‘Don’t Panic’ And The ‘Last Man Standing’

It’s funny how quickly the narrative shifts (and please, spare us your efforts to convince me to use a word other than “narrative”, because the alternative is “meme” and that’s even worse).

In 2017, it was all about “synchronous global growth” and indeed it was still all about that right up until the data started to roll over in Europe after peaking earlier this year.

Well, actually, it wasn’t all about synchronous global growth. That’s just one pillar of the “Goldilocks” meme (ahhhh no! “meme”). The other pillar is “still-subdued inflation” and while that’s still largely intact, there’s evidence that wage pressures are building in the U.S., Friday’s AHE miss notwithstanding. It’s worth reading Ben Hunt’s take on this, for those of you interested in more on the inflation narrative.

Lately, the synchronous global growth story has given way to a U.S.-centric story about the extent to which late-cycle fiscal stimulus can prolong an expansion that’s already the second-longest in recorded history. The prospect of the U.S. expansion dragging on while the rest of the world rolls over is creating a self-feeding loop in the dollar. The same late-cycle fiscal stimulus is stoking concerns about inflation and those concerns are leading market participants to expect more hikes. Those expectations are feeding the dollar’s renewed correlation with 10Y yields. Short rates at the highest levels in a decade help a lot too. As U.S. yields continue to rise, rate diffs are moving in favor of the greenback – simultaneously, the dollar’s correlation with rate differentials has been restored (more here).

“The issue is the same I’ve noted in prior weeks–the ‘synchronized global growth’ narrative is now being capitulated against, and as such, the dollar has recoupled with rates differentials because the US is again viewed as the world’s leading growth-story,” Nomura’s Charlie McElligott wrote last week, adding that “the flipside of this of course is the ‘slowing growth’ trend in rest-of-world too has driven the resumption of the widening in rates differentials.”

Right. And one manifestation of this problem is Europe (see the second linked post above) but also China. Consider this from a post I penned earlier this week:

You might recall that China has been in the habit of hiking OMO rates hours after Fed hikes (latest example was in March). That’s an effort to keep the premium on Chinese bonds over Treasurys from contracting too much and triggering capital flight. The problem, of course, is that 5bp OMO hikes hardly compensate for 25bps Fed hikes. Remember, China has shied away from using policy rates because hikes there would potentially choke off growth. They prefer to go the money market rate route as that’s less likely to spill over into the real economy and is generally consistent with Beijing’s efforts to squeeze leverage out of the shadow banking complex. But as you might have noticed, China delivered an RRR cut less than a month after hiking OMO rates, underscoring the delicate balancing act for the PBoC. That RRR cut catalyzed a massive bond rally which narrowed the yield spread between China and the U.S. That’s an example of the dynamic at play here.

Ok, so the bottom line in all of this is that, as Oanda’s Stephen Innes told Bloomberg, “we seem to be moving from what appeared to be a synchronized global growth narrative only a few weeks ago to a synchronized global downturn.”

How seriously should we all take the new narrative? Well, that depends on who you want to ask. For their part, Barclays is pretty agnostic. The title of their weekly rates note is “Last man standing”, a reference to the U.S. as the last bastion of the expansion. Here are a couple of quick excerpts from their take:

Investors seem to be questioning the synchronous global growth narrative, given recent data surprises and it is being exacerbated by elevated uncertainty about trade between US and China. News reports suggest that the latest trade talks ended without any agreement. The US has asked China to cut the trade deficit by $200bn by the end of 2020, reduce support for high tech industries, and avoid any retaliation. Meanwhile, China has asked the US to stop investigations into IP issues, drop planned tariffs, and give equal treatment to Chinese companies in national security reviews. Given major differences, negotiations are unlikely to lead to quick results, keeping alive the uncertainty around trade, in our view.

