Where The Risks Are: It’s Not Where You Might Think…

August 5, 2016

Where The Risks Are: It’s Not Where You Might Think…

  • Car sales are in a downtrend and PMI is falling, which ties the FED’s hands.
  • Japan has just entered into direct economic stimulus with $273 billion.
  • The Bank of England behaves like the economy is in a depression, cutting rates and printing money.

Introduction

Yesterday we discussed how China isn’t as big of a risk as many would like to make it out to be. Today, we are going to go through the latest data from the U.S., Japan and Europe in order to assess their riskiness.

The U.S. 

We already discussed on Tuesday how the GDP has grown at a slower rate than expected and the actual growth is fueled by increased consumer debt, which isn’t a sustainable long term situation. Going into more detail will enable us to better forecast what will happen in the short to midterm.

One area of consumer spending that is currently essential for U.S. GDP is car sales. In the first 7 months of 2016 car sales have hit a plateau, which means there is more downside than upside. Car sales peaked in October 2015 and it looks like a downtrend is forming. The peak reached in sales is especially worrisome as car loan rates have hit historical lows and are currently around an average of 4%.

figure 1 car sales and rate
Figure 1: U.S. Total vehicle sales and car loan interest rates. Source: FRED.

This explains why the FED’s hands are tied when it comes to interest rate increases. Increased rates would increase the costs for consumer debt and therefore immediately lower consumption, sending the U.S. into a recession.

If you are overweight car stocks, be careful and watch what is going on because the low valuations are there for a reason and any kind of economic turmoil might be very negative on stock prices.

Continuing on the state of the U.S. economy, the Institute for Supply Management’s (ISM) Purchasing Managers Index (PMI), which measures factory activity, came in positive but below expectations on Wednesday. The PMI declined from 53.2 in June to 52.6. Any reading above 50 signals activity is expanding which is a good sign, but a downward trend isn’t ideal to see as most indicators were slower than in the previous month.

figure 2 manufacturing
Figure 2: U.S. manufacturing. Source: ISM.

Apart from the decline in activity, it is also important to note how the PMI reacted to the FED increasing interest rates in December 2015. The expectation of an interest rate increase alone decreased the PMI, and only with the later change in the FED’s rhetoric did the PMI return back into positive territory.

figure 3 the fed and PMI
Figure 3: PMI index in the last 12 months. Source: ISM.

This is yet another indication of how difficult it will be for the FED to increase rates as businesses and people have gotten used to low rates and any increase would immediately lower economic activity, pushing the FED to step backwards.

Japan’s Easing

On Tuesday Japan’s prime minister, Shinzo Abe, approved a $274 billion stimulus package aimed to help the Japanese economy and to help ensure his political survival. The package includes $173 billion of fiscal measures, $73 billion of government spending and $59 billion in low cost loans.

As this is a step beyond monetary easing, we will see what the impact will be on the Japanese economy. Analysts expect added economic growth of 0.4%.

The conclusion is that, if everybody is easing, it doesn’t make much of a difference and forces other central banks to do the same. This is the third reason in this article that makes it difficult for the FED to increase rates.

UK

The situation isn’t better in the UK.

While the major economic impact of BREXIT won’t be seen for two to four years, the first signs of a slowdown can be seen from the weaker sentiment. The UK Manufacturing PMI came in at its lowest level since 2013, which was a recession year in Europe. What is also important is the sharp decline, the PMI index fell to 48.2 in July from 52.4 in June which confirms BREXIT related uncertainty.

figure 4 uk pmi index
Figure 4: UK manufacturing PMI index. Source: Markit Economics.

On top of the negative PMI, the Bank of England has slashed its growth forecast to 0.8% from 2.3% for 2017, lowered interest rates to a record low, and announced increased lending of 100 billion pounds to banks. It will also increase bond purchases by 60 billion pounds. The Bank’s actions portend an outright depression in the UK rather than a possible future economic slowdown, but this is what central banks do these days.

Europe

A positive note comes from Europe which saw its PMI grow in July to 53.2.

figure 5 gdp pmi europe
Figure 5: Europe PMI. Source: Business Insider.

But the negative news is that GDP growth in Europe is expected to only be 0.3% in Q3 2016, further emphasizing the already bad decline to the 1.2% annualized growth rate in Q2 2016. All eyes are on the ECB which has stated many times that it will do whatever it takes to keep things stable and growing, thus, more stimulus.

Conclusion

The main question is: how long will central banks be able to keep things stable and markets high, and when will monetary and fiscal stimulus become inefficient and spur inflation? All factors indicate that the markets are overvalued, the economies are stretched and monetary stimulus is reaching its limits. As soon as signs of a normal economic cyclical downturn emerge, central banks step on the gas and print more money.

On one hand, investing logic would indicate that investors stay in cash as a bear market is imminent, but the fact that central banks keep printing money and saving markets, or not even allowing markets to decline, indicates that stocks and bonds will be artificially propelled even higher and investors might want to stay long these markets for the time being rather than fight the trend.  However, having well thought out stop loss orders in place is a must, and raising some cash would be prudent too because at some point things will turn.

It is important to keep an eye on inflation because low or no inflation is what is enabling central banks to continue with easing. As soon as inflation increases, central banks will have to start tightening.  Consumer price inflation is still at only 1%.

figure 6 inflation rate
Figure 6: U.S. inflation annual inflation rate per month. Source: Trading Economics.

As we discussed yesterday, China is growing at 6.7% per year, has low debt when compared to developed countries yet and is considered a risk. While developed countries use desperate measures to keep things as they are, fight deflation and spur some economic growth. Logic suggests that the risks lie in the developed world and China is a much safer bet.