Macro

17th century British poet, George Herbert, penned “Do not wait; the time will never be ‘just right’.” This is, of course, a challenging retort for investors confronted with the current long economic cycle where asset prices appear far less attractive than they did a few years ago.

And for some time, we have been cognisant of the risk that, while the typical historical preconditions for a global recession were largely absent, there are factors that could throw the global economy off course, laying the foundation for a market correction in the period ahead. Were this to occur, it would be a good time to put more risk to work and implement new capital.

The catalyst for any correction has best been captured by the tug-of-war between the global economy’s strong fundamentals—low inflation, low rates and low unemployment, versus rising geo-political tensions and escalating trade tariffs that are proving to be a strong headwind to global activity. Indeed, the unemployment rate is at a 50-year low in the US, at a 27-year low in Japan and at an 11-year low in Europe. But tariffs in the US, even before the scheduled mid- December increase (yes, still due to be implemented despite the still vague ‘phase one’ deal between the US and China), are at their highest since 1971, seemingly unwinding 40 years of globalisation.

In this article, we take a fresh look at the ongoing battle between strong economic fundamentals and geo-political headwinds ahead of our 2020 market outlook due at the start of December.

We remain constructive on the outlook

We continue to expect the macro backdrop, not geo-politics, to ultimately triumph and global growth to likely stabilise and strengthen through 2020. This should be fostered by recent central bank easing (now at its most frequent since the GFC), tight jobs markets and President Trump’s awareness that first-term presidents have struggled to be re-elected when the US economy has been in recession. The US goes to the polls in November 2020.

Still, since August this year, we have positioned portfolios defensively, with moderate underweights in equities and bonds balanced by overweights to alternatives, credit and cash. For most of H2 2019, the trade dispute has been deteriorating, Brexit developments have been shambolic and there has been growing evidence that this geo-political uncertainty is weighing heavily on global industry. Collapsing industrial production, weak international trade and waning business investment intentions flag the potential for this to spill over into otherwise healthy consumer activity.

Equity markets have largely tracked sideways since August. Investors have seemingly ignored a deterioration in the macro data globally and weaker company earnings trends across the US, Europe and Asia. Instead, market performance has been supported by the recent de-escalation in geo-political hotspots, including Brexit and the US-China trade dispute. Bond yields have also moved higher, seemingly painting a less bearish global outlook. In Australia, a stabilising housing sector has been a similar panacea.

Have these developments come in the nick of time before 2019’s elevated geo- political uncertainty has gravely damaged the 2020 outlook? If tensions can recede, are we left then with just the positive economic fundamentals to condition the outlook ahead? We ask five key macros questions that we think are critical for markets in 2020. Collectively, they raise the issue of whether investors should now lean more positively into risk given the recent progress in de-escalating tensions. The time may never be ‘just right’.

1. Can US growth prove resilient as trade tensions ease?

Over recent months, there have been increasing signs that the pace of US growth has been slowing through H2 2019. In particular, the weakness in manufacturing and export growth—which this week contributed to the slowest US growth since 2016 in Q3—have shown early signs of spilling over to the consumer (with retail sales unexpectedly retracing in September).

Some of the slowing in growth is likely to reflect the fading of 2018’s tax cut stimulus. But it is almost certain that the disruption to demand and supply chains from the US-China trade dispute has increasingly weighed on business sentiment (reflected by the weakness unfolding in US capex orders).

Recent developments have taken a more positive tone:

  • US President Trump and China’s President Xi now appear on track to sign a ‘phase one’ trade deal in mid-November. Whether or not such an agreement can be reached, and any signs that it can be sustained ahead of the US presidential election in November 2020, will be key.

  • The US Federal Reserve (Fed) has eased financial conditions by lowering the fed funds rate from a peak of 2.50% mid-year to 1.75% in October, a stimulus that should support growth in 2020. The Fed is also expanding its balance sheet to calm volatility in short-term money markets.

While the ‘phase one’ trade deal fails to address many of the complex areas of dispute between the US and China, such as intellectual property theft and China’s subsidies to state owned enterprises, it still has the potential to improve business sentiment, stabilise US growth and encourage stronger activity through 2020. As noted by Société Générale “the scope for additional protectionist measures that the US and China are likely to impose on one another has shrunk considerably”. It also may signal that Trump is under pressure to ensure US growth strengthens ahead of the 2020 election.

