Was it all really just about France?

Market Views And Insights | May 22, 2017

Geoff Lewis, Senior Strategist (Asia), Capital Markets & Strategy Team

Global markets continued their rally in April after Emmanuel Macron’s victory in France’s election. Equity markets in Europe moved higher on the election news and data showing continued economic improvement. First quarter earnings in the United States surprised to the upside showing a healthy corporate sector despite seemingly weak GDP data. Investors are right to capitalise on politics-driven market dips. But underlying economics are the key to forming a more sustainable investment strategy. Read why in this edition of Macro Monthly View.

April Markets Overview: Europe takes centre stage1

Over much of April, global stock markets were held back by various factors, including: weaker US economic data, disappointment at the lack of details in President Trump's tax plan and geo-political tensions over the Korean peninsula.

The MSCI stock index was marginally down for most of April – that is until European politics emerged as a big positive driver for markets after the first round of the French presidential election on 23 April. France's benchmark CAC 40 index soared 4.14% (24 April 2017) on the news of a Macron-Le Pen second round contest on 7 May, propelling French stocks to their highest level in nine years.

Other European bourses also saw gains of 2% to 4% (on 24 April 2017) – an indication of the extent of contagion fears associated with a bad election outcome. Equities worldwide responded positively to the news while the euro rose to a 6-month high against the dollar. Investors correctly anticipated that liberal candidate Emmanuel Macron would beat the National Front's Marine Le Pen in the runoff (as shown in initial polls).

Europe was the outright winner in April

For April overall, the MSCI World index rose 1.3% in US dollars, taking the year-to-date (YTD) gain to 7.3%. Unsurprisingly, the eurozone was the outright winner among regions, with a 1.3% return in local currency terms, increasing to 3.2% with euro appreciation thrown in. This marks a YTD return of 10.2% in US dollars.

Emerging markets, however, took a back seat in April. A couple of laggard markets in Asia saw catch-up gains, with Malaysia up 3.4% and the Philippines 5.1%, both in US dollars. India continued to power ahead, with a 2.3% MSCI gain in US dollars that took the YTD return to a “best-in-class” 19.8%.

In the US, the S&P500 only managed a 1.0% rise in April. At 6.7% YTD, the S&P appears to have surrendered equity market leadership to Europe and emerging markets.

Consumer, industrial and technology took the lead

By sector, global consumer, industrial, and technology stocks rose the most in April. Oil and gas, utilities, and non-European financials all weakened. In terms of style, April saw growth factors outperform in many markets. That said, Asian and emerging markets saw both value and growth factors contributing positively to performance2.

In the US, growth factors beat value in April, except for momentum. US investors are clearly beginning to harbour strong doubts over the Trump reflation trade. Many of the value stocks which had outperformed so strongly in the second half of 2016 have been in retreat this year.

The commodity complex remained weak in April, led by iron ore and other base metals, which we regard as having overshot fundamentals following China's pickup in growth in the second half of 2016. Bonds generally had a quiet month in April, as the yield on the 10-year US Treasury closed at 2.28%, 10 basis points (bps) lower over the month.

The US Treasury yields and the trade-weighted DXY dollar index in April remained comfortably within their trading ranges, which was naturally of considerable benefit to emerging market equities.

Stalling US yields benefitted Asian equities

CLSA's technical analyst Laurence Balanco estimates that India, China, and Hong Kong were the Asian bourses which benefited the most from the stalling in US government bond yields3. Notably, India (MSCI index in US dollars) has broken out of its 2015–2017 downtrend channel against the region (MSCI Asia Pacific ex Japan index) and the world.

Conversely, a sharp break below the US 10-year's 2.30% support level in April could have put considerable pressure on reflation trades, triggering a bout of capitulation selling in markets. Ever since the US 10-year yield peaked at 2.64% intraday in December, along with the 10-year to 2-year Treasury yield gap, the cyclical reflation trade has looked to be on the back foot.

Figure 1: Europe and Emerging Markets show better relative performance than US market year-to-date

Earnings and economic fundamentals give support to markets

After the strong equity returns of the first quarter of 2017, we suggested in last month's Monthly Macro View that equity investors would probably need to be “shown the money” if the rally was to continue. The numbers have duly obliged, with first quarter corporate results strong across all geographies. In the US, about 77% of the S&P 500 constituents beat analysts’ EPS estimates in the first quarter of 20174.

Energy bounced the most, although earnings-per-share (EPS) and sales improvements have been broadly based, with IT and financials looking well placed to strongly contribute to 2017 earnings growth. Encouragingly, S&P500 sales growth in the first quarter is on track to be the strongest in over five years, up 8% year-on-year.

