Cumberland Advisors Market Commentary – Draghi Signals “You Go First” to the Fed While Johnson Threatens

The European Central Bank (ECB) did not reduce key interest rates at its July meeting ending last week, contrary to the expectations of some observers. This decision leaves the US central bank, the Federal Reserve, to take the lead with a widely forecast rate cut at its meeting this week.

Cumberland Advisors Market Commentary by Bill Witherell, Ph.D.

However, ECB president Mario Draghi did strongly suggest that new monetary stimulus is likely to be adopted at the September meeting of the ECB’s governing council. This stimulus will probably include both rate cuts and new quantitative easing measures. Notably, the governing council stated that it expected rates to remain at their present or lower levels at least through the next twelve months. Draghi indicated that the European economy does not appear to be headed for a recession, although the outlook for the trade-dependent manufacturing sector has become “worse and worse.” He emphasized his concerns about inflation expectations, which now are close to an all-time low. The ECB does not want to see inflation expectations become entrenched at current levels.

The expected monetary stimulus looks timely in view of the latest data on the state of the European economy. The Flash Eurozone PMI for July indicates a relapse in the economy over the course of the month, giving up the gains of May and June. A downturn in manufacturing is the culprit, with production experiencing the steepest fall since April 2013. European trade is being hit hard by the US-China trade dispute as exports to China have suffered. Brexit concerns, serious weakness in the auto sector, and slowing world trade are also factors. A resilient service sector and healthy private consumption facilitated by lower unemployment and higher wages continue to support the subdued forward momentum of the economy.

An important uncertainty affecting prospects for the European economy, cited by Draghi, is the outcome of the United Kingdom’s efforts to withdraw from membership in the European Union. Last week the new British prime minister chosen by the Conservative Party, Boris Johnson, made clear in his opening statements that the party has become a Brexit party, with no room for those who wish to remain in the EU. He also made clear that he intends to confront the EU and showed no willingness to compromise. He has stated to the EU officials that unless the EU is willing to compromise – in particular, to abolish the “backstop” which is the part of the deal agreed by the previous British government that is designed to prevent a hard border with Ireland – the UK will be leaving the EU on October 31 without a deal. The EU immediately responded that it will not reopen the withdrawal agreement, emphasizing that abolishing the backstop would be “impossible.”

By downplaying the likely harm to the UK economy that would follow, Johnson is seeking to demonstrate that he is very willing to see the United Kingdom go through a no-deal Brexit. He has filled his government with Brexit true believers and is starting a campaign directed at advising companies how to adjust to a no-deal Brexit. He has made clear that under a no-deal Brexit he will keep the 39 billion pounds that the previous government had agreed to pay the EU. Of course, all this may prove to be negotiation bluster by the populist leader, who is viewed by many as a British Trump; and a deal may eventually be struck. But Johnson does seem to be painting himself and Britain into a corner. He still faces the problem that Parliament is strongly against a no-deal Brexit, and the government has a very thin majority. While a no-deal exit is looking increasingly likely, an early election, possibly before October 31, is also possible. The Liberal Democrats clearly support remaining in the EU, and the Labour party appears to be moving in that direction.

Despite Johnson’s assurances to the contrary, a no-deal exit would be, in the words of the IMF, one of the greatest threats to the world economy, along with further US-China tariffs and US car tariffs. These threats, should any of them occur, would “… sap confidence, weaken investment, dislocate local supply chains and severely slow global growth.” There would also be a risk of “financial vulnerabilities.”

The UK economy is not in good shape to deal with the likely shock. In June, the UK manufacturing PMI was at a 76-month low. Business optimism fell to its third-lowest level in the series history, weighted heavily by Brexit-related uncertainty and disruption. Capital spending plans are on hold because of Brexit uncertainty. The critical financial services sector is already losing jobs. Even if business is helped by increased government stimulus to offset somewhat the impact of a no-deal Brexit, the UK would likely suffer long-term damage to its reputation and security. And it would still have to negotiate a trade agreement with its largest trading partner, the EU.

Sources: The Financial Times, the Wall Street Journal, HIS Markit, CNBC

Bill Witherell, Ph.D.
Chief Global Economist & Portfolio Manager
Email | Bio


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European Growth Concerns Deepen

The latest economic indicators reveal that the economic slowdown in Europe persists. President Draghi of the European Central Bank (ECB) has underlined the continued weakness, expectations for softer near-term growth, and downside risks. The International Monetary Fund (IMF) has lowered its economic projections for the euro area. Political uncertainties in Europe add to the headwinds affecting investor sentiment.

