The end of the mid-cycle adjustment

Summary

• Global matters — The right to protest.

• US Economic update — Manufacturing and services.

• Market reaction — Fed cuts rates.

• The week ahead — Data dump in Europe.

It was a relatively quiet week outside the US, equities were generally higher and bond yields were lower. The Bank of Canada (BoC) held rates unchanged last week at 1.75 percent, no longer describing the current policy rate as stimulative. The BoC also dropped any reference to the economy operating at/near capacity, focusing on geopolitical developments as the main source of risk to global growth. The Canadian dollar (CAD) has been one of the top-performing currencies year to date, up nearly 3.8 percent against the US dollar. With interest rates remaining unchanged, the CAD has become one of the higher-yielding currencies in developed markets, making it highly attractive for Carry Traders (investors who borrow in low-interest currencies and invest in higher-yielding ones). In Saudi Arabia, the Kingdom announced that the capital markets regulators have approved the IPO. Saudi Aramco is expected to begin trading in Tadawul in December. This state-run oil company, which pumps around 10 percent of the earth’s oil, had $US 111 billion in net income in 2018. For context, Apple, Google, and Exon mobile combined made less in 2018. The IPO is a key facet of Prince Mohammed’s “Vision 2030” plan to transform the Kingdom — I wonder how cutting up journalists fits into that plan. In China, the latest manufacturing data prints both contradicted each other, with one showing a decline and another showing a large rebound. Putting this aside, the large broad-based stimulus that the market wants the PBOC to deliver is likely not coming, and this has raised the question about stagflation in the world's second-largest economy. The reality is that output is falling and consumer prices are rising. Chinese policymakers are in a bit of a pickle now — if they decided to use the “kitchen sink” style stimulus, they run the risk of creating even more inflation in addition to undermining President Xi’s efforts to control leverage. Meanwhile, Hong Kong unsurprisingly entered into a recession after nearly 5-months of anti-government protests. What’s shocking is that, and get this, the city contracted by 3.6 percent year over year — That’s enormous. The City’s finance minister said that it is unlikely to achieve any growth this year and tourism has completely collapsed. That’s not surprising, a normal Sunday in Hong Kong now consists of throwing a molotov cocktail at a storefront window. Needless to say that the protests haven’t dissipated and nor is there any end in sight.  Latin America was also hit with a wave of protests in Bolivia, Argentina, Honduras, Haiti, Ecuador, and Uruguay. Why the sudden uproar you might ask? Well, the "commodity boom” helped bring tens of millions of people out of poverty but governments in a lot of these countries did not plan for when the boom would go bust. The US Shale boom in many ways put an end to the commodity boom and left plenty of these countries high and dry. When you throw a few political scandals into the mix, it comes as no surprise that citizens are upset. What’s interesting is that this appears to be more of outsiders against insiders issue and not left against right according to Alex Kliment at Gzero Media, a subsidiary of Eurasia Group. Alex cites a poll that indicates that nearly 80 percent of people in Latin America think that parties don’t govern in the popular interest. This number is up 60 percent from 10 years ago. If you’re not convinced that this is worth writing about, remember that Chile canceled the APEC conference where President Xi and Trump were expected to have face-to-face talks regarding trade. Of course, this goes well beyond the trade talks. The fact that Chile moved the conference to Spain helps underscore how social unrest is undermining global governance and the ability of global leaders to come together to tackle other issues like trade and climate change. The combination of a weaker manufacturing print and a strong payrolls report strikes a fine balance between Fed easing and alleviating fears of a downturn in the US. The US manufacturing sector slipped into contraction in September as the effects of the trade war boomeranged back to the US. The latest manufacturing print for October showed a faint bounce and, when taken in context with the Chicago Purchase Managers Survey, was broadly viewed as bad news. As I’ve highlighted in the past, manufacturing has become less relevant to US growth. Goldman Sachs has done work on this and suggests that the Manufacturing sector now accounts for only 10 percent of nominal GDP. In the ’80s and ’90s, this number was closer to 20 percent. So why does the market even care? Well, there are