GLOBAL HEAD OF INVESTMENT STRATEGY
Global Market Outlook 2020: Cycle, interrupted
Signs point to a mini-cycle recovery in 2020, with central bank easing in particular helping to stave off short-term recession fears.
Hold the epitaphs: this aging cycle seems likely to last beyond 2020. This time last year, it appeared that U.S. Federal Reserve (Fed) tightening, the China-U.S. trade war and diminishing economic slack1 could push the U.S. dangerously close to recession by the end of 2019. At times during the year, recession seemed possible as global manufacturing contracted and the U.S. yield curve inverted. However, central bank easing, the de-escalation in the trade war and tentative green shoots in global manufacturing suggest we might be on the cusp of another "mini-cycle" recovery through the first half of 2020.
The chart below shows the percentage of central banks from a sample of 32 that have lowered interest rates over the past three months. 2019 has seen the largest amount of central bank easing since the 2008 financial crisis.
The interrupted cycle has the following asset class implications for 2020:
- equities should outperform bonds
- higher long-term bond yields, though the rise should be limited by muted inflation pressures and central banks remaining on hold
- steeper yield curves
- a weaker U.S. dollar given its countercyclical nature
- non-U.S. to outperform U.S. equities given the more cyclical nature of non-U.S. stocks and their relative valuation advantage
- pro-cyclical value stocks should beat both growth and low-volatility stocks
A step back in China-U.S. trade relations and the outcome of the U.S. presidential election are among the key risks that could accelerate the timing of the next recession.
The main risks to our 2020 outlook, in order of importance, are:
- A re-escalation in the trade war that delivers a fatal blow to global business confidence, investment spending and global supply chains.
- Central banks resume hiking if they believe the growth risks have passed and inflation pressures are building.
- The U.S. presidential election, where the victory of a progressive Democrat, such as either U.S. Senator Elizabeth Warren or Bernie Sanders, could trigger a policy shift that is negative for corporate profits.
- Other geopolitical risks such as an escalation of Hong Kong unrest, which triggers an aggressive China response and subsequent global sanctions on China, or actions by Iran that threaten global oil supply.
Regarding the trade war, our view is that both China and the U.S. have incentives to reach a “phase 1” deal soon. U.S. President Donald Trump would like to declare victory in the trade war ahead of his 2020 reelection bid. He also needs to lift the economic threat that the trade war poses to the near-term outlook.
President Xi Jinping of China is balancing the short-term requirement for economic stimulus against the medium-term need to reduce debt levels in the Chinese economy. He would like to limit the risk of a further trade-shock. He will probably take a “devil you know” approach to the U.S. election and not want to undermine Trump’s reelection through trade-war escalation. The alternative would be to possibly face a progressive Democrat, who could bring a much sharper focus on human rights and the environment to trade negotiations.
The last innings of this cycle
Central banks will probably need to tighten monetary policy by 2021 to combat inflation, which should bring about an end to the long-running economic expansion.
The central bank easing of 2019 may prolong the aged cycle, but this could be the final “mini-cycle” before the turning point of the “major cycle”, potentially in 2021. The main reason for the longevity of this cycle has been the persistence of economic slack. This has allowed the U.S. and other developed economies to grow without generating significant inflation pressure. This has deterred the Fed from lifting interest rates by enough to cause a recession.
The trade war has been a cycle-extending global deflationary shock, in that it forced the Fed and other central banks to reverse previous tightening before monetary policy became restrictive.
Economic slack, however, is limited at this advanced stage of the cycle. Nowhere is this more apparent than in the United States, where the 3.5% unemployment rate for November 2019 is at levels last seen in the 1960s and wage pressures are building. It’s likely that central bankers, worried about “secular stagnation” and “Japanification2”, will take a cautious approach to the next tightening phase and wait until inflation is clearly lifting before acting.
Tighter monetary policy will eventually be required, either by late 2020 or early 2021, which we believe should ultimately push the global economy into recession.
Our baseline scenario calls for a thaw in the trade war as well as a recharged economy, but an escalation in trade tensions could easily send things into a downward spiral.
