Over the past three months, markets have become prone to greater volatility and frequent reversal. The underlying cause is shifting perceptions about global growth. At mid-year, concerns that weakness in trade and manufacturing would spill over to services, employment and consumption led investors to anticipate significant monetary policy easing. Bond yields plunged and equities slumped as earnings estimates were cut. Then, in early September, markets abruptly reversed as positive growth surprises lifted bond yields and equity markets. Fleetingly, cyclically sensitive sectors and value outperformed more defensive plays.
Over the remainder of the year asset allocation performance is likely to remain dominated by shifting global growth expectations. Recession or resilience: getting that call right will be the critical determinant of portfolio performance in the final months of 2019.
Global growth perceptions will be influenced significantly by monetary, fiscal and trade policy outcomes. To understand how policy, the cycle and asset prices are interconnected it is important to first understand what is driving growth, and restraint, in the world economy.
The global economy today is more divided by sector than region. In all economies, emerging or developed, weakness is concentrated in manufacturing, in trade and in related capital expenditures. In contrast, services, employment, consumption and information technology spending are areas of resilience, even strength, across most regions.
Uncertainty is the x-factor. The sharp slowing of merchandise trade growth, readily apparent in every major economic region, stems from global trade conflict unleashed by US trade disputes with nearly every major trading partner over the past 18 months. Uncertainty about the nature, extent and longevity of trade disputes has dampened not just trade, but also related expenditures, such as investment in global supply chains.
Until recently, services, consumption and household employment were largely immune to concerns about global trade conflict. That may be changing, a risk not lost on financial market participants. The latest disappointing services purchasing managers’ indices (PMIs) in Europe, as well as recent mixed labour market data in Germany and the US, point to the potential for spreading economic risk to infect erstwhile bulwarks of the global economic expansion.
More broad-based economic weakness, if it materialises, could lead to significant asset re-pricing. Bond yields could fall to fresh lows, given recent strong assurances from central bankers that lower growth and slowing inflation are intolerable. We believe equities could relinquish their 2019 gains, as the combination of de-rating, an earnings recession and the liquidation of overweight positions sends global equity markets tumbling back to their Q4 2018 lows, if not even lower.
Importantly, central bank easing would probably do little to arrest slowing growth and hence would not address the markets’ travails. As Keynes correctly noted nearly a century ago, investment and savings (or consumption) are functions of confidence in future outcomes (‘animal spirits’) and are not necessarily restored to equilibrium, as classical economists argued, via changes in the real rate of interest. When uncertainty is high, easy money loses its effectiveness to spur investment and induce spending (reduce savings). In periods of extreme uncertainty, the result is a ‘liquidity trap’.
Nor can investors count on fiscal policy to save the day. Politically and financially, fiscal easing is a spent force in the US. German intransigence rules out effective counter-cyclical fiscal policy in Europe. China has capacity and flexibility, and could be a potential swing factor (see below), but as yet has seen little reason to go ‘all in’.
Given that earnings growth in the US has virtually slowed to a standstill (and profit share in GDP is now falling sharply – see Chart 1 below) any signs of economic weakness are likely to generate expectations of an ‘earnings recession’. Indeed, we believe negative US earnings growth is considerably more likely than negative US GDP growth. At prevailing multiples, the implication is falling share prices, potentially wiping out this year’s gains. Hence, the first conclusion is that the ‘skew’ of outcomes has greater downside risk than upside opportunity for US equities.
Chart 1: US Profit share in GDP
Second, we believe the presence of weak global economic and earnings growth amid continued trade and political uncertainty will lead to more frequent bouts of volatility. Hence, equity risk-adjusted returns are likely to be poor.
Alternatively, if equity returns are going to be high, rotation will be required into regions, sectors and styles that have lagged in recent years, namely into cyclicals, value and emerging markets. Yet for those outcomes to materialise, global growth must improve, yield curves must steepen and the dollar must weaken. That combination of outcomes can only come about if growth outside the US picks up.
Simply put, strong equity market performance into year-end requires confidence in a global economic upturn. For that to happen we believe either trade tensions must credibly abate or China must provide significant stimulus. Neither is sufficiently self-evident to be the base case today.
Accordingly, despite the crowded nature of the position, we prefer to hold overweight positions in global quality, minimum volatility and US consumer sectors, where growth is more predictable and transparent. We continue to favour short duration, high quality credit fixed income. And we favour holding a greater amount of cash than, on average, we typically would suggest.