11 November 2019

Easy monetary conditions have fueled the global equity index to an all-time high. Looking forward, key market risks centre on the likelihood of a 2020 global recession, the possibilty of a trade deal between the United States and China, and political risks, especially as US and UK voters go to the polls. In addressing these issues and identifying the key drivers of global markets, I will answer the 10 questions I most frequently receive. In order to make life easy for readers, I will make extensive use of many of my favourite charts (to save on verbiage!).

Let me the first to wish you a Happy New Year?! I wanted to get an early start on identifying key global macro-themes for 2020, and to be the first report (of what I suspect will be many) to use this rather predictable title (I wish financial markets were as easy to gauge)!

At the beginning of 2018, I adopted a defensive approach to global markets. I proposed that while equity prices would continue to rise during the next few years, annual investment returns would be modest (low single-digit gains per year). Overall, that’s been pretty accurate as the world-wide index has advanced only 1% annually during the interval. Likewise, the outperforming US market has recorded 5% yearly returns.

In July, I established my year-end 2020 S&P target at 3,150. As we are already approaching that level, do I need to re-assess? In this blog, I will outline why I suspect the combination of easy US Federal Reserve financial policy and relatively stagnant EPS growth will lead to another year of modest returns. However, more attractive payoffs are likely to be found in Europe and Emerging Markets. (Be sure to take a look at my explicit forecasts for global stock, bond, and FX markets presented at the end of this blog).

Synchronised Slowdown: Can Recession Be Avoided?

The intensification of the US-China trade war has been the key driver global activity in 2019. The Chart above illustrates exports from of both countries have declined about 3%. However, other nations, especially the trade-oriented Asian economies, have been impact even more adversely, as global supply chains have been disrupted. Likewise, the resulting decline in business confidence has taken a toll on flagging capital spending. Indeed, the following Chart underestimates the problem, as investment has declined during Q2 2019 on a QoQ basis in the USA, Germany, UK, Korea, Switzerland, amongst others.

Overall, the Chart below highlights the Sino-American dispute has hit manufacturing areas particularly hard. Indeed, factory sector PMI surveys not only suggest world-wide industrial activity has weakened significantly, but recent readings have fallen below 50 in many nations — the level consistent with recessionary conditions. So far, fortunately, service sector activity has remained strong enough to prevent an outright global slump (next Chart), led primarily by resilient consumer spending (especially in the USA). However, recent non-manufacturing surveys suggest that troubles in the industrial area are now spilling over into the service sector world-wide as well.

Of course, the situation in the USA is particularly important. The Chart above illustrates while the US maufacturing PMI remains above 50 (and well above Germany and Japan which have been hit by slumping automobile production), the slowdown in American industry has intensified in recent months. Equally worrisome has been the sharp deceleration in US service sector activity — the latest PMI reading is now near the recessionary 50 level.

I will discuss the trade war and household spending in the next sections. However, I do not expect problems in the global manufacturing sector will be quickly resolved by a seemingly likely mini-trade deal. Meanwhile, I expect global consumer spending to cool next year, but probably not enough to tip the world economy into recession. To be sure, the risk of a 2020 global recession is high (perhaps 40%), but it still is not the base case outcome. Overall, therefore, I expect global activity to weaken further, led by slower US growth. The Chart above illustrates that American activity was stronger than in Europe and Japan in 2019. As a result of the anticipated synchronised global slowdown, however, this gap will narrow next year. Meanwhile, the growth differential between the USA and Emerging Market economies, which has narrowed sharply during past decade, should again widen as the USA cools off in 2020.

Will Consumer Spending Remain Resilient?

As resilient household spending helped the world dodge recession in 2019, the fate of the consumer will remain vital next year. In reality, healthy household spending is primarily a US and emerging Asia story. Indeed, while US real consumption is up 2.6% this year, outlays in Europe and Japan have risen only 1.4% and 0.7% respectively.

To make a long story short, consumer spending is driven primarily by employment and income growth. Tightening world-wide labour markets, therefore, lie behind the resilience in spending. The Chart above illustrates unemployment is still declining in most cases (not so in sluggish Brazil and Mexico). As usual, however, the pace of labour market improvement is slowing in many countries as the current economic cycle matures. This is particularly evident in the USA. In contrast, France and Italy are still experiencing sharp declines in joblessness.

In 2020, tight labour markets should produce sufficient wage and income growth to sustain enough consumption to avoid recession yet again. However, US spending should slow more than in Europe, as the scope for labour market gains in the latter remains greater.

Trade War: No Quick Fix?

As I have written several blogs on the US-China trade dispute (which, of course, I heartily recommend to you), I will simily present conclusions. First of all, both sides have incentives to reach at least a mini-deal before the imposition of additional US tariffs in December. From an American political perspective, President Trump will want to be able to point to tangible results from his confrontational trade tactics prior to the 2020 election. Likewise, despite China’s willingness to take a long-term view on the trade issue, President Xi is aware that China’s slowing economy is 4 times more vulnerable than the USA to a full-blown trade war.