Our subjective probabilities on the following three scenarios for the next 12 months suggest some caution is warranted.
- Bull (35%): A trade deal sets the scene for a deeper agreement on intellectual property rights and market openness. Uncertainty clears. Purchasing Managers’ Index (PMI) surveys rebound as monetary stimulus kicks in. Corporate earnings rebound through 1H 2020.
- Central(40%): Mini-deal puts trade tensions temporarily on hold and does not reverse tariffs. The global economy responds to monetary easing, but trade-war uncertainty remains. Central banks maintain easing bias.
- Bear(25%): Q4 trade talks fail. The trade war escalates further. The global economy dips into a mild recession. PMIs decrease. Corporate earnings suffer a double-digit decline.
We’re giving the Bear scenario a significant 25% probability despite our bias toward a glass-half-full 2020 outlook. There are several factors that suggest an elevated risk of a recession and bear market:
- This year’s inversion of the U.S. yield curve
- The damage already sustained to business confidence and global supply chains from the trade war
- High corporate debt levels that create vulnerability to rising interest rates or declining profits
The signal that concerns us most is flashing from the Business Cycle Indicator (BCI) model. This model estimates U.S. recession probabilities based on the yield curve, credit spreads, bank credit risk, consumption growth and employment. The BCI forecasts a 33% probability of recession in one year, which extends slightly above the model’s warning threshold. The rising recession probability looks similar to the model’s predictions in mid-2006 prior to the 2008 Financial Crisis.
We suspect the model is overestimating recession risk given the lack of consistent yield curve inversion. The 10-year/3-month curve has spent most of 2019 inverted, but the 10-year/2-year curve was only very briefly inverted in September. We also suspect that the three ‘insurance’ rate cuts by the Fed and the easing in trade tensions have reduced recession risks. There are similarities to 1998, when the yield curve inverted, but recession was avoided. The Fed quickly cut rates three times, and the issues that triggered recession fears in 1998 – the Asian economic crisis, the Russian bond crisis and the Long-Term Capital Management collapse – turned out to be less damaging than feared.
The challenge of investing late in the cycle is that the upside for equity markets is likely smaller than the downside. The last five bear markets saw the S&P 500® Index fall by an average of 43%. An optimistic assessment would give global equities, at most, low double-digit upside. This asymmetry adds a degree of caution to the outlook.
We believe economic growth, along with the Bank of Canada’s patience, will be tested in 2020. High household indebtedness will increasingly weigh on consumers ability to spend. Meanwhile business investment is expected to be tepid due to both global and domestic issues. However, Canadian shares could benefit if the global economy reflates, supporting cyclicals.
The Bank of Canada (BoC) did not cave to the pressures of a global manufacturing slowdown at its November 2019 meeting, choosing instead to keep their target rate steady at 1.75% (with one meeting remaining in December). The resoluteness is commendable considering the course of action for many of their central bank peers has been to ease policy throughout the year. Fortunately for the BoC, the global easing cycle led to a rapid decline in bond yields around the world, Canada included. This in turn eased domestic financial conditions. In other words, Canadian financial conditions improved simply due to a global phenomenon and with no formal assistance from the BoC.
The times are changing, however. We believe the U.S. Federal Reserve (Fed) is now on hold, and the BoC may just be getting started. Despite the resilience the BoC displayed in 2019, their stance meant that growth was compromised. In their final 2018 Monetary Policy Review, the BoC penciled in a 2019 growth forecast of 2.1%. In hindsight, this was overly ambitious. They have since downgraded that projection to 1.7%, and we believe actual growth may be closer to 1.5%. Putting it bluntly, the Canadian economy was not unscathed.
Looking ahead to 2020, we believe economic conditions will continue to soften, eventually forcing the BoC off the sidelines. The conditions that we believe will prevail and, ultimately, lead to BoC cuts are:
- Inflation: The rate of inflation has been remarkably stable around 2% for most of 2019. This in turn has enabled the BoC to remain neutral despite increasing trade tensions. As the chart below highlights, that may be changing soon. Canadian financial conditions often lag that of the U.S., and the deterioration in US manufacturing over 2019 has not yet translated into softer inflation data in Canada, but we believe they may.