It is improving nominal sales growth – revenues in current not constant dollars – that matter most to equity investors and which has been so lacklustre in recent years. This now seems to be changing. An improving global economy may be sufficient to sustain above-trend earnings growth through 2017. Equity analysts in the first quarter have been revising up their earnings forecasts for 2017 globally. This is a big departure from the pattern of downward revisions in the first quarter to the year ahead seen over the last five years.

Global economic expansion remains robust

The financial media worked itself into quite a lather over the weak US first quarter GDP report. Globally, however, most economic data releases in April were robust enough. They are consistent with a gradually improving global economy, which was the key message from the IMF's April World Economic Outlook economic forecast. Our base case continues to be a synchronised global upturn in the second half of 2017, even without the benefit of a Trump fiscal stimulus.

Diffusion indices like the Purchasing Managers’ Index (PMI) reflect the net balance of optimism among businesspeople, but they cannot continue to rise indefinitely. A higher base reading will eventually pull PMI momentum back. That may already be happening, given the dips in the latest PMI readings for China. In the developed economies, PMIs still managed slight gains in the US, the Eurozone and the UK last month. This leaves the global PMI in April unchanged from the previous month, and still at an elevated level.

Figure 2: Global PMI Activity Composite & Global GDP Growth

Economic data for the Eurozone continued to show improvement, with a first quarter GDP print of 1.7% (seasonally adjusted annual rate, or saar) and an April PMI that rose marginally from 56.2 to 56.7 – a multi-year high.

The European Central Bank’s (ECB) survey of bank lending shows that credit is expanding, while export demand remains strong, particularly from Asia. In the past, the tight link between weak potential output trend and price inflation has often been the Achilles’ heel of the European economy5. But on this occasion, there are few signs of inflation road bumps. There is still considerable spare capacity. Core inflation – the Consumer Price Index (CPI) excluding food and energy – remains well-behaved and below 1% as of March 2017(jumped to 1.2% in April 2017)6, is unlikely to cause the ECB immediate concern.

French manufacturing confidence in April was the highest since June 20117. Investment and hiring plans held back by a level of French political uncertainty three times higher than normal are now likely to go ahead following Emmanuel Macron's emphatic victory.

Outside of Europe, the latest economic data releases and surveys are also encouraging. In Asia, for example, Japan's Shoko Chukin survey of SME sales is currently the best since mid-2014.

In South Korea, business and consumer confidence appears to be little affected by the election of left-leaning Moon Jae-in as the new president. The latest business surveys of manufacturing and the whole economy from the Bank of Korea are surprisingly upbeat. There is also a good chance of progress on corporate governance reforms in South Korea, which is an issue that has traditionally held the Kospi back.

In China, PMIs disappointed in April as did exports. That said, China's economic recovery still appears to be broadening out as manufacturing and private sector Fixed Asset Investment finally join the upswing. China is again fulfilling the role of regional growth driver for Asia, as Asia ex-Japan exports to China were up 28% year-on-year in the first quarter of 2017, versus a much lower 15% for exports to other Asian destinations8.

In summary: global trade picked up significantly in the second half of 2016 due to policy stimulus in China, but annual growth in international trade remains far from pre-crisis levels. Despite the latest gains, cyclical momentum in the global economy may currently be close to peaking.

“Hard” economic data should continue to improve in the second quarter. A sharp reversal in global momentum appears unlikely. However, a growing risk for 2018 is that Chinese policymakers tap on the brakes of policy stimulus following this autumn’s party conference. That would surely cause a slowdown in China, and noticeably reduce its contribution to world growth.

The US economy is somewhat self-contained, so a China slowdown in 2018 is unlikely to have a major direct impact on US GDP growth. It may, however, have a major direct impact on EU and Japanese growth. Investors should keep an eye on this emerging risk in the months ahead.

Weak first quarter US GDP could be a false signal

US GDP growth for the first quarter of 2017 came in even softer than expected, at 0.7% on a seasonally adjusted annual rate (saar) basis. Like the Fed, we saw the weak first quarter numbers as providing a false signal. Manulife's Chief Economist, Megan Greene notes that first quarter US GDP in recent years has often looked weak due to problems of seasonal adjustment experienced by the Bureau of Economic Analysis (BEA)9. Other factors depressing first quarter growth included a large inventory draw down and unusually weak consumption. This was partly weather-related. Warm weather in January and February resulted in lower utilities consumption by US households, while tax refunds from the IRS were delayed this year. Auto sales were poor in March. This is significant because they are a key component of spending on consumer durables, which can be volatile from month to month.

There has been little in the post-national income and product accounts (NIPA) release data to suggest any significant upward revision to first quarter GDP growth. Upward revisions to non-residential, state, and local government construction spending have been offset by downward revisions to inventories of nondurable goods.

