Avoiding the worst, not expecting the best

Key points:

  • ECB: communication realignment is failing for now. The public debate is pre-empting the “strategy review” as Lagarde is readying for her first post-Council press conference.
  • Industrial cycle: some soft data suggest the manufacturing cycle has bottomed out. We are cautious, as available hard data, in particular in Germany, remains concerning and the “trade war” front has woken up again.
  • Our 2020-2021 outlook: we have probably enough to avoid a nasty global downturn in early 2020. The potential for a significant re-acceleration is low though.  
  • Correcting the inventory correction: we noticed a lot of optimistic papers from the sell-side on “the end of the inventory correction”. We disagree.

ECB: communication realignment failing for now

From a communication point of view, the recent macro developments are exactly what the ECB could have dreamed of ahead of Christine Lagarde’s first post-Governing Council press conference this Thursday. The data is bad enough to fully justify the latest stimulus package and drown any question on a central bank overreaction in September, while not catastrophic enough to trigger uncomfortable queries about how the ECB could technically provide additional support to the economy. For now Lagarde can easily stick to the script left to her by Draghi. We do not expect any announcement or major change of message this week, apart from a timeline for the “strategy review”.

Still, with comforting regularity December comes with Christmas and new forecasts from the ECB, with one year added to the horizon. Focus might well be on the inflation side. In the September batch, core inflation - which is more and more explicitly the ECB’s favourite measure - was significantly below target (1.2% in 2020 and 1.5% in 2021). We suspect the ECBs economists must have agonised over what to pencil in for 2022. It would be surprising for them to assume a relapse in economic activity in 2022, so odds are the mid-point for their inflation projection at the end of their horizon is not going to be too far to “below but close to 2%”.

An obvious question then for journalists would be to ask Lagarde whether this means that in the central bank’s baseline 2022 would mark the beginning of monetary policy normalisation. Given the current forward guidance, this would mean that one could legitimately expect a continuation of QE throughout 2021 and the first movement on the depo rate at the beginning of 2022.

Implicitly pencilling in a deposit rate stuck at -0.5% for another two years would not necessarily be the favourite outcome of many members of the Governing Council (even if it is actually our baseline). If anything, the movement we’ve been observing since the summer, with doves and centrists becoming more and more vocal on the side effects of negative rates, continues to gather strength, exemplified last week by Bank of Spain’s Governor mentioning the possibility that we are already in counter-productive territory.

The ECB’s dilemma is that the Council’s heart no longer is in the current forward guidance, but exiting this forward guidance without macro damage is next to impossible - for instance because of the risks of an exchange rate over-reaction, as highlighted by Philip Lane.

At this stage, Christine Lagarde can still dodge those questions by pointing to the strategy review which is about to start. However, a key purpose of this review would be to allow for a re-alignment of the Governing Council over shared decisions on the definition of the ECB’s target and the operational framework. For now though it seems that a fair number of members are perfectly happy to have this debate quite publicly. Re-building consensus is going to be tough.

Industrial cycle: it’s less bad, It’s not better

One of the few things your humble servant has learned over three decades of data watching is that if you are forced to look at second derivatives to feel positive, the overall situation is probably quite dim. Recently the data flow has come out with quite a few positive surprises, but at least when it comes to the global manufacturing cycle it would be better described as “less bad” than as “actually improving”. Keeping this in mind helps to understand apparent disconnects between soft and hard data.

There was quite a lot of cheerful comments when the German manufacturing Purchasing Managers Index (PMI) rebounded by 2 points in November, following a smaller improvement in October. This was hailed as the sign the German industry has finally bottomed out. The level of the index however was still quite concerning at 44.1, in the range found during the last German technical recession in 2012/early 2013. Manufacturing activity is still contracting, and we had a confirmation of this with the release of the October data for industrial production, with another steep decline of 1.6% on the month, following a contraction of 1.4% in September. This is a very noisy series but we would not count too much on a clear recovery in November given the (in principle) forward-looking signal we had from orders (which unexpectedly fell by 0.4% on the month in October).

Since a peak in November 2017 manufacturing output has dropped by nearly 10% in Germany. It is now a much more significant decline than during the 2012/2013 technical recession (-5.2% from the peak in July 2011 to the January 2013 trough). The contrast with France has been notable (Exhibit 1) and it has been very tempting to ascribe this to the specific developments in the car industry. We think this is only a small part of the story.

Exhibit 1 - Specific weakness in German manufacturing

Production in the car industry has initially been more resilient in France than in Germany, avoiding in particular the sharp drop due to the implementation issues surrounding the introduction of new norms on engines, but cumulatively the difference between the two countries in this sector is now fairly small (Exhibit 2). True, the car industry’s weight in overall industrial production is three times bigger in Germany than in France, but over the November 2017-September 2019 period (industrial production for October is not yet available in France) we can explain only 1.5 percentage points out of the 6 percentage points German overall underperformance (Exhibit 3). The specific difficulties of the German industry cannot be ascribed to one single sector.

Exhibit 2 – French car industry converging towards its German counterparts

Exhibit 3 – Even excluding the car effect, German output is particularly depressed

True, the signals from non-European demand – crucial for the German industry – have been ambiguous lately. In the US, the manufacturing ISM disappointed again in November and at 48.1 is staying well into contraction territory, while in China both the official and non-official PMIs have nicely rebounded. But more fundamentally the fate of the global industrial cycle will depend on developments on the trade war front. There, the signals have been less supportive than over the last month.

