The art of the no-deal
Markets appear trapped in an episode of Deal or No Deal. The uncertainties surrounding the China/U.S. trade talks, and to a lesser extent Brexit, dominate the outlook. Manufacturing is contracting globally, trade is weakening and corporate profits are under pressure. The U.S. yield curve is signaling that recession risks are increasing, and Chinese economic indicators are weakening. There is a risk that global uncertainties generate a self-fulfilling cycle where rising pessimism leads to less private-sector spending and higher unemployment. This in turn would cause lower profits and equity markets—and ultimately, deeper pessimism.
The added concern is that central banks have limited ammunition to fight a downturn. Interest rates are already at zero or negative in Japan and Europe. The U.S. Fed has more scope to ease, but it also faces the zero-lower bound constraint. Previous recessions have seen the Fed cut rates by over five percentage points on average, something that would be impossible this time with the Fed funds rate in a target range of 1.75% to 2%.
Curb your pessimism
Although the risks are elevated, there are reasons that a recession might be avoided, and the market cycle extended for a couple more years.
First, in contrast to manufacturing, service sector activity is still robust in most economies as we move into the fourth quarter. Unemployment is low and consumer confidence is relatively high in the U.S. and Europe.
Second, policy stimulus is being ramped up with numerous central banks now cutting interest rates and indicating that more cuts are on the way; the Fed has started easing and the European Central Bank (ECB) has restarted quantitative easing. China is talking more aggressively about policy stimulus, while fiscal easing is being debated in Germany and U.S. Treasury Secretary Steven Mnuchin has discussed possible tax cuts in 2020.
This is a contrast to last year when the Fed was tightening, the ECB ended quantitative easing and Chinese officials were worried about high debt levels from previous episodes of stimulus. A timely policy response will go some way to offsetting limited central bank firepower.
Third, an easing of trade tensions seems likely, even if only temporarily. U.S. President Trump has shown a tendency this year to de-escalate trade tensions whenever the equity market falls. He has an incentive to limit the trade-war damage to the U.S. economy ahead of next year’s election. To do this, he needs some form of trade deal before the end of the year.
China’s stance is more complicated, but ultimately should favor a deal of sorts. Of course, China cannot be seen to reward Trump for aggressive and unilateral protectionist moves. However, China’s economy is struggling from the combined impact of the 2017/18 deleveraging campaign and the tariff escalation. The purchasing managers’ index (PMI) surveys highlight China’s labor market weakness, something that the ruling Communist Party leadership is likely to take seriously.
The bottom line is that President Trump has a clear motivation to avoid a recession before the November 2020 election. China’s pain threshold is higher, but job losses and the threat of social instability provide an incentive to de-escalate the trade tensions and pursue domestic policy stimulus. However, it may take further equity market volatility to prod both sides into action.
We view the ongoing trade war as the most significant risk to the outlook. Although de-escalation makes sense for both sides, political uncertainties mean trade tensions have the potential to spiral out of control. Under that scenario, the yield curve will have correctly predicted a recession and equity bear market.
On balance, we think it is more likely that the combination of trade-war resolution and policy stimulus will see the global economy recover in 2020. The asymmetry of the different outcomes—bear market versus limited upside—keeps us cautious until there is more clarity on the trade and stimulus outlook.
Asset class preferences
Our cycle, value and sentiment investment decision-making process points to a slightly cautious view on global equities and a relatively neutral view on fixed income. Global equities and government bonds are expensive from our medium-term perspective. The trade war and China weakness have the global cycle under pressure. Our sentiment measures are broadly neutral to slightly oversold, but not yet close to the level of investor pessimism that would trigger a contrarian buy-signal.
- We have an underweight preference for U.S. equities, driven by expensive valuation and cycle concerns around the trade-war escalation, fading fiscal stimulus and yield curve inversion. We’re broadly neutral on non-U.S. developed equities. UK equities offer good value as demonstrated by the 5% dividend yield. Valuation in Japan is slightly positive and neutral in Europe. Both should benefit from eventual China policy stimulus, which would help bolster export demand.
- We like the value offered by emerging markets (EM) equities. Regional central banks are easing policy and EM markets will benefit from China stimulus. EM markets are, however, at near-term risk from the trade-war escalation and the disruption in global supply chains. Near-term caution is warranted.
- 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. As of mid-August, around 30% of global developed government bonds on issue were trading at a negative yield. U.S. Treasuries offer the most attractive relative value.
- The Japanese yen continues to be our preferred currency. It’s still undervalued despite this year’s rally and has safe-haven appeal if the trade war escalates. A resolution to the trade war could see the U.S. dollar weaken, given its counter-cyclical tendency. British sterling is very undervalued, but likely to be volatile around Brexit uncertainty and a potential general election before year-end. Sterling should rebound if Prime Minister Boris Johnson can secure a deal with Europe, or if a second referendum is called.