Political theater has dominated the past few months, as markets have fretted over U.S. President Donald Trump’s tariff moves and political uncertainty in Italy. Trade wars will likely be an ongoing headwind for markets. President Trump appears committed to his protectionist agenda and a tough approach towards China. We hope cooler heads on all sides will prevent escalation, but this issue will require close monitoring.
Political turmoil in Italy, by contrast, appears to have calmed. The populist ruling coalition has witnessed firsthand the negative bond market reaction to reckless spending policies and any hint of leaving the euro. We’ll be on watch for bouts of Italian bond volatility as the new government negotiates slightly easier fiscal terms with the European Union. However, as of mid-June, we believe the likelihood of a sustained Italian risk-off event is low.
Cycle leadership to rotate away from the U.S.
The main economic data trend has been the growing gap between the economic performance of the U.S. and the rest of the world. The chart below compares the manufacturing purchasing managers’ indices (PMI) for the major developed economies.
The manufacturing PMI for the U.S. has trended higher this year, while Europe and Japan have reversed some of last year’s gains.
This theme of U.S. growth leadership is one reason U.S. equity market returns have outpaced those in Europe and Japan in the first half of 2018. We expect a rotation away from the U.S. in coming months. A PMI above 60 for Europe was never sustainable in our view and the May value of 55.5 signals a still-healthy manufacturing sector. The economic surprise index tracks economic data releases relative to industry consensus forecasts. Europe has moved from a significant positive surprise in late 2017 to the depths of data disappointment in June. The U.S. is still experiencing positive data surprise at mid-year, although this is becoming more modest as industry consensus forecasts are ratcheted higher.
Data surprise is cyclical and Europe should rebound to positive data surprise as industry consensus forecasts are downgraded and the region maintains its above-trend growth path.
The one-year to 18-month outlook favors regions with the potential for low inflationary above-trend growth, continued accommodative policy settings and corporate margin expansion. This puts Europe, Japan and emerging markets in our view ahead of the U.S. in the cycle pecking order.
U.S. recession watch
The current bull market as reflected by the S&P 500® Index is the second oldest on record, the U.S. economic expansion is one-year away from the longest ever, and the Fed is well advanced in its tightening phase. In other words, the next recession is getting closer.
The business cycle index model, which uses a range of economic and financial variables to estimate the strength of the U.S. economy, says recession risks at midyear 2018 are still relatively muted for this late stage of the expansion.
The yield-curve slope, measured as the difference between the yield on the 10-year and 2-year U.S. Treasury bonds, is a good indicator to watch. This spread narrowed to under 40 basis points in mid-June. It typically turns negative ahead of a recession, and the equity market usually peaks around six months prior to a recession. In the last 50 years, the market has never peaked more than 12 months before a recession (although the 1987 bear market was outside of a recession).
We expect that the risks of a recession will become elevated in late 2019 and through 2020. The Fed is likely to raise rates another four to five times before the end of next year, which could cause the yield curve to invert by the middle of next year.
Treasuries: resistance at 3%
The 10-year U.S. Treasury yield has always faced strong resistance at 3%. Our fair value estimate is 2.6%. This is based on our expected path for the Fed funds rate over the next few years, plus the term premium. It includes our expectation that the U.S. will possibly experience a recession by 2020, which means the Fed likely will be lowering rates by then.
The break-even inflation rate, or the difference between the yield on the nominal and 10-year inflation-protected bond, has been close to 2.1% since the beginning of the year. This could reach 2.2-2.5% as inflation picks up. This means cycle forces are moderately negative for U.S. Treasuries, but valuation is a constraint on how much further yields can rise.
German bunds, UK gilts and Japanese government bonds (JGB) are very expensive, based on our methodology. The cycle forces on JGBs and gilts are broadly neutral and unlikely to push yields higher. The Bank of Japan (BoJ) remains committed to “yield curve control” and is targeting the 10-year JGB yield to remain below 0.1%. The U.K. economy is sagging under the weight of Brexit uncertainty, which likely will keep inflation and the Bank of England (BoE) contained.
The cycle is moving against bunds as the European Central Bank (ECB) approaches tapering and inflation pressures build. This makes bunds our least preferred government bond exposure.
Currency: USD bounce technical, not fundamental
The U.S. dollar (USD) trade-weighted index rebounded 5% from mid-April to mid-June, reversing some of the downward trend since the beginning of 2017. This downward trend was an important driver of the strong returns from emerging markets debt and equities. The USD reversal has put these asset classes under pressure.
Our cycle, value and sentiment (CVS) investment decision-making process suggests that the upside for the USD is limited from here. We estimate that the USD is around 10% overvalued in purchasing power parity terms against a basket of developed market currencies.
The positive interest rate differential for the U.S. against other countries is a favorable cycle factor, but this is offset by the twin U.S. current account and federal budget deficits.
Speculators moved into a very crowded short position on the USD as it declined during the early part of the year. This one-sided trade made the USD vulnerable to a correction. With these short positions now largely cleared out, we see sentiment as more neutral for the outlook, diminishing the risk of a further appreciation.
Conclusion: monitor the trade-war and Europe
The two key market trends of early 2018—U.S. growth leadership and the USD bounce—have probably run their course. Be alert for an escalation in the trade-war issue, and keep an eye on the yield curve for a U.S. recession warning, although we believe this seems unlikely before late 2019.