Donald Trump’s statement on the possibility of waiting until after the elections for the conclusion of the phase one deal with China triggered some transitory but noticeable correction on the equity market, which had been operating on the assumption that the 15 December tariff hike would be avoided. This is no longer as likely. While Kudlow talked up the negotiations, stating on Friday that “ a China deal is still close”, December 15th is becoming an important date. It is still our baseline that the deal will go through, but in our view this is more consistent with a avoiding escalation than with a proper roll-back of the tariff hikes already implemented. On the European front, the US administration  chose to let the deadline for taxing European cars slip,  but the possibility of some tariff retaliation against France and its digital tax – a hearing will be hold on this on January 7, which does not mean that a decision will be made that day – should remind us of the fragility of any truce when it come with trade issues and the current US administration.

Our 2020-2021 outlook: no space for re-acceleration

With December comes Christmas, new ECB forecasts and a flurry of “year aheads” from various institutions. We are happy to respect this tradition with our own write-up [see our Macroenomic Outlook 2020: Fragile 20-20 vision]. We think the global economy is going to avoid a major further downturn in the months ahead. The very latest noise has been a tad concerning trade war - as we have just discussed in the previous section - but our baseline assumption is that we should avoid further escalation between the US and China while the spat between France and the US on the digital tax would remain contained. While we are still waiting for the result of the British general elections, it seems that an immediate “no deal “ Brexit is now off the table (even if we think noise with come back when the negotiations of the free trade agreement between the UK and the EU starts in earnest, in case of a Tory victory this week).

However, we think actual GDP growth will remain below potential in all the major economic regions in 2020. In China we think the authorities, once somewhat reassured on trade war, will tolerate the further slowdown in domestic demand which the necessary balance sheet clean-up entails, given the quantum of accumulated financial imbalances. In the US, as we suggested last week, we think the limits to corporate investment set by the decline in profitability have become hard to overcome. In the Euro area, pressure on capacity has abated massively over the last year which makes it unlikely to see a significant rebound in hiring and capex, while just like in the US in some countries, notably Germany, profits are also struggling.

This would put US GDP growth at 1.6% in 2020 in the US, 0.7% in the Euro area and 5.8% in China. Given the lack of capacity/willingness to provide more policy support next year, we think the natural slope for the global economy in 2021 is a further deceleration. In a nutshell, in the debate between a “mid-cycle breather” and an “end of cycle mild downturn”, we are in the second camp.

Correcting the inventory correction

Our outlook puts us slightly below consensus for 2020. When reading recent sell-side research we have been surprised by the number of houses mentioning “the end of the inventory correction” as a positive force underpinning their cheerful scenario. Goldman Sachs in particular is quite keen on that narrative. For our part we find no compelling evidence for declaring the recent inventory cycle as over.

When looking at the US, the ISM index in manufacturing suggests that companies have stopped building more stock, but the inventory component only marginally moved below its long term average recently (see exhibit 4). Order books are still deteriorating so we find it difficult to argue it is obvious firms have by now brought back inventories to their desired level given where they think expected demand is. To compare with previous episodes, the ISM inventory component is now back to what it was at the trough at the last mini-cycle in late 2016, but order books are much more depressed.  

In the Euro area manufacturing companies are asked whether the level of stock is above or below normal. A majority now answer the former (see exhibit 5).

Exhibit 4 – Still way to go on de-stocking in the US

Exhibit 5 – No disconnect between orders and inventories in the euro area

We looked at this issue for the Euro area in a more formal way. In theory, the level of inventories should depend on four factors. First, the level of expected orders: firms don’t want to take the risk of missing out on orders if for a reason or another output cannot be raised (the insurance factor). Second, the level of expected selling prices (if firms believe they can sell their products are a higher price tomorrow they should front-load output today). Third, the difference between production as it was expected and where it actually stood (the “surprise” factor). Fourth, the level of interest rates (when interest rates are high so is the cost of carrying inventories).

We estimated a model using these variables taken from the European Commission survey since 1999. The first three factors come out as statistically significant. As Exhibit 6 illustrates, the model does a very good job at predicting the actual balance of opinion on inventories. There is absolutely no sign of an “inventory overhang” in the Euro area – i.e. an excessive build-up in inventory whose absorption would have forced a significant decline in output in the recent period. Inventories are exactly where they should be, and while the “surprise” component is now less of a drag (firms have adjusted their production expectations downward) it would take a proper rebound in the order book to justify some restocking.

Exhibit 6 - Inventories are exactly where they should be in the Euro area

Upcoming events
US :
Tue: NFIB small business optimism; Wed: CPI, FOMC meeting and decision; Thu: PPI; Fri: retail sales
Euro Area:
Mon: German trade balance; Tue: German ZEW Survey, French and Italian industrial production; Thu: ECB meeting and decision, Eurozone industrial production, first day of EU Council Summit
Mon: TV election debate for under-30s; Tue: October GDP; Thu: General Election, exit poll expected about 22:00
Tue : CPI
Wed: Private machinery orders; Thu: Tankan large manufacturers’ index

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