3rd Quarter 2016
Content: Switzerland, Eurozone, USA, Overview of Purchasing Managers’ Indices worldwide
In the second quarter, growth accelerated to a strong 2.0%. Positive impulses came from foreign trade as well as from government spending. However, consumer spending by private households stagnated. Construction and capital investment fell slightly. On the production side, growth was broad-based. The Swiss industrial PMI hinted at the acceleration in growth that took place in the second quarter. It has been in the growth zone since December 2015 and rose in May to 55.8%. However in June, a trend reversal began and the index returned to the growth threshold. Thus, the growth in industrial production virtually came to a halt in the third quarter. A look at the subcomponents reveals that, although manufacturing is still brisk at the moment, the order books are not really filling up. Staffing levels are also being further reduced. However, leading indicators, such as the KOF Barometer and the ZEW Indicator, continue to point to an average growth rate of 1.5% up to mid-2017, which roughly corresponds to the trend growth rate of the Swiss economy. This assessment is supported by the current SECO forecast, which estimates a growth rate for 2016 and 2017 of 1.5% and 1.8% respectively.
In the second quarter, GDP growth year-on-year stabilised at 1.6%. Leading indicators currently show that the upturn in the eurozone has lost some of its impetus. Both consumer confidence and the Economic Sentiment Index fell up to the end of August, but recovered slightly in September. The Purchasing Managers’ Index rose in September to 52.6 points and is still well in the growth zone. A growth rate of around 1.5% is expected for the full year 2016. The generally low level of capacity utilisation and the continuing high unemployment rate of 10.1%, which has not decreased in the last four months, is preventing any inflationary pressures from arising in the eurozone. In August, core inflation fell to 0.8%, where it also remained in September, having been stable at 0.9% in the previous months. The rate of inflation including energy and food prices will rise sharply in the coming months due to the oil-price induced base effect and is expected to reach a level of around 1.5% in early 2017.
In the second quarter, the US economy grew by an annualised rate of 1.4% over the previous quarter, having grown by 0.8% in the first quarter. The fact that any positive growth was achieved is mainly due to higher consumer spending. On the other hand, the lower level of investment activity in both the private and public sectors had a negative impact. Since early 2015, the annual growth rate has declined steadily from around three percent and was only slightly above one percent in the second quarter of 2016. Current leading indicators initially pointed to growth of around 3% in the third quarter. The Purchasing Managers’ Index calculated by the data provider Markit rose significantly after a sharp decline and consumer confidence also remained at a very high level, which should support consumption. However, following the publication of the ISM Purchasing Managers’ Index, which tracks the mood in the US service sector, this economic optimism must be called into question. The indicator fell in August to its lowest level in six years, the mood in US industry already having deteriorated significantly in August.
Assuming that the annual economic growth stabilises at the current growth rate of 1.3% during the rest of 2016, this would result in a growth rate for the full year of only 1.3%, compared to 2.6% in 2015. The US labour market continues to show signs of positive development. Thus, around 200,000 new jobs were created each month in July and August. The unemployment rate remains unchanged at 4.9% - a value which, according to estimates, is close to full employment. The shortage in the labour market is gradually having an impact on wages: Annual wage inflation has accelerated to around 2.5% during the current year. Core inflation has also risen and now stands at 2.3%.
Chart 5 shows the development of the PMIs since September 2015 for selected economies that together make up a large part of total world production. The Purchasing Managers’ Index (PMI) is a highly respected and promptly available indicator of economic activity. The indicator is based on a survey of purchasing managers regarding production, the order backlog and other key metrics. Information is provided on whether the subcomponent improved, deteriorated, or if there was no change compared to the previous month. If 25% of respondents indicate an improvement, 25% a deterioration and 50% no change, the index stands at 50 points. If it is above 50, the economy is expanding, and if it is below, it is shrinking. In the USA, after a slight cooling, growth appears to have stabilised at a low level in the second quarter of 2016. In the eurozone, the PMI was also in the blue region for the entire period. However, there are significant differences between Member States. According to the PMI, France is one of the few countries whose industrial sector is shrinking. Italy's economy has also lost considerable momentum in recent months. In Germany, on the other hand, the PMI has increased for the most part since the first quarter. Economic divergence appears to be increasing again in the eurozone.
