While the second quarter saw a number of reversals–or at least pauses–in policy, we believe a recession is unlikely in the near term. The peak of global growth is likely behind us, but economies should continue to expand
"When the facts change, I change my mind"
The second quarter saw a number of reversals–or at least pauses–in policy as central bankers, energy ministers and trade negotiators appeared to react to contemporaneous and fast-moving facts on the ground. Most important, the G-20 Summit in Japan was the occasion for a “truce” in the U.S.-China trade war. This included a reprieve for Chinese national champion and communication products maker Huawei, just as it appeared to be on the ropes. The clearly dovish tone of central banks around the world, OPEC’s decision to extend supply cuts despite U.S. objections, and the White House’s decision not to renew waivers on Iran sanctions (at least for now) rounded out the decision crosswinds that portfolio managers faced in the quarter.
We are acutely aware that policy actions and perceptions can change quickly. Our portfolios therefore remain neutral to modestly overweight equities, even as we have slightly reduced the non-U.S. overweight. Furthermore, we retain exposure to diversifiers or tail hedges including core fixed income, gold, gold miners and energy equities.
Short-term rates, GDP-weighted
Global economic indicators have been mostly disappointing
The majority of economic surprises during the quarter were disappointing, with many non-U.S. indicators slipping slightly into levels that would indicate contraction. With overall economic data weak, there remains for the most part a stark contrast between the manufacturing/corporate versus the services/consumer sides of the global economy. Despite short-term caution signs, we maintain conviction in our view that neither the U.S. nor China is near a recession.
Much of our confidence stems from continued and potential consumer strength. In the U.S. in particular, consumers are in very good shape given the levels of real wage gains, unemployment, job openings, debt-to-disposable income, savings, total net worth and the more ephemeral confidence indicators. The recent fall in residential mortgage rates and corporate borrowing costs are likely to help sustain this strength, thus supporting our view that a recession is unlikely in the near term.
As for China, we believe that President Xi and the Communist Party have every incentive to maintain a healthy economic environment, especially given the importance of the upcoming 70th anniversary of the founding of the People’s Republic. By most accounts, an extensive slate of separate stimulative measures have been adopted since economic weakness appeared in 2018, owing to the economic deleveraging/rebalancing campaign and the commencement of the trade war. Regardless of the latest count, we believe whatever stimulus is needed will be delivered, albeit without the excesses of the 2015-2016 period. The challenge here is predicting when that stimulus will counterbalance the trade war and slowdown uncertainty.
Global Purchasing Managers' Index, SA
Household debt service ratio
Quits rate, % of unemployed
Impact of central bank responses likely to be felt late in the second half of the year
As economic weakness has become widespread, central banks around the world have responded with policy rate cuts, lower reserve requirements for lending institutions and other pro-growth measures. In the case of the U.S., the Federal Reserve has shifted from a hawkish to a dovish stance focused on sustaining the expansion, and it is widely expected to cut policy rates in July. To be sure, corporate uncertainty around trade and the merit of new fixed capital investments represent headwinds to what has been a long economic cycle. Taken together with support from policy makers, we are forecasting a return to trend-line expansion. Whether the interest rate cuts and other measures are the beginning of a multi-quarter (or multi-year) policy change as it appears in the case of the emerging markets, or a general continuation of policy as it seems in the case of the Eurozone and Japan, or an insurance policy cut as we expect in the U.S., policy moves intended to extend the current economic cycle are likely to have a positive effect in the coming quarters. For our purposes, we do not expect a recession in any major market in the near term and would not be surprised by a small economic uptick in the coming quarters, principally in the emerging markets.
FOMC and market expectations for the federal funds rate
Fair value and lower risk versus better value and higher uncertainty
The outperformance of the U.S. equity market relative to global indices over the past 10 years has been extraordinary and interrupted by only brief periods of non-U.S. and emerging market leadership. The reasons for this are many and include the Federal Reserve’s flexibility going into the financial crisis, the U.S. economy’s domestic orientation (which reduces its vulnerability to foreign shocks), an innovative and increasingly profitable technology sector, and a strong dollar that made non-U.S. returns less attractive. More recently, corporate tax cuts, accelerated depreciation and a reduction in the regulatory burden have served as a boost to the stock prices of U.S. companies. Investors in U.S. markets have, therefore, benefitted both from high economic growth rates and a relatively safer risk profile amid an uncertain global macro environment. We will continue to look for pockets of opportunity in areas such as financials, technology and energy producers. But the American market is fairly valued and mid-single digit gains are, in our view, the most likely scenario over the next 12 months.
However, if the trade war can stay in “truce mode” for a quarter or two, and assuming that the dollar is relatively range bound, a period of non-U.S. outperformance may be at hand, especially given relative valuations. That being said, it is worth highlighting that emerging market equity investing is volatile and outperformance is an episodic affair not easily given to market timing. India, for example, has by all demographic and potential productivity measures an outstanding long-term growth profile yet it has underperformed significantly for extended periods. On the other hand, the Chinese market (as measured by the MSCI China Index) has slightly outperformed the S&P 500 and significantly outpaced the MSCI All Country World Index over the last three years despite the 2018 deleveraging campaign and the trade war with the U.S.
The U.S. dollar and interest rate differentials
Policy risks are of the greatest concern, but the earnings outlook is mediocre
A re-escalation of the trade war, a Federal Reserve that disappoints investors with a less dovish posture than what the market expects, and the geopolitical risks around oil/Iran, are potential developments that are well above average concerns as non-fundamental risks go. Closer to the ground, the global earnings outlook is mediocre. Low to mid-single digit growth for the U.S., mid-single digit growth in Europe and possibly low double digit growth in select emerging markets like China and India cap the upside for equities even as central bank support and very low-to-negative real returns in fixed income limit the downside for the time being. In the U.S., corporations continue to buy back their stock even as other investors have generally reduced their equity exposure. This represents a dynamic that, we believe, is not widely appreciated.
If we had to succinctly characterize our current portfolio positioning, we would describe it as increasingly focused on idiosyncratic, one-off opportunities (e.g., financials, technology, energy exploration & production, India and China, Master Limited Partnerships, gold stocks) that aim to add incrementally to returns versus the benchmark. We also have material risk-offsetting allocations to core fixed income and gold, just in case the previously described macro risks become more than just talking points in a quarterly update.
Our active manager exposure has been significantly reduced and changed over the past year. What remains is positioned for outperformance in the more cyclical and lower valuation parts of the equity market, squarely in line with what we think is likely to develop between now and the early part of 2020.