A Strong Economy And Risks For The Markets

A Strong Economy And Risks For The Markets

George Dagnino

Summary

The latest data point to a strong cycle ahead and increased risks for the markets.

The economy is strong, no doubt about it. The trend of the business cycle and financial markets reflects the current positive economic conditions. The markets are reacting as they have typically done during this phase of the business cycle.

The business cycle moves in waves because it reflects justifiable miscalculations by business managers about the desired level of inventory needed to meet expected demand. It is a complex decision biased by the continuous vociferous comments from analysts and commentators.

The bottom line for decision makers is how much to produce to meet demand through the supply chain.

Source: www.peterdag.com

Why does the economy slow down? Why does the business cycle move from Phase 2 to Phase 3? Where is the current position of the business cycle now?

These are crucial questions. Their answer drives tactical and strategic investment decisions, and it shows the risks facing the markets.

The major causes for the economy to slow down and the business cycle to transition from Phase 2 to Phase 3 are: rising commodities, rising interest rates, and rising inflation.

During Phase 2 of the business cycle managers are focused on building inventories to meet rising demand for their products. Demand is strong and production must be increased aggressively. To do so business has to purchase raw materials, hire production workers, and increase borrowing to finance the production process.

Toward the end of Phase 2 the intensity of building up inventories causes inflation and interest rates to rise to levels hindering consumers’ purchasing power and consumers’ confidence. The outcome is demand starts slowing down.

Business remains optimistic about the future and does not recognize this change in demand. They keep ramping up production to keep plants operating at full capacity. Eventually, however, inventories are rising at a much faster pace than demand, causing profitability to suffer. The inventory/sales ratio shows a visible rise.

The decision must be made to reduce production to cut inventory accumulation and bring it in line with the slower growth in demand. Purchases of raw materials are reduced. Workers are laid off. Borrowing is cut as reduced production requires cut in financing.

This process continues through Phase 3 and Phase 4. The outcome is continued weakness in commodities, lower interest rates, and lower inflation.

Eventually, at the end of Phase 4, inventories are brought in line with demand. Consumers’ optimism improves because of lower inflation and interest rates. Demand increases and business is forced to increase production accordingly. Phase 1 is now under way.

In order to increase production business raises purchases of raw materials, hires more production workers causing income to improve, and increases borrowing to finance production. These events feed on themselves throughout Phase 1 and Phase 2.

Where are we now? Recent data about the inventory to sales ratio published every month by the Census (see chart below) help us to answer this question.

A rise in the I/S ratio means inventories are rising more rapidly than sales. This is a bearish sign for the economy because business will be forced to cut production to lower inventory accumulation and bring inventories in line with the slowdown in demand. This process and its impact on the markets have been discussed in detail in my article The Inventory Cycle – Boring But Important Market Setter. An in-depth report showing what happens during a complete business cycle is also available to visitors of www.peterdag.com.

The above graph shows the I/S ratio started to decline sharply in early 2020. It signaled business was heavily understocked compared to demand. Inventories were reduced too aggressively.

Source: Federal Reserve of St. Louis

The outcome, as shown in the above chart, has been a sharp rebound in production (blue line) and manufacturing employment (red line), reflecting the business decision to increase production to replenish inventories.

Source: StockCharts.com

Because of increased production, as shown on the above chart, yields, copper, lumber, and crude oil all moved higher. Exactly as it is supposed to happen in Phase 2 of the business cycle.

REAL-TIME BUSINESS CYCLE INDICATOR

Source: StockCharts.com

The above chart shows the graph of the business cycle. Its trend is computed in real-time and updated in each issue of The Peter Dag Portfolio Strategy and Management (a complimentary subscription is available to the readers of this article on www.peterdag.com).

The current rising trend of the graph shows the business cycle is still improving. The recent sharp increase in inflation, commodities, and long-term interest rates suggests we are much closer to the end of Phase 2 than the beginning of Phase 1.

As long as the I/S ratio declines and our business cycle indicator rises, the trends of the markets shown in a previous chart will continue to rise. They will reverse when the business cycle starts to slow down. This is the time the I/S is likely to bottom and move higher. Its increase will reflect an unwanted accumulation of inventories which will be followed by production cuts.

These trends will signal the business cycle is entering Phase 3 and the outcome will be a decline in commodities and interest rates.

Key takeaways

The current decline in the I/S ratio is forcing business to increase production.

Copper, lumber, crude oil, and bond yields are rising because of the increased production needed to build up inventories as manufacturers try to catch up with demand.

