Notes on the Week AheadContributor David Lebovitz
Getting the test back
When I was in school, one of the most agonizing periods was the time between taking an exam and getting it back. This strange, uncomfortable time would end in one of two ways. If I did well, it would generate a sort of positive momentum for my studies. On the other hand, if I did poorly, there would be an element of discouragement that weighed on my desire to engage. The U.S. economy submitted its July exam a few weeks ago; this week, we’ll get our first peek at whether the solid U.S. growth momentum seen in the second quarter carried over into the third, and what it might suggest for the broader trajectory of global growth.
Headline retail sales are expected to be flat given the already-reported weakness in auto sales. However, the core measure, which is more closely related to overall consumer spending, looks to have risen again in July. We also believe industrial production increased last month, with strength in manufacturing offsetting weakness in both mining and utility output. Solid consumption and manufacturing, coupled with a tight labor market, should continue to support above-trend U.S. growth.
But questions remain about the rest of the world.
Last week provided further confirmation of softness in the European economy, with country-level industrial production indicators contracting and pointing to a decline in the Eurozone aggregate that will be reported this week. Additionally, second quarter growth in Japan was better than the first, but taken together, the first half was underwhelming. Growth outside of the U.S. has been disappointing thus far in 2018, but the soft data suggests that there is room for developed market growth to accelerate during the second half. Questions remain, however, as to whether or not that will lead to a broader based resynchronization of global growth.
Here, the performance of the dollar will be key. With the U.S. growing faster than the rest of the world and the Fed leading the charge towards more normal monetary policy, it is not unreasonable to expect the dollar to remain firm. However, if international growth accelerates at the same time that central banks other than the Fed are moving towards a more normal policy stance, the dollar should soften, taking pressure off of emerging markets and leading global growth to realign.
But the current environment is not without risks. A continued slide in the Turkish lira coupled with a soft economic backdrop could lead to renewed concerns about European financial stability. If concerns about the stability of the broader European financial system materialize, European equity markets will find themselves under pressure given their larger weight in financials, and investors may seek refuge in U.S. Treasuries and other dollar-denominated assets. Spanish and Italian banks have the most exposure on a nominal basis, but this only represents 4.5% and 2.1% of their total balance sheets, respectively. Furthermore, European financial institutions are far better capitalized than they were a few years ago, suggesting contagion should be limited.
In the background, trade tensions continue to bubble, and broader political risks are clouding the outlook. Volatility could rise in the coming weeks, but with U.S. corporate profits expanding by nearly 27% year-over-year in the second quarter, and guidance suggesting that solid earnings momentum will be maintained into the end of the year, equity markets should have support. Importantly, the profit story is also intact outside of the U.S., with European and Japanese earnings rising 11% and 9% from a year earlier, respectively.
Political risks could derail a stabilization in global growth, but with corporate profitability solid and confidence indicators elevated, the path of least resistance for risk assets remains higher. That being said, before we get too excited, we should probably take a look at the results of the July exam.