- Investment: The BoC has repeatedly touted the inevitability of a rebound in business investment, and not without merit. Canadian businesses have had a positive outlook on investment. However, actual data has not kept pace with their intentions. The noticeable rebound in investment over the third quarter was encouraging; however, we do not foresee an investment boom. Trade tensions haven’t fully resolved, the new-NAFTA (or CUSMA*) has yet to be ratified and the energy patch continues to struggle.
- Debt: This is the perennial wild card. While household debt concerns are common in Canada, and rightly so with the debt-to-disposable income ratio at 176%, domestic corporate debt is just as disconcerting. Hesitant to further stoke animal spirits among households and business was a reason cited by the BoC to not partake in any “insurance cuts”. We believe a shaky economy would ultimately supersede those concerns.
With that as the backdrop, our key forecasts for 2020 are as follows:
GDP Growth: 1.0% - 1.5%
We expect global manufacturing trends to stabilize over the first half of 2020, supporting a pro-cyclical Canadian economy and keeping recession risks in check. As noted above, our concerns are around household debt, which we believe will limit domestic consumption, while investment trends may be lackluster at best. Taken together, we believe the Canadian economy experiences below potential growth of 1.0% to 1.5% in 2020.
BoC policy rate: 1.25% to 1.50%
Market pricing for the BoC is just shy of one rate cut by year-end 2020 – this seems overly optimistic. Considering the watchpoints noted above, we believe the balance of risks are skewed towards additional rate cuts. Moreover, the yearly change in the debt service ratio (DSR), which is just above 8%, is signaling potential stress for households. Historically, similar levels have coincided with BoC cuts. Putting it all together, we have the central bank reducing the target rate twice to 1.25% by year-end.
A caveat worth noting is the possibility of change in leadership at the BoC. Governor Stephen Poloz’s seven-year term is set to expire in June of 2020 and it is yet unclear if Poloz will return for a second term. Senior Deputy Governor Carolyn Wilkins is expected to provide continuity in the interim if there is a search for a new BoC head.
Government of Canada 10-year bond yield year-end range: 1.1% to 1.6%
An easing central bank and a soft economic backdrop means the Canadian 10-year bond yield has room to fall. In the most extreme case, we believe it can retest prior lows of around 1.0%, but generally expect it to trade in a range of 1.1% to 1.6%.
CAD/USD: $0.71 to $0.77
Roles are expected to reverse, with the BoC likely cutting while the Fed remains on hold. This could create some tension for the Canadian dollar (CAD), especially over the first half of 2020. As usual, the price of oil can be a swing factor for the CAD in either direction. Nonetheless, we peg the fair value range for the CAD/USD at $0.71 to $0.77.
Canadian equity outlook: Seeking a cyclical surge
Canadian equities have rallied impressively in 2019, returning nearly 18.5% as of November 22, 2019. While Canadian shares could benefit further from a global reflation, domestic business cycle concerns keep us on watch. Nevertheless, for a broader assessment, we look to our investment decision-making building blocks of cycle, valuation, and sentiment to assess the current state of Canadian equities:
Cycle: There will be many twists and turns in the economy, though ultimately, not recessionary. However, growth will be challenged. Moreover, earnings growth of 8% for 2020 based on Refinitiv data as of November 11, 2019 seems ambitious. Monetary policy, however, may be a positive catalyst as the BoC is expected to ease. Taken together, we believe the business cycle over a 12-month horizon is neutral.
Value: Based on Rifinitiv data as of November 19, 2019, the trailing price-to-earnings (PE) ratio for the S&P/TSX Composite Index at 16.0x sits just below its long-term average (LTA) of 17.6x; however, the forward multiple at 14.8x is near its LTA. The dividend yield, at 3.3%, is attractive. Collectively, value is neutral.
Sentiment: Momentum heading into 2020 is positive. While our contrarian signals aren’t unequivocally flashing a warning signal just yet, some consolidation may be necessary considering strong returns earned thus far in 2019. Overall, we rate sentiment towards Canadian equities as neutral to slightly positive.