The sharp increase in commodities and interest rates suggests the business cycle is much closer to the end of Phase 2 than the beginning of Phase 1.

The transition from Phase 2 to Phase 3 will be accompanied by a peak in yields and commodities and increased equity market volatility. A prolonged market correction should be expected at that time.

Date: 3/19/2021

As published on TALKMARKETS

Big Week Ahead

The ECB offers its most generous long-term targeted loan that is bound to see earlier loans rolled into this new one. Further evidence that the world’s largest economy has taken a baby step toward recovery.

Let’s unpack next week’s events. But first, let’s note that the events will take place as the recovery in risk assets appears to have come to an end with a flourish last week. That correction, which seemed overdue, appears to have more room to run. Also, the Covid virus continues to spread globally, and businesses, investors, and policymakers are sensitive to the so-called second-wave as countries and states re-open. Below are thumbnail sketches of the events and data that shape the macro picture.

EU Summit

The European Council (heads of state) hold a virtual meeting on June 18 to ostensibly discuss the EU’s May 27 Recovery Fund proposal. Some have heralded the proposal as a key turning point in the evolution of Europe, and the possibility of a so-called Hamiltonian moment, a major set toward fiscal union, has been suggested. We have been less sanguine; recognizing the potential scaffolding for a greater union, but also that projecting emergency actions into the future is fraught with danger.

Austria and Denmark, which have pushed back against grants instead of loans, could be won over by assurances that their rebates will remain intact. Others, including Eastern and Central European members, may be more difficult to persuade. Although expectations are running high, we suspect an agreement will remain elusive, in which case another try will be at the July summit, which, with a little luck, could be in person. Disappointment could weigh on the euro.

Johnson-von der Leyden

With the last round of negotiations failing to unblock the logjam, it is hoped that political leadership can intercede and reinvigorate the talks. A discussion between the two leaders and EU Council President Michel will take place at the start of next week. An extension of the standstill agreement is theoretically possible but it must be requested by the end of the month and Johnson has been adamant this was not going to happen. That leaves two possible scenarios; either a successful conclusion of negotiations or an exceptionally disruptive exit on January 1. We think the latter is more likely.

Johnson has threatened to walk away from the negotiations if there was no substantial progress by midyear, but this is likely a bluff. It might help in the political fallout from the disruption to say that the UK tried its best, which does not mean terminating negotiations midway. Several European countries, including Ireland and Belgium, are pressing the EU to accelerate preparations for no agreement.

ECB’s TLTRO

The ECB will offer the most attractive terms to date on its Targeted Long Term Refinancing Operation. These three-year loans will be available at minus 100 bp if certain relatively easy lending targets are met. There will be huge participation as banks roll some of their past borrowings into this facility with such attractive terms. Under such programs, the ECB has loaned around 1.02 trillion euros. This will inflate the gross figure.

The net figure, the new borrowings, these could also be substantial. The ECB’s balance sheet is about 5.6 trillion euros. New borrowings of 400 bln euros would expand the balance sheet to over 50% of EMU GDP. By comparison, the Fed’s balance sheet is about a third of GDP. The cheap funds will fuel peripheral bond-buying and the narrowing spreads are the ECB’s transmission mechanism in operation.

Bank of England

The Monetary Policy Committee meets on June 18. Unlike the Federal Reserve that has dismissed adopting a negative policy rate, the BOE purposely kept the option alive. Still, it is not imminent. More likely, the Bank of England will boost its asset purchase target. Recall MPC members Saunders and Haskel favored a GBP100 bln increase last month. However, the risk is asymmetrically in favor of a larger boost., especially after the UK reported April GDP contracted by a little more than 20% month-over-month. Many who see the risk of a negative base rate around the possible disruption early next year when it is outside of the EU.

Bank of Japan

The Bank of Japan meets on June 16. Most do not expect it to take fresh action but could make small adjustments in its support of commercial paper and corporate bonds. The pandemic has aggravated the disinflationary forces and Japan reports May CPI figures a couple days after the BOJ meets. In April, the core rate (which excludes fresh food prices) slipped back into negative territory for the first time since the end of 2016. Tokyo prices suggest a better national report in May.

