12 July 2019

Global equity markets are at (or approaching) all-time highs. What’s not to like? In particular, the US market has been buoyed by the Sino-US trade truce achieved at the Tokyo G20 meeting, the prospect of Federal Reserve interest rate cuts, and solid employment gains. Indeed, our year-end 2019 S&P 500 target of 3,000 has already been achieved.

However, there are numerous potential potholes that need to be assessed and avoided in the period ahead. Despite the current slowdown in global growth — and the USA in particular — I do not expect a world-wide recession in the near term. In the absence of such a slump, financial markets are likely to remain upbeat overall. However, I suspect that the potholes are significant enough that investment returns will remain modest during the next 12-18 months. To be sure, the Trump Administration enjoys highlighting this year’s sharp advance in equity prices. However, the S&P 500 is up only 3% since last summer, and experienced one 20% drawdown along the way (Global market returns have been similarly modest). I expect the period ahead to be quite similar.

Sino-US Trade Truce: Economic Risks Remain High

To be sure, the decision to maintain the status quo in the US-China trade conflict is welcome news compared to the threatened escalation. However, America’s trade strategy raises numerous concerns. First of all, the decision to ease the ban on trade with Huawei in exchange for China’s pledge to import additional US agricultural products highlights the transactional nature of President Trump’s trade policy. After stridently suggesting the Chinese telcom giant posed a serious risk to US security, the policy shift appears to be an attempt to appease US farmers in the runup to next year’s election. Such tactics suggest the President could reach a politically expedient deal prior to polling day rather than negotiating a more desirable comprehensive agreement (which would take years to achieve).

More fundamentally, however, the Trump Administration’s trade policy is taking its toll on the US economy without delivering any reduction in the US trade deficit. This is unsurprising, as America’s external deficit results from the nation’s low savings rate, which will not be remedied by focusing solely on bilateral trade relationships. Indeed, the ballooning of the US budget deficit (following last year’s tax cuts) virtually ensures the trade shortfall will continue to expand. To be sure, the Chart above illustrates the adverse impact on US exporters of lower sales to China. Likewise, higher tariffs have lowered US purchases from China. However, American spending has only been diverted towards other partners, and imports continue to rise. As a result, the world-wide US trade shortfall continues to expand, despite a 10% reduction in the bilateral gap with China.

The Chart above illustrates that China and the United States are not the only nations adversely impacted by the escalating trade war. Exports are slumping in the trade-oriented Asian economies (with the noteable exception of Vietnam). In addition, the Trump Administration’s recent threat to impose tariffs on Mexico opens a new chapter in the trade war. Indeed, these levies potentially will be imposed not only to pursue trade concessions, but also in pursuit of broader political objectives.

This strategy is unpredictable and arbitrary, and risks undermining business confidence considerably further. Indeed, India and Brazil have come in for criticism lately. Despite specific sector-level disagreements (e.g. autos), the Chart above suggests that there is not a major problem in America’s bilateral trade relationship with Europe (the exports/import ratio between the two partners is similar to the US world-wide level). Nevertheless, disputes over NATO, Iran, and even leaked comments by UK ambassadors appear likely to adversely impact trade relations in the period ahead.

JCPOA: RIP

Despite European efforts, the JCPOA appears to be deceased. Not only has the USA withdrawn and reimposed sanctions, but the sanction waivers for the eight largest importers of Iranian oil now have run their course. Iran’s recent decision to breach the Agreement’s enrichment cap was the final nail in the coffin.

I suspect the consequences for the Iranian economy of the current sanction regime will be greater than the previous episode. Prior to the JCPOA, Iran’s oil exports declined from about 2.5mbd to 1.4mbd. The Chart above shows the eight countries with waivers sharply reduced Iranian oil imports even before these exemptions expired. While the Trump Administration’s aim to completely eliminate Iran’s oil exports is unlikely to be achieved (China, India, and Turkey are not expected to fully comply), oil exports could decline up to another 1mbd — an overall cut of 70%. Meanwhile, Iranian crude production, which declined from 3.8mbd to 2.8mbd in the previous episode, is already less than 2.4mbd, and set to decline at least another 1mbd (again nearly 70% lower).

Inflation now at 50% already exceeds the previous peak. However, the Chart above illustrates the impact of current sanctions on Iran’s currency is far worse than in the past. Consequently, I expect CPI to rise above 100% in coming months.

IMF GDP projections support my belief that this episode will be more painful than in the past. Indeed, I project an additional sharp GDP decline in 2020. as well. It’s impossible to be certain of Iran’s reaction. However, Iran still has about $120bn international reserves. Therefore, even if oil exports collapse as expected, Iran has financial resources for the next 3 to 4 years. In other words, this crisis will not be short-lived. Despite the JCPOA’s shortcomings, it did ensure a decade-long curtailment of Iran’s nuclear ambitions. Now, it would appear likely Iran will restart its nuclear program. As the international community insists that Iran can not acquire nuclear weapons, confrontation appears unavoidable, especially with Israel.

