DR.CHENJIAZI ZHONG

In Brief

• U.S.: Home builder sentiment climbed in August 2017 and consumers still likely pent up demand for housing; 10-year breakeven inflation rate rose in July for the first time in five months; NAFTA changed U.S. trade with Canada and Mexico; dollar fell in July against most other currencies
• EU: The hard data released this week reconfirmed the recovery remains on track and broad based
• U.K.: Pound fell after U.K. inflation disappointed
• Japan: Better second-quarter growth than expected; second-quarter earnings climbed for 68% of the listed companies; Abe reaffirmed the plan to complete doubling of consumption tax in 2019
• China: M2 money supply 9.2% vs. 9.5% forecast; IMF raised China 2018-2020 growth outlook; economy moderating but no imminent risk; China reclaims spot as the biggest holder of U.S. Treasuries
• Thought: Consider a more diversified approach to global credit markets

On the U.S.

U.S. home builder sentiment, as measured by the National Association of Home Builders (NAHB) Wells Fargo Housing Market Index, increased to 68 in August, up four points from 64 in July and the highest level since May; a reading above 50 generally indicates more builders view sales conditions as good. On the other hand, the level of reading is still far from the pre-recession peak. One explanation for the mismatch is home builders are confident about the outlook for the U.S. economy but in short supply of materials and qualified workers.

The U.S. 10-year inflation breakeven inflation rate, the difference between nominal and real yields and a measure of inflation expectations, rose in July for the first time in five months. It began with a rate at 1.74% in July, about the same level it had been just prior to the U.S. election. President Trump’s surprise victory had propelled the rate to as high as 2.08% on the back of expectations for fiscal stimulus and its likely inflationary effect. The subsequent slide in the breakeven rate had been a mixed result of falling oil prices, underwhelming inflation data, and diminishing expectations for the extent of fiscal stimulus. The increase in July’s rate to 1.82% was contributed by oil prices rising again, but stimulus expectations, inflation data, and Fed policy will all continue to be factors in the direction of the rate moves.

The Trump administration set an intense tone on August 16 at the beginning of the renegotiation of the North American Free Trade Agreement (NAFTA), driving a wedge into its relationship with Canada and Mexico. The U.S. is also pledging to make reducing its trade deficit a priority, a point that Canada and Mexico partners sought to rebut. While the growth of the U.S. economy has followed trade, the changing dynamics have also prompted concerns about decreasing employment, especially in the well-paying manufacturing sector and the rising trade deficit.

The U.S. dollar fell again in July against other developed market currencies, as captured by the U.S. Dollar Index (DXY), touching 13-month low in its fifth consecutive monthly decline. Fed Chair Yellen’s more cautious testimony and soft inflation data contributed to the decline in the U.S. dollar, but developments in other developed markets also added to the appreciation of other currencies. In particular, euro gained 3.6% in July, yen nearly 2%, and pound 1.5%. Emerging markets (EM) currencies also saw gains against the U.S. dollar, as captured by the JP Morgan Emerging Market Currency Index. Index gains were generally broad-based and helped by Asian and Latin American currencies.

On the EU

The seasonally-adjusted GDP rose by 0.6% in both the euro area (EA)and the European Union (EU) during the second quarter from the previous quarter, and rose by 2.2% in the EA and by 2.3% in the EU, respectively, from the same quarter of the previous year, according to a flash estimate published by Eurostat, the statistical office of the EU. The hard data reconfirmed that the recovery remains on track and broad based; even in Italy, the GDP grew by 0.4% from the previous quarter and by 1.5% from the same quarter of the previous year.

On the U.K.

The British Pound fell to almost eight-year low against the euro after another disappointing inflation report. The U.K. prices rose at an annual rate of 2.6% in July on the consumer price index measure, matching the June print and below economists’ expectation of 2.7%, lowering the likelihood of an imminent interest rate hike from the Bank of England. The near-instantaneous response from markets after that inflation print came in was a drop in GBP.

