The past week has been a very difficult one for many financial markets as the severity of the risk-off phase – which began a few weeks ago – intensified further. Global equities are now more than 5% down from their previous peak. The year-to-date gains in global equities have now been eliminated: of the main indices, only US equities are still in positive territory. There has also been a major correction in commodity prices and, while the weakness this past week has been across the board, the $20 decline in the oil price over the past few months remains the most noteworthy move. Credit spreads have widened in recent days, but the selling pressure on investment-grade spreads has been relatively muted. Almost inevitably, high-quality government bond yields in this environment have declined further, but they have edged lower rather than collapsed. They still remain within recent ranges in the US and the UK, but the 10-year German government bond yield has hit new lows. So what’s driving these moves? Are we looking at a technical correction within a bull market, or a more fundamental change in the global financial background? And if this is a more fundamental move, exactly what fundamentals are we talking about? It’s important to emphasise that some of this correction does appear to be technical. The consensus in the global financial community has been more risk-on than risk-off, hence the chance that positions would get closed out if markets move in the opposite direction. This factor does appear to have been at work in recent weeks, with volumes relatively high. On a technical basis, many markets do now appear to be rather oversold. However, if we focus more on the fundamental factors, it appears that you’re potentially spoiled for choice. The dominant fundamental factor at the moment seems to be – not for the first time this cycle – about global growth, or rather, the lack of it. It’s pretty clear that the global economy had been subdued at the first half of the year, but there’s been a fairly widespread expectation of some lift-off occurring in the second half and into 2015. However, this expectation has been challenged, to date, rather than confirmed by recent data. At the global level, industrial production just seems to have stalled over the summer.
Digging deeper, there’s been some acceleration in US growth, but not really a powerful lift-off. Elsewhere, there have been clear losses in growth momentum in China and the Eurozone. The rebound in economic activity in Japan, after the inevitable slowdown following the tax rise earlier in the year, has been muted. Digging deeper still, within the Eurozone, it’s Germany – rather than the more troubled peripheral countries – that is at the core of the slowdown. German growth had been negative in the second quarter, and has been soft again recently, raising concerns about a potential shift back into recession. It’s worth emphasising that the markets are reacting to what is a fairly small incremental change in the global growth backdrop. There is little evidence that there is a marked slowdown in economic activity underway. There is a case to be made that the weakness in commodity prices is telling a different story, but this week, this appears to be as much supply-driven as demand-driven. We have seen many fluctuations in global growth before, and while we know that these are important, it is also potentially dangerous to extrapolate them.
Eyes on US earnings
It is possible to make some broad generalisations about recent events in the global economy. First, underlying demand conditions have remained stronger than output growth. Weakness in industrial output does seem to have been partly the result of inventory reductions, which are more likely to prove a temporary rather than permanent influence. Second, this inventory challenge has been concentrated in the global auto industry, where output looks likely to rebound quickly and possibly strongly. And third, some corrective mechanisms are potentially coming into play. In particular, much lower food and energy prices should increase consumer spending power. There is also the possibility that slower growth would lead the Federal Reserve and the Bank of England to delay rate rises, which are a particular issue hanging over markets. So our current conclusion is that the global economy is not in free-fall, and there is scope for a rebound as we go into 2015. However, in environments like the one we’re in, the market’s sensitivity to macro data is even greater than usual, so the upcoming earnings season in the US will be particularly important in providing a greater outlook on what really is going on in the global economy
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