Stranger Things

Not much happened over the week. Certainty nothing strange, which is almost strange for the strange World we live in. Markets consolidated somewhat, with bond yields moving sideways and risky assets fading a bit after their strong post-Brexit run. Meanwhile, volatility remained very low with volatility metrics in both bond and equity markets hovering around their 2-year lows. The news flow from data and policy also did not inspire unexpected moves in markets, as little indication of a shift in the macro landscape was seen. Limited economic data came out, but those that were seen had a constructive undertone. Global data surprises remained firmly in positive territory and global earnings revisions have started to drift up.

Furthermore, the latest European data hinted that not only mainland Europe has been resilient post-Brexit (flash PMI’s, consumer confidence), but that even the UK itself might be less negatively impacted than initially feared. Retail sales and labour market (claimant count) data for July surprised to the upside. It remains too early to draw strong conclusions from the latter, as monthly data releases can easily be completely reversed (and more) by the following release and accompanying downward revisions. 

Still, from where we stand today, the post-Brexit reality looks better than anticipated late June.

One of the reasons for this more comfortable outlook might be stemming from the complex nature of our global economic system. Multiple factors are in a continuous interplay below the surface of the observed economic news flow. The interaction and mutual adaptation of households, corporates, policy makers, income and balance sheet dynamics, sentiment, hope, fear and popularity of certain economic themes (optimistic “Goldilocks” stories in the 1990’s, depressing “Secular Stagnation” visions now) in the end result in the emergence of our economic reality.

Signs of the upside-down world flipping back up
One of the persistent undercurrents in the strange macro environment of the last decade has been the under utilization of economic resources. It can be seen very clearly in Figure 1 about the evolution of the US output gap. While being far from the complete story, the under-utilization has prevented upward wage and price pressures from emerging and thereby contributed to the persistent down-drift in global inflation and interest rates. Also, it plays an important role in the investment outlook as it limits enthusiasm with companies to increase investments for as long as ample capacity is avail-able and the prospect of stronger (nominal) cash flows remains muted.

So, taking the recourse utilization picture into account, the upside-down world of falling capex, declining international trade and negative interest rates is less of a strange thing than it looks at first sight. Excess capacity takes away the need to invest, less investment reduces the need for manufacturing activity and trade and, the resulting, excess cash on balance sheets eventually flows into global bond markets (pushing down bond yields) if alternatives remain unattractive.

It also explains, however, that the market is sensitive to green shoots suggesting the world might be flipping back up again. For the first time in two years the US output gap has started to tighten again. Moreover, after multiple years of fading momentum in global trade, the EM region and commodity sectors, there have been signs of bottoming in this spectrum in the first half of the year. And although business investment numbers still look soft, industrial output started to show signs of life during the second quarter of the year (see Figure 2).

Stranger things have happened
Brexit news and its potential shock to the system got most attention of investors over the summer. However, it might well be that other parts of the system were also moving and gradually markets have come to realise that the underlying cyclical story is some-thing worthwhile paying attention to. If a less negative fallout from Brexit is now coinciding with more strength elsewhere in the economic system, investor confidence could well rise further going forward and risky assets could benefit from the support of rising growth prospects and a further strengthening of investor flows.

Admittedly, it is too early to have a very strong conviction on this scenario. Too often in recent years have there been disappointments and false starts in emerging markets, global trade and the manufacturing sector to already aggressively start betting on a turnaround in the composition of global growth dynamics. Still, both some of the macro trends mentioned above and the recent market behaviour hint at a higher probability of such an outcome than during the first months of the year. And who knows, just once everybody starts to be convinced that we are stuck forever in an upside-down world, we might finally escape it. Stranger things have happened.

Find out more about our views on the tactical asset allocation for this week, read the full article: click here. You can also follow me on Twitter: @ValentijnvN.