by: Prieur du Plessis
October 12, 2010
After not having posted articles for a while, the logical first bite at the cherry is a quick review of the overall investment landscape and major asset classes. Covering the globe necessitated a somewhat longer post than usual, but hopefully the read will be useful.
Global manufacturing: growth slowing rapidly
Manufacturing Purchasing Managers Indices (“PMIs”) released for September indicate a rapid slowdown in global manufacturing growth.
On a GDP-weighted basis our global manufacturing PMI (U.S., Japan, China, Eurozone and U.K.) fell for the fifth consecutive month to 53.0 in September.
Sources: Markit, Li & Fung; ISM; Various internet sources; Plexus Asset Management.
Among the major economies only China managed to report faster growth. Growth in the Eurozone weakened mainly as a result of a significant slowdown in Germany. Growth in the U.S. slowed, while the manufacturing sector in Japan contracted for the first time in 14 months. Growth in the Czech Republic and France remained robust. In the East, the manufacturing sector in Australia contracted alarmingly, the contraction in Taiwan continued, while growth in India slowed. The austerity measures in the Eurozone’s problem children have started to take effect, with the manufacturing sectors in Ireland and Spain contracting. The manufacturing sector in South Africa is contracting too.
Global non-manufacturing/services: faltering
Non-manufacturing and services PMIs of most countries bar those of the U.S., China and U.K. registered slower growth in September. The contraction in Japan’s services sector continued, while the contraction in Australia deepened. The services sectors in most of the Eurozone’s debt-ridden economies are reeling, with Italy the exception.
It is evident that faster growth in China’s manufacturing sector saved the day for most economies due to the interconnectivity between China and the other major economies, especially the U.S. A case in point is the relationship between the U.S. ISM non-manufacturing PMI for exports and China’s manufacturing PMI for imports.
The interconnectivity is also evident in our GDP-weighted PMI (manufacturing and non-manufacturing combined) for the U.S. depicted against China’s manufacturing PMI for new export orders.
However, the outlook for global manufacturing growth is not rosy. China’s manufacturing PMI is following the broad seasonal trend of the pre-crash period from 2005 to 2007. October is generally a seasonally weak month for China’s manufacturing PMI, November is somewhat better, but weakness can be expected in December. China’s manufacturing PMI in 2010 is following a weaker trend than the average from 2005 to 2007. If the current gap between September’s historical average (2005 – 2007) and that of 2010 holds in October, it means China’s manufacturing PMI will fall back to 51.6 compared to 53.8 in September.
What concerns me most is that, looking at the trend over the past two years, China’s non-manufacturing sector normally holds up in October while November is exceptionally weak. If the seasonal pattern holds, the manufacturing PMIs of China’s main trading partners will soon reflect lower export orders and therefore indicate slower growth in their manufacturing sectors. In fact, more countries are likely to report contraction.
One may argue that this not what the equity markets are saying, with the MSCI World Index displaying enormous strength having had its best quarter in 23 years and the rally continuing.
Consider that a Black Swan may soon be entering air space over China and the Eurozone!
After surging over the past nine months containerized cargo volumes by sea between China and Europe are weakening. This is reflected in a drop of more than 11% in spot market freight rates since the middle of September. Although the drop can be attributed to excess weekly capacity on the Far East/North Europe routes due to increased capacity of 14.9% compared to a year ago, weaker-than-expected cargo demand seems to be the main factor.
The downward trends of the Chinese containerized and bulk freight indices are similar to those of the Baltic Dry Index. In dollar the latter has fallen by more than 10.0% since its September high. In euros the Index has declined by 17.8%.
The slump of the Baltic Dry Index since September 10, the development in the Shanghai Containerised Freight Index for the North Europe route, a seasonally weaker October for China’s manufacturing PMI and a possible major seasonal weak November for the non-manufacturing PMI are certainly dark clouds on the horizon for China’s economy! We expect 9% year-on-year growth for China by year end – a significant slowdown compared to 11.9% achieved in the first quarter of this year and 10.7% in the last quarter of 2009.
Currency war
To stave off a double-dip recession in the U.S., the Federal Reserve Board is contemplating a second round of quantitative easing by buying back government stock to force down the yields on bonds and therefore rates on mortgage bonds. At the same time the aim is to lower the external value of the U.S. dollar to increase the competitiveness of U.S. goods and services and avoid deflation. In a similar fashion the Bank of Japan is intervening in the foreign exchange markets to weaken the yen against the major currencies to stimulate growth and to end the spiraling deflation.
Most of these efforts are effectively aimed at improving the terms of trade, especially with China, but the latter’s effective coupling of its currency against the U.S. dollar does little to improve the U.S.’s situation in particular. The combined impact of the quantitative easing in Japan, U.S. and effectively China leaves the rest of the world out in the cold. The euro and the currencies of emerging economies are strengthening against the yuan, yen and U.S. dollar, thereby threatening economic growth in these regions.
During the second quarter, the slump of the euro on concerns about the impact of austerity measures in the Eurozone’s debt-ridden countries aided the economic region through increased export orders. However, only France, Germany and the Netherlands have really benefited. The strength of the euro as a result of the quantitative easing in Japan and the U.S. will undeniably undermine economic growth in the Eurozone. Worse, though, is that the economic contraction in most countries in the Eurozone is likely to deepen, while growth in Germany and France, the stalwarts in the Eurozone, is likely to falter.
