Global recovery but China deleveraging a drag further out

In Strategy: The global IP cycle is bottoming out, 6 November 2015, we argued that the global industrial production (IP) cycle is bottoming out and we are now seeing further signs of that. Our MacroScope models, which provide systematic macro signals, have turned more positive in November. First, the global signal strength has turned positive for the first time since April. Second, synchronicity has improved significantly as more models across regions have turned positive. Finally, the medium-term models, which provide the best signal for the change in growth momentum on a three-four month horizon have turned positive in the US, Europe and Japan (see Chart 2). The clearest signal is in Europe, where the latest data has shifted the medium-term model to a clear picture of positive momentum after sending somewhat mixed signals over the past two months.

Based on historical performance, this is supportive for risk assets, particularly equities and especially in Europe where the signal is most clear. In our view, this will be further supported by a very aggressive ECB on 3 December. Yes, market expectations are running high that the ECB will deliver but ECB board members this week have done nothing to dampen expectations of aggressive easing, which is exactly the reason to believe that they will be very aggressive. For euro yields, we see the current environment as broadly neutral with ECB easing being counterweighed by higher US yields and a turn higher in the global IP cycle. 

In the midst of a global cyclical recovery and a stabilisation in China, challenges for global growth over the medium term remain, with the industrial/investment cycle in China in a structural decline. China has experienced more than 30 years of investment boom with investment to GDP reaching close to 50% at its peak. Meanwhile, total leverage (government, household and corporate) rose to around 225% in 2013 from around 165% in 2008 and there are no signs that the tide has turned yet. The build-up in leverage since 2008 came in the aftermath of the significant fiscal and credit stimulus in late 2008 and early 2009. In coming years, China will have to deleverage exactly as the west has been forced to do since the global financial crisis. This, combined with the much overdue rebalancing of its economy from investment- to consumption-driven growth, will drive a consistent slowdown in the Chinese economy over the medium term. This will be a major drag on the global economy in coming years and will have important implications for investment returns over the medium term.

Several clients have asked us how the USD and EUR/USD will trade into and after the ECB and Fed meetings in December. In Chart 3 , we show the USD performance through the DXY Index and against the EUR over the last Fed rate hiking cycles in 1994, 1998 and 2004. We note that the USD tends to strengthen in the three months prior to the start of the Fed hiking cycle while weakening thereafter. Then some clients are arguing that this time is different as the Fed is tightening exactly at the same time as the ECB will ease. However, the 1994 Fed rate hiking cycle was accompanied by a Bundesbank easing cycle. Again, this time may of course be different due to other reasons but it does make a point. And the DXY index has already rallied 3.87% since 16 September (three months prior to the expected Fed hike) and the euro has fallen 5.1% over the same period. We expect one final leg of USD strength, EUR weakness over the coming one-three months but we have come a very long way and the mediumterm outlook is for a higher EUR/USD. CNY has been stable since China changed its fixing methodology and weakened the CNY in August. However, with the IMF’s Managing Director Christine Langarde’s statement on 13 November that she supports the staff’s finding that the Renminbi (RMB) should be included in the Special Drawing Rights (SDR) alongside USD, EUR, GBP and JPY, we expect that the Chinese authorities will allow gradual CNY depreciation. 

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