Conclusion: Value is not as attractive entering 2020 as it was in 2019; however, it’s also not at disturbing levels. The stabilization of global manufacturing trends is crucial given the cyclical orientation of Canadian equities. On the flip side, we expect some growing pains in the domestic economy which may pressure corporate earnings. Collectively, we are neutral on our outlook toward domestic equities. However, our higher conviction preference is for domestic over US shares.
Risks to our outlook
Forecasting is a humbling exercise in the best of times, and even more so today given the longevity of this economic expansion. Although we place higher odds on the central scenario outlined above, we acknowledge the distribution of outcomes is quite wide and describe the conditions that could contribute to a deviation from our baseline:
In a more positive outlook, global economic reflation is more pronounced than we anticipate. Trade uncertainties dissipate and business investment improves, commodity prices get a lift, employment remains robust — boosting incomes, and the housing market continues to perform well. Economic growth would be above our forecasted range in this scenario with the BoC eventually hiking rates in 2020.
In a more negative outlook, global reflation fails to materialize, and trade tensions intensify. The “new-NAFTA” gets lost in the shuffle, business confidence and investment craters, job losses spike. Recession is inevitable under this scenario and the BoC reduces the target rate to a global financial crisis low of 0.25%.
We expect a rebound in growth across the eurozone and the UK as political uncertainty fades, while economic growth in China is likely to remain unchanged.
Fed rate cuts and the easing of the business sentiment drag from the China-U.S. trade war should support the U.S. economy over 2020. There will be headwinds from the fading of the 2017 Trump tax cuts and lingering uncertainty over future tariff policy.
Low inflation should keep the Fed on hold during 2020, although it may move to a tightening bias by year-end if bond market inflation expectations rise toward 2.2% from their current 1.7%. We expect non-farm payrolls growth to remain above 100,000 per month, which should lower the unemployment rate to levels not seen since the Korean war in the early 1950s. A Fed on hold and improving economy should lead to higher Treasury yields and a steeper yield curve. The 10-year Treasury yield could rise to around 2.25%.
The November presidential election is likely to be a major source of uncertainty. Low unemployment and trend economic growth favor Trump’s reelection. The Democrat frontrunners in the primary race all favor at least a partial repeal of the 2017 corporate tax cuts, which would have negative implications for corporate earnings growth in 2021.
Europe’s exposure to trade and reliance on manufacturing made it a casualty of the trade war and the global downturn in automobile production. 2019 saw the European Central Bank (ECB) take policy rates further negative and re-start quantitative easing. The Eurozone should benefit in 2020 from easier monetary conditions, the recovery in global manufacturing, the lifting of trade-war uncertainty and Chinese policy stimulus that increases import demand from emerging markets.
The easing of political risk is also a boost to the outlook. This time last year, Italian 10-year government bond (BTP) yields were heading toward 4% and creating concerns about the solvency of Italian banks. BTP yields are under 1.2% in late 2019, mirroring declines across Southern Europe and supporting financial conditions. This is being reflected in declining non-performing bank loans across Spain and Italy. The potential lifting of Brexit uncertainty is also a positive.
Overall, we look for a gradual pick-up in growth across the Eurozone during 2020. The absence of inflation pressure means the ECB is unlikely to consider lifting interest rates.
The lifting of Brexit uncertainty and increased fiscal stimulus should support the U.K. economy in 2020. Both major parties in the December 12 general election are proposing pathways to Brexit resolution and the end of fiscal austerity. The Conservatives are offering a relatively quick and clear path to Brexit, albeit with uncertainty about the future trading relationship with Europe. A Labour administration, most likely in a minority government, opens the possibility of a second referendum and a potential “Remain” outcome.
A significant boost from fiscal policy is likely regardless of the election outcome, which would reverse a decade of deficit-reducing “austerity”. Labour is proposing a radical program of public investment, while the Conservatives’ more modest plans would still represent an economic boost.
A post-election economic revival combined with low unemployment and relatively high inflation could have the Bank of England considering policy tightening by the end of 2020.
