Why today's Philly Fed report is not as strong as it seems
Today's figures from the Philadelphia Federal Reserve appear bullish at first glance, but a closer examination reveals some mixed signals amidst a decidedly end-of-cycle overall tone.
Head of Macro Analysis
We see three main themes that will influence markets and policymakers in the coming months: growth is pointing down, indicators of financial stress are rising and inflation is back in the forefront, at least in the United States. We reaffirm that China will certainly does what it has always done to avoid derailing growth. It will step in in order to re-stimulate the economy but the expected positive impact on hard data should only be noticeable in 2019. Meanwhile, we expect that volatility will increase in the coming months and, on the back of lower global trade due to rising protectionism, investors will keep an eye on the US dollar to face potential market turmoil.
Leading indicators of growth confirm the Goldilocks era is done
The macro backdrop that we were fearing at the end of 2017 is mostly concentrated in Europe and in Asia/EM countries while the USA is doing well. Global leading indicators are pointing to a further slowdown in the coming months. Our in-house global credit impulse model covering 18 countries that represent 69.4% of global GDP is still in contraction while the OECD leading indicator, that has proved to be quite accurate over the past decades, is close to zero.
More anecdotal signals are also indicating the end of the global synchronised growth narrative and the risk of slowdown. South Korea, which is known to be a good proxy for global trade, is one of these signals. South Korean industrial production correlates well with global industrial production (excluding the US) and leads the latter by four months. It has been in negative territory all year long for the first time since 2014-2015 which tends to confirm that, with or without US protectionism, global trade is doomed to slowdown.
Though the USA is doing fine, there is accumulating evidence that it is approaching the end of the business cycle despite the Trump tax cuts. These were supposed to extend the cycle but San Francisco Fed Economists have recently published a study concluding that it may stimulate economy less than expected, or maybe not at all. Normally, such a fiscal stimulus tends to have a bigger effect when there is more slack in the economy. So far, it seems that the stimulus has not been much used by companies to invest more, which was the sine qua non condition for stronger growth. In this context, the risk of downturn in the industrial cycle has considerably increased. US manufacturing, which is an efficient coincident indicator of the industrial earnings cycle, has certainly already reached a peak in the cycle (in September 2017 when it hit a 13-year high).
The inflation theme is not going anywhere anytime soon
A common characteristic of most mature business cycles is that inflation accelerates as a consequence of high rates of resource employment. While it was believed that inflation was dead in 2015-2016, it seems to be finally well-alive. In the long-term, we remain convinced that we have entered into a world of lowflation due to structural factors, such as demographics (that leads CPI by 30 years in the US), but in the short and medium term, there are many triggers pushing inflation up in the United States.
We expect that the recent increase in oil prices will be fully priced-in in the July CPI print. Considering the evolution of the US labour market, we also anticipate that rising wages will fuel headline inflation price in the second half of 2018. There have recently been many questions on how long unemployment can fall without sparking inflation. The long-term NAIRU estimate by the OECD is currently at 4.4%, slightly higher than total US unemployment.
It seems that we are finally seeing some wage inflation. Better than looking at NFP data, we look at the last NFIB report: 36% of small firms indicated that they had positions they were unable to fill, matching the all-time high from the late 90s. To face skilled-labour shortages, 24% of them plan to increase wages in the next three months, which is close to the highest post-GFC level. Interestingly, this data leads the employment cost index by nine months, confirming that we should expect rising wage costs over the medium term.
In this situation of full employment (even broader measures of underemployment like U-6 are back to pre-crisis level), the Marxist dialectic proves to be right again: low unemployment tilts the balance of power in favor of employees, at least the most qualified and geographically mobile, over employers. It constitutes a strong incentive for the Federal Reserve to further tighten monetary policy, potentially at a faster path than expected by the market if ongoing protectionism drives inflation up, which would be ultimately negative for risky assets.
These red flag indicators should worry you…but there is hope
Though we are not facing a scenario of full-blown trade war yet, the US-China fight, along with quantitative tightening, are pushing investors away from markets that are less liquid and less integrated, meaning emerging and frontier markets. Since 2007, the fluctuations in Asian currencies have been a useful indicator of stress in the global economy. As a result of trade war noise, our basket of Asian currencies vs USD has decreased by 3.6% in Q2 2018 compared to Q1 2018. The magnitude of the drop is similar to that of Q3 2011 when the US lost its AAA credit rating but it is still lower than the impact of the CNY devaluation in 2015.
In a sense, what is happening in Asian markets is perhaps a glimpse of what lies ahead for developed markets in coming months. The flattening yield curve represents an important signal from the bond market. This is typically what you see at this stage of the business cycle as monetary policy tightens. It is an early signal of recession when it is inverted (which is not the case yet) and it is also an early signal of spike in volatility and end of stock market cycle. As you can see in the chart below, the US yield curve tends to lead the VIX by 30 months.
Monetary policy tightening has also for consequence a deterioration of liquidity conditions. Dollar liquidity is essential to monitor. Basically, lower dollar liquidity, which is currently the case, means the price of money will increase, especially for emerging countries that use foreign flow to fund their economy. In the graph below, we use USD money supply growth based on the 25 largest economies to assess the evolution of liquidity. Lower liquidity is a key driver behind weakness in emerging markets and constitutes a strong signal that the global credit cycle is turning down.
However, there are reasons to be a bit optimistic since China, whose contribution to global growth is greater than Europe, the USA and Japan combined, is trying to push credit impulse back in positive territory in order to re-stimulate its economy and, as a consequence, the global economy. Another positive signal coming from China is that year-on-year loans to non-banking financial institutions are back in positive territory, which is the first time since mid-2016. We believe that China is ready to do “whatever it takes” to overcome the macroeconomic impact of the ongoing trade war. A sharp CNY devaluation like in 2015 is not our baseline scenario since we consider that the short-term gains from devaluation are too low compared to the long-term positive gains from financial and monetary stability but we expect that financial deleveraging will be delayed and that more RRR cut are coming.
Since it will take time until these measures bear fruit, we consider that the risk/reward ratio favours a defensive approach, especially due to summer risks linked to low volume and the “Trump risk” which is still very hard to quantify.