In an attempt to keep an open mind on the future outcome for the global economy and financial markets, we thought we would share some thoughts and see how they fit into the economic and financial mosaic. With the debate over the efficacy of Central Bank’s experimental policies heating up, financial market volatility rising and recession risks increasing, it seems difficult to find any stable outcome upon which to anchor expectations.

For what it’s worth (and we have been on this bandwagon for a year and more now), our view remains that a) most Emerging Market economies are struggling b) developed economies growth is being hampered by serious structural headwinds, and c) the global economy is vulnerable and likely to suffer a recession IF asset prices fall substantially. The tipping point between the current mediocre growth and recession is likely to be falling asset prices, and so the declines in equity/credit/EM/commodity markets over the last 6 months should be seen as very worrisome indeed.

However, let’s start on some positive notes. The US employment situation remains reasonably robust and jobless claims remain near historic lows. In chart 1 below, we show the year on year change in jobless claims along with the monthly layoffs measured by the Challenger group. The shaded areas represent recessions, and both claims and layoffs clearly rise sharply during these periods. Although each measure has risen in the last few months, they do not indicate we are in recession at this time.

Chart 1 – US weekly jobless claims and Challenger layoffs announced

Perhaps the biggest positive out there today is the low oil price and the boost to disposable income that means for consumers. The optimists are telling us that consumers are benefitting from rising real incomes and lower petrol prices, and having deleveraged since the crisis, are in a position to boost spending in the months ahead. This may well happen, but the picture so far indicates that both spending and GDP growth have been decelerating even as the oil price has plunged.

With the US becoming more self-sufficient in energy, what is good for consumers is bad for domestic energy companies with both somewhat cancelling each other out (we are massively over simplifying this claim). Furthermore, the household savings rate has edged up from below 5% to 5.5% since peak oil prices in mid 2014. So it appears that consumers are saving some of their energy windfall, and simply diverting some to other areas of expenditure such as healthcare. We continue to believe that there will be minimal economic uplift from consumption despite lower petrol prices.

The US inflation picture appears to be somewhat confusing. On the one hand, market based measures such as breakevens and 5 year 5 year forwards are indicating deflationary tendencies, whereas actual inflation measures are trending a bit higher. The picture could easily get a bit more complicated as and when the oil price stabilises and begins to increase. Furthermore, there are problems with measuring actual inflation, with some measures including too many spreadsheet assumptions. There is also a potential problem in taking a signal from market based measures as investors are prone to herding and these are not deep and efficient markets.

In our opinion, the Fed is now on hold, and a Core CPI print above 2% will not bother them. They have a target of 2% on the core PCE (currently at 1.4%) and they seem increasingly happy for this to run above target for a period if needed. The Fed also watch market based measures and survey based measures and with both now at their lowest outside of recession and financial crisis periods, we have to suspect that the Fed will ignore the recent increase in actual inflation, especially as inflation is the most lagging of all economic indicators.

Central bank stimulus measures, previously seen as an unambiguous positive for markets, if not the economy, are now being openly criticised by big investment houses and investment banks alike. Moreover, signs of Chinese stimulus also used to get the bullish juices flowing, although the unprecedented increase in borrowing in recent months seems to be causing a degree of consternation now.

It appears that monetary stimulus is finally losing its power to boost markets (having struggled to boost economic growth). The worry now must be how much harm QE/NIRP/ZIRP is doing to the financial system. It is perhaps no coincidence that the relative performance of Bank’s shares everywhere has been struggling for months, with the underperformance accelerating when the ECB and BoJ recently cut rates.

There is some vague talk that the G20 next week in Shanghai may bring some sort of co-ordinated package to help markets and the global economy. We don’t see this happening at the moment as it’s still every man for himself and actions that would make a difference, economically speaking, are simply not on the agenda (think Germany trying to reduce its massive current account deficit and intervention to weaken the too strong US Dollar). At best, we will hear a lot of spin and PR which will have only a fleeting positive effect on markets.

So it seems to us that we are stuck in a very low economic gear globally. Monetary policy is spent and fiscal policymakers appear inept. At best, we can expect a continued muddle through and markets staggering sideways with the occasional bout of volatility. However, the financial system appears increasingly fragile to us, and a new bear market (many assets are there already) in US equities will likely be the tipping point for the US and global economy. We said last week that equities were oversold and they duly bounced in robust fashion. We have quickly moved towards first resistance in the 1940/50 area for the S&P 500. We are watching closely for signs of a downside reversal in the days/weeks ahead.

Stewart Richardson
Chief Investment Officer