Japan’s economy is suffering the after-effects of the consumption tax hike on October 1 and its exposure to the global manufacturing downturn. The uncertainty around the China-U.S. trade negotiations as well as Japan’s own tensions with South Korea have weighed on economic sentiment.
Easing trade tensions and an improvement in global manufacturing should support Japan’s economy, as will a boost to spending and tourism from hosting the 2020 Olympics. There is also speculation that Prime Minister Shinzō Abe’s administration will launch a sizeable fiscal stimulus. Japan, however, is likely to remain an economic laggard relative to other developed economies and we expect persistent disinflationary pressures will keep the Bank of Japan in ultra-accommodative mode.
Chinese policy makers are balancing the short-term requirement for stimulus against the medium-term necessity to reduce leverage in the economy. The net result is that stimulus will likely be modest—enough to stabilize or provide a small boost to the Chinese economy, but smaller than the previous stimulus episodes in 2016 and 2012. Credit growth is unlikely to accelerate sharply, but the authorities have already reduced bank reserve requirements and cut policy rates. They are also likely to increase local government bond issuance to boost infrastructure spending. Gross domestic product (GDP) growth, however, is unlikely to rebound and should remain near 6%.
The outlook for the Australian economy remains soft. We expect consumers will remain cautious given high debt levels and slow wage growth. Potential income tax cuts could provide a boost, but a sluggish economy will have the Reserve Bank of Australia considering another interest rate cut.
Business confidence in New Zealand is at the lowest levels since the 2008 financial crisis, and we expect further rate cuts from the Reserve Bank of New Zealand.
The Bank of Canada (BoC) has been an outlier. It has the highest policy rate among the Group of Seven3 countries and has resisted cutting rates despite softening global and domestic economic conditions. The hesitation is in part due to fears of stoking increased household debt. Although the housing market has reaccelerated, lackluster consumer and investment trends should eventually force the BoC to consider rate cuts.
Asset class preferences
We expect global equities to fare better than government bonds in 2020.
Our cycle, value and sentiment investment decision-making process in late 2019 has become more optimistic on global equities and is shifting toward a negative view on government bonds. Our equity sentiment measures are becoming over-bought, but the signals are not yet strong enough to offset positive price momentum.
- We have a small underweight preference for U.S. equities in a global portfolio, driven mostly by relatively expensive valuation, but also because the cycle conditions appear firmer outside of the U.S. We favor non-U.S. developed equities. U.K. equities offer good value as demonstrated by the 5% dividend yield. Valuation is neutral in Japan and Europe. Both should benefit from China policy stimulus, which will help bolster export demand, and the fading of trade-war concerns.
- We like the value offered by emerging markets (EM) equities. Regional central banks are easing policy and EM markets likely will benefit from China stimulus. The smaller scale of the China stimulus, however, limits the upside for EM.
- High yield credit is slightly expensive and at risk from slowing corporate profit growth.
- Investment grade credit is expensive, with a slightly below-average spread to government bonds and a decline in the average rating quality.
- Government bonds are universally expensive. U.S. Treasuries offer the most attractive relative value.
- The Japanese yen remains our preferred currency. It remains undervalued despite this year’s rally and has safe-haven appeal if the trade war escalates. A mini-cycle recovery as the trade war is resolved, at least temporarily, could see the U.S. dollar weaken, given its counter-cyclical tendency. British sterling is very undervalued, but it should have upside on most scenarios following the UK’s December 12 election.
1 Economic slack refers to the amount of resources in the economy that are not used. Machines left idle in a factory or people who cannot find a job represent slack to an economist. The reason slack exists is usually due to insufficient demand relative to what the economy is capable of producing.
2 Japanification is the term economists use to describe the country’s nearly 30-year battle against deflation and anemic growth, characterized by extraordinary but ineffective monetary stimulus propelling bond yields lower even as debt burdens balloon.
3 The Group of Seven (G7) is an international intergovernmental economic organization comprised of the following advanced economies: Canada, France, Germany, Italy, Japan, the United Kingdom and the United States.