My equity portfolio manager brethren often remind bond types such as me that we are different than they are in two fundamental ways: (a) we have no imagination in that we can’t imagine a world with totally different circumstances, and (b) we worry about things even when there is not much to worry about.
I will leave the first one for another blog but the second one is relevant today.
If you look at the capital markets in general and equity markets in particular, you would be forgiven for concluding that all is right with the world: Indices are reaching new highs seemingly on a daily basis, volatility is still plumbing the lows, and no new market or geopolitical development seems to dampen investor sentiment. It is truly a goldilocks time.
Three Worries: U.S. Slowdown, China, the Fed
But being a bond manager by training, I am going to validate my equity brethren’s characterization and worry about things when apparently there is not much to worry about. Specifically, despite the current market calm, I am worried about three things:
1. A slowdown in the U.S. economy. On the surface the U.S. economy looks solid:
- The employment picture continues to improve;
- The U.S. Manufacturing Purchasing Managers Index (PMI) has ticked up;
- Income growth is moderately positive and consumption for now is holding up well; and
- Overall economic activity seems to have picked up meaningfully in 2Q17 after an unexpectedly tepid 1Q17.
However, despite the healthy picture at the surface, there are some clearly worrisome signs that cannot be ignored and need to be monitored.
Among the signs to watch is that the U.S. data surprise index is plumbing new lows (Exhibit 1).
At a fundamental level, the key pillar of U.S. economic strength – consumption – seems to be softening. That is evident in declining retail sales, declining auto sales, and high auto inventory levels.
Further, if the economy were to gain any strength in the second half, consumption would have to hold up and investment would have to pick up. Unfortunately, despite off-the-charts business sentiment, investments are not going anywhere in a hurry and the positive initiatives that were to come out of Washington, D.C. to jump-start consumption and investment have been mired in politics. No substantive policy has been implemented and none seem likely over the next few quarters.
2. Chinese policy tightening. The primary catalyst for the global synchronized recovery that began in 1Q16 and continues to this day was the fiscal stimulus in China. As China’s PMI and Producer Price Index (PPI) spiked last year, the rest of the world benefitted in a big way as commodities stabilized and global growth came back from the brink of a potential recession.
Having succeeded at their task too well, Chinese policymakers are once again hell bent on deleveraging their economy. While the objective of deleveraging the Chinese economy is commendable from a long-term perspective, unfortunately, China’s policymakers are using the bluntest of tools – monetary policy and policy rate-setting – to accomplish that. Chinese short rates are up big and we are already seeing a slowdown in Chinese activity, which of course will have repercussions for global manufacturing and commodity prices. Europe and other emerging markets are especially vulnerable to a potential rollover in Chinese growth due to a policy mistake.
3. U.S. Federal Reserve (Fed) balance sheet adjustment. Despite several rounds of Fed tightening, real financial conditions in the U.S. are still quite easy. Further, with the inflation outlook rolling over, nominal long rates in the U.S. are getting uncomfortably close to the short rates as the curves flatten.
With a June rate hike almost certain, the path for future rate hikes is getting narrower. At the same time, the Fed has almost committed itself to continue down the path of further policy tightening and, irrespective of inflation expectations, its policy options are dwindling.
At the current pace, I think it is quite likely that after the expected June rate hike, the Fed may focus more on doing things with its balance sheet rather than continue to hike fed funds rates.
Therein lies the challenge. As investors we have dealt with Fed fund hikes forever; however, the markets have no experience whatsoever dealing with a balance sheet unwind. This is especially problematic in an environment where the economy may already be slowing.
While I, for one, have had a great deal of confidence in the Fed’s communication and execution capabilities ever since the beginning of the financial crisis, this is a totally new ball game and I worry about it a lot, especially its impact on one of the bright spots in the economy: Housing. Housing is getting going again and the Fed’s balance sheet machinations have the potential to smother that recovery. Further, any negative impact on housing and home prices will carry over to overall consumption spending and savings rates.
To be clear, I still believe that the global economy is in a good place and both U.S. and Chinese growth rates will stabilize after some softening. Nevertheless, as we bond busybodies know well, there is a lot to worry about in this still-fragile world. Don’t let high equity prices get you too complacent.
For more news and commentary on current market developments, view the full archive of Krishna Memani’s CIO Insights and follow @KrishnaMemani.
The U.S. Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. The purpose of the PMI is to provide information about current business conditions to company decision makers, analysts and purchasing managers.
China Manufacturing Purchasing Managers Index (PMI) provides an early indication each month of economic activities in the Chinese manufacturing sector. It is compiled by the China Federation of Logistics & Purchasing (CFLP) and China Logistics Information Centre (CLIC), based on data collected by the National Bureau of Statistics (NBS).
China Producer Price Index (PPI) measures the monthly changes in prices of industrial products for the domestic market by comparing prices in the current month with prices in the same month of the previous year. The coverage is more than 85% of total manufacturing turnover. The source of turnover statistics is the annual survey of enterprises consisting of annual reports submitted by enterprises to China’s National Bureau of Statistics (NBS).
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These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.