A slowdown in the US economy – predicted over and over due to the expectation that the longest post-war boom is drawing to a close – currently seems to be taking shape. Moreover, unless Washington and Beijing clinch a major trade deal or forthright fiscal stimulus policies are adopted, the deceleration under way looks set to continue. Now, at this stage we can’t really rule out the chances of a decent trade agreement, one that might not be able to kick-start global growth but could at least stabilise it. Such an agreement is doubly crucial since the Federal government is unlikely to loosen the purse strings over the coming twelve months. In Europe as well, the ongoing gridlock in German politics will probably keep a sizeable increase in government spending off the agenda until next spring. Then again, financial markets can look forward to a rising tide of liquidity pumped into the system by the only central bank with the firepower to do so – the US Federal Reserve.
The global outlook
Our previous report discussed the reasons for the policy U-turn through which central banks reasserted their commitment early in the year to countering the nascent economic slowdown and the resumption of deflationary pressures that are being intensified by the slowdown. Though we admitted to being somewhat surprised by how eager they were to take preventive action against what we viewed as a fairly mild global soft patch, we voiced the following concern: “… how serious is the threat of a marked global economic slowdown – which, if it came to pass, would undermine our baseline scenario of an ongoing financial market rally?”
The continuing tug-of-war between Chinese and US negotiators played a part in weakening global economic growth. It reduced international trade and, more importantly, it discouraged companies around the world from investing – just when the political climate was heating up in Hong Kong, the United Kingdom and even the United States. At the same time, with global liquidity still tight, the greenback continued to gain ground while emerging economies underperformed. The main leading indicators for the world economy were therefore pointing in the wrong direction and there were very few signs of imminent domestic recovery anywhere.
One might have expected such a pile-up of negative conditions to be bad news for risk assets. But as we had forecast, international equity markets maintained a rally of sorts, driven by defensive sectors with secular growth prospects that were buoyed by the steady retreat in key government bond yields. During the third quarter , the 10-year German yield slumped to –0.73%, while the yield on the longest-dated US bonds (30 years) hit an all-time low of 1.90%. Our expectation of a continuing slowdown over the months to come can explain at least some of these unconventional movements in bond yields.
We get the impression, however, that in its efforts to counter a slowing economy, the US Federal Reserve would rather be accused of moving too slowly than acting too fast. Unlike all other major central banks, the Fed has succeeded in normalising monetary policy and interest rates, so its reluctance to deplete such an enviable war chest at the slightest hint of waning growth is quite understandable. In contrast, the European Central Bank is struggling to deal with both the end of the Draghi era and its rapidly eroding room for manoeuvre. On the whole, then, we can expect central banks to respond less promptly to signs of a flagging economy. It follows that a revival of world trade and greater fiscal spending are emerging as the key potential allies of global growth.
A slowdown in the US economy – predicted over and over due to the expectation that the longest post-war boom is drawing to a close – currently seems to be taking shape, however gradually. After increasing at a 2.0% clip on an annualised basis in the second quarter , US GDP is now expected to grow by a meagre 1.7% in the third, making it the weakest third quarter in the last three years – that is, since Donald Trump took office.
While the uncertainty generated directly by the endless trade talks imposed by Trump has seriously undermined capital expenditure, consumer spending is still going strong, thanks in part to what is in essence full employment. The jobless rate fell in September to 3.5% of the country’s labour force – lower than at any time in over fifty years. On the other hand, the rise in wages slowed from 3.4% in February to 2.9% in September, meaning that full employment still doesn’t seem to be enough to produce steady wage inflation. It is, however, a boon to US workers and has played a part since 2015 in keeping corporate profit margins stagnant by increasing the share of wages in output. That stagnation already bears some responsibility for the country’s low level of business spending, whose growth rate shrank from 6.9% in June 2018 to just 2.6% in June 2019.
There is clearly a close medium-term correlation between an increase in profit margins and an increase in capex, and currently all the relevant leading indicators are still pointing downwards. Rising pay for US workers has only partially been passed on to selling prices even though underlying inflation inched up in September from 1.6% to 2.4%, i.e. near the top of its range for the past five years. The mild recent uptick in prices is primarily attributable to a one-off hike in healthcare costs, as well as to rising rents, a factor that may, in contrast, prove to be more lasting.
However, there is no demand-pull inflation in the United States at present. With productivity growth stuck below the 2% mark, business profitability is thus becoming an issue and, further down the road, so will continued full employment. To be sure, if the US and China strike a far-reaching deal, we will likely be heading for a more peaceful trade climate that could boost capital spending and sustain full employment in the United States. But that positive outcome now appears to be a condition sine qua non for both the US and global economies to keep humming. In the absence of such a trade deal, we won’t be seeing a standard trend reversal in the business cycle – i.e., brought about by inflation and rising interest rates. The cyclical expansion will end instead as result of dwindling profits and the attendant fall in business investment.
