Mixed Messages from the Global Economy

As we finish the first quarter of 2016, the global economy is sending out mixed messages about what is likely to happen over the balance of the year and beyond. These contradictory signals simultaneously create both an opportunity and a problem for traders.

But these contradictions may in fact be the natural result of diverging monetary policy and economic cycles amongst some of the world’s largest economies. In this article we will examine the opportunities and the pitfalls that may lie ahead, using the US as an example.

US in the lead

As with so many areas of the modern world it is the USA that is taking the lead in producing seemingly contradictory economic data. Unemployment in the US has continued to fall and job creation rates have to date exceeded analyst expectations in 2016. But at the same time we have seen a series of softer data points from influential regional reports such as the Philly Fed, Empire State, Kansas City and Dallas Fed manufacturing surveys. Even within these surveys there is a mixed picture. For example the Philly Fed manufacturing index rebounded to +12.4 in March after six consecutive negative readings. Whilst its Texan counterpart, the Dallas Fed manufacturing index, came in at -13.6 in March. Though that figure was a much better number than the sub -30 readings seen in both Jan. and Feb.2016.

The bigger part of the cake

Of course as with most modern developed economies, manufacturing is only part of the picture and often the smaller part of the whole, with the service sector making up the lion’s share.  That in itself is not necessarily a source of comfort however. Because if we look at the Services PMI (Purchasing Managers Index) which tracks activity in non-manufacturing enterprises within the USA, we find that this data has itself been trending lower over the last 12 months. Though it did return to growth in March 2016 with a read of 51.

US Services PMI (source Trading Economics)

The continued downtrend in the service sector and the weaker patterns seen amongst manufacturing survey data to some extent fly in the face of the improving employment situation, whose only weak spot has been in hours worked and the rate of wage growth.

We note the recent observation from Credit Suisse that there has only been one occasion since 1950 (that was 1955) in which an industrial recession did not precede a wider economic downturn in the US economy. With that in mind we will want to see a consistent and sustained rebound in measures of industrial activity in the USA, starting with the ISM / PMI data on 1 April and to see the Service sector PMI make a sustained and sustainable return to the mid-50s in the coming months. Without which the US economy might be thought of as being in trouble.

Inflation is telling a different story

Whilst measures of economic activity at an enterprise level are flashing red, there are some green lights as far as measures of inflation in the US are concerned. Though even here the picture is mixed if not contradictory as we can see below.

Inflation in the USA (source Trading Economics)

The chart above plots core inflation (inflation ex food and fuel) against the broader inflation rate in the USA. As we can see there is clear divergence between these two metrics. With broad inflation heading lower, even as the core figure pushes strongly higher. This difference in performance could be explained by the composition of the baskets. That is to say, that the plunge in oil prices seen over the last year has dragged the broader inflation measure lower.  Whilst the core figure, which does not include the price of fuel, has moved higher unhindered.

Whether this is an accurate reflection of the situation on the ground as far as American consumers are concerned it’s hard to say for certain (and there is a wider debate about the effectiveness of current inflation measurements, but that’s for another time). However surveys suggest that US consumers are not expecting inflation to move dramatically higher in the near or even medium term.

Are markets now leading the FED?

Conversely the markets are more receptive to this idea. As evidenced by the sharp moves higher in future inflation expectations that are derived from the bond market. Which jumped markedly higher across the two, five and ten year maturities, after March’s dovish Fed meeting. See the chart below.

US Bond Markets inflation expectations as of 18 March (source Bloomberg/ FT.com)

At the same time the markets have become receptive to the idea of further US rate rises in 2016. With the Fed Fund Futures now suggesting a 63% chance of rate rise by September 2016 and a 75% probability of rise by December this year (as of 29/03/16). That’s quite a turnaround because prior to the March FOMC meeting the markets had effectively discounted any further rate rises in 2016.

Whilst the Fed had maintained that it would raise rates this year and probably multiple times. Now the markets have bought into the inflation story in the USA whilst the FED is backing off from rate rises because of its concerns about the wider global economy. Despite the fact that core inflation is running well ahead of the central bank’s 2% target.

Where does that leave us?

The answer is to some extent in the dark, because even if we want to follow the markets take, there are contradictions here as well. The US dollar, as measured by Dollar Index, its trade weighted basket, has weakened since late February. Just at the time that inflation and rate rise expectations were picking up.

Logically and classically we would have expected the Dollar to strengthen, as money moved out of currencies with negative interest rates and into the green back. Where the prospects for higher interest rates could be seen as gathering momentum. But both the Yen and the Euro have been well bid in much of 2016 to date. Despite or perhaps even because of the negative interest rates at work in both currencies.

US bond markets seem to have reconciled themselves to rate rises in 2016, whilst equities seem to be hoping for softer data to defer any “premature” end to almost a decade of easy money. Whilst currency markets are opposing the ECB, the Bank of Japan and classical economic theory.

All about timing

To my mind it is not so much a question of who is right here but rather one of timing. In that we are 7 years into the Bull Run in the S&P 500, yet US corporate earnings and margins are declining. That could suggest that the economic cycle is itself peaking.

Noting the Credit Suisse comments mentioned earlier, it also pertinent to point out that the investment bank additionally referenced, in the same report, the fact that dips below 50 in the ISM New Orders data (as seen in in Nov and Dec. 2015) can signal that a formal recession has begun or is on its way. Furthermore that the occasions on which recession has been averted have been down to central bank easing. Something which the FED even with its dovish pause is unlikely to consider or enact.

Inflation and interest rates can move higher even as a recession unfolds and in the worst case scenario the Fed could find itself stuck firmly between the rock and the hard place. As core inflation pushes for higher interest rates whilst the softening economic cycle calls for easier monetary policy.

What we can’t know is just how close a wider economic downturn the US is, if one is coming at all. But I do note a softening in GDP expectations for Q1 2016 in the USA. The Atlanta GDPNow model (still an experiment but an increasingly accurate one) has reduced it forecast to +0.6% from its prior forecast of +1.4%. The model will be watching Friday’s data releases (Non-Farms, ISM, and PMI etc.) and factoring these into its deliberations and as traders we will need to do the same.

This is a guest post written by Darren Sinden, an analyst at Admiral Markets