We do, however, expect something of a rebound in second quarter growth. Recent surveys of private investment, for example, suggest some pick up in capex in the June quarter. Against this, disappointing core capital goods orders over the past three months do not augur well in this direction. Second quarter GDP growth is likely to be more muted than the surprisingly high initial Nowcast forecast from the Atlanta Fed of 4.3%.

Perhaps the real lesson of the recent “hard” versus “soft” data forecast debate is that quarterly GDP statistics are inherently volatile and a potentially misleading guide to the underlying trend. To quote our Chief Economist Megan Greene on this key point, the UD GDP print "has done nothing to change our view that the US is fundamentally a 2% growth economy. There may be temporary, policy-driven sugar hits or drags on the economy in the next few years, but they are unlikely to move the dial on potential US GDP growth."9

Fed policy "normalisation/tightening" on track

As expected, the Fed like us saw the 1Q GDP data as temporary weakness in the economy and signalled that it is on track with policy tightening. We continue to expect two further 25bp increases in Fed funds this year. After the strong April nonfarm payrolls data (+211,000), the probability of a June Fed rate hike has risen to over 90%, with a 50% expectation of a further increase in December. Further out, market forecasts continue to lie below the median FOMC projection. With GDP growth expected to pick up in coming quarters and unemployment at 4.67% now below the Fed's estimate of the 'full employment' level, or NAIRU, the balance of risks on US short rates is shifting to the upside. Federal Reserve Bank of Boston President Eric Rosengren, who was relatively dovish until last year, is now calling for another 3 rate hikes this year and for the Fed to announce a decision on shrinking its balance sheet before year end.

Ever since the release of the March FOMC minutes in early May, it has been clear that most Fed senior officials expect a change in the reinvestment policy later this year. We believe that shrinking the Fed's balance sheet, if properly communicated, will be a very smooth, gradual affair that will not disrupt financial markets. Others think that after such a long period of zero rates, the withdrawal of Fed support from the Treasury and MBS markets carries considerable risks. They cite Ben Bernanke's 'Taper Tantrum' shock to global markets in 2013 as an example of what could happen, though in our view that was essentially the result of poor policy communication. It is expected that the FED will gradually reduce its balance sheet from roughly $4.3 trillion to ultimately something closer to $2.75 trillion over a two to three year period, perhaps longer. The key to balance sheet reduction was set out in the FOMC's September 2014 Policy Normalisation Principles and Plans: "no sales of securities and when reinvestments end, the securities holdings decline in a gradual and predictable manner." One recent empirical study by FRB economists suggests that the US 10-year bond yield might rise by some 70bps a over this period10. This is a material increase in the real long term bond yield, but as the rise will occur over several years it should prove manageable and easily digested by markets.

French election: Populism is on the back foot for now!

Macron's landslide victory (near 66% of votes) was the second widest in recent French history, but his biggest issue may lie ahead. Without an established party machine, it seems unlikely his “En Marche!” party can win a working majority in the June National Assembly elections, though polls suggest it may well win the most seats, an incredible achievement for a party that celebrated its first birthday on 6 April. President Macron will likely need to form a national coalition, something that does not have a strong tradition in France.

Figure 3: Macron’s landslide victory
Source: Statista Infographics Bulletin, 8 May 2017.

Manulife's Chief Economist, Megan Greene, argues that France's new president may face an uphill battle in tackling France's structural problems11. He can expect considerable resistance to some of his proposed economic reforms from the traditional centre left, given the considerable influence of the French trade unions. His election victory is cause for short term celebration given the unpalatable alternative, but success is by no means assured when it comes to reversing France's lacklustre economic performance since the Global Financial Crisis.

For Europe, we have long maintained that Italian politics may represent a key risk. The ECB tapering its quantitative easing (QE) programme as Italy goes into a general election early next year represents one potential risk for the eurozone. A win by the anti-EU populist Five Star Party (M5S), which has promised a referendum on continued Italian EU membership, could trigger a Europe-wide equity correction or even a run on Italian banks.

All that said, the near-term outlook for European politics has improved. Macron may get off to a reasonable start in France, Mrs Merkel looks safer in Germany, and a serious Brexit negotiation row with the UK is probably twelve months away. Business is improving in Europe and equity valuations appear cheaper than in the US.

David Hussey, Manulife's Head of Europe, Australasia and Far East (EAFE) Equities, believes that while the Macron victory may have been discounted by markets ahead of the second round election, investor interest in European equities will increase in 201712. Free cashflow yields appear attractive relative to peers elsewhere, and economic momentum could see profit margins as well as earnings expand in 2017 and beyond.