Norges Bank

Norway’s central bank will likely shrug off the firm May CPI readings when it meets on June 18 and stand pat. Headline inflation rose to 1.3% from 0.8% in April. The core rate, which excludes energy and adjusts for tax changes rose to 3%, the most since September-October 2016. The krone has come storming back. It performed miserably in Q1, losing 15.5% against the US dollar, the most among the major currencies. Here in Q2, it has appreciated by around 11.5%, trailing behind the Australian dollar’s 14.25% rally to lead the majors. The central bank has stepped up its daily currency buying to NOK2.3 bln a day here in June from NOK2.1 bln as it converts its oil proceeds to fund the government.

EM Central Banks

At least six emerging market central banks will meet. In the Asia Pacific region, Indonesia and Taiwan central banks meet. Indonesia has scope to cut at least 50 bp in its 4.5% key seven-day reverse repo rate. The rupiah is the strongest emerging market currency here in Q2, appreciating by about 16.7% after falling 15% in Q1. Taiwan has deflation in the headline CPI and the core is just above zero.

Its benchmark interest rate is at 1.125%. A small cut cannot be ruled out. In eastern and central Europe, the Polish and Russian central banks meet. Poland’s base rate is 10 bp and is well below inflation where CPI is a little less than 3.0%. Russia, on the other hand, is in desperate need of more supportive policies. Its key rate is at 5.5%, more than double the CPI.

It delivered a 50 bp cut in April and the rouble appreciated by nearly 8.4% since the end of April. A 75 bp move would not surprise. In South America, Chile may be reluctant to cut its 50 bp overnight target rate, but the Chilean peso is the third strongest emerging market currency this quarter behind Indonesia and Russia, with an 11.25% gain. With falling inflation and a 6% recovery in the Brazilian real, the central bank may be bold enough to cut the Selic Rate by 75 bp to 2.25% when it meets on June 17.

US Data

While a second wave of the virus cannot be ruled out by any means, it does look the US economy has begun the long process of recovering from a steep contraction. There will be more evidence next week as the US reports May retail sales and industrial output figures. Retail sales fell 16.4% in April and may have risen by 7.5%-8.0% in May.

Investors already learned that auto sales rose more than economists expected (12.2 mln saar from about 8.6 mln in April and median forecast in the Bloomberg survey for 11.1 mln). Industrial production is expected to rise 2.5%-3.0% after the 11.2% drop in April. Separately, May housing starts and permits are likely to jump after three months of declines. The Empire State and Philadelphia Fed surveys start the cycle of high-frequency June data. Both surveys are expected to show improvement for the second consecutive month.

For a look at all of today’s economic events, check out our economic calendar.

This article was written by Marc Chandler, MarctoMarket.

Euro Area’s Fiscal Plans Face Financing Challenges Following Covid-19

Understanding gross financing needs (GFNs) is essential to assessing the sustainability of sovereign borrowing by providing an aggregate figure of the maturing debt volume, primary fiscal deficits and interest payments in a fiscal or calendar year.

In 2020, Scope Ratings expects euro area gross financing needs of around 18% of it’s GDP, assuming an aggregate primary deficit of 6% of the GDP and interest payments of 1.8%. By comparison, in 2019, GFNs amounted to 12% of GDP.

“We expect for 2020 a similar overall size for euro area gross financing needs compared with that in 2009, at the peak of the Global Financial Crisis, but this time the focus around the composition will be different,” says Giulia Branz, an analyst at Scope and co-author of the Euro Area Gross Financing Needs in 2020:
rise mitigated by favourable composition . “Hefty fiscal stimulus is the main driver of the rise in GFNs in 2020 while interest payments and the amount of maturing debt remain lower than in 2009,” she says. “Governments are issuing debt to counter-cyclically address the crisis, rather than to service past borrowing. This may support faster economic recovery and thus strengthen debt sustainability over the medium term.”

The euro area’s total GFNs this year might remain comparable to those during the Global Financial Crisis in 2009 if the economic contraction from the Covid-19 remains close to Scope’s baseline estimate of around 6.5% of the GDP. At the same time, euro area governments have varying degrees of fiscal space, with projected GFNs in 2020 ranging from 8% in the case of Estonia to over 30% of GDP in Italy’s case.

The Italian exception

“Italy is among the few countries facing very similar amounts of amortisations and interest expenditures this year compared to 2009, despite recurrent primary surpluses in the aftermath of the financial crisis and the extraordinary interventions of the ECB,” says Branz.

Italy’s gross financing needs in 2020 nonetheless remain far below those projected for other reserve currency sovereigns such as the United States (38.5% of GDP) or Japan (45.6% of GDP). In addition, the European Central Bank’s enhanced role as a lender of last resort and will support fiscal sustainability despite the one-time surge in fiscal deficits. ECB support is expected to keep interest costs low to mitigate spreads in risk premia across countries and absorb part of the additional gross financing needs resulting from higher primary deficits.

