October 29, 2018

Insights into Macro/Capital Market

There is little doubt the global economy is doing fairly well, although it is running at different speeds in different countries and regions.

The US economy is running very hot with 200K+ new jobs/month, unemployment claims at all-time lows (labour force adjusted), unemployment at just 3.7% (well below the Fed’s full-employment estimate near 4.5%), Q2 GDP of 4.2% with Q3 likely to be between 3.5% – 4.0%, and a sizable output gap over 1% of GDP.

Europe is rebounding modestly from the Q1 hiccup (possibly weather related), but certainly isn’t running as hot as the US. A similar trend is emerging in Japan as well.

China continues to manage its slowdown with credit growth picking up to offset recent manufacturing weakness. General weakness in the yuan will help, but China is propping up the RMB because it doesn’t want a disorderly fall in the currency to ignite capital outflows as we saw in 2015.

Emerging market economies remain solid, but they too are wrestling with China slowing (slowing export demand to China) and a sell-off in most commodities other than oil. However, don’t misread the signals from Turkey and Argentina. These countries got into trouble years ago brought on by over-investment and too much borrowing. These countries’ problems look idiosyncratic, not systemic to EM broadly at this point.

In summary, global growth is solid. It probably peaked in Q4:2017, slowed a bit in Q1-Q2, but is gradually gaining traction again… for now.

In spite of solid global growth, there are many headwinds on the horizon

This is macro battle right now.  The two factions are those that think solid global growth will continue fostered by a “virtuous cycle” (stronger employment, better wages, more business investment, a pick-up in exports, etc.) and those that think the global economy will slow due to the oncoming headwinds.

We believe the latter (growth will slow), but we have to appreciate that the current macroeconomic momentum can be sustained for some time. Our best guess is another 6-18 months.

Before jumping into the headwinds, I would highlight that most of these factors are relatively well understood, likely to happen, or are time-specific.  Second, none of these factors individually are cause for concern or likely to lead to a slowdown/recession. Our concern is based on the cumulative weight of all of these factors eventually taking their toll on growth.

