17 April 2019

In our 2019 Global Strategy blog entitled “Turning (Even More) Defensive” (published in September 2018), we outlined the broad macro themes we expected to drive financial markets. Given the sharp market swings that have occurred since last Autumn, I thought it would be worthwhile to review these themes in light of subsequent events and data releases. Likewise, I am updating my explicit market forecasts: marking to market in the industry jargon (projections are found at the end of the blog). Let’s kick the tires! (As usual I will use lots of Charts to save your time before the Easter holiday!).

Theme 1: Global Growth Would Slow, But 2019 Recession Unlikely

During Q4 2018, the S&P 500 declined 25%, as financial markets panicked over the prospects of a global recession in 2019. This narrative was supported by the dramatic flattening of the US yield curve. The Chart above illustrates yield curve inversions are reliable predictors of future economic slumps.

In our blog entitled “Heading For Global Recession in 2019?” (all previous research can be found in the archives of my website) we argued that while world-wide GDP growth would decelerate, a severe slump was unlikely until 2020 or later. In addition, we projected that global activity in 2019 would become more synchronised, as the US economy cooled (reflecting the fading impact of the previous fiscal stimulus) and European growth stabilised. Indeed, while the yield curve is a good predictor of future downturns, the Chart above illustrates it is the level of real interest rates (not the shape of the curve) that leads to recession. With real interest rates remaining low, a severe slump remains unlikely.

To be sure, weak US capital spending and residential investment remain concerning. Therefore, the continuation of the business cycle is reliant on resilient consumer spending. The Chart above highlights that labour markets in the USA and elsewhere continue to tighten (low and declining unemployment rates). Solid employment and income growth provide healthy fundamentals for household spending. The next Chart indicates that consumer sentiment remains upbeat in most Emerging Markets. However, spending in the developed markets has been a bit disappointing, especially in the USA. As we expect the American consumer to perk up in coming months, global economic activity should remain resilient in 2019. Recession risks are higher in 2020, but the likelihood remains less than 30%.

Theme 2: Global Central Banks –Taking 2019 Off!

In our September blog, we had anticipated that G4 inflation would remain modest. However, the following Chart illustrates that despite tight labour markets, price pressures have subsided even more than anticipated. Even in the USA, where wages have accelerated the most, core inflation during the past 6 months has cooled to only 1.5%.

The US Federal Reserve’s decision to postpone any further tightening of monetary conditions for the forseeable future required the only major change in our projections. We had anticipated two interest rate hikes this year, but now we expect the Fed to remain on hold for the remainder of 2019. Unlike the market, however, we still anticipate the next move in rates is up. But, that’s a story for 2020. We outlined the implications of the Fed’s U-turn in our blog “Fed Pauses: Searching for a Soft Landing“.

However, the Fed is not alone. The other G4 central banks will also remain on the sidelines this year. Indeed, the Chart above illustrates that Emerging Market inflation is either already low or declining (Granted the inflationary impact of past FX devaluations is still lifting prices in Brazil, Russia, and South Africa, but this will fade in coming months). As a result, we expect most EM monetary authourities will also keep policy steady this year. Indeed, of the 20 countries we forecast, we expect only Mexico, Turkey, and Russia will alter interest rates (all cuts). Global central banks are taking 2019 off! (For market implications see my blog “Global Central Banks: Taking 2019 Off!)

Theme 3: Europe — Slipping Towards Recession?

After a disappointing 2018, the consensus at the beginning of this year believed that Europe was sliding into recession (even before the ECB began normalising monetary conditions). In our blog entitled “Europe: Slipping Towards Recession?“, we suggested that in addition to special one-time factors — e.g problems in the German auto sector, Brexit, and political risks everywhere — Europe’s slowdown largely reflected a return to the region’s anemic long-term growth rate of 1.25-1.5%. We anticipated Europe would avoid recession.