Content: Switzerland, Europe, USA
In the wake of the uncertainty caused by Brexit, 10-year Swiss government bonds reached a new low of -0.63% in early July (Chart 10). After the first shock was digested, the yield increased to -0.35% up to mid-September due to decreasing risk aversion. At the end of September, volatility picked up again and the yield fell back down to -0.58% at the end of the quarter. The Swiss National Bank (SNB) is sticking to its monetary policy despite growing criticism of its record low negative interest rates. The target range for the three-month Libor remains unchanged at -1.25% to - 0.25%. The negative interest rate on sight deposits remains at -0.75%. The SNB received praise from economists at the International Monetary Fund, which welcome the current interest rate policy. According to the IMF, the monetary policy has helped to reduce the threat of deflation.
10-year German Federal bonds reached a new all-time low of -0.19% in early July. From there they recovered slightly, with yields moving back into positive territory in September before dropping to -0.12% at the end of September. After the yield on 10-year Spanish government bonds dropped back below the return of their Italian counterparts in the second quarter for the first time in quite a while, this advantage was further extended in the third quarter (Chart 7). At quarter-end, 10-year Spanish bonds were quoted at 0.88% while Italian government bonds yielded 1.19%.
The European Central Bank (ECB) is not intensifying its stance for the time being in spite of persistently low inflation. At its meeting in September, the ECB’s Governing Council left interest rates as they were. However, many market participants expect an extension of the bond-buying programme beyond March 2017 and an easing of purchasing restrictions. With regard to inflation, the corporate bond-buying programme launched in June has so far demonstrated only limited success. However, it has led to declining yields on corporate bonds and high issuance (Chart 8).
10-year US Treasuries initially recorded a new record low of 1.37% in the third quarter, subsequently recovering to 1.73%. After the Federal Reserve again decided against raising interest rates at the end of September, the yield fell back down to 1.59% up to the end of the quarter (Chart 10). The decision not to hike rates is due to both the disappointing GDP growth rate and the labour market data published in September, which came in below expectations. Provided the economic situation does not deteriorate significantly due to uncertainty in the USA linked to the presidential election, a rate hike is considered likely in December.
The EUR/CHF exchange rate moved within a narrow band between 1.081 and 1.093 up to mid-August, before a new trend was established which resulted in a devaluation of the Swiss franc down to 1.096 against the euro. The CHF appreciated again in the run-up to the meeting of the US Federal Open Market Committee, which was awaited with uncertainty. After dipping to 1.084, the EUR/CHF ended the third quarter at 1.091. The British pound stabilised at 1.30 after a slight recovery, before dropping back to around CHF 1.25 up to mid-August. After another recovery attempt, the GBP/CHF exchange rate closed the quarter at 1.26. The ongoing weakness of the British pound is mainly due to the UK's enormous foreign trade deficit, which has been financed in the past mainly by foreign direct investment, which could reduce long-term due to the Brexit. The forthcoming, protracted political negotiations with an unknown outcome are also scaring off foreign investors. One US dollar cost 0.97 Swiss francs at the end of the third quarter, 2.8% less than at the start of the year. The driver for this has been the hesitancy of the US Federal Reserve, which repeatedly postponed further key interest rate increases during the year and again held off from a rate hike in September.
In July the EuroStoxx50 and the SMI increased by 4.4% and 1.3% respectively. The S&P500 advanced by 3.6% to a new record high. Although it was assumed that the markets would recover after the Brexit shock, the strength of the recovery rally surprised the majority of market observers. The reasons for the strong performance were surprisingly good US economic data and hopes of a good earnings season. Added to this was the expectation among investors that the monetary policy of the major central banks would continue to be very expansionary and that the likelihood of further easing was high. In Japan, there were rumours that the central bank was planning on giving the sluggish economy a boost by providing “helicopter money”. The Bank of England did not reduce its key interest rate after the Brexit decision, but held out the prospect of a rate cut in August. The ECB continued its QE programme and the US Federal Reserve continued to hold off the next rate hike.