With the central banks pumping money into the system while consumers are loath to borrow money, banks and investors are seeking higher returns in other markets. Emerging economies are on the receiving end of huge foreign capital inflows in this frantic bid. Although rising commodity prices in U.S. dollar offset the strength of emerging-market currencies somewhat for commodity exporters, the manufacturing sectors in emerging economies are suffering as a result of uncompetitive exports. The barriers of entry into Japan, the U.S. and China have therefore increased significantly. Furthermore, although the emerging-market currencies remain fairly stable against the euro, the Eurozone’s demand for goods and services is likely to decline rapidly, resulting in lower demand for manufactured goods from emerging economies. The risks of running large current account deficits are therefore increasing and threatening economic growth in emerging economies.
The end-game is that something has to give to get things back to equilibrium. While the European Central Bank may eventually start quantitative easing, it is known that the ECB is more hawkish and conservative than the Fed and will therefore delay actions to do so. Policymakers in emerging economies are already under severe pressure to take action to devalue their currencies. It could take the form of slashing interest rates or other forms to curb the inflows.
However, they are fully aware of the fickleness of global capital, especially short-term or speculative capital. Thirteen years ago the East Asian financial crisis started when rogue speculators attacked Thailand’s currency, the baht. The crisis was preceded by the government allowing too many short-term capital flows to accumulate with a high degree of currency speculation and the build-up of large current account deficits funded by the short-term capital inflows. When the rogue investors decided to pull the plug, the country spent billions in an effort to defend its currency but was forced to devalue the currency by as much as 20%. The attacks then quickly spread to other East Asian countries, resulting in the devaluation of most currencies in the region.
In my view the current economic situation in most emerging economies is reminiscent of that which preceded the East Asian financial crisis – massive short-term capital inflows have been permitted to accumulate while the risks of large current account deficits have increased significantly as a result of the global currency war.
Global bonds
Global bonds had their fifth best quarter in 15 years, returning nearly 8% in the third quarter. While the slower growth in the global economy is reflected in lower bond rates in developed economies, the quantitative easing by the Fed through the buy-back of U.S. bonds had much to do with the lower bond yields and higher bond prices. At some stage the market will eventually begin to focus on the inflationary impact of the quantitative easing by the Fed and the Bank of Japan as higher inflation expectations will be factored in, resulting in bond yield spreads increasing against German and Swiss bonds.
The significant capital flows to emerging economies are reflected in the yield spread between the JP Morgan Emerging Market Bond Index and JP Morgan Global Government Bond Index, which narrowed to 274 basis points. The spread has now entered the bottom range that preceded the start of the global financial crisis in 2008. During the crisis the spread increased to more than 700 basis points. The risk of investing in emerging market bonds has therefore increased significantly, especially in the light of the uncertainties regarding the fallout of the global currency war.
Global equities
After suffering the worst quarter in eight years, mature-market equities had their best quarter in more than 23 years. The debt crisis in the EU appeared less troublesome than expected initially and the fears of an imminent implosion of China’s real estate market were allayed by China’s manufacturing PMI surprising on the upside. The MSCI World Index returned 13.2% in U.S. dollar, nearly wiping out the losses in the previous quarter. Emerging-market equities as measured by the MSCI Emerging Market Free Index continued to outperform mature markets and notched up a 17.2% gain after losing 9.1% in U.S. dollar in the previous quarter.
The outlook for global equities is extremely uncertain with the storm clouds of the global currency war, weaker Chinese PMIs and vast capital flows to risk assets such as emerging market bonds appearing on the horizon. Although the weaker U.S. dollar will benefit U.S. exporters and the economic translation of the foreign interests of U.S. companies, the worsening economic situation in Europe is likely to put paid to further upside in equity prices. Trailing price-to-earnings multiples are reasonable but the risks have increased considerably.
We are particularly concerned about non-exporters in emerging markets and especially the financial and industrial sectors. They are as vulnerable as the currencies of their economies. Where exporters and dual-listed mature-market stocks are likely to be somewhat immune to currency sell-offs, the interest-related stocks are exposed to higher interest rate expectations.
Commodities
We do not share the extreme bullishness of most market commentators on commodity prices. Although the strength in these prices over the past quarter was as a result of strong Chinese demand, most of the recent run-up in commodity prices has been largely U.S. dollar weakness induced. The anticipated seasonal weakness in China’s economy is likely to lead non-U.S. dollar prices of commodities lower during the fourth quarter. Coupled with the uncertainties arising from the currency war, the outlook for commodities ex gold is cloudy.
Gold is likely to continue to benefit from the currency war as a store of value in these uncertain times.
Currencies
The weakness of the U.S. dollar is likely to reverse as soon as the seasonal weakness of China’s economy becomes evident and the ramifications of the lower yen and U.S. dollar on the economies of the Eurozone and emerging economies are interpreted. Fickle money may again find refuge in the U.S. dollar as a “safe haven”.
The currencies of emerging economies are likely to weaken as slower growth in China and the Eurozone emerges. They are increasingly vulnerable to attacks by rogue speculators, though. Of particular interest is the South African rand whose strength as a result of significantly improved sentiment on the back of the successful FIFA World Cup is severely undermining employment, manufacturing output and exports.
Disclosure: None
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