An elevated 2020 euro area deficit but a more homogenous fiscal response

“In absolute terms, we currently estimate the euro area’s fiscal deficit for 2020 at around EUR 890bn. This compares with the ECB’s additional purchase programmes totalling around EUR 1trn, of which we can assume around 70% relate to euro area government securities purchases.”

Scope’s forecast of an aggregate euro area fiscal deficit of around 8% of GDP can be broken down into the pre-shock primary balance, shock-related discretionary spending, the cyclical component including higher unemployment benefits and lower tax revenues, in addition to interest payments. While the projection for the cyclical component deterioration is comparable to that seen in 2009, interest payments are significantly lower this time – thus creating the space for greater stimulus.

“We see greater use of fiscal spending in 2020 and more homogeneous fiscal responses across euro area countries, as the discrepancies in their fiscal balances, are set to be much lower than in 2009,” says Branz. Counter-cyclical and coordinated fiscal policy are what countries have to do to mitigate the impact of the economic shock. Still, this will inevitably translate into an increase in the stock of public debt.

A rise in regional debt, but via growth-enhancing spending rather than higher interest cost

“We project the euro area’s debt-to-GDP ratio will increase to a record high of around 98% in 2020, up from 84% in 2019. However, thanks to prudent fiscal policies over the past ten years, much of the increase in public debt results from higher primary spending rather than from higher interest payments.”

Euro-area governments have several ways to offset the impact of higher GFNs on future economic performance, including:

  1. Lengthening debt maturities to lower annual refinancing needs.
  2. Improving the euro area’s long-term fiscal capacity (such as creating a recovery fund, new forms of emergency lending, region-wide unemployment insurance).
  3. Monetary policy support during times of market volatility.
  4. Common endeavours to raise the euro area’s growth potential.

Download Scope’s full report

Giulia Branz is an Associate Analyst in Public Finance at Scope Ratings GmbH.

Germany’s QE Opposition is pressuring the Euro

However, they are not quite sure about the future economic outlook. This can be seen in the index charts. If we look at the American S&P500, we can see the profit-taking in March and April.

The same trends, on a smaller scale, are repeated inside the day. On the intraday charts this week you can see the declines at the end of the day, but most of the time, purchases prevail and we are likely to see the same trend today as well.

A similar situation around oil. It has been enjoying buying from stress-low levels since last week. Reducing its volatility has also taken away an essential irritant for markets in general. But soon we got two new negative factors.

First of all, it’s the U.S. accusations of withholding information about the virus and the threat that “China will pay for everything”. In this case, the markets operate based on the news. Chinese markets and the yuan are confidently recovering losses at the end of April amid confidence that the conflict won’t go into a phase of real and significant damage. They bet that leaders will be able to reach an agreement. After all, this has happened before.

Germany’s recent announcement

A new factor appeared yesterday, and this is the opposition of the German Constitutional Court to the ECB actions. Germany calls for the next three months to correct legal discrepancies for the asset purchase program, held since 2015. And this not only threatens a big revision of past actions but also puts a spoke in the wheels of the ECB, which intends to expand and deepen QE. Otherwise, the Bundesbank (the largest and most influential in the eurozone) will be on the sidelines.

In this case, the experience is on the side of the pessimists. The past German opposition to support troubled Greece, Spain, Italy was probably an essential factor that slowed the region’s recovery from the financial crisis and turned into years of low growth. Worse yet, it destabilized the debt markets of peripheral countries, causing the Euro to sell out.

The vital factor is that it has permanently eroded confidence in the eurozone, instilling in investors’ minds the idea that the Euro is not forever. However, if previously, investors were afraid of peripheral countries’ exit, now the risk of Germany’s exit is increasing. So far, on the level of unity of monetary policy and the ECB. The single currency was the cement that united the eurozone.

EURUSD

Two rounds of the debt crisis (first Greece, then Spain and Italy) took 20% of the Euro’s value twice. EURUSD failed to fully recover to 1.50, where it was before the acute phase of the crisis. Partly, it is the fault of the slow economic growth of troubled countries, which turned out to be within strict limits of budgetary discipline. This pushed the ECB to QE, causing pressure on rates and the price of Euro, which is so displeased to the residents of Germany, who prefer savings and expensive national currency. Will they succeed? Perhaps, only if they can do it alone.

 by Alex Kuptsikevich, the FxPro senior market analyst