What’s the likely impact on oil prices of an additional 1mbd decline in Iranian oil production? The Chart above (apologises for the poor quality) illustrates the relentless rise in US oil production. On the other hand, Saudi Arabia has had to balance America’s demand for cooperation in preventing a spike in oil prices, and its interest in preventing petroleum quotes from falling too much. The Chart shows the Kingdom initially raised production, but has since sharply cut output in line with with other OPEC and non-OPEC producers.

Currently, KSA oil production is well below its OPEC target (9.7mbd versus 10.3mbd). The combination of the scope for higher US and Saudi output — in addition to continued adherence of Russia and other OPEC members to their production targets — suggests that further declines in Iranian supply should not dramatically impact oil prices.

Brexit: Parliamentary Showdown Looming

The Brexit saga should reach a climax this Autumn (I’ve heard that one before!). Both candidates to replace Theresa May as the next leader of the Conservative Party (and Prime Minister) are commited to a No Deal Brexit, if an agreement with the EU cannot be reached by 31 October. With Parliament vowing to prevent that outcome, the new government will inevitably face a constitutional showdown in the next few months. Volatility awaits.

I will deal with the UK outlook in detail next week, but consider two brief obervations. Brexiteers shrug off predictions of economic hardship after leaving the EU. To be sure, while the UK economy has lagged the Euro area since the referendum, the gap has not been large. But, there is a reason for that. The Chart above shows the Brexit uncertainty has led to a large underperformance in business investment — a key contributor to productivity, competitiveness, and future prosperity.

Recent UK growth has been led by the consumer, and fueled by a sharp decline in the savings rate since the 2016 referendum (Chart above). Borrowing increased initially to offset the decline in real incomes caused by sterling’s collapse. More recently, consumers have dipped into their savings hoping that Brexit uncertainties would be temporary.

Whatever one’s thoughts about the long-term Brexit impact, weak business investment and the prospect of UK households boosting savings will be major drags on growth during the next 12-24 months. The UK economy will continue to lag their European partners.

The Fed to the Rescue?!

As a result of slowing US economic growth and lower-than-expected inflation, the Federal Reserve has signaled its intention to reduce interest rates. Bond markets now anticipate at least two rate cuts (plus a 50% expectation of a third) by year-end, and up to four reductions by the end of 2020. With an aggressive easing in monetary conditions already discounted, how will equity markets react to lower rates?

First of all, while I do expect two rate cuts this year, I believe the Fed may not deliver the four rate cuts markets expect in the next 18 months unless the economy slumps considerably further. As we have observed, exports are weak, and the Chart above illustrates that capital spending is slowing. Both are likely to slip furhter in the coming year. However, after a gittery start this year, consumer spending has revived, reflecting solid employment and income gains. The Chart also shows that final sales to domestic purchasers (e.g. GDP excluding inventory swings and exports) have remained relatively steady. Putting these pieces together, I am not convinced that the Fed will reduce rates 4 times if the GDP only downshifts towards a 1.5% pace. Markets could be disappointed.

Secondly, I am concerned by the huge Fed U-turn this year: at the beginning of the year projecting two rate hikes! To be sure, the Fed has done a masterful job since the Global Financial Crisis (GFC). But, this has been the first tightening cycle since the GFC. I am quite concerned that the Fed’s ability to predict the economy’s response to its actions is more limited following the GFC. This has received little market attention.

In addition, Fed rate cuts will be accompanied by a sharper-than-expected slowdown in coroprate profits (Chart above provided by Morgan Stanley). Indeed, the Fed rate cuts already priced into the market will require a much more significant GDP slowdown than expected. The combination of overly agressive pricing of Fed action, slowing EPS growth, and the Fed’s reduced ability to forecast the economy’s response to its actions will limit the market’s reaction to lower interest rates this time.

Strategic Implications

• In the absence of a recession, which appears doubtful during the next 12 months, an end to the bull market is unlikely. In addition, the Chart above indicates equities are not expensive, and very cheap compared to bonds. Nevertheless, slumping US EPS and a muted response to Fed rate cuts will limit returns to 3-5% during the next 12-18 months (year-end 2020 target is 3,150). In addition, given the numerous potholes, I expect at least one 10% drawndown during the next 12 months.
• In both Europe and Japan, GDP growth expectations are already low, and investment sentiment lacklustre. With the ECB and BOJ still in the “we’ll do whatever it takes” mode, international markets are likely to outperform the USA.
• The US dollar’s rally is nearing its end (but not quite yet). Eventually, slowing US growth, growing twin deficits, and the Trump Administration’s preference for a weak currency will lead to USD depreciation prior to the 2020 election.