Following strong US equity sell-off in December, we have witnessed sharp risk appetite reversal at the beginning of 2019. The S&P 500 recorded five gains in the past six trading sessions and volatility in the US equity market has retreated to its lowest level since early October (see chart below).
Chart 1: Cboe VIX index
Dovish Fed in combination with strong data releases boosted investors' risk appetite. Non-farm payrolls rose by 304k in January which was significantly above the market consensus of 165k increase. The US employment has grown at an above-average rate in the past two months and average hourly earnings growth remained strong at above 3.0% on a yearly level. The unemployment rate increased one-tenth to 4.0%, reflecting a further rise in labor force participation.
Chart 2: Non-farm employment growth (average, in thousands)
The US ISM manufacturing index unexpectedly rose in January, with a sizeable increase in the orders and production subcomponents. The headline index at the level of 56.6 is consistent with strong growth in the manufacturing sector in the coming period. The University of Michigan index of consumer sentiment also rebounded in the final January report. The Federal reserve bank of Atlanta GDP tracker currently suggests 2.7% GDP growth in the fourth quarter of 2018.
However, the latest eurozone data releases failed to provide investors the required optimism. In detail, eurozone real GDP expanded by 0.2% qoq in Q4 according to Eurostat's first release. This brings the 2018 growth to +1.8%, down from +2.5% in 2017. Furthermore, Italian Q4 GDP growth of -0.2% qoq disappointed the market. This was the second consecutive quarter of negative GDP growth, which puts Italy in a technical recession.
The latest sentiment indicator releases suggest that the growth slowdown/correction is still not over. The composite purchasing managers' index for the eurozone fell again by 0.9 points to 50.5 in January. The indicator is, therefore, just slightly above the 50 points which separate expansion from contraction. The HIS Markit purchasing managers' index for Italy slipped to 49.7 in January from 50.5 the previous month. A slowdown in new order growth and a decline in international demand were "central" to the shrinkage of the overall PMI index according to the HIS Markit.
Chart 3: ISM manufacturing indices
The Ifo business climate fell unexpectedly sharply in January (from 101.0 to 99.1) mainly due to the expectation component, which collapsed from 97.3 to 94.2 points. The decline was even more pronounced in the export-oriented sector than in the service sector. Industrial production in Germany disappointed once again in December with a minus of 0.4% after falling by 1.3% in the previous month. This means a minus of 1.5% qoq for the fourth quarter. New orders in German manufacturing fell 1.6% m-o-m in December, far worse than the 0.3% rise predicted by the Reuters poll.
The European Commission released its Winter Forecasts where it was stated that the eurozone economy is expected to grow by 1.3% in 2019 which is 0.6pp below the Autumn Forecast released just three months ago.
The dynamic of the US data outperforming the eurozone is not new as it was the case for much of 2018. However, the data have shown extreme divergence in the past few weeks as it was demonstrated above. The result has been that while US equities were the sharp underperformer for the biggest part of fourth quarter, last week, they had among the best returns. The EUR/USD has fallen again below the 1.14 mark as it depreciated after the latest round of disappointing data.
UST 10Y yield - GER 10Y yield
The eurozone growth slowdown is broad based both in terms of the countries it affected and the sectors. The magnitude of the US growth deceleration is expected to be much lower and predominately caused by fading fiscal boost and global growth slowdown. Recent credit and bonds development show that the market is pricing a more negative growth outlook in eurozone relative to the US. Indeed, in spite of recently dovish Fed, Bund yields remain extremely depressed when compared to US 10Y yields while EUR high-yield spread ratio is significantly wider than the US high-yield spread. (A high yields bond spread shows the percentage difference in current yields of various classes of high-yield bonds compared against investment-grade treasury bonds). All this shows that the market is rather skeptical about the eurozone growth development. In such circumstances, I believe that the US equity market will profit further and additional USD dollar strengthening should not be surprising as well (see more in No Reason For The USD Weakness). Emerging market equities benefited from the US dollar weakening that occurred in January. One should be careful as this will be reversed as the US dollar regains its strength.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.