What is the data telling us now? Fortunately, greenshoots of recovery are appearing. First of all, while Europe’s slowdown was broad-based, the Chart above illustrates the industrial sector has been particularly weak. Meanwhile, recent PMI indicators suggest service sector activity has picked up in the past few months. In addition, retail sales advanced 2.8% in February compared to 1.6% during the past six months, suggesting the consumer is gaining traction.

Even in the hard-hit manufacturing sector, there are signs of life. The Chart points to healthy output gains in early 2019. Even the beleagured German factory sector appears to have hit bottom. It’s also worth noting, Eastern Europe emerged pretty much unscathed from the adjustment in the German auto sector. Even growth in Scandinavia has proven relatively resilient. The worst appears over (although it’s worth noting that manufacturing PMIs are still slumping)!

Theme 4: Is China Rebounding?

Financial markets are hopeful that macro-policy stimulus has stemmed the slowdown in China’s economy. Indeed, recent data releases support that view. In particular, after declining sharply throughout 2018 (and spending two months below the recession threshold of 50), the manufacturing sector PMI has risen during the past two months. Likewise, the recent pickup in bank lending has raised hopes that capital spending may soon rebound. Perhaps most noteable, the 14% gain in exports in March has encouraged investors that China can deal with higher US tariffs. And, optimism is growing that a Sino-US trade deal is likely.

All true, but a few words of caution. First, export data is volatile, especially during the Lunar New Year. And, in the first quarter overall sales abroad advanced only 1.4%. Secondly, in an earlier blog entitled “China: Slowdown Just Beginning“, we suggested that deleveraging and the transition to a consumer-led economy would remain headwinds for several years ahead.

To be sure, policy stimulus is welcome if it boosts housedhold incomes and spending. Planned VAT and other tax cuts should be viewed favourably. On the other hand, however, if monetary stimulus supports unprofitable SOEs and impedes deleveraging (as has often been the case during the past few years), the inevitable adjustment could be even more painful and disruptive. The jury is still out. But, the Chart above indicates that both consumer spending fixed asset investment are still slowing. I believe the Chinese economy will continue to slow towards 5% during the next two years (even if official data do not confirm such a severe slowdown).

Theme 5: Emerging Markets — Global Outlook More Benign

The Fed’s pause, rebounding global growth, a more stable US dollar, low/declining EM inflation, reasonble valuations, and the prospects of a Sino-US trade deal all bode well for Emerging Markets. But, as the economist in the room, I offer a word of caution to what I agree is a promising outlook. Even though improved March exports from China and Korea have raised hopes that the region has adjusted to higher US tariffs on China, the Chart above continues to indicate that the region’s exporters are still struggling.

Nevertheless, with G4 central banks on hold, the search for yield will continue. We view the high real yields in many EM markts as highly attractive, and identify opportunities in Brazil, Mexico, Turkey, Russia, and Indonesia (see Chart above). For details see my blogs “Turkey: Boom, Bust, What Comes Next?” and “Mexico and Brazil: Populism’s First 100 Days“.

After last year’s EM FX volatility, the following Chart illustrates that TRY, MXN, ZAR, and RUB are undervalued. Could be a hair raising ride, but opportunities do exist.

Strategic Implications

• Quiet central banks and rebounding growth are supportive for global markets. Indeed, the Fed’s pause also reduces the likelihood of a policy mistake in the near term, thereby reducing the risk of a recession in 2020 as well. Therefore, following the postponement of further US rate hikes, we lifted (and narrowed) our S&P 500 target range to 2,600 to 3,000. Our earlier range was 2,400 to 2,900, and we used all of it both on the upside and downside (as expected)!!
• More synchronised global growth suggests that the US dollar’s rally is nearing — but not quite at — its conclusion.
• If the European recovery gains traction, regional markets should outperform, as they trade at a historically deep discount to the USA.
• Attractive opportunities exist in EM bonds and FX.
• EM equities are also cheap relative to the USA.