Euro Area Growth: Current Consensus Is Too Low

Regardless of the ECB’s actions last week, four forces are coming together that will lift euro area growth over the next two years to a level that is well above the current consensus of 1.1% for 2015, and 1.6% for 2016.

DIN-20150123-174908

  • Diminished Fiscal Drag: given the improvement in structural budget balances, the need for additional austerity measures has diminished. As a consequence, the contribution of government spending to real GDP growth in the euro area as a whole should increase from 0.1% in 2013-14 to around 0.5 percentage points over the next two years. The peripheral countries should see a growth boost of around one percentage point.
  • Lower Oil Prices: The euro price of oil has fallen by almost 50% since last summer. Granted, the forward curve implies that about a quarter of this decline will be unwound over the next two years. Nevertheless, even taking this into account, the IMF estimates that lower oil prices will boost euro area GDP by around 0.9% relative to a baseline where oil prices had stayed elevated.

A weaker euro and a swing from negative to modestly positive credit growth will also propel euro area growth.

Energy Stocks: Where’s The Bottom?

Our Global Investment Strategy service argues against buying energy-related equities.

DIN-20150116-172555

 

Based on price-to-book, price-to-earnings, and price-to-sales, the energy sector looks relatively cheap today compared with 2004 (the last time that real oil prices were at current levels). That said, the prospect of significant asset write-downs, negative earnings revisions, and lower sales all suggest that these valuation measures may present a misleading view of the underlying health of energy companies.
Our sense is that while the equity and credit of these companies will present a buying opportunity later this year, investors are better off waiting for a better entry point.

EM: Beware Of Breakdown In Industrial Metals Prices

The recent breakdown in industrial metals prices in general and copper in particular is heralding more downside in EM risk assets.

DIN-20150115-090425

Historically, EM share prices have been tightly correlated with commodity prices in general and industrial metals prices in particular. The reason is that all of them correlate with global growth, especially EM economic conditions.

While a rise in commodities supply is certainly a major factor behind the commodities price deflation, global commodities demand is weakening as well.

We see no reason for the correlation between commodity prices and EM risk assets to change.

Our country allocation in the EM space has been positioned for a broad-based decline in commodity prices and our EM team maintains their stance: equity overweights are Taiwan, China, Korean technology and domestic stocks, Malaysia, Poland, the Czech Republic and Mexico. EM equity underweights remain Brazil, Colombia, Indonesia, Turkey, South Africa and Thailand as well as Korean autos, materials and industrials.

China Stimulus Package: Curb Your Enthusiasm

China officials recently announced that the government is accelerating 300 infrastructure projects valued at 7 trillion yuan ($1.1 trillion) this year. At first sight, that is considerably larger than the stimulus package of 2009-2010, which gave a significant boost to Chinese growth at the time. However, we doubt a re-play is about to occur.

DIN-20150106-102950

This time, China’s anticorruption pledges will have meaningful consequences for the speed at which investment can get done. The announced projects will be funded by the central and local governments, state-owned firms, loans and the private sector. At various levels of bureaucracy in China, officials are now far more worried about staying out of the crossfire of anticorruption initiatives than about boosting GDP numbers. This is a significant change since 2010: despite the larger stimulus numbers today, it will take much longer for investment spending to be delivered.

Our view continues to be that stimulus initiatives to date will not be enough to meaningfully change the outlook for China. The economy continues to grind away at or near 7%, which appears enough to keep unemployment in check. As long as this is the case, the Chinese government is unlikely to be forthcoming about “game-changing” growth-boosting policy initiatives.

FOMC: Oil Supports Fed’s Gameplan

Carnage in the oil market spells trouble for the short-end of the Treasury curve.

The FOMC Minutes from the December policy meeting reinforced the message that plunging oil prices and eroding market-based inflation expectations are not reasons to alter the Fed’s expected policy timetable. Oil’s impact on inflation should be temporary, and solid labor market momentum will justify a mid-year start to the tightening cycle. Indeed, some FOMC members suggested that the “…boost to domestic spending coming from lower energy prices could turn out to be quite large.”

DIN-20150108-105143

As for inflation pre-conditions, the FOMC set the bar low; the door to rate hikes is open as long as core inflation does not fall and policymakers are “reasonably confident” that it will reach the 2% target by 2016 or 2017.

One of our lingering concerns last year was that the U.S. economy might not be able to sustain above-trend growth throughout 2015. However, the oil shock changes the growth calculus. We agree with the FOMC that the stimulus from cheaper oil will provide a substantial lift to growth this year, despite the hit to the domestic energy patch. The positive supply shock comes at a time when interest rates are low, consumer deleveraging is well advanced and the labor market is humming.

The short-end of the Treasury curve is vulnerable if the FOMC is indeed on track for a mid-year rate hike. The market is discounting a path for policy tightening that is later and slower compared to the Fed’s roadmap. The FOMC attributed this divergence to a low term premium and/or a greater weight assigned to less favorable economic outcomes in the money market. It is difficult to disentangle those two explanations. Nonetheless, the implication is that short-term Treasury yields have a lot of upside potential if the Fed’s economic forecasts are realized. Market expectations for a September start to the rate cycle will likely shift closer to June in the coming months.

It is a different story at the long-end of the curve, which has been dominated by global events in recent weeks. A bottom in the 10-year yield will likely require some combination of the following:

  • a bottom in oil prices;
  • the ECB announcement of sovereign QE, followed by some positive economic surprises in Europe; and
  • policy stimulus in China that stabilizes asset prices in emerging markets.

The first two items could fall into place in the next couple of months, although long-term Treasury yields do not have much upside given the global backdrop.