US macroeconomic data in the first quarter appears to be even softer than first estimated. Quarter-on-quarter growth was revised down to an annualized -0.7%, mainly because of a wider trade deficit, while the positive contribution from inventories was also revised up. These two items may well be linked by the port strikes that disrupted goods transportation. In this respect, the April trade data already show a normalization of the export and import data. Consumer spending remained close to its average rate over the past few years and capital expenditure was held down by the oil sector. Evidence suggests that the economy is poised to bounce out of the first-quarter pothole.
Euro peripheral spreads over Bund yields
The second estimate of GDP included an estimate of Gross Domestic Income (GDI). GDI is the sum of income received by different sectors, such as wages, profits, rental income and interest income, while GDP measures the sum of all expenditures — consumer spending, investment, government spending and net exports. In theory the two should be equal, but in practice they can differ, at least in the short run. In the first quarter, GDI grew by an annualized 1.8% quarter-on-quarter, which raises questions on the extent to which first-quarter GDP growth represents the true underlying situation.
Labour market evidence suggests a comeback
Additional evidence that suggests the economy is staging a comeback comes from the labour market. After the strong May payroll report, the three-month average gain now stands at 207,000 and the six-month average gain is at 218,000. These numbers suggest the corporate sector remains in the mood to expand. The unemployment rate ticked up by 0.1 percentage point but this was largely attributable to an increase in the participation rate. At 5.5%, the jobless rate remains within a half percentage point of the Fed’s equilibrium estimate.
Other evidence from the labour market also remains constructive. Hiring/quits rates remain on a moderate upward trend and are back at levels seen during the 2000’s boom. The trend in jobless claims remains consistent with monthly employment gains well above 200,000, and the employment component of the composite Purchasing Managers’ Index has risen somewhat again, maintaining a robust level. Finally, consumer assessment of the labour market in the Conference Board survey of consumers’ assessments of the job market – reflecting the difference in the number of respondents who think jobs are plentiful, and those who say jobs are hard to get — eased a bit but remains near the most positive levels since the crisis.
Consumer spending may be ready to bounce back
It should be only a matter of time before we see consumer spending rebound. Until April the momentum in retail sales remained very subdued but the May data as well as backward revisions now show a more positive picture, which suggests the consumer is waking up from a first-quarter hibernation. There is still a reservoir of wealth gains that have accumulated amid falling consumer debt levels
European markets start to care about Greece
In Europe, the current act of the Greek saga draws to a some sort of close at the end of June. Signs of contagion of the Greek drama to other parts of financial markets have only recently started to emerge. A combination of stronger firewalls and the amount of time remaining before the deadline kept markets relatively calm until recent weeks.
Some volatility was evident in the previous weeks, but that was more related to the sell-off in German Bunds and actually coincided with limited widening in peripheral spreads. The chart shows what has changed. For the first five months of the year volatility in the Greek bond market had little influence on the level of peripheral spreads, but since the beginning of June peripheral spreads have clearly started to push higher. Diminishing hope for an agreement was probably key. However, a proposal presented by Greek Prime Minister Alexis Tsipras before Monday’s summit may help break the impasse, EU officials said.
In our opinion the worst possible outcome would have a significantly smaller global impact than it would have been during most of the last five years, but it would still be very disruptive and trigger turmoil in financial markets for at least a couple of weeks. So, our faith in the resilience of underlying fundamentals globally notwithstanding, the Greece question weighs on our risk appetite in the near-term.
Also important for us is that technical and sentiment indicators are not yet sending contrarian buying signals. A modest rise in risk aversion has been visible, but no broad-based oversold conditions are present. The key questions are whether fundamentals are still on track, whether the Greek risk is rising and whether we have already entered into a market environment where risk aversion is creating attractive entry opportunities.
Shift in equities from Europe to US
Tactically, we decided to take some further chips from the risk-on table. Real estate was reduced from a small overweight to neutral on the back of near-term market turbulence, weak investment flows and momentum and a rising yield backdrop.
We reduced the overweight in Eurozone equities and added to US equities. Greece is of course a source of volatility and reason enough to become more cautious, but this is not our only motivation. Earnings momentum has deteriorated rapidly for Eurozone equities whereas in the US this indicator has stabilized.
Possible explanations for the earnings momentum slowdown in the euro region are the gains in the euro, which is 7% higher than its March lows, and in the price of crude oil, up 20% since mid-March. Interest rates may also play a role, with Eurozone investment grade corporate spreads up 60 basis points since the end of February. We still expect strong growth in Eurozone earnings in 2015 and in 2016, in contrast with the US, where we see little or no earnings growth in 2015 and about 5% in 2016. Another reason to reduce the gap between the Eurozone and the US is the convergence in economic surprise indicators.
Better US economic data will of course feed into rate expectations. In the past, higher policy rates did not stop a rising market. Lower valuation ratios were compensated by an improving earnings outlook. This time may be different. We do not expect a lot of US earnings growth, given the already elevated level of net profit margins (7.2%), a stronger USD and the lack of productivity growth. On top of this, the earnings cycle is in a much more advanced stage than in the Eurozone. US earnings are currently far above their long-term growth trend whereas Eurozone earnings are far below theirs. These medium- to longer-term considerations prevent us from being even more positive on US equities for the time being.