 Cumberland Advisors Market Commentary by Bill Witherell, Ph.D.

The HIS Markit Flash Euro Area Composite Purchasing Managers’ Index (PMI) , which combines manufacturing and service sector data, fell to 50.7 for January, following a reading of 51.7 in December. The January mark was significantly weaker than the consensus expectation of 51.4. The moderation in the euro area’s economic growth, which began a year ago, is continuing in the first quarter of 2019.

The Flash Composite PMI for France fell unexpectedly to 47.9 because a sharp drop in the services component more than offset a pick-up in the manufacturing component. Conversely, the Flash Composite PMI for Germany recovered slightly to 52.1, following a 66-month low of 51.6 in December. A further decline in the manufacturing component was offset by a stronger performance in the services sector. Adding in the other euro area economies, we observe overall declines in both manufacturing and services PMIs for the region. Manufacturing new orders as well as services incoming new business fell in January.

The IMF, in the quarterly update of its World Economic Outlook, lowered its projection of economic growth in the euro area to 1.6% in 2019. Last fall, their projection was for 1.9% growth. They continue to expect 1.7% growth in 2020. Subdued external demand due to a projected global growth slowdown is one reason for this weaker outlook for the euro area, particularly for Germany. The IMF cites some country-specific factors affecting the near-term outlook: revised auto emission standards in Germany, weak domestic demand and higher borrowing costs in Italy, and demonstrations and strikes in France.

The ECB Governing Council at its January meeting also warned that near-term growth prospects have softened. While markets will have to wait until the Bank’s March meeting for new economic projections, the risk assessment guidance has “moved to the downside.” Mario Draghi, ECB president, said, “We were unanimous about acknowledging the weaker momentum and changing the balance of risk for growth.” The Governing Council cited the continuing uncertainties of Brexit and trade disputes as important downside risks for the region. While the ECB did not announce any change in policy, market expectations for a rate increase later in the year have weakened. On the other hand, a new round of long-term refinancing operations (TLTROs) is looking more likely.

Euro area equity markets have joined in the global equity market recovery in January but are down significantly over the past 12 months. The iShares MSCI Eurozone ETF, EZU, is up 6.0% year-to-date January 25 but is still down 20.5% over the last 12 months. Similarly, the iShares MSCI Germany ETF, EWG, is up 6.3% year-to-date but down 23.7% over the past 12 months. The iShares MSCI France ETF, EWQ, is up 4.1% year-to-date and down 17.2% over the past 12 months. In these and the other euro area markets, the moderation in the euro area’s economic growth appears to be largely priced in. Also, several of the negative factors are likely to prove transitory, including the new emission standards in Germany and the demonstrations in France. While the uncertainties relating to Brexit remain high, the tail risk of a hard or no-deal break of the UK from Europe appears to have been substantially reduced. Positive developments with respect to Brexit and/or an easing of trade disputes with the US would certainly be welcomed by investors. We remain cautious with respect to the euro area in our International and Global portfolios, monitoring developments closely.

William Witherell, Ph.D.
Chief Global Economist
Email | Bio


Sources: Financial Times, Markit Economics, International Monetary Fund, Goldman Sachs Research, BBH Global Currency Strategy


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The Global Economy Moderation & International Equity Markets

As 2018 draws to a close, economic growth in almost all economies, including that of the US, is moderating but is still expansionary and in most cases remains above long-term trends.

Market Commentary - Cumberland Advisors - The Global Economy Moderation and International Equity Markets 

For the year 2018 as a whole, global growth looks likely to be the same as for 2017, 3.7%, with advanced economies advancing at a 2.4% pace and emerging markets at a robust 5% pace. The recent moderation in growth appears likely to continue into 2019, but with annual rates for the year remaining very close to those for the current year. This outcome would be far better than the recession some are predicting. Downside risks, however, are growing.

