Moving into the fourth quarter, markets face an inflection point. The trade war and associated uncertainty have rattled business confidence, capital expenditures have stalled, earnings growth is lackluster, the U.S. Treasury yield curve is inverted and we’re left waiting to see what happens with the high-level China/U.S. negotiations that are slated for early October.
The tea leaves coming out of Washington, D.C., look rosier in September. President Trump’s “good gesture” to postpone the scheduled 1 October tariff increase by a couple of weeks was met by favourable steps from China toward U.S. agricultural products. The market consensus seems to be extrapolating these positive vibes and is converging on the possibility of a “mini deal” in which the tariff tranches currently threatened for 15 October and 15 December get withdrawn. While that would clearly be a welcome development from the tit-for-tat roller coaster that we have been on during the third quarter, it may not be big enough to move the dial for the corporate sector. Management teams will need to feel confident in their respective five-year outlook to invest. For impacted industries, rebuilding that confidence will likely require the partial removal of existing tariffs and a clear, committed and believable de-escalation plan.
If the clouds of uncertainty are indeed removed by year-end, the global economy should reaccelerate. U.S. equities would likely rally in this period of fundamental strength but lag their international peers, which trade at more attractive valuation multiples.
A failure of trade talks and a further escalation of tariffs could easily tip the U.S. and global economy into recession. Some important leading indicators are already signaling that eventuality. The trusty Treasury yield curve has been inverted since May, while the Institute for Supply Management’s manufacturing data for new orders in August showed a drop to a recessionary level of 47.
The Federal Reserve is playing second fiddle to these developments. They cut interest rates in July and September to push back against the downside risks from the trade war. Inflation expectations remain very low, which makes the Fed’s calculus in favour of cuts much easier as well. Our baseline has one additional rate cut by year-end (most likely in October). But with this much policy-driven uncertainty, it is hard to say with conviction how many more rate cuts the Fed will need to deliver. The range of answers is somewhere between one and eight. One useful benchmark for the Fed outlook that investors can consider is the yield curve. The inversion suggests that Fed policy may be restrictive into all of this trade-driven uncertainty. The Fed wants to be accommodative, which at current pricing would require two more cuts (our baseline). Our tactical preferred positioning on U.S. Treasury duration is neutral. We believe bonds still have a very important diversifying role to play in multi-asset portfolios if downside risks intensify.
- Business cycle: Slightly negative. We are late cycle and the further trade war escalation in August is likely to challenge U.S. manufacturing and global capital expenditure. The path forward will be determined by what happens with Sino-American trade policy. For now, we assume a downside risk bias given the asymmetry of what a negative outcome could mean for the drawdown potential in U.S. equities. The warning signals from the yield curve and our Business Cycle Index model are instructive in this regard. We expect 2020 election-year politics in the U.S. make an eventual trade deal the more likely scenario. But given the risks, we would prefer to be more reactive to this positive cyclical wave than to step in front of a recession.
- Valuation: Expensive. The year-to-date rally has pushed U.S. equity market valuations significantly higher. Lower discount rates have been very supportive. But assuming a mean reversion (lower) in corporate profit margins over the next 10 years, our risk premium estimates for the S&P 500® Index are below historical norms.
- Sentiment: Neutral. Our momentum indicators are nothing to write home about at the beginning of the fourth quarter, with the U.S. equity market returning a paltry 2.6% over the past 12 months. Our proprietary aggregation of behavioral indicators did not flag a panic or euphoria in the zigzags of August, and it remains squarely in the neutral zone.
- Conclusion: Our underweight preference for U.S. equities in global portfolios rests solely on the back of their expensive valuations. We would expect this return driver to be rewarded over the medium- to longer-term. Our conviction levels on regional allocations tactically are low.