Product Cycles Imply Looming PMI Inflection Point…

‘I even think the President has recognized it’s not cost effective to push the tariffs anymore, and if he wants to continue pressure on China, which I think he probably does, I think this would be a good path to pursue. I do think we reached the end of the road with regard to cost-benefit analysis on the tariff side. In fact, I think a lot of the tariffs that have been recently suggested on the last tranches aren’t going to take effect…this is a matter, in my mind, of consumer protection…” Economist Larry Lindsay, former Fed governor and director of the National Economic Council under President GW Bush, speaking recently

In the course of recent client meetings in London and Asia, I’ve reiterated the message contained in the notes since late August  – tariffs had outlived their usefulness for the US as a trade policy tool given the negative feedback via consumer and business.  Even if this ‘phase one’ trade agreement hadn’t been announced, it seemed doubtful the December hike would have been implemented and further US containment measures will likely shift toward technology and capital flow restrictions, with a narrower market impact. China and the US acted in their narrow self-interest and therefore this ‘non-deal’ which has attracted much dismissive comment stands a good chance of surviving to a Trump-Xi photo opportunity in Chile.

As usual, sentiment will follow price action into year end, and extremely defensive positioning is fitfully unwinding and that will accelerate if we see a second derivative improvement in the macro data through year-end. The market has been  braced for more bad news and hugging long duration bonds and their equity expression via quality/low-vol equities as an expensive comfort blanket. In fact, we’ve seen a strong rally over the past six weeks in high global beta, deep cyclical markets from the DAX to KOSPI and Topix. For students of behavioural finance, the next few BoAML institutional surveys will be fascinating to read after the ‘hunkered in the bunker’ fearful tone of recent ones. The dollar index reacted predictably to trade relief,  crucial to EM participating in a wider risk appetite reversal and for the White House is as important as selling more pork and soybeans (even if the FX ‘stability’ aspect of the deal is a theatrical stunt).

To sustain the recent rotation toward cyclical value, we need a rebound in two key industrial sectors we’ve been structurally bearish on since 2016/17 – autos and smartphones. In both cases, a technology shift (diesel to hybrid electric in Europe/Euro 6 equivalent in China, 4 to 5G in mobile) and the rapid rise of a second-hand market in China have dented new sales. Those postponed consumption/extended replacement cycle headwinds are now abating – mainstream German car brands have electrified, and buyers of ICE cars worried about residual values can now choose a VW e-Golf over a Tesla.

Indeed, the Ifo survey of German auto sector confidence is showing signs of stabilisation, while annualised output is also likely bottoming at just over 5m units. Last month, EU demand for new passenger cars increased by 14.5% to 1.2m units – the growth is certainly flattered by a low base following the introduction of a new emissions testing regime last year, but its striking that four of the five major EU markets saw double-digit gains. Over the first nine months of 2019, new car registrations were down 1.6% y/y but that should be turning positive into early 2020 – much of the slump in demand has been due to a technical industry transition creating consumer confusion over residual values etc. Tighter emissions standards have also been a drag in China, which adopted the local equivalent of Euro 6 for ICE engines in June this summer – sales have begun to recover since.

As for smartphones, while 5G handsets are still only about 1% of Chinese sales, with 40 cities fully networked by mid-2020 and operators offering 30-40% discounts on 3000-4500 RMB handsets (taking them closer to 4G prices), that proportion should surge toward double digits through H1. Given this upgrade cycle and flattering base effects, the overall market which has been falling 5% or so y/y in recent months should turn strongly positive by mid-2020. Pre-registrations for 5G service are approaching 10m users, even with just a handful of handsets currently available (although dozens more Chinese designs will be launched by mid next year).

Making China the biggest and fastest 5G deployment is a key technology priority for Beijing, not only for the direct benefits in terms of stimulating the service economy with related new products but the scale economies it affords to then dominate the global market for handset and infrastructure hardware. It’s critical to dig beneath the headlines to understand the role of say weaker semi pricing in the slump in Korean exports by value and the resurgence in the Chinese current account surplus YTD, as much as the role of Boeing’s 737 fiasco in US export/durables data. A semi restocking cycle into Q1 now seems plausible and the divergence between chip equipment names like ASML and the commodity chipmakers in Asia, who have lagged US peers YTD, should close.

Against this backdrop of a nascent cyclical recovery in key global sectors which have been a drag on PMI and trade data, you can be constructive on risk exposure at this point while utterly realistic about the low odds of any comprehensive trade settlement over the next year. The weakness seen in global PMI and other industrial data over the past 12-18mths was as much about a transition in key technology product cycles as it was trade uncertainty…that will be true of any ‘surprise’ rebound in H1 20 also.