We were promised growth. The Fed told us growth would be recovering after a very weak (weather/port strike affected) first quarter. Europe, with the benefit of a cheaper Euro and ultra easy monetary policy, is supposed to be recovering. China, with several rate cuts, reserve requirement cuts and liquidity injections, apparently stabilised in the second quarter. And not least, we keep hearing that Abenomics is working its magic in Japan. With all this good economic news, the Fed and the Bank of England feel encouraged to openly talk of the start of a rate rising cycle. However, there appear to be dark storm clouds gathering on the horizon.
In no particular order, we note the following;
- The NFIB Small Business Index declined by over 4 points to 94.1 in June. The ‘internals’ of the report were overwhelmingly poor.
- Commodities are collapsing. There is obvious over-supply in some markets, but there is also a demand shortfall problem here as well.
- The US Dollar is rising again, and is only about 1% below the high reached in March on a trade weighted index.
- The Caixin China Manufacturing PMI for July (preliminary number) fell to 48.2 the lowest since the growth scare in early 2014.
- Global trade, according to the CPB Netherlands Bureau for Economic Policy Analysis, has deteriorated in Q2, having struggled to grow meaningfully since the Global Financial Crisis.
- Results from Caterpillar were poor reflecting weak infrastructure demand globally and in Emerging Markets especially.
- Breakeven inflation rates have fallen to the lowest in several months and yield curves are flattening.
- Signs of a broad US equity market deterioration continue to mount.
As has been very widely discussed in the media, commodities have been crushed in recent days with broad commodity indices at multi-year lows. Ordinarily, the negative press would have our contrarian antennae raised, however, there is a structural story here to consider.
Chart 1 – The CRB Commodity Index
Demand for commodities exploded in 2009 as China embarked on a massive fiscal stimulus focused on infrastructure spending. With statistics bandied around such as China consumed more cement in a few years than America did in the entire twentieth century, it should have been obvious to all the China Infrastructure boom could not last forever. To meet the new Chinese demand, commodity companies invested heavily in new mines and production capacity, and with the long lead time on such investments, this new supply came on stream between say 2012 and 2014. With significant upfront (or ‘sunk’) costs involved in bringing new mines/production online, commodity producers will keep producing even as price falls to or even below the marginal cost of production.
Simply put, the structural story in many commodities seems to be one where demand is falling short of previous expectations (due to low global growth and a weak Chinese economy) and supply remains relatively high. We therefore expect prices for many commodities to remain relatively low for an extended period of time. Our belief in this view is bolstered when we see weak manufacturing surveys from China, weak sales numbers from bell weather companies like Caterpillar, and weak global growth data released by the CPB Netherlands Bureau (see chart 2 below).
Chart 2 - Growth in global trade
In the US, the weak June reading on the NFIB Small Business Index has piqued our interest. Of course, one month’s data point may be just noise, so will be watching the next couple of months reports very closely for further signs of economic weakness. The small business sector is interesting for several reasons. For example, small companies generally are the source of job creation whereas large companies are more mature and less likely to add new jobs over time. We also believe that small companies are more sensitive to economic changes as they are less able to beat up on suppliers, have less access to bank of capital markets funding and of course are likely to be more domestically rather than internationally focused.
So, when we see comments from the chief economist at the NFIB such as these, our interest is definitely piqued (emphasis ours);
- (on the survey result) It’s not a recession signal, but a clear sign that economic growth on Main Street is not set for a strong second half of growth.
- The 5 point decline in job openings anticipates deterioration in the unemployment rate in coming months.
- Expected real sales volumes posted a 3 point decline…overall, a rather stunning decline in expectations since late last year.
- The net percentage of owners raising selling prices was 5%, down 1 point and a weak reading. There are no signs of inflation bubbling on Main Street.
- Net 11% plan to raise compensation in coming months, lowest reading since October 2013. Official reports of hourly wages suggest that these gains are being absorbed by “benefits”, as little is getting through to take home pay. (NB by “benefits”, this is a reference to the increased costs of Obamacare).
If the weak readings in the NFIB survey continue for another month or two, then we can safely assume that the US economy is most likely stuck in the slow lane, or worse.
So what are we looking at here on the global economic front, and what does it mean for markets? Well emerging markets, especially those reliant on commodities, are either in recession or very close to it. Those mercantile emerging markets (South Korea, Taiwan) are beginning to struggle as global trade weakens. We have been warning of an Emerging Market crisis for months now and the difficult economic situation will only worsen if capital flows reverse meaningfully. Will an EM crisis impact the developed markets? Well, EM including China are economically much more important than they were at the time of the 1997 Asian crisis, and so we have to believe that the developed markets will be more sensitive to an EM crisis.
With the dark clouds gathering, will the Fed be able to raise rates later this year? And if they do, will they be tightening right into the teeth of a global slowdown (a.k.a. a policy error)? In this outcome, we would have to expect equities to struggle and rates and bond yields to remain near historically low levels. We would expect Emerging Market assets to crack first and so we need to watch these assets very closely along with credit markets and broad equity market indicators (not the high flying tech stocks which are helping some of the large cap weighted indices perform better).
As can be seen in Chart 3 below, Emerging Market equities are on the cusp of a major breakdown which could easily lead to accelerated market weakness if the economic crisis gathers pace and investors withdraw capital.
Chart 3 – Emerging Market Equity ETF
Chart 4 below shows the performance of junk bond spreads over US Treasury yields and also the S&P 500. We don’t have room to show all of our charts tracking negative divergences US equities and various indicators; suffice to say they are all flashing a warning signal that all is not well in the broad US equity market. Most stocks are not going up and it is a diminishing number of glamour stocks that are helping large cap indices appear to be relative healthy.
Chart 4 – S&P 500 with junk bond spreads
The bond markets are beginning to show signs that all is not well with the US economic growth story. Yield curves are beginning to flatten, breakeven inflation rates are edging lower and nominal yields appear to be close to reversing lower as well. If these emerging trends continue, then the signal will be unambiguous and we will have to seriously entertain the thought that the Federal Reserve may be sleep walking into a policy error if they raise rates a couple of times into Q1 2016.
Chart 5 – US Bond Market Indicators
So to try and sum up here. Having seen a ray of light after the cobbled together Greek deal two weeks ago, we are now having to recognise that dark storm clouds are indeed gathering. The ingredients for an Emerging Market crisis are fully in place, and we believe an EM crisis will have a greater effect on developed economies than in 1997. At the same time, the sensitive parts of the US economy (the small business sector) are flashing warning signals that the expected second half 2015 US economic recovery may in fact be aborted. To cap it all, the Federal Reserve may well begin to tighten policy at just the wrong time.
This scenario is plainly bad news for financial markets, and has a number of similarities to the late 1990s. We look to emerging market assets to crack first which could easily spill over into developed market assets. We are short EM equities and hold PUT options on the S&P 500. We have begun to make investments in the US interest rates market that will benefit from US rates staying low for longer, and for what it’s worth, our roadmap here is that the Fed may raise rates twice and then move to the sidelines. However, the window for raising rates may be shutting quite quickly, and these interest rates investments would work under both our “two and done” roadmap or no Fed rate rise at all.
All we can say here is that having been warning about potentially escalating financial market risks for months now, we see the risks as being pretty immediate here. The second half of 2015 could prove to be a very difficult time for markets indeed, and we feel fully prepared for such a scenario.