It is always difficult for long-term investors to adjust to short-term changes. Are recent movements fragile, will indices fall apart soon, or are we witnessing major changes ? We have already answered that question several times, we think those are major changes. Of course, this point of view will become easier to trust once we do get signs from the economy that it does improve, but those signals usually come after the market has made significant progress. We have developed our own methodology to anticipate economic developments. We rely on cycles. It allows us to decide whether we can trust index price directions because the economic cycle will soon be improving -and confirming prices- or whether the market is going berserk because the economic cycle is still in the course of slowing down. A year ago, we had written that we expected the German economy to slow until 2019 Q3. We update that research. The data is not very supportive yet. The economic improvement is only minor. But it occurs at a time when an important bottom can be expected according to our methodology. This is one of the reasons that helped us maintaining our bullish view over the past months, through the consolidation. There will be hiccups of course, but for the time being, one should still favour risk-taking strategies.
The grey lines show the previous German Manufacturing cycles. The red line shows the current cycle.
The German Manufacturing production evolves according to a 33/35-year cycle. We only have enough data for one complete cycle in the past, but we base this assumption on the fact that this cycle appears on most production cycles that we study.
This cycle, and the evolution of the IFO index, allowed us to write a year ago that we expected the German economy to slow down for another year.The last data we have on our chart is August. We are approaching the timing for a turn-around.
The black line is the average 10/11-year Manufacturing production cycle in Germany. The red line is the current cycle.
We can focus with more detail on the 10/11-year cycle, which is a division of the previous cycle, between two blue arrows on the chart above.
Here too, we can see that we are approaching a bottom. On our average, it usually comes a little later (early 2020). There is some room for uncertainty here as the ideal timing for the first cycle bottom is at 33% of its overall duration -that is now. We have to make a provision for reality to differ a little from theory, and for our interpretation of the past not to be perfect.We are now entering a period when improvement should not be disregarded as accidental.
We display the 12-month variation in business climate horizontally, and 12-month variation of business expectations vertically. We know by experience that the data tends to move clockwise from one quadrant to the next -though not in mathematically-perfect circles.
Leading indicators such as the IFO can also help with the timing of the improvement.
We display in purple the recent periods through which the IFO allowed us to anticipate an improvement of the German industrial production (2015 to early 2018), and in green the periods when we could expect a deterioration (from April 2018, as March 2018 was the last data point in the expansion quadrant). The latest IFO data (red square) shows a small improvement, but it remains very fragile. We are still in the contraction quadrant.
This chart displays the 12-month variation of the Zew situation in black, and the 12-month variation of the Zew expectations in green.
The Zew survey is more interesting.
We had underlined the beginning of a divergence in the summer. This divergence occurred at the end of each of the previous important slow-downs, circled in red.
This chart does confirm that we are now at a juncture when we have to be very careful about improvements in the German economy.
Though we do not have proof, we have a strong suspicion that a bottom is building…
The 30-year yield has risen since the end of August but in the medium-term, it has not yet passed the level (38% Fibo and 2016 low at around 37 bps) that will interrupt the falling yield trend. There is still a little scope for yields to rise in the coming weeks, slowly, but one should not expect passing the major resistance without a fight. By the end of 2019, what one can reasonably expect on German 30-year yields is to evolve between 9 and 37 bps.
Later in 2020, the major resistance may be passed.
As for the DAX 30, though we are still below the all-time high, the trend is bullish in the long-term, medium-term and short-term. In the short-term, one may worry about being overbought. In our experience, one has to under-weigh the short-term view when important medium-term changes occur. There will be a time for consolidation, but in the immediate future, apart from closing the weekly gap, we cannot report major risks on European indices at large.