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Trade Insight December 2014

Outlook 2015: risks ahead | “Febrile Stability” may not last


Executive Summary


Delta Economics is forecasting a small increase in growth in world trade from 1.2% in 2014 to just below 2% in 2015
: the increase is due to a resurgent US through rapid export-led growth and a rebalancing of trade within Asia, from China to other emerging Asian economies. This is the first increase in trade we have forecast for three years but is still too flat to suggest any kind of dramatic recovery. For example, Europe looks less positive with trade forecast to fall back by 3.5% while MENA will be hit by falling oil prices if the current trend continues, we are forecasting that trade growth will fall to 1.9% from its current 3.6%.

Lower oil prices put downward pressure on prices, or disinflation, which is transmitted through the trade system: for oil producers and heavily oil-dependent economies, lower import prices are a good thing. However, they lower revenues for many oil-producing economies, largely in emerging markets, and dampen domestic demand (and therefore demand for imports) as a result.

Geo-politics has dominated 2014 but to a large extent has been priced in even though it has flattened trade. Trade is the first thing to be affected by geo-political crises either indirectly, because it creates uncertainties that hinder investment, or directly through sanctions. There is no evidence that this has affected markets directly in 2014 but it has contributed to a sense of fragility and underlying nervousness that has underpinned apparent market stability in 2014.

This “Febrile Stability” was the key characteristic of 2014: equity markets continued to rise to new highs but there was no significant return to substantially higher volatility despite nervousness about geo-economic and geo-political risks. The Delta Economics Asset Trade Corridor Index (TCI-A) has been reporting lower signal strengths and negative indicators of Risk Adjusted Returns since September this year. The inference is that despite the outer calm, there is greater underlying instability as we move towards 2015. Investors are apparently behaving as normal but anticipating for a tipping point.

Our trade models for 2015 are strongly indicative of a correction in asset prices: the high correlation between trade and key commodities, key equities and key currencies reinforces the Delta Economics view that financial fragilities are spread through the trade and trade finance system globally.

The Delta Economics Sentiment Trade Corridor Indices (TCI-S), which track the Purchasing Managers’ Indices, have predicted accurately the PMI direction of travel with more than 75% accuracy this year. The TCI-S indicators suggest that the PMIs will continue to fall back for the next three months well into 2015.

In spite of this, the Delta Economics TCI-A has produced above market returns through 2014: The average monthly return for our monthly Trade Corridor Index–based strategy has been 1.2%.

December 2015 is showing market uncertainty making our signals weak: Our signals are weak for commodities, equities and currencies in December 2014 meaning that we are making very few strong recommendations. USD_EUR spot is expected to fall meaning that we expect the Euro to weaken further against the US Dollar.



Economic overview
 | A small increase in world trade in 2015

World trade grew at around 1.2% during 2014. This is still a forecast but is based on the actual data from the International Monetary Fund for the first three quarters of 2014 and the Delta Economics forecast for Q4 2014. The Delta Economics forecast aligns with the CPB Netherlands Bureau Trade Monitor for the first three quarters of 2014 but is divergent from the IMF and WTO’s trade forecast for 2014 by some margin (Figure 1).

2014-12-09_tradeInsight_fig01

Figure 1 | Delta Economics, WTO forecasts versus actual trade growth, 2011-14
Source | Delta Economics, WTO and CPB Netherlands Bureau 2011-14

Delta Economics is predicting that world trade will grow in value terms slightly during 2015 from 1.2% to just below 2% by the end of 2015. Because this is a forecast in constant values, it represents likely increases in world trade volumes during the course of the year.

Care should be taken in interpreting this growth, however. While it is the first forecast of slightly faster growth that we have made since 2011, it is still too slow to suggest that there is any major resurgence of trade as a driver of economic growth or, indeed, a return to the multiples of trade growth versus GDP that was evident in the immediate aftermath of the financial crisis.

The growth in 2015 will be led by two regions, Asia and North America (Figure 2). Asia’s growth, to an extent will be driven by:

  • China’s recovery from slow trade growth (at just 4%) in 2014 to above 7% in 2015. Although this is still a long way below post-crisis peaks.
  • Re-distribution of trade around the region away from China. We expect particularly rapid trade growth in Indonesia and Malaysia at over 10% and 7% respectively in 2015.

North America’s growth is driven by exports which, following a sustained period of re-shoring, are forecast to grow by nearly 4.5% in 2015.