Time will tell whether these positive developments have unfolded soon enough to avoid the recent US growth slowdown becoming entrenched. While corporate earnings through Q3 have been better than expected, they remain on track to deliver three straight quarters of year-on-year earnings declines, the first time since mid-2016. The Bank Credit Analyst also recently opined that “a corporate profit margin squeeze is looming”.

2. Can lower ‘hard Brexit’ risk drive a positive UK outlook?

According to Northern Trust, despite the resilience of the UK economy, “the uncertainty of Brexit has exacted undeniable costs, growth has slowed, and Brexit will also disrupt supply chains.” Recent data support this perspective. While unemployment has dropped to a 27-year low, economic growth fell in Q2. Moreover, one of the UK’s key business sentiment surveys, the composite purchasing managers’ index (PMI), slumped below the critical 50 mark in September and industrial activity collapsed to its weakest in five years.

Still, with the recent mid-October deal struck between the UK government and the European Union (EU), Parliament has now erected a new high barrier to a no- deal Brexit. Indeed, Société Générale has slashed its expectation of a no-deal Brexit from 45% to only 15%.

The increased likelihood of a 31 January 2020 Brexit, together with a 14-month transition, has the potential to release pent-up business investment, recently forestalled by an elevated level of uncertainty. According to UBS, recent polling also suggests the 12 December election is likely to deliver a majority to the Conservative Party, potentially easing the recent policy log jam.

Since the initial Brexit referendum, the UK equity market has been under- performing global markets, particularly in US dollar terms. Reflecting this, valuations have become increasingly attractive across a range of metrics (especially dividend yield). In light of recent developments, we are closing our underweight to UK equities, and acknowledge that further progress to avoid a hard Brexit could support a more positive multi-year outlook for both the UK economy and its equity market.

3. New ECB chief, new fiscal stimulus...can it save Europe?

Over recent months, Europe’s economic data has gone from bad to ugly. Europe’s jobs market somewhat mirrors the strength in the UK and the US, recently falling to 7.4%, its lowest in over a decade. At the same time, consumer spending has proved resilient at around a 2% pace. However, overall growth in Q3 has been little changed at just over 1%, well below its trend. The EU’s PMI, a leading indicator, remains weak near the critical 50 mark, while industrial production fell around 3% annually in August, its tenth consecutive monthly contraction.

According to UBS, the weakness is now reflected in company earnings where “downgrades to margins have been their worst since 2012”. Despite this, consensus earnings are elevated at 10% for the coming year, even though UBS’ model points to -4%. US-EU trade tensions are also weighing on the outlook, with the threat of auto tariffs only delayed until November 2019, while tensions have also flared over who is subsidising their aviation industry more, leading to retaliatory tariffs from both sides.

Still, there have been some positive developments. Progress toward avoiding a hard UK Brexit has reduced any potential European uncertainty shock, while the risk of a serious conflict between the Italian government and the European Commission over its public finances has receded. While scepticism surrounding the effectiveness of September’s comprehensive European Central Bank’s (ECB) policy easing seems justified, at least some stimulus is being added to support the otherwise weak European economy.

Looking ahead, the focus now turns to mid-December where new ECB President Christine Lagarde will receive new macro projections and have the floor to set the tone of future policy. Whether or not Germany has fallen into a technical recession will also be known by mid-December and the prospect of potentially positive German fiscal stimulus better understood.

4. Asian corporate ‘self-help’...can it limit the downside?

Recent data continues to reveal an ongoing slowdown in activity across Asia. China’s growth dipped to 6.0% in Q3 from 6.2%. However, estimates of sequential growth were actually closer to 5%, reflecting weakness in China’s manufacturing and property activity, as well as retail spending (autos). Elsewhere in Asia (where China’s slowing is also being felt), growth has also been trending weaker. Exports have fallen across the region, while consumer trends have been particularly weak in India. Looking forward, after recent downward revisions, most forecasts paint a more stable outlook.

Asia would clearly be a beneficiary of any trade truce between the US and China. A number of other observations surrounding the potential for fiscal support and corporate ‘self-help’ have also taken a more positive tilt:

  • UBS research recently highlighted that corporates in the Asian region were “managing costs faster and earlier than the turndown in revenue”. This has the potential to cushion margins if demand were to weaken further. This was particularly the case for Chinese corporates.

