While equity markets in Europe and the US lost ground last week, and volatility on these equity markets rose to its highest level since March/April, economic indicators improved across the board. I take heart from the economic data. Many challenges remain, but economic conditions in the eurozone are improving at the margin and forward-looking indicators suggest a further improvement lies ahead. The ECB's bank lending survey contained important positive messages. The US economy is moving along quite nicely, though the occasional disappointment is persisting. Japan is doing all right in the aftermath of its tax hike and the emerging world appears to be turning the corner.
Economic conditions in the eurozone are improving at the margin and forward-looking indicators suggest a further improvement lies ahead
Han de Jong Chief Economist
Contrarian equity markets
Equity markets in the US and Europe suffered losses of just over 3% last week, while Japan and particularly the Asian emerging markets fared considerably better. At the best of times it can be hard to explain short-term movements in financial markets, but the correction seems at odds with the generally improving economic conditions. So what is going on? There are a number of possible answers. It could be that the market is signalling that the improvement in the economy won't last. That theory does not appeal to me as it is not consistent with our view on economic prospects.
Some commentators point at fear over earnings as a reason for the pull back. That explanation does not convince me either. As far as I understand the data, it would appear that the US earnings season is actually good, with a relatively large share of companies beating expectations. It is a different story in Europe, which has seen considerably fewer positive earnings surprises, and European companies have, on average, actually missed expectations. But then, the European economy is behind in the global economic cycle and should therefore also be behind in the earnings cycle. Anyway, positive surprises in the US contrast with negative surprises in Europe, which does not fit in with equity markets on both sides of the Atlantic giving up ground to a comparable degree. Another explanation is that markets had got ahead of themselves and need to correct and take a breather. Valuation, allegedly, had got stretched and the low levels of volatility suggest that complacency had set in. That line of thinking could be right, though our assessment is that valuation, generally, is not so stretched that a significant correction is inevitable. If we are right, the correction should remain modest.
Others argue that all sorts of tensions in the world are causing nervousness. Potential causes of the nervousness range from the conflict between Russia and the Western world over Ukraine and the tit-for-tat sanctions, the war between Israel and Gaza, the fear that US monetary tightening might come sooner than expected, Argentina's debt woes, to the problems of Banco Espirito Santo in Portugal (and I might have omitted something here). To me, the most plausible explanation - at least for now - is a combination of the need to correct during long rallies and nervousness. Stay tuned.
European banks are easing lending criteria
The ECB's bank lending survey provided perhaps the biggest economic news from Europe last week (though it was shamefully under-reported in the media), and my reading of it is unequivocally positive. The survey showed that banks are (on balance and only by a modest margin), easing lending criteria for the first time since 2007! In addition, and as shown in the graph, loan demand is on the rise according to the survey!! This rise is broad based. Banks are saying that corporates are seeking money for working capital, M&A activity and capex, while demand for consumer credit rose at its fastest pace since 2006. In contrast to the message from the lending survey, the talk about the eurozone economy is generally downbeat. Growth is lacklustre, the credit channel, allegedly, isn't working and deflation, supposedly, isn't far away. But if households and companies truly believe deflation will take hold, they should be postponing investment and spending and certainly not look to borrow for it. According to this survey, they are doing the opposite. And the easing of credit standards suggests that the financial sector is healing. That is good news. All this seems to be at odds with the general view on the economy and the financial system. This doesn't add up. Either the survey will prove to be unreliable or economic developments will turn out more positive than many people fear. As I have also drawn GDP growth in the same graph (see above), you can see that this survey has quite a reasonable track record as a leading indicator for GDP growth. My conclusion is that there is every reason to be optimistic. But who knows, may this time is different...
Eurozone unemployment inched lower again in June, falling to 11.5% from 11.6% in May, while it peaked at 12.0% from March to September last year. Encouragingly, unemployment is falling the most rapidly in a number of peripheral countries. Over the last 12 months, Portugal, Ireland and Spain are the leaders. And that would not appear to be just because people are leaving these countries.
Inflation also inched lower in July. Eurozone headline inflation amounted to 0.4% yoy (down from 0.5% in June). Given that inflation eased more than that in Germany, Italy and Spain, I would not be totally surprised if the July data was revised even a tad lower. Core inflation, on the other hand, remained at 0.8%. We believe that inflation will soon bottom. A period of sustained painful deflation is still unlikely in our view. There is, however, no doubt that the ECB is significantly undershooting its target. Its efforts to get inflation back up by ultra-loose monetary policy will therefore remain completely justifiable for an extended period.
Rich data flow in the US
Last week saw a relatively large number of US economic data. The data was mostly good, but there were exceptions and the picture remains a little patchy. The Chicago PMI dropped an amazing ten points, from 62.6 to 52.6. This seems completely inconsistent with other business confidence surveys. The national ISM moved in the opposite direction: rising from 55.3 in June to 57.1 in July. Perhaps the Chicago PMI had overstated underlying strength in recent months and was due a substantial correction. If that is so, we can shrug it off as noise, but this bears watching. The employment index of the ISM survey was at its highest level since 2011, though the final reading of the rival Markit PMI was lower than the initial estimate and down on the previous month. The US employment report disappointed slightly. The economy gained 209,000 jobs in July, a little lower than the 230,000 which analysts were expecting and clearly below the 298,000 added in June. Still, any reading over 200,000 is certainly good and the numbers for the previous two months were revised up by 15,000 in total.
US consumer confidence rose in July to its highest level since 2008 according to the measure of the Conference Board. Personal income and spending went up 0.4% mom. Personal income has increased at an annualised rate of 6.2% so far this year - not bad. No wonder consumers are confident, though consumer spending has lagged behind somewhat, rising at an annualised rate of only 3.7% (in nominal terms) in the first half of the year. This suggests there is potential for stronger consumer activity in the months ahead. Inflation pressures remained modest with the core PCE deflator rising 0.1% mom and the yoy rate stabilising at 1.5%.
US GDP rose at an annualised rate of 4.0% in Q2, above expectations while the number for Q1 was revised up. Although a rise in inventories made a significant contribution
to Q2's growth, strength in business investment was an encouraging sign.
On balance, I think there is also every reason to remain optimistic about the US outlook.
Elsewhere in the world, what struck me most last week was that the majority of Asian economies saw business confidence increase in July. That was the case in, for example China, Taiwan, Korea and India. Japan and Vietnam were the exceptions. But Japanese data is, on balance, not disappointing as the economy seems to be holding up relatively well after the tax hike earlier this year.