Overview:
- Recent plunge in copper suggests a global growth scare is coming
- Implies financial stress should build and stock markets stumble
- Expect fireworks with widely anticipated ECB meeting on January 22nd
First investors had to grapple with the implications of the crash in oil prices and now another shoe is dropping—copper. Copper is commonly referred to by economists as “Dr. Copper” since it provides a decent health assessment of the global economy. Right now the prognosis from Dr. Copper isn’t good as the global economic patient appears to be developing signs of growth sickness.
The JP Morgan Global Manufacturing PMI (a survey that tracks sentiment among global purchasing managers at manufacturing, construction and/or service firms) reached a bottom in the middle of 2012 below 50 (readings below 50 indicate contracting growth while readings above 50 indicate positive growth). It then improved into early 2014 before peaking in the middle 50s. However, the PMI had been on a downward path with December’s reading coming in at 51.6. Given the sharp slide in copper, there is a decent chance that January’s reading may push the global economy back into contracting territory.
Source: Bloomberg
Along the same lines, the OECD’s Leading Economic Index (LEI) typically tracks the trends in copper and the recent slide suggests we could see another growth scare in the global economy similar to the 2010-2011 growth scare in which the growth rate in the OECD LEI dropped sharply and almost dipped into negative territory for the first time since 2008.
Source: Bloomberg
Confirming the message from Dr. Copper is the relative performance of global early cyclicals to global late cyclicals. The weakness seen by early to late cyclicals last year portends a deceleration in the OECD LEI into late spring before a second half rebound. It appears as though we are going to go through a replay of the global growth scare of 2011 before experiencing a recovery in the second half.
Source: Bloomberg
Implications for Financial Markets
Straight to the point, financial risks rise when growth slows. When economic growth slows, companies have less cash flow to service their debt, employees get laid off and have a smaller capacity to service their debt load and governments take in less tax revenue and budget deficits rise. Thus, when growth slows, bad things happen—it’s that simple. Whenever we see global growth slow, default risk picks up and the cost of insuring against default (credit default swaps, CDS) rises and we can see this relationship in the image below. The thick black line is the OECD LEI growth rate we showed in the charts above except it is inverted for directional similarity along with global sovereigns CDS rates on 5-yr sovereign debt. Highlighted in Red are periods in which the OECD LEI is declining and the green regions are when the LEI is rising (again, the LEI is inverted). You can see that global CDS rise when the LEI falls and fall when the LEI rises and, while it is hard to see, most CDS values bottomed in the middle of last year and have been rising over the last several months as the LEI continues to decline. While investors have not had to worry about sovereign defaults in Europe and other parts of the world in several years, there appears to be mounting evidence that sovereign debt default concerns will be picking up meaningfully in the coming months.
Source: Bloomberg
A simple quick news search for the keyword “sovereign default” shows it isn’t on investors' radar as news volume with the keyword is probing the lows seen over the last six years. Note the massive spike in 2010 and 2011 in news stories with the keyword jumped alongside the decline in the OECD LEI which lead to global growth concerns and large corrections in the S&P 500. Now is not the time to be complacent as global growth risks are building even if it hasn’t trickled into mainstream news.
Source: Bloomberg
In addition to rising default risk impacting credit markets across the globe we are also likely to see a selloff in global stock markets. Admittedly, we are already seeing global stock markets finally begin to track copper prices lower after bucking the trend in lower copper prices throughout 2013 and 2014. Over the last several months though the MSCI World Index excluding the U.S. has seen a double-digit correction and the recent plunge in copper suggests more downside ahead.
Source: Bloomberg
The Elephant in the Room
Based on the information above, moving towards a defensive investment stance appears warranted. However, the massive elephant in the room is the European Central Bank (ECB). The ECB’s next meeting occurs on January 22nd and it is widely expected that the ECB will launch some form of quantitative easing (QE). Benoit Coeure, a top ECB policymaker, told a German Newspaper that discussion on sovereign bond buying QE was “far advanced” and on inflation he said “the continually falling oil price strengthens the risk in the current environment that people lose trust in our inflation goal” (click for article link). In regards to the ECB’s 2% inflation goal, today ECB President Mario Draghi said the governing council is united in its determination to achieve that goal (click for article link). Another development today was that the European Court of Justice (ECJ) removed a hurdle for the bank’s plans to buy government debt as highlighted in the following article:
EU court adviser paves way for ECB money printing
Pedro Cruz Villalon, advocate general to the European Court of Justice, said a 2012 ECB bond-buying blueprint, designed at the height of the euro zone crisis to avert a break-up of the single currency and unused so far, did not break EU law.
The opinion was a clear rebuff to German critics of bond-buying, who argue the ECB would reward spendthrift states with cheap credit by printing fresh money and deter painful reforms.
"The OMT (Outright Monetary Transactions) program ... falls within the monetary policy for which the (EU) Treaty makes the ECB responsible," said Cruz Villalon, in an opinion which was met by enthusiasm on financial markets.
The euro tumbled to below its launch level for the first time in a decade after the court opinion was published, as investors took the view that the ECB had received a green light to push ahead with its plans.
The adviser's opinion, which is usually followed by the court's judges, was a milestone in a long-running dispute about printing money and the limits of central bank powers between the ECB and Germany, the largest member of the 19-country bloc.
It was a setback for those in Germany's conservative financial establishment who want to stop ECB plans to print fresh money to buy government bonds and a boost for the Frankfurt-based central bank.
Investors aren’t the only ones who are expecting the ECB to make a big announcement at their January 22nd meeting as the Swiss National Bank (SNB) will begin charging banks 0.25% interest on bank deposits exceeding a certain threshold beginning January 22nd. What is so significant about January 22nd? Oh yeah, that’s when the ECB will meet, so evidently the SNB expects the ECB to act and in order to prevent capital flows into the Swiss Franc the SNB will be moving to negative interest rates. The recent development is replaying echoes of 2011 when we last had a global growth scare as the following New York Times article highlights:
Swiss National Bank to Adopt a Negative Interest Rate
“Over the past few days, a number of factors have prompted increased demand for safe investments,” the central bank said. “The introduction of negative interest rates makes it less attractive to hold Swiss franc investments, and thereby supports the minimum exchange rate.”
In September 2011, with the eurozone’s sovereign debt crisis in full swing, the central bank announced a policy of restraining the franc’s value to no less than 1.2 francs per euro, and said it was “prepared to buy foreign currency in unlimited quantities” to defend that level. It said on Thursday that it remained committed to enforcing that policy “with the utmost determination.”
If the ECB does in fact launch QE and buy sovereign debt we could see a risk rally that moves countertrend to the coming global economic growth slump. This could soften the blow and lead to a rally in risk assets. The details of any planned announcement at its January 22nd meeting will not be known for a little over a week and it is unlikely global investment managers will make any big asset allocation changes prior to the big meeting. Should the ECB underwhelm market expectations we could see one force holding back managers propensity to sell evaporate and a sharp selloff ensue. However, should the ECB deliver, risk assets may enjoy a short bounce before the global growth slowdown reaches its peak and weighs on investor sentiment. In essence, expect fireworks in either direction based on the ECB’s decision as global market volatility is set to pick up meaningfully ahead. Will the ECB act and will it be enough to fight back global growth concerns? We are about to find out—buckle up!
