Standard Life Investments

Published Article

Investment Adviser - Global Strategy


Some commentators have recently suggested investors should put money back into the stock markets. The sell-off in the first half of 2011 was largely driven by concerns that the global economy would slow too quickly, even that the fabled ‘double dip’ might appear. On the back of some better than expected figures, forecasts are now being made that the global economy should recover into 2012. Does that call look correct, and if so what triggers should investors look out for?

Before discussing the business cycle in any detail, it is certainly necessary to accept that some key risks exist. While China hopes to be getting on top of its inflation pressures, which would allow it to begin to relax monetary policy, the government faces worries about food prices, local government debts and property bubbles which could force a change in tack. The debate in Washington about raising the debt ceiling will probably be settled in August, but bitter experience has demonstrated that Congress does not understand financial markets and can manufacture a crisis. Peripheral debt in Europe is an on-going saga, with the Eurozone packages expected to keep the situation under some semblance of control - but again politics are difficult to forecast. All or any of these could cause a sharp knock to business or household confidence - but let us assume for the time being that they do not.

Each month a series of business surveys, the Purchasing Manager Institute (PMI) reports, are issued in all the major economies. Aggregated together they provide a helpful real time indicator about the state of the world. The July figures were significant - in total, the series eased from 53.0 to 52.3; any figure above 50 denotes an expansion but this was the lowest level in two years and in line with modest global GDP growth.

Why the confidence then from some quarters? Firstly, the pace of the decline eased, secondly some reports surprised to the upside, notably in the USA where the ISM manufacturing survey jumped above 55. In addition, some of the latest falls can be attributed to Japan - production there slumped 15% in a single month after the earthquake. The recovery has already begun, output is half way back towards its previous peak, and other surveys point to further expansion ahead.

Investors need to consider two issues though, not only manufacturing supply but also household demand. Companies will not expand if final sales do not recover - indeed one of the coming dangers is that firms build up excess inventory and then need to retrench once again. What is the current situation and what are the prospects for consumption in coming months?

The answer is: mixed to poor across the major countries. A prime example of weak consumer spending would be the USA. Despite the best efforts of Obama’s fiscal package and Bernanke’s QE programme, consumer spending growth in Q1 was only half as brisk as in Q4 2010, and early indications are that it slowed still further into Q2 - currently running about 1-2% pa. Nor is the US alone. In the latest month German and French retail sales were, respectively, sharply down 4.5% and 1.0% from a year earlier, although admittedly the series are volatile. Even in China and Brazil, spending has slowed, albeit 17% and 9% a year, respectively, are figures that many Western economies can only dream of!

Looking forwards, where could we see some improvement? It is true that one headwind has eased - energy. In the US, for example, gasoline prices peaked about $4.00 per gallon and have fallen back to about $3.50-60. Mortgage rates in the US have also eased, from about 5% to about 4.5% for the classic 30 year loan. Such factors have to be set alongside other weak fundamentals however. Real disposable income growth is generally only modestly positive. Firms are hiring, but not yet enough to lead to an improvement in consumer confidence. This is no surprise against the backdrop of sluggish employment - manufacturing may be growing but it does not employ many people! US employment only grew 160,000 a month in Q1, only 90,000 a month in Q2 - in an economy with 130 million workers. Germany is a rare exception, as households benefit from the lowest unemployment rates for 20 years, but rates of 8% in the UK, 20% in Spain, give a more accurate flavour of the problem. Significantly households are generally uncomfortable with their financial outlook and not usually planning major purchases.

Indeed, one major purchase - cars - is a very good trigger for investors to monitor in coming months. The automobile industry ably summarises a number of the key issues facing the world economy - the longer term constraints on credit creation, the surge in demand from emerging market middle class households, the pressures from rising fuel costs, the benefits from various government incentive programmes, plus the recent disruption to supply chains from the tsunami and earthquake in Japan.

Global car sales picked up towards 70 million units at the end of last year (see chart). The most important regions by far are Asia, some 30 million sales, with China alone about 60% of the total, Europe next, about 15-16 million, and the USA with 13-14 million.

Looking into 2011, registrations are going sideways in Europe. Three countries will determine the global outcome therefore: Japan, the USA and China. In Japan, car sales slumped in March, but demand is re-appearing as insurance companies pay up and as households run down their savings. How far and how fast, will partly depend on the timing of further supplementary budgets to support the economy. One important area of weakness has been the USA - vehicle sales slumped to 9-10 million during the financial crisis, recovered to 13-14 million this spring but have fallen back again to 11.4 million in June. Part of this related to the major disruption facing Japanese firms - but there also appears to have been resistance by consumers to some big price increases. For example, Ford has raised prices three times this year, while incentives in the form of cheap credit have been scaled back too. Looking forwards, will the combination of lower gasoline prices and increased competition between manufacturers enable sales to rebound back to their previous highs by the autumn?

Fast growing emerging market demand for cars has become a major feature of the industry. In China, sales surged in 2009-10, indeed overtaking the USA as the world’s single largest market. However, they fell back sharply in 2011. Beijing has removed most of its stimulus measures, including rebates for trading in older vehicles for more fuel efficient ones, while higher interest rates and other borrowing restrictions have borne down on some households. The key issue here is whether or not the government signals any new subsidies for energy efficient cars, or instructs the central bank to ease policy in coming months, if headline inflation is brought under control. June’s auto sales were a little better, albeit driven by heavy discounting.

To sum up, some of the conditions have fallen into place for the world economy to grow once again into 2012, although certain important headwinds and risks clearly remain in place. There are indications from business surveys that companies are gearing up for stronger production. A risk though is that this largely reflects a short term impetus related to reconstruction after the Japanese earthquake. In order to ensure a sustained recovery, there has to be further improvement in consumer spending. The fundamentals there are mixed at best. Monthly car sales, especially in Japan, the USA and China, will give a very good indication to investors about whether or not final demand is being seen, or whether after a pause a further downturn in business activity remains firmly on the cards. Investors should track such data closely when deciding whether to step back into the marketplace.

Andrew Milligan, Head of Global Strategy, Standard Life Investments