Welcome to the global slowdown
James Saft is a Reuters columnist. The opinions expressed are his own.
HUNTSVILLE, Ala. — With QE2 set to end in five weeks and with Greece rolling downhill towards default, the world is not best placed to withstand a weakening economy.
That, however, is exactly what looks to be happening, as Asian demand is hit by a cooling China and a struggling Japan.
Let’s take a look at the evidence:
Japan’s economy shrank by 0.9 percent in the three months to March, battered by the earthquake, tsunami and ongoing nuclear fiasco.
The preliminary HSBC/Markit purchasing managers’ index for China fell to 51.1 in May from a final reading of 51.8 in April, holding in expansionary territory above 50 but amidst growing evidence that China is coming off the boil. Chinese demand for raw materials and semi-finished products has been one of the global economy’s principal supports, but now a monetary policy tightening campaign may be gaining traction.
The Chicago Fed national index, derived itself from 85 economic indicators, came in at negative 0.45 in April compared to 0.32 in March. There are numerous signals of an industrial slowdown in the U.S., while the housing market continues to weaken, threatening financial stability and consumer spending.
Finally, in Europe the euro zone composite flash PMI, an indicator combining service sector and manufacturing purchasing, fell to 55.4 from 57.8. More worryingly, the headline manufacturing index had its biggest fall since Lehman Brothers failed, falling by 3.1 points to 54.8.
“All in all it seems to us that the odds are high that a domestic and global economic slowdown is already in place. In the U.S. the slowdown is happening with only weeks to go before the end of QE2, a program that has been a major prop for even the tepid recovery we’ve undergone so far,” said Charlie Minter of fund managers Comstock Partners in a note to clients.
“For the stock market nothing seems to matter until, suddenly, it does.”
It has begun to matter recently to the stock market, which has fallen in recent sessions after a sustained rally. The bond market has already figured this out; since mid-April U.S. 10-year yields are down more than 12 percent to 3.12 percent. Given that the U.S. debt market faces a debt showdown and the end of QE2, both factors which should theoretically send yields higher, this slide in yields shows real doubts about future growth.
It is worth noting that the euro zone’s woes were not this time concentrated in the weak peripheral states; this time Germany got whacked too. That may well reflect the wrench thrown into production from Japanese plant closings, which in itself will self-correct. It is also likely reflecting a slowdown in demand for German products from China. If you believe that Chinese demand was artificially boosted by very easy credit, and that Chinese demand in turn was driving global growth, then this is an indicator of a very busy and volatile summer in financial markets.
Global markets have ignored, more or less, the euro zone’s issues for more than a year, but did so in a very supportive atmosphere. The Federal Reserve was buying up Treasuries, sending cash into risk markets in waves, while China continued to grow at a blistering pace. It may be that China is important not just because its slowdown affects demand, but because it lets investors focus on the actual prospects in the euro zone.
Will Germany and France be as willing to foot the bill for Greece if their own manufacturing bases begin to shrink? It is possible but a lot less likely.
Meanwhile the crisis both builds and spreads, with a dispute over debt reprofiling (a sort of doe-eyed default) between the European Central Bank and European officials and a fantasy plan by Greece to raise 15 billion euros through asset sales.
Greece may turn out to be a minor worry; Belgium and Italy have been threatened with credit downgrades by Fitch.
So what happens from here? A palatable outcome would be a gentle decline in economic momentum followed by a strong second half. This makes absorbing the impact from Europe easier, and makes it easier for Europe to come to terms with itself.
A less likely, perhaps, but still possible scenario is that the manufacturing slowdown gains speeds just as Europe faces a contagion from the periphery, either to parts of the core, to the banking system of the core, or both.
At this point the Federal Reserve will have an ugly choice; does it extend and expand quantitative easing to support the newly weakening economy, or does it sit tight, brace for the recession and hope something else will turn up?
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)