How quickly can things turn? Global PMIs showed some weakness last week. Indian services PMI dipped below 50 last week while China’s Caixin services index fell (albeit holding above 50) as did the US ISM non-manufacturing index. US factory orders contracted 1.4%. PMIs have rebounded strongly from the lows of 2016 and do not signal recession by any stretch of the imagination but it appears that the current phase may begin to lose some momentum. Industrial production fell in Germany, France, and Spain in January, by -0.1%mom, -2.0%mom, and -2.6%mom. In all cases, the data were well below consensus expectations. While the decline in German industrial production was mainly in energy, intermediate goods and construction, the Spanish and French decelerations were broad based and included all groups from consumer to capital goods. Fortunately, the picture in the US was stronger with a significantly stronger nonfarm payrolls number. Nonfarm payrolls rose 313k in February – 108k above consensus.
The ECB held rates and asset purchases constant bit dropped an explicit commitment to expand its bond buying program if the economy weakens signalling an end to its easing bias. This could be largely symbolic. EUR strength presents a problem for the ECB in that it is a de facto tightening which could make it hard for the ECB to slow asset purchases in September. EUR strength is itself at least partly built upon expectations that asset purchases would be slowed.
The BOJ kept its targets for short and long-term interest rates (short-term: -0.1%; long-term: around 0%). It also maintained its guideline for long-term JGB purchases (of increasing its net holdings at a pace of about ¥80 tn a year), as widely expected, and made no changes to its risk asset purchase program (mainly ETFs). The BoJ faces a similar problem to the ECB with a strong JPY complicating policy. Inflation is far from the BoJ’s 2% target and it now seems clear that expectations that the BoJ would normalize policy were farfetched.
How do we characterize the current environment? Growth is solid and broad and the financial infrastructure has become more stable since regulators reformed it after the crisis 10 years ago. There is no clear and present danger. However, given valuations and sentiment, there is certainly risk of a technical or sentiment driven correction. We already saw one example in February, from which the markets have largely recovered. The current environment is best described as generally positive with a raft of risks. One useful approach to investing in this kind of climate is to focus less on chasing returns since general conditions are good, investments should be easy to find, but to focus on risk management. It is important, that we identify correctly the nature and magnitude of risk of each element in the portfolio, that we understand the interdependence of assets in the portfolio and that we size positions appropriately such that each investment and asset class contributes the same marginal risk to the portfolio.