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On track, but troubled



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(Photo: NN Investment Partners)

In most news flows, economic data continue to take a back seat to events unfolding in the political sphere. As we learned in so many of the political crises of recent years – the Italian government formation, Brexit, to name a few – this does not mean that politics are actually more important for markets than trends in the real economy. 

Most of the time they are not. Markets suffer lasting damage only in exceptional circumstances when political misery triggers a substantial tightening of financial conditions and a strong negative feedback loop is created in the underlying economy.

At this point we are not there yet. Economic data remain very important and need to be tracked carefully. The simple message is that although many leading indicators have started to roll over in the first half of the year, they are not trending lower sharply. There are also signs that the global business cycle is indeed consolidating after a strong period of acceleration in recent years. The macro data are not yet showing any signs of a real slowdown, while areas like DM consumer spending seem even likely to have rebounded strongly in the second quarter of 2018. This picture was furthermore confirmed by the global PMIs for June published in the last two weeks. The manufacturing output PMI was roughly stable at what is still a pretty healthy level (-0.2 to 54.2) and continues to point to global IP growth of more than 3%. The global all-services PMI was helped by improvements in the service sector and edged up to 54.2, suggesting that global GDP growth might come in around a solid 3.5% in Q2’18.

Below the surface of these PMIs and other leading indicators there is still some softness in forward-looking expectations and new order components that will have to be monitored closely. Employment indicators within the PMIs and in the actual labour reports in the US and the Eurozone meanwhile continue to send very robust signals that seem likely to continue to support consumer confidence and demand. On the corporate side, most confidence and investment trends also look well-supported. The upcoming earnings season might provide some further nuances, but it is expected to deliver pretty strong profit growth again.

Beyond the data flow, however, tail-risks are ever-present and seem to be intensifying. The biggest cause for concern is the ratcheting up of trade war threats from the US. In recent days and weeks, President Trump continued to hammer away at “unfair trade practices”, not just of China, but of the euro area as well. Now that a first set of tariffs have been implemented between the US and some of its key trading partners (and allies), it does not yet look as though we have reached the end of this tariff game. President Trump seems to feel the US will be the winner in an all-out trade war; therefore the US Trade Representative office has in recent days released a list of an additional USD 200 billion worth of Chinese imports to be hit with higher tariffs of 10%.

Next to this, some further political drama is developing around Brexit and the UK government. Prime Minister May’s desire to create a “customs partnership”, which would allow for almost-frictionless trade in goods (but not in services), triggered a crisis in her government. Ministers Davis, Baker and Johnson decided to resign in response to this proposal, which they see as too close to a “soft” Brexit. Meanwhile, the EU’s chief Brexit negotiator seems to be pushing back on the plans, indicating that he will protect this single market, which is based on the indivisibility of the four freedoms of people, goods, services and capital. It is not yet clear how this will all balance out and whether it actually increases or decreases the risk of a hard Brexit. The main message, therefore, is more uncertainty for markets.

Another source of potential risk for the macro outlook comes from German politics. The debate over immigration in the region is threatening to break up the CDU/CSU partnership and, as a result, Germany’s current coalition government. At this point, however, it seems that the CDU-CSU will manage to resolve the conflict, because the alternative is not clearly in their interests. However, the fact that the crisis has persisted for so long and is still not fully under control is troubling and makes the outcome uncertain as well.

As said earlier, the key point to focus on as an investor is the degree to which these political tail-risks regarding trade and government stability in major economies are feeding back into real activity via financial market stress and sentiment channels. At this point the evidence suggests we remain on track for our base case outlook of healthy, steady growth in the global economy in the second half of the year. At the same time, we do note some fragility in both market sentiment (more volatile) and expectations components of leading indicators. We also know that an actual trade war between the US and the majority of its major trading partners has the potential to inflict direct and substantial damage on global growth if it escalates substantially. So, while being on track, the outlook is clearly troubled by these observations. There is never a reason for panic, but close monitoring of the feedback dynamics is more crucial than ever. And never forget that risks always create opportunities as well.

 

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