4 mai 2017

Mind the Economic Fundamentals

May 4, 2017, Jean-Jacques Ohana and Dr. Christian Witt (both YCAP Asset Management)

The « Trump trade » may still be the investment theme of the hour (in developed markets). But current economic fundamentals suggest this is likely to change soon. For one thing, European economies continue their increasingly vigorous recovery, while the US economy seems to slow again. For another, there is less and less room for positive economic surprises on both sides of the Atlantic. Thus, markets may be ripe for a test.

US and Euro Area Growth Converge

From a pure macro-perspective, the most recent data published last week illustrates US and Euro Area real GDP growth converge for the first time in years (see Figure 1). Given the still considerable slack in some Euro Area economies, such as Italy or Spain, this is very good news east of the Atlantic. However, for the US it is more than disappointing that growth did not keep up with presumably forward-looking confidence indicators.

More worryingly, the US consumer was at the center of disappointing GDP data (see Figure2). In fact, the contribution of consumption to US real GDP growth fell to a post-crisis low, frequently associated with a recession. On the positive, firms and households eventually started to invest more actively ending a period of exceptionally weak capital expenditures.

Quite to the contrary, European GDP data shows a steady consumption activity paired with gross capital formation at cycle highs (see Figure 3), although some peripheral economies still considerably lag behind. Thus, the common currency bloc seems to eventually recover from the subsequent Great Recession and sovereign debt crises. At the same time, the dependence on positive current account balances to create growth diminishes; a welcome side-effect given that protectionism is on the rise elsewhere in the world. Europe’s growth prospects still look good.

« Trump Trade » No Longer Backed by Fundamentals

Turning to markets, we find that US equity valuations appear rich compared to their European peers (see Figure 4). The discount European equities trade at today certainly reflects the higher economic growth in the US after the Great Recession ended in 2009. But as we have shown above, economic activity has converged of late. Likewise, political uncertainty––formerly a unique European feature––has risen in the US and receded in the Euro Area, making it much harder to justify a substantial premium for US equities. We therefore expect European equities to catch up with the US over the medium.

US equities also seem expensive from a tactical angle. Ever since Donald Trump was elected president, US equities rallied in line with improving economic conditions (see Figure 5). However, more recently, the economic tide seems to turn. The ISM, a measure of optimism in the manufacturing sector, has retreated for two consecutive months while economic surprises even turned negative (see Figure 6). Apparently, the shift is the result of a reversal in exceedingly optimistic growth prospects (see Figure 7). Yet, stocks remained unimpressed. What makes us all the more sceptic about stocks is that commodities, notably copper, crude oil and iron ore, have already adjusted to changing economic conditions (see Figure 8). A stock market correction seems therefore more than warranted.

Closely Monitor the « EuroFlation » Trade

The same cannot be said about European equities. Their performance largely reflects a considerable acceleration in Euro Area economic conditions that goes back more than a year (see Figure 9). Most importantly, the economic trend remains fully intact for now and receding political uncertainty may reinvigorate economic momentum.

However, we advise investors to closely monitor this « EuroFlation » trade. The current economic trend is already mature from a tactical perspective and the economic surprise indicator seems to have topped; possibly heralding a slowdown in the near future. Investors should not be caught by surprise.

Commodities at a Crossroads

In line with our assessment of the US economy, and the weakness of the US consumer in particular, we reiterate last week’s warning: Stagnating commodity prices are an indication of a decelerating global economy.

As argued above, copper, crude oil and iron ore have already lost most of the gains accumulated since late last year (see Figure 8). Also from a technical perspective, commodities look vulnerable since their moving averages seem to flatten swiftly (see Figures 10,11, 12). This lack of positive momentum, which is strongest for crude oil and iron ore, is in sharp contrast to the vigorous uptrend in the second half of 2016. Hence, global growth seems to decelerate again. For a continued expansion, a new growth impulse is needed to revitalize the global economy.

Overweight Europe, Underweight US

For a number of reasons, European equities currently offer a better reward to risk than US stocks:

  • Economic momentum is stronger in the common currency bloc;
  • Slack in some Euro Area countries offers catch-up potential;
  • The US no longer outgrows the Euro Area;
  • US equities appear richly valued;
  • Political risks concentrate in the US;

We therefore believe European risky assets should be overweight while cutting some US exposure.

Figure 1: US and Euro Area Real GDP Growth, YoY%

Figure 2: US Real GDP Growth and Contributions from Fixed Investment and Consumption, QoQ% Annualized

Figure 3: Euro Area Real GDP Growth and Contributions from Fixed Investment and Consumption, QoQ% Annualized

Figure 4: Price-to-Book Multiple for US and European Stocks

Figure 5: US Citi Economic Surprise Index and Performance of S&P 500

Figure 6: Manufacturing ISM and US Economic Surprise Index

Figure 7: US Bloomberg Economic Surprise Indices Based on Surveys and Industrial Sector Data

Figure 8: US Economic Surprise Index and Performance of Commodities (Copper, Crude, Iron Ore)

Figure 9: Euro Area Citi Economic Surprise Index, PMI and Performance of EuroStoxx 50 Index

Figure 10: WTI Crude Oil Futures vs. 50, 100, 250 Day Moving Averages

Figure 11: Copper Futures vs. 50, 100, 250 Day Moving Averages

Figure 12: Iron Ore vs. 50, 100, 250 Day Moving Averages