therefore suspect that, in the near term at least, Japan’s rate of economic growth may also disappoint the optimists.

In Europe there remains a great deal of optimism over growth but even here we find that actual momentum is slowing, particularly in Germany, Holland and Spain. Italy may well be stabilising following an “opportunistic” easing of fiscal policy but in general we see little evidence that Europe is bouncing back. Indeed, in most countries household incomes are continuing to fall and the credit crunch seems to be getting worse rather than better. It therefore seems to us that economic growth in much of the developing world is likely to disappoint, with the result that we suspect that earnings forecasts for companies will soon be revised downwards quite heavily.

Unfortunately, it is not only in the developed world that economic growth rates seem set to disappoint. In the years that followed the GFC, the West’s monetary policies gave rise to an almost unprecedented surge in global capital movements, many of which found their way into the emerging markets.

These flows had the effect of stimulating not just asset prices but also the underlying real economies, with the result that many of the emerging markets not only overheated but became addicted to further capital inflows via their expanding current account deficits.

As the developed world’s central banks have started to moderate their quantitative easing regimes over recent weeks, though, the flow of credit to the developing world has started to diminish with the result that we have witnessed weakness in many of the emerging market currencies and slowing domestic growth. These slower rates of growth are already impacting earnings forecasts not just for domestic companies but also for many of the world’s multinational corporations.

Perhaps more importantly, the weakness in the emerging market currencies is also creating a deflationary bias within world trade. Over the last 20 years, the outsourcing of production from the developed to the emerging world has made global inflation rates much more sensitive to emerging market inflation and currency trends, with the result that even the usually upbeat IMF has recently begun to warn about the rising threat of outright deflation within the global system. As Japan has shown, deflation disadvantages debtors in both the public and private sectors and compresses both corporate earnings and investment spending.

In this environment and contrary to the consensus’s expectations for 2014, we believe that the current situation is positive for high quality bonds but essentially negative for sharemarkets. We would also argue that the implied deleveraging within the emerging markets is US dollar positive but negative for the commodity and cyclically sensitive currencies, such as the Australasian dollars. We must, though, recognise that in time the world’s central bankers will be obliged to react to the weaker-than-expected economic outturn and the renewed threat of deflation. Hence, by the second half of the year, we would envisage easier monetary policies in the developed world, a revival in global capital flows and a possible return of optimism within the financial markets that will likely be sharemarket friendly, bond market negative and negative for the US dollar. Consequently, we suspect that 2014 could be a game of “two halves” in which investors may have to be quite nimble – it may even pay to “buy in May and go away”.

There are unknowns within this forecast. Firstly, we are assuming that the world’s central bankers will be prepared to launch yet another quantitative easing (QE) despite the growing dissent over the longer-term costs of QE from academia and their own ranks. Secondly, we are also assuming that the slowdown does not morph into an economic crisis before the central banks act.

With regard to the latter, we believe that China will be the key determinant of this risk.

It is now accepted that China’s rapid economic expansion since 2009 was built primarily on huge levels of credit-financed capital spending. What is less appreciated is the extent to which China’s credit boom was itself financed by massive borrowings from abroad. Indeed, China may well have become the world’s largest foreigner borrower nation over recent years.

Therefore, on the basis that global financial crises tend to occur not only when large sums are involved but also as a result of “things that the markets were previously unaware of”, China stands out as being a potential source of stress for the global system.

For example, we find that Hong Kong’s banks have borrowed very significant amounts of dollars, yen and euros in the short-term international credit markets and then used the resulting funds to fund the acquisition of very large long-term claims on Chinese entities. As a result, Hong Kong’s banking system has currency, credit and duration risk with regard to China that may be larger than is prudent.

It is therefore our fear that if the western central banks fail to reflate global capital flows quickly enough China’s economy could be drawn into the whirlpool of weak currencies, weakening financial systems and contagion effects that have already engulfed Turkey, Argentina and others.

A similar type of event befell China in 1994 but at that time China was only the equivalent of 6% of the US’s GDP and the financial links between China and the rest of the world were relatively minor.

Today, China is the second-largest economy and any balance-of-payments-induced weakness in China – that would in all probability be beyond the scope of even China’s government to manage – would lead us to become a great deal more negative over the outlook for world growth and sharemarkets this year.

In summary, although we suspect that in the near term the risk markets may find conditions difficult, if the world’s major central banks ease before China can run into too many problems, then we see no reason why optimism could not return to sharemarkets later this year but clearly there are considerable risks still present within the global economy.

Andrew Hunt International Economist London

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