  • According to UBS, Asian corporates were also increasingly disciplined in limiting their capex costs, especially in Korea and China (while Taiwan was an outlier with sharply rising capex). While this can be negative for economies, it may also limit the extent of any needed correction.

  • A plateauing of inventories for Asian companies was also now suggesting production cuts were beginning to drain excess inventory.

  • There is increasing evidence of fiscal stimulus being deployed—this includes the recent significant corporate tax cuts in India. Malaysia’s mid-October budget also had a focus on driving growth though investment, a message echoed in promises from Thai and Indonesian governments. 

    5. Is Australia exerting ‘self-harm’? Can productivity lift?

      After slowing noticeably in H1 2019, recent data has shown some stabilisation in H2. This has been most prominent in the housing data, especially stronger growth in new home loans and house prices, while new building approvals have steadied. This is despite the likelihood that housing construction will still be around 20% lower over the coming year weighing on construction jobs.

      Retail sales have also edged higher through Q3. In contrast, recent rate cuts by the Reserve Bank of Australia (RBA) have done little to support business and consumer sentiment, which has remained below average.

      Taking a closer look at house price trends, over August and September prices rose an annualised 10%, while the annual pace recovered to -3.9% from -5.2%. This stabilisation eases the negative wealth impact from falling house prices that has likely been weighing on consumer spending intentions.

      Price gains have been reasonably uniform across both houses and apartments. In contrast, price gains by state have been quite disparate.

      • In Sydney and Melbourne, recent house gains have been strong, likely in part due to the more marked peak-to-trough falls in these markets. With both markets down a little over 10% over the year to mid-2019, they have jumped strongly in August and September to be only 4-5% below levels a year ago. Daily data point to further strong gains in October.

      • For Adelaide and Brisbane, prices have ceased falling over recent months, stalling the steady slowing in growth from 3-4% a few years ago, with price inflation out at around 1-2% below levels a year ago.

      • In Perth, weakness in prices has persisted—this city continues to show the largest month-to-month declines. Annual price deflation has been in the order of 9% for the past six months, twice its 4-5% losses through 2015 to 2017. Daily data still suggest little pick-up in October. 

      We believe there are two key issues confronting Australia’s economy and markets in the year ahead. Firstly, the increase in regulation and the impact this can have on growth and earnings. As Australia’s former and longest-serving treasurer, the Honourable Peter Costello, noted at Crestone’s recent Symposium, Australia is “much more regulated than we were 10 years ago. We all know the Australian equity market is dominated by banks. There’s enormous regulation on banks coming out of the royal commission.”

      Secondly, the lack of growth in productivity. Even the simple analysis that jobs growth is expanding at 2.5% compared with 1.5% for economic growth paints a grim picture of productivity. A lack of investment growth (and rising regulation) is likely to have contributed to this, with underlying business investment in Australia falling 1.5% over the year to mid-2019 and averaging around zero growth since 2013.                                                                                      
      As we noted a few months ago in the wake of the August equity reporting season, the “positive surprises in terms of dividends and capital management may reflect that companies perceive a lack of investment opportunities”. Worryingly, calendar year consensus earnings expectations for Australian equities are around 3% compared with around 10% for the rest of the world.                                                                                                                                                    
      Moreover, when looking at Australia’s medium-term company earnings outlook, less than a fifth of companies are expected to deliver double-digit growth and a quarter are expected to deliver negative growth. In other regions, somewhere between a quarter to a half of stocks are expected to deliver double-digit growth—a much more positive earnings outlook.                       

      In summary

      Over recent months, during which we have held a moderately defensive portfolio position, equity markets have broadly drifted sideways. While the global economic data has clearly deteriorated, risk appetite has been supported by positive progress in a number of geo-political hotspots, particularly the US-China trade dispute and Brexit.
      Have these events come in the nick of time to short-circuit a potential global recession reflected in the worsening trends in the world’s industrial sectors? Over the coming weeks, in the lead-up to our 2020 outlook publication, we will take time to assess whether a more balanced rather than moderately defensive portfolio position is warranted. Time will tell. But as the poet Herbert notes, it is rare that conditions will ever be ‘just right’.

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