So far, despite the tough rhetoric, President Trump does not have much to celebrate (he will anyway!). To be sure, America’s bilateral deficit with China is $40 billion lower this year. However, the US world-wide deficit is actually larger. Total US exports have declined 3% this year. Meanwhile, even though imports from China are down 13%, Americans have simply diverted their purchases to other countries (Chart above).

Moreover, a mini-deal will do little to reduce the bloated bilateral imbalance between the two nations. In short, the trade gap results because China saves too much, and America saves too little. Until this is addressed, the bilateral trade relationship will not be resolved. Indeed, the Chart above illustrates that the savings behaviour of both countries differs significantly from other nations of similar income levels. One of China’s macro-objectives, fortunately, is to boost consumption, and the Chart indicates progress is being made. America’s already low savings rate, meanwhile, has been falling further, reflecting impact of Trump’s tax cuts on the US budget deficit (Chart below).

Meanwhile, the nationalistic Made in China 2025 program discriminates against US firms in key sectors, particularly technology. The Chart below highlights the penetration of US firms into China’s market is considerably lower than virtually all other trading partners. Understandably, US policy will continue to insist China liberalise its trade and investment regimes.

A Phase 1 mini-trade deal would be welcome, particularly if the imposition of planned December tariff hikes are postponed. However, reaching a comprehensive trade accord will take years of careful negotiation. I am not optimistic, especially until China accepts the 2025 aims are incompatible with the market opening sought by the USA and other trading partners.

Will the US Dollar Rally Continue?

Despite the expanding US twin deficits, the US currency has benefited from the outperformance of the American economy in recent years. However, more synchronised, balanced global growth next year– led by a slowing US economy — is likely to bring an end to the US dollar’s appreciation. While the greenback could strengthen a bit more near term, the overvalued dollar is likely to be weaker by the end of next year (see Chart below, and FX forecasts at the end of the blog).

US S&P 500: Should I Be More Bullish?

With the S&P 500 establishing record highs, and my year end 2020 target of 3,150 already in sight, should I turn even more optimistic? In 2019, the market has been fueled by an accommodative Fed policy combined with flat/negative growth in US corporate earnings growth. I anticipate similar market fundamentals to prevail again next year. The slowing US economy should produce sales growth in line with nominal GDP (4% at best). And, rising wages will keep margins under pressure (next Chart). As a result, I would expect EPS levels to remain relatively unchanged again in 2020. With analysts anticipating 11% EPS growth next year, signficant earnings downgrades in consensus expectations will be required again next year.

The S&P 500 is already trading at 17X overly optimistic 2020 EPS estimates, meaningfully above the long-term average valuation. To be sure, with the Federal Reserve likely to lower interest rates another 50bp in the next six months (front-loaded before the election), it is hard to get too bearish on the market’s outlook unless the economy slips into recession (which is not my base scenario yet). In a liquidity-driven market, likewise, the best measure of equity valuation is the relationship versus fixed income alternatives. On this basis, the Chart suggests stocks are very cheap compared to bonds.

However, the market appears already to anticipate a breakthrough on the US-China trade dispute. Moreover, the risk of recession, the possible impeachment of President Trump (which I doubt), or a dramatic economic policy shift following a Democratic election victory (unlikely unless Democrats win the Senate as well as the Presidency) are all being ignored. Therefore, I remain comfortable with my 3,150 target. And, while I concede the market may overshoot near term, I expect at least one 10% index decline as each of these numerous risks are given more serious consideration during the course of the next 12 months.

Can Europe Surprise?

As expectations for Europe are so low, I believe the region’s markets can surprise, and outperform the USA. Indeed, the Chart illustrates Europe’s relative valuation discount has rarely been more attractive.

To be sure, it’s always hard to get too optimistic about European growth prospects. However, Europe was hard-hit by this year’s slump in the world-wide auto sector. The impact was felt most in Germany, Italy and UK. Outside Germany, European manufacturing weakness was in line with the USA. Eventually, this sector will stabilise.

In addition, after nearly a decade of austerity, Europe has some space to boost growth by stimulating fiscal policy. France , Italy, UK, Poland, and Hungary have already announced plans to boost government spending. If Germany, Netherlands, Switzerland, Scandinavia and others follow suit (as the IMF recectly advocated), GDP could surprise relative to low expectations (see my earlier blog “Europe: Fiscal Stimulus Needed to Avoid Recession” for additional details).

Brexit: A Breakthrough?

I am an unapologetic Brexit pessimist (Remoaner). After leaving the European Union the nation’s long-term growth potential could decline 0.5% annually. Indeed, the Chart above illustrates the UK economy has underperformed by about that amount since the 2016 referendum.

