Too Many Gaps To Mind

By Elwin de Groot, head of macro strategy at Rabobank

Lots of Gaps to Mind

“Mind the gap” is a warning that most people, and certainly those who have travelled on the London Underground, will know. Admittedly, it does sound a lot friendlier than the German equivalent of “Einstei gen!, zurück bleiben!” that long was the warning message in the Berlin Metro, but both have serve important purpose: to warn people against making missteps. And it actually applies to a wide range of situations in life, economies and markets.

So let’s start with that gap that is still yawning between US lawmakers and may soon unleash mayhem. We are still witnessing a continuous flip-flopping in assessments by both parties on whether or not discussions on the US debt limit are moving in the right direction. Yesterday’s talks ended without a deal, even though Biden and McCarthy called their discussions “productive”.

The US debt ceiling saga is more or less evolving in line with our ‘game of chicken’ . The thinking here is that it is only when the pressure on both parties involved is high enough (either by markets, rating agencies or perhaps the parties’ grassroots) that a decision will be forced. If we are lucky this happens before any real damage is done. But that is not a given, especially when both sides have the confidence that they can either ‘win’ outright or can just push for more time. House Republicans, for example, are now trying the latter, by openly questioning the Treasury Secretary’s warning that the government may truly run out of money as soon as 1 June. Yesterday, House Majority leader Scalise called for more transparency on how that particular date had come about.

It is against this backdrop that equity markets slipped yesterday whilst bond yields rose, albeit just a few basis points. But if you want to look for ‘angst’, securities that redeem in early June are still your best gauge. The US Treasury’s latest 21-day cash management bill – which is non-benchmark issue – drew a 6.2% rate yesterday, the highest rate in over two decades, according to Bloomberg.

Turning to Europe, there is also a sizeable gap to report of, albeit of a completely different nature, namely the gap between the performance of industry and services. The purchasing manager surveys for May highlighted this point once again. The ‘PMI gap’ between the two sectors was the largest since records began (which is late 1990s). The Eurozone manufacturing PMI slipped further into recessionary territory, with a reading of 44.6 (from 45.8 in April), which is the lowest level in 3 years; by contrast, the services index fell only slightly to 55.9, to sit comfortably in expansion territory. This phenomenon is actually shared by many other countries outside the Eurozone, such as the UK (46.9 vs. 55.1), Japan (50.8 vs. 56.3) and now also the US, where the manufacturing PMI fell to 48.5 but the services PMI rose to 55.1.

Services have certainly benefited from a post-pandemic shift in spending from goods to services. European data are quite scattered on this front, but US data clearly show that phenomenon: in March the volume of spending on goods was down 5% from its March 2021 peak; services spending up 8% y/y. Still, we believe this effect has largely run its course by now. Activity and new orders in the European services sector increased, but the growth rate of new orders slowed a bit.

So overall, we would argue, these surveys suggest that the underlying picture is not improving. We note that a simple indicator that subtracts the services PMI from the manufacturing PMI is consistently negatively correlated with future economic activity, despite services taking up a much larger fraction of the economy than industry. In other words, the May surveys tell us that the direction of travel is towards a weakening of activity but the services sector prevents a more rapid slowdown.

Zooming in on European industry, things have been going downhill for some time. Weaker demand was the main culprit behind the declines in the most recent PMI surveys. Whilst backlogs partly upheld production, these did not compensate for a decrease in new orders. This weakening of demand also explains why industrial activity hasn’t really bounced back despite the huge decline in energy costs since last summer. The Dutch 1m gas TTF contract slipped decisively below €30/MWh; remember it stood above €300/MWh back in August 2022. Meanwhile, oil prices are down some 35% from their peak last summer. But apparently industry is not benefiting yet.

Industry is also a more capital intensive sector and tighter financing conditions are potentially standing in the way of a ramp up in capacity. Germany’s data are particularly worrisome. Its manufacturing PMI fell to 42.9, the lowest level since May 2020. This also points to weakness in China. As the FT reports, the weakness in German exports is triggering a debate “why its vast manufacturing sector has fallen behind rivals benefitting from a rebound in Chinese demand”. The struggling automotive, chemicals and energy-intensive sectors are singled out as weaklings, being at a disadvantage either because of high (energy) input costs or being late to the EV party.

There may well be a global analogy (and gap warning!) here with the semiconductor sector. The contours of the ‘chips war’ are roughly as follows. Since last summer the thumbscrews on China have been tightened with the US curbing export of high-performance semiconductors to China. Several countries have followed and end-March Japan announced that it will impose export restrictions on 23 types of equipment to produce semiconductors from July. Those restrictions are said to be broader than those put up by the US so far. Meanwhile, we have seen a flurry of deals in the sector that either look to expand in ‘friendly economies’, such the deals made on the side-lines of last week’s G7 meeting. But domestically things have also started moving more quickly – supported by the US’s $280bn CHIPS and Science Act, of which some $106bn is earmarked for semiconductor and telecom purposes.

Although these developments will likely help Western economies to reduce their reliance on China over time, the widening gap with China may also create new problems in future. Export curbs may lead to retaliation by China, undermining demand from China. Such a gap would either have to be filled with massive domestic or government orders, or it would lead to a disincentive to invest. And even though many experts believe that China cannot quickly bridge the technology gap with the US, NVIDIA chief Jensen Huang warns in an interview with the FT today that US companies would incur “enormous damage” if they were to lose demand from China. Moreover, cutting off China may speed up the process in China to produce cutting edge technology: “If [China] can’t buy from… the United States, they’ll just build it themselves,” he said.