DR.CHENJIAZI ZHONG

In Brief

• Europe: Encouraging data now; ECB studying tapering
• U.S.: Inflation down; housing permits back up
• China: New data released; PBOC to coordinate work of new financial oversight body
• U.K.: Unexpected softer inflation in June
• LEIs: Global nominal reacceleration ending; real growth drivers needed
• Given the magnitude and pace of change in the technology sector, it is vital to be early in identifying winning companies; key investment themes as followed

On Europe

Inflation is nascent in Europe. Euro Area (EA) CPI deaccelerated to 1.3% year over year in June, but that was mainly due to energy prices declining -0.9% month over month. Service prices, which is roughly 45% of the EA CPI, and core prices are in rebound mode, up to 1.6% year over year and 1.2%, respectively.

The ECB’s quarterly Bank Lending Survey (BLS) also showcased the economy’s progress. According to the ECB BLS, M&A activity and fixed investment made an important and increasingly positive contribution to demand for loans to enterprises in the second quarter of 2017. The general level of interest rates, inventories, and working capital also continued to have a positive impact on demand. Net demand for housing loans continued to be driven mainly by the low general level of interest rates and favorable housing market prospects. Spending on durable goods, the low general level of interest rates, and consumer confidence contributed positively to net demand for consumer credit.

The ECB opted for no decision and wants to be careful to avoid a “taper tantrum” in the bond market. On Thursday, the ECB left its stimulus measures unchanged but signaled it would discuss how to proceed with interest rates and bond buying, which is part of its bid to stimulate the regional economy in the fall.

On the U.S.

U.S. import prices fell for a second straight month in June amid further declines in the cost of petroleum products. The decline signaled less inflation in the pipeline. On a year-over-year basis, U.S. import prices slowed sharply to 1.5% since posting 4.7% in February. Import price pressures are, however, likely to pick up given the recent weakness in the dollar, which has declined 6.1 percent in value against the currencies of U.S.’ main trading partners this year.

U.S housing starts recovered and surged 8.3% year over year in June to a seasonally adjusted annual rate of 1.22 million units, despite it remains far below the pre-recession peak in level terms. Homebuilding has lost momentum after strong gains in both the fourth quarter of 2016 and first quarter of 2017.

On China

China’s real GDP grew 6.9% year over year again in the second quarter, both the service (7.7%) and manufacturing (6.4%) sectors contributed, while nominal GDP fell marginally to 11.1% year over year. Fixed asset investment rose 8.6%, property investment rose 8.5%, and retail sales rose 11.0% year over year. Property prices eased overall and by tier; the 70-city average growth rate cooled for the sixth month to 9.4% year over year.

Over the weekend, financial oversight changes were made to enhance the effectiveness of regulations. People’s Bank of China (PBOC) will be in charge of coordinating a new financial oversight body, namely, Financial Stability and Development Committee, mandated by President Xi Jinping to get China’s regulators to work together to contain rising credit risks. No indication has emerged on who could head the committee though. PBOC said on Tuesday that it would carry out the office duties of the new body, indicating the committee’s day-to-day operations might be conducted from PBOC. The new body’s responsibilities include formulating plans for the development of the financial sector, ensuring regulatory cohesion, formulating rules and regulations to fill in regulatory gaps, and holding regulators accountable when supervision is lacking.     

On the U.K.

The U.K. inflation fell unexpectedly in June for the first time in nine months; the CPI recorded 2.6%, as compared with an expected reading of 2.8% and a level of 2.9% in May. The fall was primarily driven by lower petrol and diesel prices, reflecting weaker global oil prices. Fuel prices fell by 1.1% between May and June, compared to a 2.2% rise over the same month a year earlier. Lower prices of games and toys also contributed to the fall. A softer inflation reading reconfirmed prices peaked earlier this year, after months of escalation.

On LEIs

The OECD’s Leading Economic Indicators (LEIs) are signaling activity will temper in most G7 countries in the second half of 2017. The reacceleration in the global economy this year bought time. Yet, the recent batch of LEIs plus inflation peaking year over year stress the urgency of real growth drivers, such as fiscal policy, to carry forward the momentum. Unlike the rest of the world, the LEIs for European countries continue to steam ahead. Further tapering of asset purchases by the ECB is looking more likely. The Italy election in 2018 is still a risk.

On Oil

Low oil prices are largely curbing both domestic and imported inflation pressures. Other factors such as declining prices for mobile phone services have also contributed to pushing inflation below the Federal Reserve’s 2% target. As oil prices have moved lower over the course of this year, some investors are beginning to wonder if they should brace for a repeat of 2015, when a sharp decline in oil prices led to an earnings recession, a blowout in high yield spreads and a slowdown across emerging markets. However, it is important to recognize that while the fall in energy prices may feel familiar, the results shouldn’t be the same.

First, the recent decline appears to have been driven by an increase in supply, rather than a softening in demand. Second, many of the most inefficient energy companies have defaulted, leaving the sector looking healthier than it was just a couple of years ago. These remaining companies have seen their earnings hit by write-downs of their oil-related assets in recent quarters, making it unlikely that this pullback in oil prices will have the same impact on earnings. Third, the lack of a fundamental threat has been reflected in markets – energy stocks have come under pressure as the price of oil has fallen, but as shown in this week’s chart, the relationship between oil prices and the S&P 500 appears to have broken down. Finally, high yield spreads outside of the energy sector look contained. As a result, it will be prudent to watch for signs of contagion going forward, but at the current juncture, energy sector weakness does not pose a threat to the economic expansion.

A big part of the Trump Administration’s economic agenda is to deregulate the energy sector in the U.S. Perhaps like the decision to remove price controls in the early 1980s this could be a development that is good for the economy as a whole but bad for energy stocks. Oil by shale is profitable below current spot prices while fiscal breakevens among OPEC members remain stubbornly high.

A Few Thoughts

In 2013, U.S. Treasury yields rose dramatically after then-Fed Chairman Ben Bernanke suggested the central bank might begin reducing its pace of monthly asset purchases. The so-called taper tantrum affected markets globally. Today, the Fed is openly discussing plans to begin shrinking its balance sheet in 2017 – yet Treasury yields remain stable. Two explanations for this striking disparity in the market’s response. First, unlike in 2013, both the Fed and market participants accept the New Neutral for U.S. monetary policy. Second, the Fed plans to continue buying duration and convexity risk for at least a year after balance sheet normalization begins.

Investors can seek out innovative companies that are taking advantage of megatrends in technology. These include cloud computing, the Internet, and the penetration of technology into areas such as factory automation and robotics, the automotive industry, health sciences, and aerospace. Given the magnitude and pace of change in technology, the early identification of companies with exceptional growth potential is vital.

In theory, investors should consider companies with strong intellectual property, high barriers to entry, a large addressable market, accelerating fundamentals, and strong cash flow and balance sheets. A company’s competitive advantage is key in assessing outcomes because success hinges on the ability to navigate challenging environments and market cycles. In addition, management is central to driving innovation and success, and investors should seek out leaders who can execute on their vision. Moreover, a company’s R&D pipeline and product pipeline are also important signals of a company’s innovation, but fundamental fitness is an important focus of the assessment. Beyond those, investors should seek far and wide for disruptive innovators in developed and emerging markets regions. Europe is a leader in some parts of industrial technology, including high precision manufacturing, science, and engineering. China has fostered the emergence of a strong domestic Internet industry. Japan has become a center of excellence in robotics.