Figure 4: Price-to-book ratios by markets13
Figure 5: Return on equity by markets (%)13

For now, we repeat our earlier advice to investors: take advantage of market dips due to politics. But stay more focused on the underlying economics. In Europe, there will always be an election in the offing somewhere or other, which might seem a good excuse for more hesitant investors to hold back. That rarely turns out to be a good investment strategy. Do not let your investment decisions depend solely on some future date in the political diary. Maintaining large cash holdings has generally proven to be a killer of long term portfolio returns, with YTD experience being a prime example!

Is China's monetary tightening the new threat to the global cycle?

Some investors now worry that overzealous efforts by the People’s Bank of China (PBoC) to better regulate shadow banking and associated Wealth Management Product's (WMPs) might result in a general tightening in Chinese monetary conditions and a sharp economic slowdown. That would have major consequences for risk assets globally – we view the cyclical recovery by China as being a big factor in the global upturn in 2016, reflected in the recent stronger-than-expected Asian exports to China. Last month, the PBoC – along with China's banking, insurance, and securities regulators – have issued a number of directives aimed at curbing the frothier or speculative credit activities in the banking and shadow banking (i.e. Non-Bank Financial Institutions). They have also been implementing the new Macro Prudential Assessment (MPA), which includes WMPs but otherwise looks to be modelled on best practice at major western central banks.

Mainland investors have shown considerable concern over the new regulations, which necessarily imply a degree of monetary tightening. In April, the Shanghai Composite Index posted its biggest weekly loss this year (17 April to 21 April, -1.52%). Some recent Chinese economic data points have disappointed, notably the April PMIs and export values. The Caixin Services PMI fell to 51.5 from 52.2 in March, an eleven-month low. Softness in the manufacturing PMI for April is thought to have been mostly due to heavy industries and renewed supply-side restraints.

Government in progress to contain financial risks

Momentum generally remains better than it was a year ago and the latest dips in the PMIs probably have little to do with tighter conditions in China's short-term funding markets. The monetary authorities in China were achieving some success in financial deleveraging, as annual growth in bank WMPs has declined from over 50% in mid-2016 to under 18.6% in March14. This suggests that Chinese authorities are making some progress in containing the financial risks built up in the years of debt-fuelled credit creation since 2009.

While conditions have tightened in the interbank and short term funding markets, Chinese government bond yields have surged to their highest level in almost two years. This is not the product of tighter financial regulations alone. It also represents the reversal of an unsustainable bubble that had developed in China's immature and rapidly expanding domestic bond market. We see it as a big long term positive that China's new regulatory bosses are making strong effort efforts to clean up legacy issues. Left unchecked, the Chinese banking sector would have become even less transparent and harder for the authorities to monitor and regulate.

What remains to be seen is whether monetary authorities can prevent swings in liquidity from exceeding tolerable levels and spilling over to damage the real economy. Sustained WMP annual growth far in excess of M2 or total social financing (TSF) increases leverage within the financial system, but does not provide additional credit resources to end users in the nonfinancial sector.

Key economic relationships are not necessarily symmetric, but it seems illogical to argue – as some China bears now do – that strong credit expansion in the past had little impact on real GDP, but curtailing shadow banking finance now will prove severely deflationary. China's private sector driven manufacturing sector, for example, does not depend on WMPs for its external financial needs.

1 Bloomberg, as of 8 May 2017.
2 See Style Research 'Monthly Summary for April 2017,' 2 May 2017.
3 See Lawrence Balanco, ' Price Action - Living on the edge,' CLSA 6 April 2017.
4 CNBC: “Stocks closed lower as Wall Street braces for French election, but post weekly gains.” 21 April 2017.
5 See "Inflation and Output Co-movement in the Euro Area: Love at Second Sight?," IMF Working Paper, WP/13/192, September 2013.
6 Eurostat, 28 April 2017.
7 Financial Times, 25 April 2017.
8 See CLSA 'Greed & Fear,' 5 May 2017.
9 See "Q1 GDP Disappoints, But The US Remains A 2% Growth Economy," M. Greene, Manulife Asset Management, 2 May 2017.
10 See FRB FEDS Notes, 'The Effect of the Federal Reserve's Securities Holdings on Longer Term Interest Rates,' 20 April 2017.
11 See "Victory For Macron, But Challenges Ahead," M. Greene, Manulife Asset Management, 8 May 2017.
12 See "French Presidential Election: A Market Friendly Outcome, But Issues Remain," D. Hussey, Manulife Asset Management, 8 May 2017.
13 Bloomberg, as of 12 May 2017.
14 Reuters, 22 April 2017.

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