2014-12-09_tradeInsight_fig02

Figure 2 | World and regional trade growth (% constant prices), 2014 and 2015 compared
Source| DeltaMetrics 2014

However, every other region’s trade is forecast to decline or grow at a slower rate in 2015 with Europe’s trade set to shrink in current prices by 3.5%. Much of this is due to declining intra-European trade: trade within the Eurozone is forecast to drop by 3.7% this year reflecting weak demand conditions within the Eurozone.



Economic overview
 | Disinflation, oil prices and the risks of contagion

MENA’s trade is forecast to drop to 1.9% in 2015 from an already disappointing 3.6% growth in 2014. At the beginning of 2014 the Delta Economics forecast was for above 4% growth. On paper at least, oil producing nations are net losers in export terms as the oil price drops while oil importers are net winners in that it reduces costs for producers and exporters.

A zero-sum game in trade terms as the oil price drops is over-simplistic, however. Trade and oil are 94% correlated. This means that trade can effectively be a mechanism through which disinflation is spread through the global economic system. Emerging markets are the largest oil producers and, as they lose export revenues, their aggregate demand falls back meaning that they demand less by way of imports from other countries. Lower oil prices reduce producer costs, but if there is little demand either within or outside of a region then export prices will also have to drop.

Against this backdrop the forecast for world trade becomes important as a predictor of when we might see oil prices increasing again (Figure 3).

2014-12-09_tradeInsight_fig03

Figure 3 | Monthly value of world trade vs. NYSE Arca oil spot, Last Price Monthly, June 2001-Nov 2011
Source | DeltaMetrics 2014, Bloomberg

The monthly predictions of trade growth suggest that there will not be any major pick-up in the oil price until the end of Q1 2015. Even then, any increase will be erratic and relatively small based on how we are predicting global trade will grow.



Economic overview
 | Geopolitics, geoeconomics and “febrile stability”

2014 was dominated by geo-political and geo-economic risks from the outset: starting with the Emerging Markets in January, Russia and Ukraine in late February, the Iraq crisis in June 2014 and subsequent crises in August to the end of tapering, with China and Japan’s economic slowdowns at the end of the year. Until the major fall in oil prices at the end of 2014, markets appeared to be pricing these in. Equity markets continue their bull run with the role of central banks increasingly seeming to be to provide re-assurance to markets that nothing precipitous is likely to happen to interest rates in the immediate future.

This creates what Delta Economics terms, “febrile stability”: markets are behaving as if there are no underlying geo-political or geo-economic concerns, yet watching for one incident that will trigger a major sell-off.

The case of Germany’s car trade with China and Russia illustrates the interplay between geo-politics and geo-economics and its dampening effect on trade (Figure 4). The DAX is 86% correlated with Germany’s trade overall, 73% correlated with its car trade to China and 84% correlated with its car trade to Russia. Figure 4 shows:

  • German car exports to China are forecast to grow during 2015 but it will not be until the end of Q2 that exports really pick up again. This suggests that China’s demand for luxury goods, while growing, is not growing at the pace that might be expected.
  • German car exports to Russia are forecast to slow during 2015 and have dropped substantially since the beginning of the Russia-Ukraine crisis. This is partly a reflection of Russia’s weakening economy but in the first instance was the result of punitive reciprocal trade restrictions.

2014-12-09_tradeInsight_fig04

Figure 4 | Monthly value of German car exports to Russia and China, USDm vs. DAX, Last Price Monthly (June 2001-Dec 2015)
Source | DeltaMetrics 2014, Bloomberg


The tipping point in 2015 is likely to be an increase in interest rates in the USA. If this is early in 2015 while oil prices are still falling, this will further strengthen the US Dollar, reducing further the export revenues for emerging economies in particular and placing at risk of default any sovereign debt or bonds denominated in US Dollars. As Russia, Argentina and Venezuela are close to default this could be the catalyst that sparks a global correction.



Economic overview
 | Global equity markets long overdue a correction

Delta Economics modelling continues to suggest that equity markets are long overdue a correction. The correlation between world trade and the S&P 500 has weakened from 68% in January to 62% now and this reflects its long bull run that has extended to the end of 2014. It has become increasingly detached from real macroeconomic indicators and increasingly determined by central bank monetary policy and short-term sentiment indicators.