plenty of service sector jobs which are linked to the manufacturing sector and the fear is that a recession in manufacturing will work it’s way over to services. There’s evidence of that — The latest ISM (Institute of Supply Management) survey showed that the service sector in the US hit a 3 year low. That’s the kind of spillover that “matters” in the US economy. Although comments from the survey were better than in September, the panel remains more cautious than optimistic — that’s in line with the University of Duke's CFO survey I’ve mentioned in my past several emails. The US GDP print painted a similar story. Although the print came in higher than expected, the break down in GDP showed a clear slowdown in business investment. Digging into the weeds shows that the burden of growth continues to be pushed onto the consumer. My concerns about this breakdown are twofold; there is a risk that bond yields snap higher due to the “good vibes” from trade and, the service sector begins to import the trouble from the manufacturing malaise. Both of these are negative for the US consumer.  Of course, economic data never paints a perfect picture and the latest news that the US labor market continues to remain firm certainly clouds the narrative. Total non-farm payrolls (which covers the number of people not working on farms that are on company payroll) increased by 128,000 in October — beating consensus estimates of 85,000.  The results are impressive, especially when you consider that the data was affected by the GM (General Motors) strike which impacted around 45,000 workers. There were also some seasonal layoffs in the Federal government due to the 2020 Census work — these amounted to around 17,000 jobs that were lost. Although the report is strong, it does show that the pace of hiring has slowed and the question now is whether the slowdown in hiring is a harbinger of things to come. Before a recession, the economy typically stagnates and recent work from Barclays places the probability of the US economy “stalling” at 30 percent condition on payrolls continuing to remain around 100,000 a month. There are nuances to such analysis but the point is that these banks are trying to identify tipping points ahead of an election that will undoubtedly be focused on trade policy and economic growth. The Federal Reserve cut interest rates this week and indicated that this may very well be the end of the easing cycle. Generally speaking, Jerome Powell did a good job of answering questions and made sure to stick with the narrative that this was the end of a mid-cycle adjustment. Powell remarked that “only serious inflation” would put rate hikes back on the table and, as such, it appears we are now holding for the foreseeable future. Average hourly earnings from the non-farm payrolls on Friday came in lower than expected, reinforcing Powell’s message of subdued inflation. It appears that the bar for more rate cuts has been set quite high by Powell and for there to be more easing, we would need to see a material deterioration in the US consumer and a fairly adverse market reaction. There is anything but consensus on the street right now, many still think a cut is on the table for December. Market pricing out to December of next year shows a 70 percent chance of at least one cut — clearly, the market isn't buying into Powell’s narrative.  Next week will bring us Eurozone retail sales, German factory orders, Chinese price data, and the RBA and BoE policy meeting. There will be no major data releases next week in the US but we will get some sprinkles of minor data like non-manufacturing ISM and some factory order data. With the FOMC out of the way, the media blackout has ended and the market will be hit with plenty of Fed speakers. Trade talks are expected to progress this week, despite the WTO throwing a curveball, allowing China to impose $US 3.6 billion of tariffs on the US in a case regarding anti-dumping duties which began well before the trade war. Canada has a relatively heavy data week — We will be getting housing data and various other activity indicators. Following the Bank of Canada’s dovish hold, markets are now pricing in a 25 percent chance of a cut by the end of the year and will be watching the data closely. The Brexit plot will likely thicken as the current parliament will be dissolved on Wednesday, leading to 5 weeks of campaigning and no legislative work. The Bank of England will meet on Thursday and is expected to keep rates steady — the recent strength in the pound will tighten financial conditions but will unlikely influence the decision. Europe will report manufacturing data as well as retail sales.  We will also get an update on Germany through factory orders. The Reserve Bank of Australia will also be up this week and is largely expected to keep rates unchanged. Tiago Figueiredo