Global equity markets, particularly those outside the United States, have significantly undershot these relatively benign economic prospects due to heightened uncertainty about a deepening trade war, slower growth in China, the Brexit negotiations in Europe and tighter global liquidity with higher interest rates as central banks around the globe, with the exception of the Bank of Japan are normalizing monetary policy (“withdrawing the punch bowl”). These uncertainties, together with leading indicators signaling slowing economic momentum, have undermined risk appetites, driving almost all international equity markets to painful losses for the year to date. Another factor was the generally elevated valuations at the beginning of the year.

The iShares All Country ex US ETF, ACWX, is down 15.6% year to date December 17th on a total return basis. Eurozone markets, as measured by the iShares MSCI Eurozone ETF, EZU, have lost 18.1%, with the iShares MSCI Germany ETF, EWG, down 23.1%; iShares MSCI France ETF, EWQ, down 14.7%; and iShares MSCI Italy ETF, EWI, down 19.9%. Elsewhere in Europe, the iShares MSCI United Kingdom ETF, EWU, has lost 18.5%; and the iShares MSCI Sweden ETF, EWD, is down a similar 17.5%. Advanced markets in Asia fared better this year. The iShares MSCI Japan ETF, EWJ, is down just 13%, perhaps in part because Japan’s expansionary monetary policy is being maintained. Also, the iShares MSCI Hong Kong ETF, EWH, has outperformed, with a loss of just 10.3%. Similarly, the iShares Taiwan ETF, EWT, is down 13.4%.

As is the case with advanced markets, emerging markets as a group are down some 17.5% year to date, as measured by the iShares MCSI Emerging Market ETF, EEM. Here also there are significant differences among the individual national markets. The economic slowdown in China, due in part to trade difficulties vis-à-vis the US and more importantly to the ongoing domestic credit crunch, is affecting other emerging-market economies. China’s equity market, as measured by the iShares MSCI China ETF, MCHI, fell 18.8%. The iShares MSCI Korea capped ETF, EWY, has lost 22.3%, while the iShares MSCI Indonesia ETF, EIDO, has performed better, losing 13.9%. In Latin America, the iShares MSCI Mexico capped ETF, EWW, has dropped 20%, while the iShares Brazil capped ETF, EWZ, has recovered from a steep fall to end up down only 5.2%.

Looking forward, while the base case economic outlook is for only a modest further slowdown in global growth, the important uncertainties present downside risks that will continue to affect market sentiment. In particular, failure of the US and China to lower trade tensions would have significant negative market and economic effects, as would a failure in UK-EU Brexit negotiations that results in the UK exiting the EU without a deal. The eventual outcome of US negotiations with North Korea is another important unknown. And investors will likely remain concerned about the possibility of a sharper economic slowdown, in particular one coming from slower growth in China. They also are seeking a clearer view of the likely pace of further monetary policy tightening by the Federal Reserve and by the European Central Bank. A positive factor is that the year will start with equity asset valuations that are more attractive than they were last January, due to a combination of price declines and positive earnings growth. Also markets are heavily oversold. If the major downside risks do not materialize, the outlook next year is for modest positive risk-adjusted returns. Close monitoring of developments and selectivity among markets will be desirable.

William Witherell, Ph.D.
Chief Global Economist
Email | Bio


Sources: Goldman Sachs Economic Research, Barclays, Financial Times, IMF, CNBC


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Italy Update: Still a Concern for Investors

The Italian drama continues, with the European bond markets demonstrating great resilience despite the risks presented by the Italian government’s proposed fiscal policy stance, which has been rejected by the European Commission (EC). Earlier, after receiving Italy’s draft budget, the EC had asked Italy to explain why the government decided not to comply with European Union rules and the agreed government deficit targets for the years 2019–2021. The Draft Budgetary Plan calls for increasing the deficit to 2.4% of GDP in 2019 from 1.8% this year. Italy responded that it is unwilling to modify its draft budget. This stance led the EC, in an unprecedented move, to formally reject the Italian budget and request the government to submit within three weeks a revised budget that complies with European Union fiscal rules.

Cumberland Advisors Market Commentary - Bill Witherell, Ph.D.