However, the Charts illustrate both the FTSE and sterling are very cheap. To be sure, the December election is very uncertain, including the possibility of a destabilising hung Parliament. However, if the Tories win a majority (as I tenatively expect) and if Prime Minister Johnson accepts that in order to reach an FTA with the EU an extended transition period is inevitable, UK markets could be the world’s top performer next year (see my blog “UK Sterling: Where Does the Brexit Pathway Lead?” for addditional details).

Wild Card Risks: What About Hong Kong and Iran?

Of course, I cannot address these complex topics here. However, the recent sharp slump in Hong Kong GDP and retail sales, as well as the 50% decline in tourist arrivals are ominous (Chart above). Should these trends continue, public acceptance of the protests may wane, and Chinese authourities may take an even tougher stance. This may prove to be the biggest 2020 political risk.

As Iran’s economy slides under the burden of US sanctions, the Middle East situation will remain unpredictable. However, in the absence of another severe disruption to Saudi Arabian oil production, US shale producers have demonstrated an ability to boost supply to offset declining output in Iran, Venezuela, and elsewhere. Indeed, oil prices are more likely to decline next year, especially if Saudi and Russian production discipline falters in 2020.

China: Slowdown Just Beginning?

In my earlier blog entitled “China: Slowdown Just Beginning”, I outlined how China’s deleveraging, the transition to consumer-led growth, and the trade war would produce economic headwinds for several years, not just a few quarters. Indeed, the Chart above highlights the downshift is well underway.

I also suggested that monetary stimulus might ease the immediate pain associated with deleveraging. However, if government policy impedes the needed reduction in debt and continues to support unprofitable State-owned enterprises, the inevitable adjustment eventually may become more disruptive and painful. The Charts illustrate that after declining for a couple of years, corporate debt (not to mention household and government liabilities) is again on the rise. And, the share of lending to SOEs is also advancing. Not good news.

In the past, the Chinese government has relied upon simulative budgetary programs to offset slowing economic activity. The IMF’s estimates of the “augmented” public sector deficits (and debt), however, indicate the scope for additional fiscal support in the future may be considerably lower than expected.

Emerging Markets: Are Global Conditions Easing?

In my earlier blog “Asia: Bending, But Not Breaking”, I suggested the external environment for Emerging Market investing is improving, but is still a mixed bag. The prospect of lower American interest rates and a weaker US dollar must be juxtaposed against weaker GDP growth both in advanced economies and China. Likewise, the prospect of an easing of the trade war is positive, but a mini-deal is only a small first step on a long, uncertain journey. Likewise, the Chart above suggests that Emerging Markets are not especially cheap compared to developed markets.

Nevertheless, external funadmentals are shifting enough to expect EM to outperform in 2020. In particular, an earlier Chart showed that the EM-DM GDP growth differential in 2020 will widen in favour of emerging nations for the first time in a decade.

However, Emerging Markets can not be consider as a monolithic bloc. Indeed, wide variation in demographics and productivity trends are creating a multi-tiered growth outlook within EM nations. I am particularly optimistic about the high-growth Asian nations, e.g. Indonesia, India, Philippines, Vietnam, and Malaysia. Emerging Europe nations have unenviable demographics, but strong efficiency trends. And, despite weak GDP growth in western Europe, CE-4 growth remains robust, as outsourcing to the region continues. On the other hand, aging populations and weak productivity gains will keep HK, Singapore, Korea, Taiwan, Thailand, Brazil and Mexico in the GDP slow lane.

Likewise, favourable opportunities exist in both EM Fixed Income and FX markets, but investors must again be selective. With DM bond yields remaining low, the high level of real interest rates make Turkey, Brazil, Mexico, and Indonesia particularly attractive. On the currency front, the Turkish lira, Mexican peso, Russian ruble are undervalued (as are ZAR, MYR, and IDR). Meanwhile, currencies in Thailand, India, the Philippines, and Korea are less attractive.

Strategic Implications

• A synchronised slowdown in the global economy will produce another year of single-digit returns. The S&P 500, for example, is projected to rise only 2% in 2020. Higher US returns would require a re-acceleration of US GDP growth (unlikely until 2021), efforts to reduce the budget deficit (zero chance), more orthodox policy prescriptions from Democratic presidential candidates (not expected until the primary elections are well-advanced), and/or details of a multi-phase approach aimed at normalising the US-China trade relationship (one lives in hope).
• Overweight European (especially) and EM equities (particularly high-growth Asian nations).
• The US dollar appreciation is nearly over, and the buck will depreciate on a 12-month view.
• Opportunities exist in selected EM bonds (Turkey, Brazil, Mexico, and Indonesia) and FX (MXN, TRY, RUB, MYR, and ZAR). But, be nimble. Perceptions of global economic and political risk can shift significantly in a slow-growing global economic environment.