From Overheating to Underwhelming: Is the Economy Hurting Stocks?
Economic growth has been an important factor driving the stocks market over the past year. Is that economic support is now fading?
The Eurozone, the world’s second largest economy, has delivered some disappointing data lately.
Fortunately, we find that most of these five reasons for weaker than expected economic data are temporary and suggest a rebound in the months ahead.
International economic diplomacy is evolving in ways that are difficult to predict. However, the strongest and broadest global economic growth in more than a decade driving double-digit earnings growth has been an important factor driving market behavior over the past year. Is that economic support now fading?
The Eurozone, the world’s second largest economy, has delivered some disappointing data recently. The economic data has gone from coming in better than expected late last year to worse than expected in the past couple of months at the same time stock prices have weakened, as you can see in the chart below.
Eurozone economy: from overheating to underwhelming?
Source: Charles Schwab, Bloomberg data as of 3/30/2018.
Five reasons
Fortunately, rather than marking the end of the economic cycle and foreshadowing a bear market for stocks, the disappointing data isn’t actually weak (in most cases it continues to maintain its fastest pace of growth since 2011). It just came in below expectations, which may be largely due to some less-worrisome factors:
- Unusual weather-related shutdowns
- Stretched supply chains hindering production
- Strong euro hurting exports
- Typical seasonal slump
- Peaking growth momentum
Weather – February saw very unusual European weather that appears to have negatively impacted production. Britain saw its coldest weather in 27 years. Even cities as far south as Rome saw the heaviest snowfall in six years, and the largest for the end of February in decades, shutting down airports, schools, and businesses.
Fraying supply chains – Stemming from Europe’s growth spurt over the past year, supply chain delays and shortages in both workers and raw materials have been increasingly common, hindering output. Manufacturing vendor delivery times are near the longest in 18 years and input costs have moved sharply higher, according to IHS Markit, publisher of the Purchasing Manager’s Index (PMI). For example, delays in German supply chains are currently more widespread than at any time in the PMI survey’s 22-year history. Both manufacturing and services sectors also saw activity being curtailed by growing incidences of skill shortages. Backlogs of work continue to rise as a result of these growth constraints.
Stretched supplier delivery times are slowing production
Source: Charles Schwab, Bloomberg data as of 3/30/2018.
Stronger euro – The Eurozone’s economic growth outpaced the U.S. over the past year, helping to lift the euro from just over $1.05 a year ago to nearly $1.25 in recent months. Export orders have stumbled, suggesting the stronger euro may be having an impact on the competitiveness of European products. The slump in exports seemed to coincide with the euro rising above $1.20.
Export orders have stumbled
Source: Charles Schwab, Bloomberg data as of 3/30/2018.
Seasonality – It’s not unusual. A spring slump from +50 to -50 (or lower) has been seen in the Citigroup Economic Surprise Index for the Eurozone in four of the past six years.
Peaking momentum – Late last year, growth in the Eurozone appeared to be at risk of overheating as demand exceeded capacity. The recent disappointingly weak data, after many months of surprisingly strong economic data, may signal a period of more stable and solid growth rather than continued acceleration. Consequently, the risk of a more aggressive than expected withdrawal of support by the European Central Bank may be reduced.
Most of these five reasons for the weaker than expected economic data are temporary and suggest a rebound in the months ahead (weather, supply chain delays, seasonality), while others point to more stable growth scenario rather than overheating (euro, peaking momentum). Importantly, none of them seem to be signaling an end to growth that would make the recent stock market slump the beginning of a bear market.
China too
It isn’t just the weaker data in the Eurozone, stronger data in the world’s third largest economy may also be due to temporary factors. As the surprise index in the Eurozone recently dropped from zero to -57, China’s surprise index soared from zero to 93, as you can see in the chart below.
Economic data surprises take opposite paths in Eurozone and China in March
Source: Charles Schwab, Bloomberg data as of 3/30/2018.
Rather than signaling a sharp acceleration in China’s growth, this jump is largely attributable to the calendar shift of lunar New Year holidays. Economists expected the one-week holiday—which fell in February this year but straddled January and February last year—to sharply drag down export growth in February. Interestingly, the export data for February reflected only a slight deceleration from January’s pace, surprising economists when the data was released on March 7. Seasonal effects around the holiday are unpredictable; it’s possible there was a rush to ship goods ahead of the holiday. Advance shipments in anticipation of U.S. tariffs doesn’t seem likely since China’s shipments to Europe reflected the same growth rate as U.S. shipments for the month of February.
No surprise
Based on our analysis, it appears that the surprises in economic data are not signaling that economic support for the stock market is fading. The trend of solid growth seems to be intact, reflected in the recent upward revisions to the pace of economic growth forecast for this year and next year by major organizations like the Organization for Economic Cooperation and Development (OECD) and International Monetary Fund (IMF). Actual earnings continue to be on the rise for global companies. Wall Street analysts have been raising their earnings forecasts. We will continue to watch the data closely as the temporary factors fade to see if our expectations are confirmed on economic growth, supporting the stock market in an environment of evolving trade, fiscal and monetary policies.