The EC will then have to decide what to do about Italy’s response (or lack of response) by the end of November. If Italy fails to take decisive steps to bring its budget within or at least closer to EU rules, the EC could begin the process leading to the opening of an Excessive Deficit Procedure, which could result in significant fines. The scene is set for an extended period of tension between the Italian government and Brussels. Italy appears determined to stick to its budget plan as long as market pressures remain within tolerable limits, which has been the case thus far. Resisting EC demands is popular domestically, but the Italian government appears to be keeping a lid on rhetoric in an effort not to stoke market concerns. The EC similarly wishes to avoid increasing tensions, with the economic commissioner, Pierre Moscovici, stressing that he wishes to “maintain a constructive dialogue” with Italy.

Italian financial markets obtained some relief through credit rating agency actions in October. First, on October 19, Moody’s downgraded Italy’s sovereign debt to Baa3 with a stable rating outlook, the lowest investment-grade rating. A week later Standard and Poor’s left Italy’s rating at BBB, two notches above its sub-investment (junk) category, and lowering its outlook to negative from stable. The market’s relief was due to concerns that the ratings decisions could well have been worse. Maintenance of investment-grade ratings is important for portfolio managers. The 10-year Italian government bond yield eased to 3.33% Monday, October 29, a one-week low; and the spread over the equivalent German Bund eased to 299 basis points. The next day the rally reversed and the 10-year rate rose back to 3.45%. On October 19, the spread had reached 333 basis points, the highest since April 2013. The deputy prime minister has suggested that it would take a spread of at least 400 basis points for the government to rethink the budget.

One of the problems with the Italian budget plans is that the deficit outcome is likely to be even worse than the government projects, since the economic growth assumptions look unrealistic. While we expect Italy’s economy to expand no more than 1% in 2019, the budget assumes a growth rate of 1.5%, with the economy’s getting a significant boost from fiscal easing. Experience has shown that the impact of higher government spending and tax cuts is small for economies with already high debts. The Bank of Italy, Italy’s central bank, reported that the Italian economy has ground almost to a halt, advancing by just 0.1% in the third quarter. The annual rate of growth, y/y, for the third quarter was reported Tuesday to be only 0.8%, less than the expected 1.0% that was expected

On the other hand, there are some positive considerations that Moody’s cited as justification for a stable outlook for Italy’s sovereign debt. While the economy’s growth is slow, the economy is very large, the third largest in the Eurozone, and it is diversified. Italian household wealth is relatively high. Moreover, Italy has a substantial current account position, and its international investment position is nearly balanced. There is little doubt that Italy will be able to service its massive 2.3 trillion euro public debt as long as responsible economic policies are pursued. However, a further significant deterioration in the economy and the country’s fiscal condition, coupled with an unwillingness on the part of the government to take needed corrective fiscal measures, would increase debt-service costs and raise the risk of losing market access.

So far there have been only very limited signs of contagion to other European bond markets from the sell-off of Italian bonds. The overall situation of European sovereign borrowers is robust, with strong macroeconomic conditions and supportive European Central Bank policies. The main peripheral countries where spillovers might be most likely, Spain and Portugal, have stabilized their debt situations, and their economies are doing well. As we noted in our October 3 commentary, “Another Italian Drama – Why It Matters,” our most immediate concerns relate instead to the health of the Italian banks because of their large holdings of Italian government debt, some 378 billion euros. The Fitch credit rating agency noted that banks’ balance sheets are under pressure. Wider spreads on the bonds held by the banks would lead to capital erosion. Should any Italian banks need support, there are EC rules as to how that can be done. Of course, any negative effects on the supply of credit to the economy would be a downside risk for the economic outlook.

Italy’s stocks have been weak recently, but so have other European equities. The FTSE MLB (Milano Italia Borsa) Index did bounce up by 1.91% on Monday, October 29, following Italian relief that S&P kept its rating unchanged. Similarly, the iShares MSCI Italy capped ETF, EWI, which also includes the effects of changes in the US dollar-euro exchange rate, rose a bit, 0.44%, on Monday. The 30 day performance of EWI was a decline of 9.47%, and the three month loss was 15.18%.The Germany ETF, EWG, performed similarly over the past 30 days, dropping 9.48%, and declined 14.06% over the past three months. The broader iShares MSCI Eurozone ETF, EZU, is down 9.99% over the past 30 days and 13.13% over the past 30 months. While weakness in Italy’s bank stocks contributed to the decline in the Italian ETF, EWI, it is difficult to separate the effects of the situation in Italy from the broad market decline in Europe and indeed in the global market. We continue not to hold EWI in our International and Global Portfolios and remain underweight for the Eurozone.