In August and until the US Fed meeting at the end of September, share prices moved mainly sideways. The EuroStoxx50 and the S&P500 fell by 0.9% and 1.6% respectively, while the SMI advanced by 1.4%. Immediately before the US interest rate decision on 20 September 2016, the likelihood of a key rate increase was 15% based on the prices of futures contracts. When the increase was postponed again, the stock markets benefited. The EuroStoxx50 and S&P500 each increased by 1.3% up to the end of September, while the SMI fell by 1.2%. From a quarterly perspective, the EuroStoxx50, SMI and S&P500 ended up by 4.8%, 1.5% and 3.3%.
Chart 14 shows the development of various country indices since the beginning of the year (dark blue diamonds). Here, performance is broken down into its two main components: Corporate earnings growth (light blue bars) and the change in valuation (yellow bars). Thus, Italian shares have lost 24% of their value since the beginning of the year, of which approximately 4% was due to an expected fall in corporate profits while the remaining 20% resulted from a contraction in valuation. On the other hand, the Brazilian stock market has achieved a phenomenal return of 60% since the start of 2016. However, only about half of the performance is the result of an increase in profits. The remaining 30 percentage points correspond to an expansion in valuation. The Swiss stock market lost about 7% of its value during the year. The expected corporate profits decreased by 10% and the valuation increased by 4%.
The price of oil closed the third quarter virtually unchanged at 49 US dollars a barrel. However, the range of variation was quite high. Thus, the price dropped to 42 US dollars in early August, rose to 51 dollars up to 18 August, then fell to around 45 dollars and, after the surprise announcement by OPEC on 29 September 2016 that it wanted to restrict oil production, jumped by around 6% to almost USD 50 a barrel. The price of gold remained in a range between USD 1,310 and USD 1,365 in the third quarter and ended the quarter virtually unchanged at a price of USD 1,318 per troy ounce. Due to slightly better economic data from China, industrial metals increased in price slightly in the third quarter. On the other hand, the price of agricultural commodities dropped during the period (see Chart 16).
Content: Shares, Bonds, Currencies
The likelihood of an increase in the US key interest rate in November is currently 17% based on the prices of the corresponding futures contracts. If the increase is postponed again, stock markets would probably benefit. In the event of a surprise increase, there could be a short-term correction, but this would be used by investors as a good buying opportunity. Thus, the latest edition of the BoAML Fund Manager Survey shows that cash is heavily overweighted in the portfolios of institutional investors. At the same time, there is an underweight in equities and the majority of respondents indicate that they believe the valuation of US stocks in particular is too high.
It is expected that the Fed will raise the key interest rate in December, a year after the first increase since mid-2006. A decisive factor in terms of the reaction of the stock market will be the central bank forecast for the future key interest rate trajectory. A flat progression with gradual interest rate hikes, ending in a relatively low interest rate, would not trigger financial turmoil. A current potential risk factor is the US election campaign. The neck-and-neck race between Clinton and Trump is significantly increasing political uncertainty.
At the current yield level, an investment in Swiss or German government bonds is extremely risky. Even a small rise in interest rates would lead to high market value losses. Investors are hardly compensated for duration, especially taking into account the risk of a longer-term commitment. Since the yield on US bonds is attractive in direct comparison, investors will probably continue to put money into this market segment, which is likely to prevent a sharp rise in interest rates at the long end of the US yield curve for the time being, despite rising inflation. However, the additional return generated on an investment in US Treasuries after currency hedging has fallen sharply in the current year from the perspective of a Swiss investor. As a result, the credit spreads on US corporate bonds are likely to continue to decline (Chart 19). Even emerging market bonds can be classed as relatively attractive in the current environment.
In the medium term, the US dollar is likely to gain in value due to the upcoming increases in the key interest rate. In addition, foreign investors will have to release part of their currency hedging in 2017 at the latest in order to also be able to generate a positive excess return net of hedging costs, which is likely to provide the US dollar with an additional boost. The British pound is likely to remain weak for the time being due to the current uncertainty surrounding Brexit.
Bloomberg Finance L.P., BIS, FRED, Eurostat, OECD, IMF, SNB, EZB, FED, KOF, SECO, editorial deadline: 30.09.2016
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