Vontobel Multi Asset Boutique
The Tate Modern in London, Barcelona’s seaside Rambla, and the Zurich University of the Arts remind us of the western world’s transition. What used to be a coal power station, a grimy port, and a humble dairy complex are now centers of culture, business and education as well as tourist attractions. While we sometimes may feel nostalgic about our past industrial glory, it is consumers and services that keep the economy going.
Europe and the US are slowly wrecking their smokestacks, placing the burden of manufacturing on the shoulders of developing nations. However, the US, Germany, and Japan, the western manufacturing behemoths, still produce lots of industrial goods, and China remains the world’s workbench despite its diversification efforts. Therefore, everything that throws a spanner in the works is worrisome.
Since the great financial crisis, we went through two meaningful manufacturing cycles. We can see this for example in disappointing Manufacturing Purchasing Managers’ Indices (PMIs) around the world (see chart).
The first downturn in 2011 and 2012 was associated with the “euro crisis”, the second in 2015 and 2016 with fears regarding a hard landing of the Chinese economy and a collapse in commodity prices, among others. During those two periods, the global economy proved more or less resilient. Consumer demand and the services sector were stabilizing factors, although sentiment in the latter took a hit. Moreover, some regions were at times doing better than others, so the relative outperformers helped in staying the overall course.
Now we are witnessing the third global manufacturing slowdown since the financial crisis, and this time it could be different. For one, the ongoing trade war between the US and China shows no sign of abating, although hope springs eternal. Another, perhaps less obvious reason is the current trouble the European auto industry is facing. Whether or not this sector will recover, or at least stabilize, will depend on its ability to adapt to long-term disruptive trends such as the shift to electric vehicles. On a positive note, consumer sentiment is still robust and PMIs for the services sector suggest a reasonably solid development.
All eyes are now on the jobs data. Should industry sentiment weaken further, it will at some point hit the labor market. This could then affect consumer sentiment and ultimately the services sector, pushing us towards a more pronounced downturn. The contagion from manufacturing is limited so far, but the clock is ticking. Consider the situation in southern Germany, the country’s manufacturing heartland. The job market there, usually in rude health, appears to be catching a slight cold already, which might soon start weighing on consumer sentiment. Meanwhile, the manufacturing cycle in the euro area seems to be bottoming out.
Although recession fears have increased, this isn’t our main scenario for the next 12 months as long as consumer sentiment and the services sector do fine. We remain reasonably optimistic, even for the accident-prone euro zone, where we expect a growth rate of around 1.2% in real terms for this year. A hard Brexit would be a manageable drag for the euro zone, not a game-changer, in our opinion.
Surging equity and bond prices notwithstanding, financial markets teeter between recession fears and growth confidence. On the one hand, the still partially inverted US yield curve has market watchers worried. On the other hand, central banks have stepped up to the plate, flooding the banking system with liquidity to keep the economy afloat. The European Central Bank (ECB) cut interest rates in September and announced a range of additional supportive measures. The US Federal Reserve has changed tack within a few months, switching from tightening the screws to turning on the tap, and the People’s Bank of China has room to stimulate the economy. The Swiss National Bank has not (yet) pushed the base rate further into negative territory, but intervenes in the currency market to steady the Swiss franc.
Given these circumstances, market participants are generally sanguine about the prospects of equities and bonds. However, any deviation from the central banks’ apparent course, not to mention a worsening of the trade war or the conflict in the Persian Gulf, would probably lead to a spike in volatility. It is also worth noting that the ECB, for instance, appears to be at its wits’ end in terms of monetary stimulus measures.
We currently see no reason to abandon our slight risk-on stance. Given the generosity of the central banks globally and a hoped-for stabilization of the global economy, the probability of a recession occurring in the next 12 months is no more than 20%, according to our model. At the same time, valuations in equity markets may be high, but stocks are still preferable to government bonds, we believe. Therefore, we are still slightly overweight equity (with a preference for developed markets over emerging ones) and underweight bonds.
Within fixed income, we stick to a small overweight in corporate paper versus government bonds, but to a lesser extent than in previous months. One of our preferred fixed income asset segments still is emerging-market debt in hard currency. Generally, we have no specific preference for any currency as a central bank induced liquidity high takes the market’s focus off fundamentals.