The ‘disconnect’ playing out between global markets, which are rallying, and the global economy, which is floundering, appears to be getting wider. Either these market rallies are not sustainable or they are the harbinger of a major economic turning point. At this point there are few signs that it will be the latter.
Last week saw a record high in the MSCI World Equity Index and new highs in the S&P500 index and the Dow Jones index. The MSCI EM Equity Index also extended its rally from early October and is moving closer to last April’s high. A softer dollar on the back of the Fed’s rate cuts and repo liquidity injections is helping sentiment in emerging markets, and these have also been a factor behind the rally in broader markets.
The other striking feature last week was a further increase in sovereign bond yields. The US 10-year Treasury yield was at 1.90 per cent, compared to this year’s low of 1.43 per cent posted on September 3. Japanese bond yields also made their biggest weekly jump in six years, while the German bond yield is up some 40 basis points from its early September low.
Parallel to these developments, the Japanese yen and gold have both softened, symptomatic of rising risk appetite. The US dollar- Chinese renminbi exchange rate has also turned down, moving below the psychological 7.0 level, a signal of rising optimism particularly over trade.
The macro focus remains squarely on the US-China trade talks, with hopes that a ‘phase one’ deal can be agreed that includes a rollback of US tariffs next month. There is also a sense of optimism among investors that the global economic slowdown is abating.
Both of these explanations for the latest bout of market optimism look overly optimistic, however. Positivity regarding the trade talks appears to be gaining ground almost regardless of the erratic news flow on the subject, which alters by the day. Markets seemed to shrug off the apparent delays to a deal being reached last week and only slightly corrected when Donald Trump warned that he may not in the end remove tariffs on China.
Even if a phase one deal is reached with the removal of some tariffs, it will take time for businesses to regain confidence that they will not be reimposed, especially in what looks likely to be a volatile election year.
Data wise, there has been little relief from the gloom. The latest Chinese trade data reported a 0.9 per cent year-on-year decline in Chinese exports — the third consecutive decline — and a 3.5 per cent year-on-year decline in Chinese imports. Chinese car sales for October were also down 6 per cent year-on-year. German industrial production for September was down 4.3 per cent year-on-year.
In addition to the International Monetary Fund (IMF), Organisation for Economic Co-operation and Development (OECD) and World Bank all revising down their forecasts for global growth recently, the EU Commission cut its forecasts for eurozone growth to their lowest levels in four years last week.
The Bank of England appears to be readying for a rate cut, revising its growth forecasts lower to reflect the weaker global backdrop and the expected effects of Prime Minister Boris Johnson’s Brexit deal. Concerned by policy paralysis amid an uncertain general election, Moody’s has cut the UK sovereign outlook to negative.
The only exception to this run of bad news is the US economy, which continues to defy the gloom to such an extent that the probability of a December rate cut from the Fed is being priced out. However, there is no guarantee that the Fed will not be forced back to the table to cut again, especially as under the headlines of steady growth and jobs, there are hints of softening domestic demand and contracting business and housing investment.
So the market rallies appear to be at odds with the fundamentals and would seem to have more to do with liquidity, giving rise to a ‘disconnect’ whereby markets ‘melt up’ seemingly regardless of the economic landscape. This can only continue if the fundamental news begins to get better, catching up with the positive market trends. So far there are few signs that this is happening and with risks over trade, Brexit and geopolitics having not gone away, it is probably wise to view such a ‘disconnect’ cautiously.
Tim Fox is chief economist and head of research at Emirates NBD