The Fed’s policymakers still seem to believe at this stage in the US economy’s resilience and accordingly feel they have sufficient grounds for taking their time about lifting interest rates. On the other hand, the recent crunch in the repo market for government bonds – due to the Treasury’s mounting need for funding to pay for a rising Federal deficit, to a flattening yield curve that makes forex hedges too expensive for potential foreign buyers of US government paper, and to the impact of banking regulations – forced the Fed to initiate a major Treasury-buying programme. That move should lead to much greater liquidity in the market, less pressure to buy greenbacks and thus more favourable financial conditions in emerging markets. The Fed has said it will begin purchasing $60 billion worth of Treasury bonds a month, a policy that should inject a good deal of cash into the system. The upcoming transition to 2020 is therefore unlikely to resemble the touch-and-go situation we experienced a year earlier when inadequate liquidity made December 2018 a disastrous month for financial markets.
In Europe, the German locomotive is showing precious little traction these days. Germany is one of the chief collateral victims of US-China trade strife because the ongoing conflict is depressing the business spending that has proved so beneficial to its economy. The country’s heavy reliance on the auto industry is likewise a handicap. Its carmakers have failed to prepare for the EU’s drastic environmental regulations and to stand up to a German environmental lobby that has managed to push through a relentless energy transition. Furthermore, the lack of economic reforms under Merkel – leaving aside those introduced by her predecessor almost fifteen years ago – has begun to take its toll. Germany has gone into an industrial recession that bodes ill for the national economy as a whole. We can safely assume, however, that German realism will eventually win out over the prevailing balanced budget mantra and move the government to opt at long last for deficit spending. That would be a big help to the entire eurozone – an entity already saddled for too long with the uncertainty surrounding Brexit.
Things look better in France, suggesting that the current economic and financial landscape calls for a fiscal stimulus boost of the kind Germany has so much trouble accepting. The “gilets jaunes” movement thus happened at exactly the right time, as it forced the government to loosen the purse strings. The latest economic readings speak for themselves. The country’s PMI leading indicators for manufacturing and services have steadied at around 50, whereas their German equivalents stand closer to 40. In addition, the French property market is still going strong. The consumer confidence index has jumped from 87 six months ago to 105, which should lift the growth in consumer spending from 1% today to nearly 2%. And capital expenditure is progressing at an annual pace of roughly 4%. Even so, it would be nice if France’s neighbours followed suit. Otherwise, the current Keynesian recovery may well trigger an equivalent surge in the country’s trade deficit with its European partners.
What makes fiscal stimulus so vital at this time is that the European Central Bank appears to have only limited scope to loosen policy. Nor is there any guarantee that investors will feel comfortable with bold steps taken by the ECB now that they’ve lost their guide – Mr “Whatever-it-takes”. They also need to get acquainted with his successor, a figure who has little experience with the complexities of managing monetary policy.
Meanwhile, a strong US dollar (reflecting insufficient liquidity) has continued to hold back the emerging world. In China as well, the government’s determined drive to stem the economic slowdown under way hasn’t been an unqualified success. The deleveraging programme implemented by Beijing in 2018 has produced carryover effects that have been amplified by plummeting business sentiment in response to trade war.
At the same time, a worsening balance of payments has prevented the People’s Bank of China from aggressively slashing interest rates. So a favourable outcome to trade negotiations with Washington now seems to be more crucial than ever to spurring an economic recovery that could be further strengthened by the lagged effect of China’s stimulus measures implemented several months ago. Despite the dollar appreciation, a number of emerging markets have managed to cut interest rates to revive their economies. The prospect that the Fed’s latest steps towards monetary policy easing will weaken the US currency could therefore pave the way to much higher GDP growth rates in the emerging world.
Now that central banks are likely to be less proactive about combating economic slowdown and there is a distinct possibility that a candidate advocating income redistribution will win the next US presidential election, we would do well to brace ourselves for major spikes in financial market volatility. Unless Washington and Beijing clinch a major trade deal or forthright fiscal stimulus policies are adopted, the deceleration under way looks set to continue.
Now, at this stage we can’t really rule out the chances of a decent trade agreement, one that might not be able to kick-start global growth but could at least stabilise it. Such an agreement is doubly crucial since the Federal government is unlikely to loosen the purse strings over the coming twelve months. In Europe as well, the ongoing gridlock in German politics will probably keep a sizeable increase in government spending off the agenda until next spring. Then again, financial markets can look forward to a rising tide of liquidity pumped into the system by the only central bank with the firepower to do so – the US Federal Reserve.
With volatility most likely on the agenda, we believe that moderate risk-taking across all asset classes – which would position us to take advantage of excessive swings created by that volatility – is the best approach to navigating the environment we have just described.
In the equity market, we are holding to our preference for more defensive names and sectors that enjoy predictable earnings growth. At the same time, we are poised to return to cyclical themes if a far-reaching trade deal is reached, major fiscal stimulus programmes are implemented or the US dollar falls sharply.
In fixed income, we intend to steer clear of extreme positioning in terms of duration, while keeping our exposure under the benchmark. We are also sticking to our cautious stance on corporate bonds and still expect sovereign credit spreads to narrow in Southern Europe. EM debt is becoming increasingly attractive, due to low inflation and the potential for the greenback to lose ground.
A key focus for us is the forex market, above all the euro–dollar exchange rate. The Fed’s recent acceleration of monetary policy easing and the chances of a trade agreement in the coming months should help drive the dollar down. We will therefore be introducing additional hedges against that depreciation.
Source: Carmignac, 30/9/2019.
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