NO. 12 ∙ DECEMBER 2019
Are we facing a liquidity tsunami?
AUTHOR: Frank Borchers
Senior Portfolio Manager
Many market participants are still surprised at the rise in risk assets in recent weeks and months. The new highs in equities and falls in credit spreads do not quite fit the narrative of a flagging global economy. The main culprit in the weak growth is the manufacturing sector. This branch of industry has been hit particularly hard by the trade war between the U.S. and China and by the tariffs imposed during it. The consequences have been dwindling orders and a lower production capacity utilisation.
So, what is the explanation for the latest rise in risk assets? Are we seeing signs of recovery in the manufacturing sector? To determine this, we tend to look at leading indicators such as the purchasing managers’ indices (PMIs) to tell us the current sentiment in this industry. Readings of more than 50 signal economic expansion, while values of less than 50 indicate economic contraction. The large number of orange and light orange cells in Figure 1 is striking. The good news is that the downward trend in many economies has been halted for the time being. However, for the three biggest economies in the world – the U.S., China and the eurozone – we still see values below the growth mark of 50 points. That being said, in the case of the U.S. and the eurozone at least, there are signs of stabilisation at a low level versus the previous month.
Figure 1: Purchasing managers’ index for the manufacturing sector (calculated monthly)
Orange: deterioration below 50; Light orange: improvement below 50; Green: improvement above 50; Light green: deterioration above 50.
Germany remains bottom of the table by far in the eurozone at 42.1. This is due partly to the heavily export-oriented nature of the country’s industry and the weaker global economy as a result of the trade disputes, and partly to the Brexit uncertainty. For months now, the leading indicator for the biggest economy in the eurozone has been well below the growth mark of 50. One positive to note, however, is that the momentum of the German industry has not deteriorated further. This is backed up by the ifo Business Climate Index, with German firms’ expectations improving slightly of late. The French economy is the poster child within Europe. The PMI for the EU’s second-largest member state hardly went below 50 at all this year, climbing to 50.7 points in October. Italy – number three in the eurozone – is also showing signs of stabilisation. The country’s leading indicator changed marginally from 47.8 to 47.7 points. Only Spain recorded a further decline of almost one whole point. Its reading of 46.8 points for October is the lowest value since April 2013.
What goes down must come up at some point. We’re not quite there yet, but the leading indicators for the manufacturing sector have stabilised for the time being. While this could be the first sign of a bottoming out, we should keep a close eye on the PMIs to see whether a lasting recovery sets in. However, in our opinion this stabilisation does not justify such a high rise in risk assets.
On the positive side, there has been hardly any spillover effect from the manufacturing sector to the larger services sector. Should that happen, the probability of recession will increase significantly. We will also closely monitor this situation.
Looking at corporate profits isn’t much help in finding an explanation either because analysts’ consensus estimates for corporate profits have been successively revised downwards this year. The crucial factor seems more to be the change in central bank policy over the course of the year. Liquidity in capital markets has greatly increased thanks to numerous key rate cuts and the resumption of the ECB’s asset purchase programme.
The U.S. central bank, the Federal Reserve, made a U-turn in its money market policy: in the space of just 20 months up to the end of August 2019, around USD 700 billion was taken out of the market and the central bank’s balance sheet went from around USD 4.5 trillion to around USD 3.8 trillion (see Figure 2). The Fed resumed buying Treasury Bills in mid-October to the tune of around USD 60 billion a month to ease tensions in the money market. Even though the Fed insists that under no circumstances should this be taken for a Quantitative Easing (QE) programme, these purchases clearly do appear in the central bank balance sheet and indicate an expansion of the balance sheet (Figure 2). In addition, the Fed has made several cuts to the Fed Funds rate. After nine interest rate hikes between December 2015 and December 2018, this year there were three successive rate cuts from July to October in order to mitigate the potential negative effects of the trade war on the U.S. economy. The interest rate level is currently within the range of 1.50% to 1.75%.
Figure 2: Fed balance sheet
Figure 3: ECB balance sheet
On this side of the Atlantic, the ECB has also resumed providing the market with liquidity in the usual manner. Since the beginning of November it has been purchasing EUR 20 billion of sovereign and corporate bonds from the eurozone per month – and for an indefinite period at that! In addition, it is reinvesting the cash from maturing bonds in new securities. Through its last bond purchase programme, the ECB had already bought securities to the tune of EUR 2.6 trillion by the end of 2018. The central bank’s balance sheet then increased to almost EUR 4.7 trillion (see Figure 3). It will now expand successively once again due to the programme having restarted in November of this year. Since the key rate has been firmly fixed at 0% for some time now, banks can continue to obtain fresh money from the central banks at no cost.
In comparison with previous central bank liquidity programmes, these measures can hardly be described as a tsunami of liquidity, but are certainly a large wave of support. Central banks have already shown in the past that they are doing everything to ensure good (re)financing conditions for businesses, banks and governments as well, and to support the economy. That is very much still the case today. It is this very environment that is having such a positive effect on risk assets such as equities and credit spreads and explains how they have developed in recent months – even though the economic data does not reflect this. We are taking the fact that the leading indicators for the manufacturing sector are showing signs of a stabilisation at a low level globally as a first positive sign. However, in our opinion, what is much more significant is that the central banks have taken a distinct change in tack this year. This shows that they are prepared to do everything they can to kick-start the economy again. And that’s why they are supplying the markets with plenty of liquidity. For this reason, we at ETHENEA are confident of the positive medium-term performance of risk assets.