NN IP: European growth scare

In times of low data visibility, a meaningful data disappointment tends to have a large market impact. Last Friday’s European data provided such a shudder. The Eurozone manufacturing PMI came in two points below expectations, diving far below the neutral 50 mark. This caused a red day for global equity markets and pushed Bund yields into negative territory.

A day earlier, a more-dovish-than-expected Fed had already put serious downward pressure on yields. Meanwhile, the increased medium-term clarity on monetary policy failed to have an immediate positive impact on risky assets, probably because of the large uncertainties surrounding growth, trade and Brexit. Nevertheless, the positive trend in risky assets, which began after Christmas, is intact. For now, the prospects of easier monetary policy seem to be good enough to offset the modest growth concerns.

Flash PMI came as a shock to investors

The high relevance of the European PMIs for financial markets lies in Europe’s large dependence on global trade and its sensitivity to internal political uncertainty. In this respect, the release of the flash PMI for March came as a shock to investors, especially because of the weakness seen in German manufacturing and in France in general. While it confirms the deterioration we had already seen in Asian manufacturing data, it even justifies a more cautious approach to the Chinese and Asian demand picture. This because we have problems reading the most recent Asian data due to the seasonal distortions linked to the Chinese New Year. As a result, if credible data outside of China point to more weakness in Asian demand, we should give that a significant weighting in our analysis until the data visibility in Asia increases again. In this context, we decided to reduce our exposure to EM equities from a medium to a small overweight.

We see bright spots within the data

Looking a bit more closely at the European data, Friday’s flash PMI release raised more questions than it answered. Global manufacturing weakness is largely driven by a slowdown in capital expenditure due to trade and political uncertainties. Germany is highly sensitive to this trend. Still, in the same month, both the German IFO index and the Belgian BNB index improved. The better readings of these relevant leading indicators suggest that the German industrial sector is perhaps starting to bottom out. Also, the European services sector and labour market continue to perform strongly; combined with the prospect of fiscal stimulus, this should offer substantial support for domestic demand. Meanwhile, in France, we see a discrepancy between the weak PMI and the more upbeat message from the INSEE survey and the most recent economic data.

Eurozone PMI and German IFO

Source: Bloomberg

Europe could be one shock away from recession

All in all, a European recession is still not a foregone conclusion. Nevertheless, markets have pushed Bund yields into negative territory. We could interpret this by saying that Europe might be only one shock away from a recession. The main question here is to what extent external and industrial weakness will spill over to the services sector and the labour market. A high level of reported labour shortages and still-good corporate profit growth should act as buffers against such a spill-over. Still, the longer the period of political uncertainty, the bigger the risk that businesses will lose their nerve. We increasingly believe that, given the decline in business confidence seen so far, a hard Brexit would likely be sufficient to tip the scale towards recession territory.

A more structural reason for negative Bund yields is that investors increasingly recognise that the ECB is standing with its back against the monetary wall. As such, the next recession could push Europe further towards a Japanification scenario. A growing awareness of this danger makes safe EMU sovereign bonds more and more attractive as a hedge against lowflation risks. The flip side could be a structural increase in equity and credit risk premiums, which would complicate the ECB’s efforts to stimulate the economy.

Brexit turmoil continues with no clear path forward

Having identified Brexit as one of the main risks to European growth, we cannot leave the latest developments in the Brexit drama undiscussed. Since last week’s EU summit, when Prime Minister Theresa May was granted a short and conditional extension of the 29 March deadline, the probability of a no-deal Brexit has seemingly increased. On Wednesday evening, May indicated that she would step down if her withdrawal agreement manages to obtain a Parliamentary majority. This is by no means certain, however. Many members of her own party are deeply opposed to the deal, and the Speaker of the House of Commons has stated he will block a third meaningful vote. Also on Wednesday evening, the British Parliament conducted a series of nonbinding indicative votes on specified Brexit scenarios (such as no deal, a soft Norway-style deal, a second referendum, and so on). This process resulted in no overall majority for any scenario, and although further debate and votes will take place on Monday, it is hard to see any way through the Brexit turmoil as it currently stands.

US-China trade deal still likely by end-April

The other big market event that should drive investor risk appetite in the coming months is the outcome of the US-China trade negotiations. In the past week, little new information has come out. Talks are continuing, this week in Beijing, next week in Washington. These talks probably concern Chinese concessions in the field of forced technology transfers, the opening up of the Chinese market to US companies, the level of remaining US tariffs and – a difficult matter – the eventual enforcement of any agreed steps. We still believe that a meaningful deal will be presented by the end of April. Meanwhile, to get a better feel for the actual Asian growth picture ahead of a possible trade agreement, we are anxiously awaiting the March data for China and the main East Asian trading economies. We received an initial indication earlier this week from South Korea, where export growth for the first 20 days of the month surprised on the upside (-5% versus -12% expected). Early next week, the Asian PMIs should indicate whether this Korean surprise will turn out to be a false or an early signal of a more broad-based demand recovery. For now, we stick to our view that Asian and EM growth will trough in the second quarter.

Asset allocation

Our view that global growth should not be far from bottoming out and that central banks in developed and emerging markets are likely to remain dovish for the foreseeable future, is keeping us confident that we should maintain a positive bias to risky assets. For now, we prefer to implement this view via a spreads overweight rather than an equity overweight, given the still-high growth uncertainty and the improved prospects for a stronger and longer search for yield. Meanwhile, the disappointing European flash PMIs, the increased risk of a hard Brexit and the latest confirmation of a more dovish Fed were the main reasons why we increased our position in Bunds in our overall tactical asset allocation from a medium to a small underweight. Within equities, apart from reducing our overweight in emerging markets, we also neutralised our small overweight in the Eurozone. The weaker-than-expected PMIs and the higher probability of a no-deal Brexit were the main reasons for this.