Interest rate cuts continue to support the global expansion
Some macro data has been sluggish of late. The latest US manufacturing ISM survey disappointed expectations and global trade volumes fell 0.4% in July from a year ago. Part of the slowdown can be traced back to ongoing US-China trade tensions, which have particularly affected the manufacturing and trade sector.
While the equity market rally has looked through this weak macro data, the US 10-year Treasury yield is trading close to all-time lows. That suggests the bond market takes a more sombre view of the investment outlook. If the bond market is to be believed, the risk of a slowdown in the global economy has increased, and that could potentially put downward pressure on equities.
Nevertheless, equity investors could argue that global interest rate cuts and low inflation are already reflected in subdued bond yields and that they have yet to work through to the economy. The Smith & Williamson World Interest rate Indicator (WII), which is constructed to track shifts in interest rates by some of the world’s largest central banks, concurs with this view. The WII shows that 62% of central banks are cutting interest rates. Given the relationship between the WII and the global manufacturing sector, there could be a recovery in global growth, which would sustain the equity rally — see market highlights page opposite.
Consumer demand remains resilient
As a cross-check, we see evidence that falling rates, led by the Federal Reserve, are filtering through to final demand. For instance, lower rates in the US has led to a notable pick-up in mortgage purchase applications, which are typically a lead indicator for housing market activity. Indeed, August housing starts rose at their fastest pace since mid-2007. Moreover, increased construction will have ripple effects that bolsters private demand: think of refurbishments and greater spending for the latest electronic gadgets as buyers move into new homes.
Aside from interest rates, consumption is supported by buoyant labour markets and improving wage growth. Despite ongoing uncertainty from Brexit and a potential general election before Christmas, the UK unemployment rate fell to its lowest rate for 50 years, and hourly earnings rose by more than 4% from a year ago, the first time that has happened since June 2008. Encouragingly, there are currently 812,000 job vacancies, suggesting plenty of hiring opportunities are being generated by the economy. Even in hard-pressed Germany, the unemployment rate has trended down to its lowest level since reunification in 1990. This combination of employment and wage gains lifts labour income and spending.
Rising wealth provides another layer of support for the consumer. US household assets have been boosted by rising stock, bond and property prices, while liabilities have declined as a share of disposable income. Rising assets and falling liabilities has lifted US household net wealth to nearly seven times annual take-home disposable income, close to a record high. Putting together financial resources available to consumers from wealth gains, take-home pay (wages after tax is deducted) and consumer credit, we have calculated a measure of real consumer purchasing power. From our estimates, US real consumer purchasing power is running at an annual rate of 4.5%, higher than current personal consumption growth of 2.6%. Not only does this metric suggest that consumers have the financial wherewithal to maintain their rate of expenditure, but it also points to upside in growth, provided shoppers remain confident enough to spend, rather than save.
In summary, while the bond market appears to project a sharp economic slowdown and geopolitical risks remain high, central bank interest rate cuts and consumer purchasing power continue to support the global economic expansion.
Financial sector risk from Eurozone and Japan
In September, the ECB restarted its asset purchases program of government (and corporate) bonds and reduced its key deposit rate to -0.5% from -0.4% previously. One of the unintended consequences of asset purchases of government securities (quantitative easing) and interest rate cuts is that around a third of outstanding global fixed income now trades with a negative yield to maturity. As we pointed out in last month’s investment outlook the bulk of this negative yielding debt is in the Eurozone and Japan.
The risk for investors is that negative rates can hinder economic performance. European banks are struggling to raise their profitability when lending at long-term rates offers a lower return than short-term rates. Given that banks seem unable or unwilling to pass on negative interest costs to retail depositors, this has squeezed net interest margins and has weighed down on the overall financial sector. Other Eurozone financials are likely to struggle in a low yield environment. Insurance companies and pension providers are finding it difficult to match assets with liabilities in a profitable way, as purchasing a negative yielding bond locks in a guaranteed at maturity loss. Looking forward, headwinds for financial and global stocks over the coming quarters from negative yielding debt could well intensify and is a risk we continue