Stock prices and the economy have diverged, and that makes it even harder than usual to judge whether there is a true global slowdown under way.
There are three possibilities, and investors need to distinguish between them.
One, a string of one-off hits to the economy in autumn—bad weather, a nasty flu season and new European rules on car emissions—is continuing to be felt now. Two, there really is a dangerous global slowdown, led by China. Three, the world’s political order is coming unstuck: an intensifying trade fight between the U.S. and China, a messy Brexit and other dysfunction across Europe.
The first effect will fade; the second could last a long time; the third is merely preparing the ground for how bad things might get.
Blurring the picture is the behavior of markets, with stocks and other risky assets rallying everywhere in January, even as the mood darkened in countries more reliant on high-value exports to China. Shareholders have begun to discriminate this month, marking down Germany and Japan, both of which export a lot of highly profitable equipment to China. Yet, industrial-metals prices are usually painfully sensitive to Chinese demand, and show no signs of concern.
What’s going on? There is no way to be sure, but it looks like a confusing mix of the delayed effects of last year’s one-off hits feeding into supply chains, and Chinese companies reining back investments as they worry about growth and tariffs. Neither is good, but it could be worse.
Start with markets: Last month pretty much every major stock market rose, between 6% (France, Germany, Japan) and 9% (Chinese domestic stocks, emerging markets).
Even as stock performance synchronized after last year’s U.S. exceptionalism, economic data suggested the U.S. has again jumped out in front. One closely watched lead indicator, the ISM manufacturing purchasing managers index, unexpectedly rebounded to show healthy expansion in the U.S., and jobs figures stayed strong. PMIs elsewhere suggest German and Italian manufacturing is shrinking more than forecast, while Japan is stagnating.
There is some evidence that stocks are paying attention to the economic data again, with European and Japanese markets falling more than others in the past few days.
This fits the first and third explanations: one-off effects are still reverberating through supply chains and hitting confidence while CEOs are concerned about politics. It doesn’t really fit the tale of China’s economy weakening fast, which ought to feed through to commodity prices as soon as investors come to believe it.
Chinese companies worried about an uncertain outlook seem to be cutting back on new machinery, even as they keep existing factories and steel mills humming. And that makes German and Japanese machinery manufacturers the victims, rather than the Australian and Brazilian iron ore miners who suffer from a broader downturn.
Japanese robot-maker Fanuc (FANUY) is typical. In its results to the end of December, it said Chinese demand in its three divisions had declined sharply, was weak or had plummeted. Industry data showed machine-tool exports from Japan to the rest of Asia down more than 25% in December compared with a year earlier, with foreign new orders down 24%. Meanwhile, machine-tool exports to Europe and the U.S. were flat, and Japanese domestic orders, while down, were down far less.
Confidence among German machine-tool manufacturers has collapsed, according to the regular survey by the Ifo Institute in Munich. In November 2017, they were the most positive they had ever been on the business climate, but by the end of last year positive and negative views canceled out—and they were the most negative on the six-month outlook since the end of the 2009 recession.
If the trade dispute somehow gets resolved before President Trump’s March 1 deadline to reach a trade deal, CEO confidence might improve, machinery orders could rebound and last year’s one-offs could fade.
Unfortunately, that is not guaranteed. Even without a worsening trade fight, the global economy is a complex beast with much depending on confidence, which is in short supply in Europe. Italy is back in recession thanks in part to the lack of confidence the bond market has in its populist government. France has a crisis of confidence in its business model. And German businesses have the lowest confidence in their outlook since 2012, when the euro was fighting for survival. If any economy is likely to talk itself into recession, it is Europe’s.
There are a couple of crumbs of comfort for investors. The “soft” sentiment data in Europe is far more disappointing than more solid measures of the economy, according to Citigroup . The mood can swing very quickly if there is a run of good news.
Even better, a terrible economy is already priced into European stocks and bonds. The German 10-year bond yield briefly dropped below 0.1% last week for the first time since 2016. Stock investors are trying to protect themselves by buying the economy-independent growth of the technology sector and the safe income of consumer staples, driving both to valuation premiums over the U.S. Every other sector trades at a lower multiple of price to 12-month forward earnings than the U.S., with consumer discretionary—including recession-priced auto stocks—at less than 10 times, compared with 20 times in the U.S.
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