JUST when you thought the market narrative was set for the year, the mood seems to change. We were in a “risk on” mode, with equity markets rising and bond markets falling, based on the idea that the economy was looking rather better than feared and that the Europeans had averted complete disaster with the Greek deal.
But that story was already looking shaky when today, the Chinese PMI came in at a disappointing 48.1, the European composite PMI fell to 48.7 and the UK’s retail sales dropped 0.8% in February. Fortunately, both the US initial jobless claims and the leading indicators were positive, so the mood is not all doom and gloom.
One snowflake does not a winter make. Clearly the European economy is weak but the ECB’s liquidity injection into the banks in December (and its earlier rate cuts) will have an effect in time. In China, there is plenty of scope for policy easing, since the authorities raised bank reserve requirements many times in an attempt to slow the property boom. But the China bears are sounding rather more confident; read Edward Chancellor’s piece in the FT today.
David Rosenberg of Gluskin Sheff is an avid chronicler of bearish developments. In his latest note, he points to a 20.3% fall in US mortgage refinancings over the last five weeks (a consequence of that pick-up in bond yields) and the “sputtering” of the Korean Kospi stockmarket index, which is stuck at around the 2000 level. There is certainly logic in looking at other Asian markets as a guide to China’s health (where the growth data are suspiciously steady) but the Kospi is up 11% so far this year.
A more robust case is advanced by James Montier of GMO. In a paper on the fund management group’s website, Mr Montier show with some nifty maths, that US corporate profit margins (at their highest in 60 years) are dependent on government spending. A fiscal surplus would count as government savings and government savings are a drag on profits.
Photo: GMO LLC
When the government dis-saves, of course, it spends more than it takes in. That spending either goes on goods and services (bought from the corporate sector) or is paid to workers or benefit recipients, and is then spent on goods and services. (Before you leap to comment. of course repeated deficits mean higher taxes later on, but that doesn’t affect profit margins now.) Profits are 10.2% of US GDP, and the deficit is 7.6%, so one can roughly (very roughly, as there are many offsetting factors) say that the deficit is responsible for three-quarters of profits.
As the government tries to unwind its deficit after the election, thus it seems natural that profit margins will revert to normal. That is why forecasts of further improvements in profit margins, on which the earnings predictions of many brokers depend, are so unlikely. This only reinforces the point made in last week’s issue that the likely return from equities, going forward, will be modest because of the low starting valuation. This won’t be the last equity wobble this year.