While the domestic backdrop has not materially unchanged, we believe uncertainty about the global outlook has increased. In a speech titled “Navigating Monetary Policy as Headwinds Shift to Tailwinds” in March, Fed Governor Brainard highlighted how headwinds from the global backdrop have turned into tailwinds, citing synchronized growth leading to a global tightening of monetary policy. That may very well still be the case, however, the narrative has weakened recently, particularly with worsening trade rhetoric. We believe that the Fed will be wary of hiking more aggressively and avoid a sharp strengthening of the USD, unless it is evident that it is not on the lone path of tightening monetary policy.

Ok, so that last point is obviously key. At some point, the market will need to start taking out some of the additional hikes in order to let some steam off this kettle. For now, we’re kind of muddling through (see Friday’s rally for example), but there are only so many “Buffett buys a shit load of Apple shares” headlines to be had when it comes to weekly stick saves and the proximate cause of the angst (well, outside of the obvious, which is Donald Trump) is the possibility that the Fed will hike more aggressively than the market is pricing.

A more interesting take comes from BNP’s Paul Mortimer-Lee, who you might recall recently penned a good note on the likelihood that the Fed, the ECB and the BoJ will bump up against the next downturn without having sufficiently replenished their ammo. We’ve discussed that possibility on too many occasions to count and we incorporated those discussions into our take on BNP’s recent efforts to expound the issue. You can read that in “Spiraling Down The Rabbit Hole: What Happens When The Ammo Is Gone?”

Ok, so when it comes to whether the “global slowdown” narrative is a worry, BNP says there are three key questions for forecasters, policy makers and markets in terms of why the data appears to be rolling over:

1. Is it noise, in which case we should expect a bounce back?
2. Or could it be a step down in the growth rate from frothy levels but still leaving the prospect of above trend growth?
3. Or is it may be the start of a serious global slowdown?

The bank then delivers a “spoiler alert” as follows: “it’s probably a mix of all three.” Here’s what they say about the “noise” argument:

On the noise front, the passing of the US tax plan may have led to a bringing forward of investment to 2017, though we doubt this was significant. A recovery in consumer spending to replace goods damaged in the prior quarter’s hurricanes gave Q4 an artificial shot in the arm. The European Q4 numbers looked exceptionally frothy and there may have been some give back in Q1. In the first quarter, Europe was hit by bad weather (termed “The Beast from the East” in the UK) and by flu. The timing of the Chinese New Year may have boosted January output elsewhere and led to a weak February.

As far as the “step down” idea is concerned, the bank says that it “carries some weight in that the end of last year looks exceptional and while leading indicators suggest we are past the peak they do not appear to flag a sharp slowdown.”

For instance, OECD leading economic indicators do suggest a bit of deceleration in Europe and the UK, but BNP says the following chart is not indicative of anything particularly serious:

On the notion that this is the start of something more serious, BNP breaks this into two separate arguments and we’ll just excerpt a couple of short passages from the longer explanations as that should be sufficient to communicate the points:

1. The demand engendered by soft global monetary conditions is fading as the Fed tightens, delivering a reduced stimulus not only in the US but also in dollar-linked economies, and that the eurozone is feeling the impact of a near 20 cent rise in EURUSD. Moreover, the argument runs, monetary policy works by bringing forward demand, leaving a trough once the wave is past, and that we are now in that trough.
2. Shortages of labor and disruptions to supply are increasing. We see this in the eurozone in a serious way where the shortage of labor as a constraint on output has shot up. But it is also true in the US where the latest ISM report is replete with stories of labor shortages and supply chain problems (eg, a severe shortage of truckers and increasing freight costs).

The implications of the former argument are obvious, while the latter point raises questions about what happens to an interconnected, interdependent global economy when bottlenecks start showing up in one place (hint: they affect everyone else in one way or another).

Ok, so the bottom line for BNP is that there will be a Fred Sanford “Elizabeth” moment – just not right now:

A flatter US curve, wider BBB bond spreads and a grudging response of stocks to very good profit increases all smell sour. But nothing suggests an imminent downturn — the warnings such as from the yield curve are about next year, we believe.

The signals from the real economy, as well as markets, reinforce our call for a big slowdown next year. The chances of this coming sooner have increased: but don’t panic.

Douglas Adams.