  • First and most important is central bank policy and primarily the US Fed. The Fed is, according to Chair Powell, still a long way from “neutral” and the FOMC shows no signs of backing off rate hikes with inflation now at or above its 2% target and unemployment below “full-employment.” No, almost 3 years of rate hikes haven’t hurt stocks yet, but that’s a poor precedent for thinking about equities today. The real Fed funds rate was moving from obscenely negative to just less negative. Money in the inter-bank market was still free. Now the Fed is going to pass two major milestone. The real Fed funds rate is now positive, with a nominal midpoint of 2.125%, greater than inflation at roughly 2%. Also, the Fed estimates the “neutral rate” to be around 3%. Given the Fed’s own estimate of 1 more hike this year and 3 more hikes next year, at some point in the 2H:2019, the Fed funds rate will be in “restrictive” territory. In Europe, the ECB is reluctant to taper but it has little choice as they have so few assets left to buy. If the global/European economy slows into the latter half of next year, when most economist think the ECB will begin raising rates, there is a 50/50 chance these hikes don’t materialize. The Bank of Japan isn’t raising rates anytime soon, but is already undergoing a “stealth taper” as it is buying fewer JGBs and fewer equity ETFs than their explicit targets. In summarise, central banks are not going to pull-the-rug-out from under the global economy, but the Fed is raising rates and this will begin to bite the US and global economy in a way that hasn’t happened in the last 3 years. Moreover, the other central banks are sucking up liquidity by tapering/ending QE even if they aren’t explicitly raising rates yet.
  • Second, the trade/tariff spat between the US and China will eventually create pain for the world’s two biggest economies. Unlike the NAFTA 2.0 agreement (USMCA), the US/China tensions are not really about trade.  They are about industrial policy. As labour costs rise in China, it is no longer the world’s low cost producer (losing out to neighbours like Vietnam, Thailand, Malaysia, Indonesia, etc.). As a result, China must move up the value chain and produce higher valued-added goods. This necessitates the Made In China 2025 plan where they want to gain global dominance in 40 related industrial/technology areas including things like semiconductors, 5G wireless, biotech, mobile computing, AI, robotics, etc. This creates 2 related problems: 1) it justifies many of the anti-competitive practices we’ve seen in China such as forced technology transfer, closed markets, regulated/forced joint ventures, intellectual property theft, etc., and 2) it runs headlong into President Trump’s “Make America Great Again” (MAGA) platform where he wants the US to bring many of these same products/services back to America. Trump is hitting the Chinese with 25% tariffs because that’s about all he can do. This isn’t really about trade, it’s about industrial policy: China’s 2025 Plan vs. MAGA. As a result, I don’t seen this tension disappearing anytime soon. I do expect small, largely inconsequential “breakthroughs” on trade relations with China in the coming year, but under it all will be the underlying conflict of industrial policy. The US may “win” this trade war in relative terms, but both countries will suffer in absolute terms.
  • Third, the US Tax stimulus wanes. Again, this isn’t a forecast, just a recognition that most of the stimulus occurs in 2018 and will fade into 2019. What might make the stimulus have a longer tail of growth? Productivity gains, but we don’t see a lot of that as most US companies are paying down debt or buying back their shares, not reinvesting in their businesses. To be sure, private non-residential investment (a proxy for business investment) is growing, but at about the same rate as before the tax cut and on the same trend of the late Obama years. There is little evidence that the tax cut has created a jump in business investment that would spur productivity gains and create more supply-side growth.
  • Fourth, Brexit. Given the underlying complexities UK politics, we have no clear forecast for Brexit. Without a clear roadmap, we see a spectrum of possible supply shocks ranging from mildly negative to potentially catastrophic. All the scenarios are bad for the UK, EU, and global economy, they only vary in their severity. All we can say at this point is that some last minute deal the largely preserves the UK/EU economic relationship is a relatively low probability event.
  • Fifth, recent US Fiscal Stimulus is likely to fade as the Democrats have a 65% chance at recapturing the US House of Reps. No, the Democrats will not be able to roll –back either the recent tax package or the presidents deregulatory program, but anything new is dead. There is some talk that both Democrats and Republicans could agree on an infrastructure spending bill, but this seems unlikely to me.  It would be giving Trump a “win” which Democrats are loathe to do and with deficits skyrocketing, there isn’t much fiscal space to accomplish it.

Where are the capital markets?

Stocks are bit expensive, but this is understated. Earnings and margins are inflated so P/Es are a bit more expensive than they look. Emerging market stocks are arguably cheap after the Argentina/Turkey chaos dragged them lower. There is good long term value in EM stocks now, but investors have to have a long horizon and strong stomach because the Fed is still ratcheting up rates. European stocks are pretty cheap, but that’s a by-product of all the big banks struggling. European financial are probably the cheapest asset on the planet, but again, profiting in this area will take a longer horizon. We don’t see a bear market in the near-term, but sales growth is above trend (booming US economy), profit margins are high, and P/Es are above average. These variables are all mean reverting so gains are likely to slow.

Credit spreads remain very tight so they clearly aren’t pricing in a recession or slowdown probabilities.

Recent volatility notwithstanding, rates may rise a bit a bit more or as the economic momentum continues, but we’re closer to a peak than many believe – maybe 3.5% in US 10-year treasury. If the US and global economy eventually slow as we expect, rates in the US will begin to come back down as Fed tightening takes inflation and growth pressures out of the long-end of the yield curve. In summary, rates can go higher in the near term, but not that much higher unless the Fed lets inflation get out of control which is unlikely.

To summarise, we don’t see global growth falling off a cliff and it would be premature to forecast a US or global recession. However, the headwinds are gathering into 2019 – 2020. If a slowdown does emerge, it will largely be dependent on policymakers if it turns into a recession. So far, there are few big excesses in the real economy. A recession is most likely to be caused (or averted) by policy coming from the Fed, Trump, Xi, and/or Theresa May. Good policy choices could stave off a recession for a while longer while poor choices could result in a global recession much sooner.