Risky assets took another tumble last week. Equities continued their slide, High Yield bonds suffered further losses and spread widening hit peripheral bonds in the eurozone. What started as a phase of profit taking on markets for risky assets is turning into a severe correction in some markets. Rising geopolitical tension is the main culprit, while economic data across the globe varied last week from 'so-so' to very good. Assuming no significant further escalation of conflicts, we think the economic impact of the various sources of tension will remain limited. Economic fundamentals should take over again as drivers of financial markets in due course.
Equities continued their slide, High Yield bonds suffered further losses and spread widening hit peripheral bonds in the eurozone
Han de Jong Chief Economist
Geopolitical risks have surged in recent weeks and days. Russian retaliatory sanctions may not have huge effects on the eurozone economy at large, but the imposition of these sanctions indicates that the conflict is not easing. The main risk is a further escalation. This is dangerous.
It is hard to assess what steps the different parties will take next. If the Ukrainian army succeeds regaining all of Ukraine's territory, will Russia step up its support for the separatists? And what is the EU/US approach? So far, the EU/US response of imposing sanctions has not been very successful in trying to get the Russian leadership to change direction. One has to wonder how successful sanctions will ultimately be. Allow me to make a couple of simple observations. First, President Putin's approval rating at home is very high and appears to have risen as a result of his refusal to back down in the course of this conflict. We may argue that this is due to the control Putin has over the Russian media, but it is what it is. In any case, Russian public opinion is unlikely to force him to soften his stance. Second, it is true that the Russian economy has fallen into a (mild) recession and this may undermine support for Putin. However, my guess is that it will take a lot of economic hardship to lead to a significant loss of support for Putin. That will take a while. Third, the pain threshold in Russia is probably higher than in the West, meaning that Russia is willing to stomach more pain during this conflict than the West might be. And last, proximity is important. Military intervention in Ukraine (or stepping up its current involvement) is much easier for Russia than it is for the West. Might Putin consider calling the West's bluff?
What we need is for leaders on both sides to keep their cool, not engage in tit-for-tat actions and, instead, seriously engage in efforts aimed at de-escalating the tension.
There is more
The world was shaken last week by an escalation of problems in Iraq, as if the Ukraine/Russia/EU/US conflict isn't bad enough. US president Obama has authorised air strikes in Northern Iraq where ISIS (or IS as they are now referred to) are threatening to slaughter the Yezidis, a religious minority. Obama's decision is understandable, but does not guarantee a peaceful solution to the problems there. The effect ISIS actions have has on oil proces has been relatively small, but should they direct their resources to sabotaging Iraqi oil production, then oil prices will rise, which could affect the global economy.
The conflict in Gaza was only pushed away from the front pages of the newspapers last week because of a (temporary) truce and the prominence of other conflicts. Then there are several politically troubled spots in the rest of the world also.
And just in case the world wasn't troubled enough, the Ebola outbreak has been declared an 'international public health emergency' by the World Health Organisation. An epidemic, let alone a pandemic, is the last thing we need.
Economic fundamentals will strike back
While markets are nervous and geopolitical tensions are rising, the global economy is doing more or less what we expected. We believe that markets are ultimately driven by fundamental factors. So we need to ask what the economic situation will be like when economics take over again from geopolitics as the main driver. That depends partly on the effect geopolitical developments will have on the economy in the meantime. Various scenarios are possible. Suffice it to say here that our main scenario is that the economic situation will not be significantly, negatively affected. If we are right, one should expect the downturn in risky assets will prove to be a temporary correction, which will be erased again sooner or later. So, we must do what we do all the time: follow, analyse and interpret the incoming economic data.
Many commentators seem to take the view that the US economy is doing well, while the eurozone keeps stumbling. And many argue that inflation in the US might move higher while Europe could fall victim to deflation. Such divergence is very unlikely to be sustained for long.
The European and US business cycles have a high correlation. Ups and downs in both economies tend to occur in parallel fashion. The exception is when one of the economic regions is either hit by an asymmetric shock or mismanaged by its policymakers. That happened in 2011 when the euro crisis escalated. The eurozone fell into a recession, but the US continued its growth path. What factors could now be weighing on the eurozone economy heavily enough to lead to divergence of the business cycle? The Ukrainian/Russian conflict would be a candidate, but economic ties with these economies are not big enough to cause very serious macro pain. Earlier weakness in emerging economies and the weaker investment activity there, combined with the sharp drop in the yen over the last 18 months are not favourable to German industry. While German industry is one of the leading lights of the eurozone economy, we do not think that the weaker investment demand in the emerging world and the lower yen will cause a sufficient headwind to make the eurozone economy stall. I am, thus, struggling to identify factors that might currently cause a meaningful cyclical weakening in Europe while the US recovery continues to gain momentum. Therefore I think we should dismiss weak European data as noise, or at least as temporary, so long as the US recovery remains on track.
Having said that, German industrial orders data was particularly soft last week. Orders fell 3.2% mom in June, following a 1.6% decline in the previous month. Orders can be volatile, but this is a big (cumulative) decline. We need to see a meaningful improvement soon, or my theory that this is noise will be shattered. In any event, it is clear that, after a surprisingly strong Q1, the German economy did not make further progress in Q2. We expect GDP growth, to be published this week, to have more or less stagnated in Q2. The eurozone as a whole might have done marginally better. But that poor performance can still be explained partly by the good winter weather in Q1, which boosted activity in the first three months of the year, leading to 'pay-back' in Q2. The sharp decline in German orders in June was led by a 19.5% drop in orders from other eurozone countries for capital goods. It may sound strange, but I find that encouraging. Such a collapse, without an obvious reason, is unlikely to be the beginning of a new trend. More likely, it is pay-back for strong previous numbers. In April and May, these orders had risen by 11.1% and 15.7%, respectively. That must have been too strong.
Eurozone retail sales, on the other hand, were surprisingly robust in June. They were up 2.4% yoy, the best number since before the crisis. I must admit that retail sales data is notoriously volatile and prone to revision. In fact, the Markit PMI for the retail sector weakened in July, suggesting that retail sales may have dropped again.
US data was generally strong last week. Business confidence in the non-manufacturing sector surged in July, according the ISM's gauge. In fact, the July level was the highest on record since 2005. Jobless claims were also strong last week, registering their second reading below 300,000, although the 289,000 was a little higher than two weeks ago. One has to go back to 2006 to find similar readings. It must be said, though, that comparisons of levels of claims over such a long time are troublesome, as the size and the circumstances of the labour market were different then. Nevertheless, it is clear that the improvement of the labour market is continuing.
The Fed's Senior Loan Officers Opinion Survey showed further improvement. Banks are continuing to ease lending criteria and are experiencing stronger demand for credit. Credit quality is improving. The percentage of US home mortgages that are delinquent or in foreclosure continued to fall in Q2.
Chinese trade data was strong in July. Exports were up 14.5% yoy, while imports were down 1.6%. This combination is a little odd, but the export data and the acceleration of growth appears to be consistent with data from other countries. The conclusion we draw is that China is growing at a decent clip and the policymakers have succeeded in their efforts to halt the slide in economic growth.