From crisis to crisis

In stock markets, the familiar and safe red flatlining has continued. Of course, investors of the peripheral Nasdaq Helsinki get a double whammy, as many of our companies are quite cyclical. The adversities of the global economy hit us hard, while the good times are more limited.

In this post, we talk about the eurozone's economic turmoil and the unpopularity of European equities. Then we’ll talk about past and future crises of this year, despite which stocks have done well, especially in the US.

Eurozone economy (still) continues to flatline

The eurozone continues to grumble economically, according to the latest Purchasing Managers' Index data. The PMI is constructed from a sentiment survey sent to the managers of hundreds of companies. The response rate this time was 85 %. The PMI for manufacturing rattles at 43.4 points and for services at 48.4 points. Readings below 50 indicate a decrease in activity relative to the previous month, in this case August. So, the services reading was less bad than the previous month, but it still suggests less activity in the services sector, which is the larger block of the economy.

The overall picture is that companies are creating only marginally more jobs as demand weakens. Costs such as wages are still rising rapidly, while companies are struggling to raise the prices of their own products, reflecting limited pricing power. Both of the eurozone's largest economies, Germany and France, posted weak readings.

PMIs give a timely message about the state of the economy, but they can’t be directly linked to the stock market. All kinds of companies respond to the surveys, while the stock market is dominated by the biggest companies with the most muscle to get out of tough spots. Although the PMIs show a weakening economy now, the stock market is anticipating future cash flows for years to come. The European stock market has remained resilient so far in the light of the bad data, unlike Nasdaq Helsinki.



However, the PMI data gives a reasonable picture of the general economy. Gross domestic product tends to fall at times when indices hover below 50 and vice versa. As the economy weakens, inflation should also abate and the ECB's pressure to raise interest rates should ease, or else we would be in an awkward stagflation where the economy flirts with recession while inflation and interest rates bully stocks.

In this context, it should be briefly mentioned that despite the weak economy, the market expects average inflation in Germany over the next 10 years to be higher than in the US. While these expectations are going back and forth like a seesaw, this helps illustrate how the inflation problem in Europe is getting worse than in the US, while the economy is close to recession.

Investors' distaste for European shares is obvious. The relative valuation gap with US equities is at an all-time low as far as Bloomberg's short data snippet up to 2006 is concerned. According to the Bank of America Global Fund Manager Survey, portfolio managers are shifting their focus to US equities and avoiding Europe. In addition to the weak economy and inflationary risk, Europe is seeing more China risk, as many of our companies are more dependent on the Chinese economy than their US counterparts. Of course, the difference in valuation is also explained by the chronically lower returns on capital for European companies than for US stocks.

From crisis to crisis

This economic year has been marked by a crawl from crisis to crisis. So far, however, the crises have been less severe than feared or virtually duds. Let's quickly review the dramas this year and then look at the next crisis candidates in line.

In the spring, the budding banking crisis was in the headlines. So far, however, banks' deposit and loan portfolios appear to have leveled off. On the other hand, in the past, borrowing merely levelling off has been enough to push the economy into recession.

The recovery in bank stocks has stalled, as both small and large bank stocks have taken a beating recently. This raises some questions. Do investors see the economy in a very bright light when they do not want to pay higher valuation multiples for the banks that act as its arteries?

The process of rebalancing the Chinese economy, which is likely to take decades after decades of investment and debt rallies, was back in the headlines until investors remembered that the command economy does not let itself go into crisis. The bursting of the country's massive property bubble is not a pop, but a slow whistling of air out. Just recently, the last-minute cancellation of a meeting with creditors of real estate giant Evergrande has been in the news, which does not exactly inspire confidence. Several other property developers face imminent insolvency or liquidation. 

In addition to these concerns, investors have been constantly worried about the economic downturn - although to a lesser and lesser degree. The global economy is expected to continue growing at an annual rate of 3%. The strength of the US economy has surprised investors. According to Bloomberg data, mentions of a soft landing, which refers to a slowdown in economic growth without a recession, have increased to near-record levels. Ominously, there’s always talk about a soft landing before a recession. Sometimes, for shares, the speeches turn out to be right, many times not.

So far, stock markets as a whole have shrugged off the crisis concerns. The S&P 500, the world's most followed stock index, is only 10% away from its early 2022 peak. The balanced index, which better reflects the performance of the average stock, is 13% off its peak. The global stock market is not impossibly far from its recent peaks. So, on average, equities have been much like Teflon amidst an endless stream of negative news.

And the negative news doesn't stop there.

The most acute headline issue is the US government shutdown. If Republicans and Democrats fail to agree on a budget, part of the administration will cease to function and 800,000 people will be out of work from the beginning of October. The last time this happened was in December 2018, although the impact on economic growth was measured in per mil and the loss was quickly reversed when the administration restarted after five weeks of stagnation.

Another little nuisance that isn't necessarily that impactful - but even a small nuisance is a nuisance - is the end of student loan repayment holidays in the US from the beginning of October. The average interest payment for the tens of millions of people with student loans is $200-300 per month. Such an additional expenditure of perhaps $100 billion in total is not a drop in the ocean for a US economy of $25,000 billion, but consumers are also under pressure from rising fuel prices.

Of course, stocks will ultimately be driven by results and the strong US economy is likely to withstand these bumps on the road. More information on the results will be available soon, as the earnings season starts in a couple of weeks.

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