On Japan

The growth of Japan continues to be an under-the-radar story. The second-quarter GDP expanded an annualized 4.0% versus a forecast of 2.5% growth; compared to the previous quarter, the GDP grew 1.0%, much stronger than expected. Real GDP was more diverse than in the past, with investment contributing 0.7%, consumer spending 0.5%, and government spending 0.1%. Net trade was a drag. The Japan GDP deflator rose to 102.6 after falling the last four quarters.

The Nikkei 225 remains almost 17-year high in both JYP and USD terms. Japan’s corporate earnings have broadly recovered, with a record 68% of nearly 1,600 listed companies booking higher net profit for the second quarter, as growth among makers of autos and electronics spread to their materials and equipment suppliers.

To restore Japan’s fiscal health, Prime Minister Shinzo Abe remains committed to a plan to complete the doubling of the consumption tax to 10% in October 2019. Under the initial plan, the consumption tax was to be raised to 10% from the current 8% in October 2015, but Abe has already postponed it twice to try to ensure a solid economic recovery.

On China

Growth in China’s broad money supply, as measured by M2, the money supply that includes cash, checking deposits, savings deposits, money market securities, mutual funds, and other time deposits, slipped to a new record low, indicating the People’s Bank of China (PBOC) is not letting up in their drive to control excess borrowing and safeguard the financial system. Aggregate financing stood at 1.22 trillion yuan ($182.7 billion) in July, the PBOC said on August 15, compared with an estimated 1 trillion yuan in a Bloomberg survey. New yuan loans stood at 825.5 billion yuan, as compared to a projected 800 billion yuan. M2 increased 9.2%, versus economists’ forecast of a 9.5% growth rate. The slower increase in M2 will become a “new normal,” and “The relevance of M2 growth to China’s economy and its predictability has reduced, and its changes should not be overinterpreted” the PBOC said in its quarterly monetary policy report. The divergence between M2 growth and aggregate financing mirrors that the PBOC is attempting to adjust cutting leverage while ensuring enough funds to support the real economy.

The International Monetary Fund (IMF) raised the growth outlook for China for the period between 2017 and 2021 but cautioned the projected sharp increase in nonfinancial sector debt could hurt growth. Although China’s retail sales, investment, industrial production, and lending all slowed further in July, they remain rapid. Imbalances exist in the economy, but probably few immediate risks.

China’s holdings of U.S. bonds, notes, and bills rose to $1.15 trillion in June, up $44.3 billion from a month earlier, according to Treasury Department data released August 15 in Washington. Japan owned $1.09 trillion; Japan had overtaken China in October 2016 as the largest holder of U.S. Treasuries. China and Japan account for more than a third of all foreign ownership of Treasuries.

Thoughts

Low market volatility continued to fuel risk appetite, driving equities higher and interest rate curves steeper. The MSCI World Index rose 2.4% amid a strong start to the second-quarter earnings season, taking year-to-date gains to 13.3%. With a robust 6% return in July, EM equities, as measured by the MSCI Emerging Markets Index Daily Net TR, extended their positive run in 2017 to over 25%; Brazilian stocks reacted positively to the conviction of former President Lula on corruption charges, Russia benefitted from higher oil prices, and Chinese equities were supported by better-than-expected second-quarter GDP growth.

After a turbulent 2015 and inconsistent start to 2016, global credit markets have since bounced back and continued to rally. This has led investors to ask whether there is still value in corporate bond markets and how they can balance their return objectives against the downside risks. Many credit investors focus on specific areas of the global credit markets, such as U.S. investment grade corporate bonds, high yield bonds, EM debt, and securitized loans. In addition, many investors attempt to time their allocations to various credit sectors. An active, tactical, and multi-sector approach to credit investing can produce better long-term results through structural diversification, bottom-up credit selection, and the ability to scale into and out of risk as relative valuations become compelling.