European stocks plunged and US indices fell moderately as shrinking world trade and capital investment dimmed the profit outlook. German industrials fell by 3% to 5% after Germany reported a 3.9% year-on-year fall in industrial production, the worst result since 2009. European banks fell sharply, led by Societe Generale, down 7% on the day.
These are nasty numbers and suggest a shift in expectations. Germany appears to have followed Italy into recession, and investors are pricing stocks at recession levels. SocGen now has lost half its value since last February and is trading at just 5.5 times earnings and 30% of book value.
Germany’s Deutsche Bank, for that matter, trades at 22% of book value. Chinese and Turkish banks trade at higher multiples. Banks are the vultures in the coal mine, and their distress is a recession signal.
Another warning sign about the European economy is a prospective fall in core inflation. Expected inflation at a 10-year horizon is embedded in the difference between ordinary government bonds and inflation-linked government bonds. The chart below shows daily data since Sept. 1, 2018.
In the US, expected inflation tracked commodity prices very closely. In Europe, expected inflation failed to rise as commodity prices recovered during the past couple of months. The drop in the expected inflation rate in Europe isn’t coming from commodities, which means that it is coming from weaker demand.
I wrote on November 30 that the US-China tariff war had crushed capital investment plans, as corporations waited to see where they should locate their supply chains. A global contraction of world trade appears to have started in September, and is responsible for economic weakness in the major trading economies, notably Germany and Japan.
The chart below from IHS-Markit shows that export orders are leading world purchasing manager indices down.
Judging from the Baltic Dry Index, the cost of reserving freighters, trade took a sharp downward turn in January.
As I wrote yesterday, the trade war is a bomb that is not so easy to un-explode. Speculation about the status of US-Chinese negotiations fluttered the US stock market today, which fell on comments by White House economic adviser Larry Kudlow that a great deal of work remained to be done before a trade deal could be signed. That really is beside the point: The damage to the world economy has been done, and it will take more than the postponement of new American tariffs in an interim trade deal to conjure up the animal spirits of investors.
In the US, the biggest loser was oil and gas equipment, followed by automobiles, auto equipment, and construction and engineering. The oil exploration ETF (XOP) was down 4.3%, with its smaller, shale-dependent constituents down by high single digits for the week and mid-double digits for the week. At $50 and change, oil is trading right around the marginal cost of production of the shale producers, which isn’t good for their prospective earnings.
That’s one pocket of weakness in the US economy. Another is capital goods. As shown in the chart below, CapGoods orders are roughly where they were five years ago, and lower than they were a year ago. The Trump tax cut did wonders for small business, which accounts for more than 100% of the last year’s job creation, but it did nothing for capital investment.
The biggest winners in the US market today were the carry trades: Real estate investment trusts of all varieties, and electric utilities. The US economy is still growing, although the growth is concentrated in the lowest-productivity sectors (leisure and entertainment, healthcare and other services).
Small business hiring momentum adds about 1.5% a year to the size of the labor force, and with 3% growth in hourly earnings, nominal spending power should continue to grow by 4.5% a year, or by 2.5% after inflation. Add to that a modest rate of increase in consumer credit, and consumer spending should rise by about 3.5% a year. Consumer spending is 70% of GDP, so that amounts to a 2% tailwind in GDP growth. Everybody has to be somewhere, so real estate should hold value.
But the US isn’t getting any help from either corporate CapEx or residential investment, which means that GDP growth is likely to come out at around 2%, with diminished S&P 500 per-share earnings growth. Today’s winners, such as real estate and utilities, offer threadbare returns to investors, but at least they aren’t likely to vaporize. Carry is OK for the time being. Not much else is.