Delta Economics considers the bull run to be unsustainable given the pressures of disinflationary contagion and geo-political and geo-economic risk that spread through the global trade system. Economies do not operate in isolation in the same way as they did pre-crisis and a hike in interest rates in one country, particularly the USA, will impact others through trade and debt dependencies. Against this fragile backdrop, it is likely that a major correction in asset prices will take place during 2015.

2014-12-09_tradeInsight_fig05
Figure 5 | Monthly value of world trade (USDbn) vs. S&P 500, Last Price Monthly, June 2001-Dec 2015
Source | DeltaMetrics 2014, Bloomberg



Sentiment Indicators

The Sentiment Trade Corridor Index (TCI-S) suggests that the Purchasing Managers Indices for November (published at the beginning of December) will fall. The Flash PMIs, published at the end of November, reinforced this view. We expect PMIs to be set on a downward trend into 2015.

The TCIs are based on actual data and although they are highly correlated are in no sense an alternative to the PMIs since the methodologies differ. PMIs, being survey-based, are sentiment indicators while the TCIs give an actual and a forecast indication of how underlying trade conditions, including trade finance, are moving. In other words, the TCIs provide a predictable and quantifiable view of how changes in the global economy are affecting trade at an individual country level.

Figure 6 shows the correlations of the TCI-S indices for 12 countries and regions with their respective PMIs, our forecast accuracy, and our prediction for the direction of travel for PMI data that will be published at the beginning of December.

2014-12-09_tradeInsight_fig06_v01

Figure 6 | TCI-S correlations with PMIs and predicted direction of travel for December PMI data
Source | Delta Economics analysis

Method note | The TCIs measure the trade flows of any one country and forecasts these forward using its proprietorial forecasting methodology. Each index is specific to the country it relates to in that the trade corridors and flows will differ for each country. The rate of change in the index is correlated with the Purchasing Managers’ Index (PMI) for that country.



Outlook for December 2014
 | TCI-A track record

The Delta Economics TCI-based asset management strategy takes the top-500 trade corridors (trade between two countries by sector) against an asset price. It creates an optimum corridor index of those trade corridors each month and has been tracking its performance over the past 16 months. This is a systematic model and assets are included in the portfolio if one of the following conditions is met:

  • The signal strength, which measures the percentage of trade corridors that are pointing to a long or short call, must be higher than 95%.
  • The signal strength is greater than 85% and the Information Ratio, which measures the performance of that optimum corridor relative to benchmark returns, is greater than 0.5 (indicating good or very good back-tested performance).
  • Where there is signal strength of 100 and only one corridor in the index, the Information Ratio must be above 0.5.

The returns, which are not optimised and based purely on an equally weighted portfolio strategy, were 1.2%. This means that over the past 16 months, returns have averaged 1.2% per month. There has only been one month in which returns have entered negative territory.

2014-12-09_tradeInsight_fig07

Figure 7 | Monthly Returns of TCI-A strategy (%) June 2013-November 2014
Source | Delta Economics analysis

All calls for December 2015 have a substantial downside risk to them. The information ratios, which measure the returns performance of a particular index in the past against market returns, are negative or low while the signal strengths themselves are largely below strong recommendation thresholds.



Commodities

The model is suggesting that oil prices may climb again during December. The information ratio is strong. However, the broader trends in trade and the downward market pressures suggest that despite the high information ratio there would be a substantial downside risk on this call. The other commodities do not have strong enough signals to recommend any, but confirm that commodities are more generally on a downward trend in price terms. This reflects the broader challenges to the world economy as Chinese growth slows.

2014-12-09_tradeInsight_fig08
Figure 8 | Delta Economics TCI-A based strategy, commodity calls for December 2014
Source | Delta Economics analysis



Equities

The picture for equity markets is mixed: generally the calls are long for European and technology stocks, but short for emerging markets. This reflects the weaknesses in EM equities that have been a feature of 2014.

2014-12-09_tradeInsight_fig09
Figure 9 | Delta Economics TCI-A based strategy, equity calls for December 2014
Source | Delta Economics



Currencies

We expect the US Dollar to continue to strengthen during December 2014. All other currency calls have weak signals and therefore carry a strong downside risk. Proxied by the Thai Bhat, we expect most emerging market currencies and the Yen to deteriorate against the US Dollar in December.

2014-12-09_tradeInsight_fig10
Figure 10 | Delta Economics TCI-A based strategy, currency calls for December 2014
Source | Delta Economics


Delta Economics Trade Insight December 2014  |  Author  |  Rebecca Harding  |  CEO Delta Economics


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