As far as risk appetite is concerned, last week produced very inconsistent signals. Equity markets in the US, Europe and particularly Japan suffered painful losses. At the same time, Greece sold EUR 3 bn of 5 year bonds at a very low yield in absolute terms for a country with a debt-to-GDP ratio of 17%. I was travelling in Germany all week last week presenting our economic and market views to German clients and to my amazement I discovered that virtually none of our clients there fear a rise of inflation during the next 24 months. I have never experienced such lack of inflation concern in Germany before. Have they gone complacent? Should we use this mood as a contrarian indicator and start worrying?
It certainly looks like the valuation of tech stocks might have been stretched, requiring a correction.
Han de Jong Chief Economist
An isolated correction
The correction on the equity markets in the advanced economies was vicious last week. As many of these markets had recently made new highs, a correction could perhaps have been expected at some stage, but the discussion always is whether such a move is, indeed, just a correction or the beginning of a longer-term downward move. As we have been positive on equities for a long time and are still long this asset class in our portfolios, we need to be vigilant and we would like to be able to identify a serious sustained downturn as early as possible. If one wanted to build a case that the current move is the beginning of something lasting, the argument would most likely include valuation concerns, considerations of monetary policy support being withdrawn and perhaps something related to the economy and corporate earnings.
Looking at the possible arguments and market action in a broader sense, I am not at all convinced that this is the early phase of a sustained move lower in equities. The argument about valuation is complicated as there are various measures that give different results. It certainly looks like the valuation of tech stocks might have been stretched, requiring a correction. But it must ultimately be earnings that drive returns in the longer run and earnings depend on the economic cycle. There was nothing in the economic news in recent weeks that should have worried equity markets particularly. In fact, quite the opposite I would think. The European economy seems to have done well in the early months of the year, although the mild winter probably helped. Last week's industrial production data from Germany was encouraging and manufacturing data in France was also relatively good. In the US, the initial jobless claims fell to their lowest level in some years, suggesting that the labour market is improving. This view was further supported by an improvement in consumer confidence and by strengthening confidence among small businesses.
Another important observation is that last week's drop in equities was limited to advanced markets. Emerging equities hardly budged. Credit and eurozone peripheral sovereign bonds also performed well. This suggests that the markets have not fallen victim to a broader wave of risk aversion or that the Fed's tapering was a key culprit. The FOMC minutes, released last week, were balanced and Bundesbank boss Weidmann seems to be a "little less unwilling" to consider additional ECB easing measures should that be necessary to take out insurance against deflation. On balance, therefore, I am inclined to see last week's equity market moves as a temporary step back. That does not mean, of course, it cannot go further.
Another sign that the equity market losses were not an element of general risk aversion was the return of Greece as an issuer of sovereign bonds. Reportedly, investors bid for EUR 20 bn of these 5-yr bonds. In the event, Greece borrowed EUR 3 bn, paying a yield of 4.95%. That is really quite something for a country with a debt level of some 170%, which can only be sustainable if you are willing to make some optimistic assumptions.
My tour of Germany
I met clients of the Bethmann Bank, our German Private Banking subsidiary, last week in Munich, Cologne, Düsseldorf, Hamburg and Berlin. On balance, they were a little more cautious than I am on the outlook for the global economy. That is not so unusual; the same applies to when I meet clients in Holland. What I found most surprising, however, was the almost complete absence of inflation fear. I asked all the groups I spoke to if they fear an appreciable rise in inflation during the next 24 months. I counted, at the very most, a handful of hands out of a total of hundreds of clients. I had never seen that before in Germany. I know, inflation is very low and perhaps expectations are strongly affected by the most recent trend of lower inflation. But given the very loose monetary policies and German history, I did not expect such 'complacency'. Our view of inflation is consistent with the view of our German clients, but experience suggests that when everybody is thinking the same thing, that is often wrong.
Several German clients expressed concern over France and to a lesser extent Italy. Will these countries be able to adequately and sufficiently quickly improve their economic performance? The industrial production data released last week illustrates the problem clearly. German industrial production has recovered nicely in recent quarters. While France and Italy have also registered an improvement, they are clearly lagging Germany. What can we say? I tried to provide some comfort by making a couple of points. First, France is perhaps not quite as bad as many in Germany think. France is not Germany and never will be. The French have their own way of doing things, which is distinctly unGerman and which the Germans, incorrectly in my view, see as French failure. That does not mean that France should improve its economic performance. The second point I usually make is that the new governance structure of the euro implies much more intense scrutiny of a country's policies and much more severe peer pressure, which should help. Last, I could point to the new French prime minister, finance minister and the appointment of other officials. We will believe it when we see it, but it looks as though President Hollande has, finally got the message and is now going for a radically different approach to economic policy. In Italy, the new prime minister is doing the same.
Last week's Chinese trade data was very weak. Exports were down 6.6% yoy in March, following a drop of 18.1% in the previous month. Imports were off 11.3% yoy after a rise of 10.1% yoy in February. This is not looking good. However, we must be cautious interpreting this data. A number of factors have distorted the numbers. This time of year, the monthly data can jump around due to the Lunar New Year. Second, exporters had been 'over invoicing' in recent years which blew up the export numbers. Since about a year, administrative procedures have been tightened and the result is that over-invoicing has been reduced sharply, which lowers the export data. The import data can be affected by lumpiness of some imports, and also by price trends. There is little doubt that the Chinese economy slowed in Q1, but almost certainly not to the degree that that the imports data appears to suggest.