William Witherell, Ph.D.
Chief Global Economist
Email | Bio


Sources: CNBC.com, Financial Times, Barclays Research, Reuters.com, Goldman Sachs Economic Research; Bloomberg


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Eurozone Economy’s Expansion Ongoing and Broad-Based, Downside Risks Worrying

The European Central Bank (ECB) left its monetary policy stance unchanged at its September 13 meeting. Net asset purchases will end in December, but with the Bank’s maintaining its stock of assets, the reinvestment of redemptions will maintain substantial stimulus. No increase in policy interest rates is signaled until at least after the end of next summer. Note that the main ECB refinancing rate is still zero.

Cumberland Advisors Market Commentary - Bill Witherell, Ph.D.

Attention, therefore, focused on the updates of the ECB staff’s macroeconomic forecasts as presented by ECB President Mario Draghi. The Bank’s assessment of the economy is upbeat, viewing the expansion as ongoing and broad-based. The economic growth projections reflected very small downward revisions. GDP growth for the current year is now forecast at 2.0% instead of 2.1%. Growth in 2019 is forecast to be 1.8%, also a reduction of 0.1% from the previous projection. The moderation from the 2.5% pace in 2017 is due mainly to a weakening of global trade, while domestic demand remains strong.

The Eurozone Purchasing Managers’ Index (PMI) for August continued to indicate a robust economy but one with a growing imbalance. Growth accelerated in the two largest economies, Germany and France, while Italy, the third largest, experienced a sharp growth slowdown, and Spain also looks weak. A disturbing development is that business confidence concerning future activity has declined to its lowest level in 23 months. For Italian and Spanish companies, expectations are at a five-year low. Global trade tensions and political uncertainties, including the difficult BREXIT negotiations and the battle in Italy over the budget, are undermining confidence.

The positive factors cited by Draghi as underlying the ECB’s upbeat analysis related to the underlying strength of the domestic economies in the region. These factors include the continuing monetary stimulus, record-low interest rates, a more positive fiscal stance, and the strength of the labor market, with healthy employment growth and rising wages that are fueling consumer demand. Draghi argued that the strength of the economy balances the downside risks from global factors. He also offered assurances with respect to Italy, noting that the rise in Italy’s borrowing cost did not spread to other member states, and the cost has recently declined.

Downside risks to the outlook were underlined last Friday, September 21, by the release of the Flash Eurozone PMI for September. The drop in this statistic to a 4-month low, according to preliminary data, indicates that Eurozone manufacturing-sector business activity is growing in September at the second weakest rate since late 2016. The slowdown is said to be due to a stagnation of exports. New orders were the weakest since October 2016. Trade war concerns and reduced global demand, notably in the auto sector; increased risk aversion; and political uncertainties, both within the Eurozone and globally, were all cited as factors. On the positive side the service sector is continuing to experience buoyant growth and strong job gains. Also, despite the current slowdown, business optimism about future activity ticked up somewhat from the gloomy August levels.

Eurozone equities are recovering from declines earlier in the year and so far have been shrugging off the negative concerns cited above. The comprehensive iShares MSCI Eurozone ETF, EZU, while still down 3.2% year-to-date, is up 1.06% over the past three months and has gained 3.10% over the past five market days through September 21. The decline in the euro versus the US dollar earlier this year (still down 2.7% year-to-date) accounts for much of this performance for dollar-based investors. The equity market of the largest Eurozone economy, Germany, has been underperforming in the region but is finally getting a bid. The iShares MSCI Germany ETF, EWG, is still down slightly over the past three months, -0.23%, but is up 2.96% over the past five days. The French market has been outperforming most of its neighbors, with a positive year-to-date return for the iShares MSCI France ETF, EWQ, of 1.83% and a three-month return of 3.11%. The equity markets of Italy and Spain, despite the current concerns about their economies and political uncertainties, are performing strongly, with the iShares Italy ETF, EWI, rising 4.29% and the iShares Spain ETF, EWP, up 3.87% over the past five days. We are maintaining market-weight positions for the Eurozone in our International Portfolios.

Bill Witherell, Ph.D.
Chief Global Economist & Portfolio Manager
Email | Bio

Sources: European Central Bank, Financial Times, Goldman Sachs Economic Research, HIS Markit, CNBC, ETF.com


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