Markets may be more sensitive to negative headlines and global macroeconomic forces as we approach the end of the cycle, but we believe there is still pent-up demand in the US economy that could be unleashed by a lasting resolution of the US-China trade conflict. If this happens, it could reinvigorate confidence, fixed investment, and broader economic growth, causing the Fed to do another volte-face on rates and start to tighten again. In such a climate, investors need to be cautious not only of higher volatility, but also of low-volatility strategies that appear defensive but may be exposed to interest rate risk.
Global Trade Tests 2016 Lows
Following the ramp up in trade tensions last year, growth in global trading volumes and industrial production has shrunk (Figure 1). But the impact of this on both the US and China appears to have prompted a shift in each side’s approach to the issue. Even if there continues to be disagreement and deadlock in some areas, a resolution of some kind now appears far more likely than it did a few months ago when the US was threatening to impose 25% tariffs on Chinese goods in January.
Possible Signs of Stabilization in China
The trade war’s impact on China has no doubt been significant but much of China’s growth slowdown actually relates to the government’s efforts to deal with excess leverage in the corporate sector. With ongoing negotiations having stalled tariff escalation in January, the Markit PMI index showed some signs of improvement in China’s export orders in December and January. This could continue. While China’s trend growth will inevitably slow—it needs to in order to prevent the build-up of dangerous imbalances—it is in no one’s interests for it to experience a hard landing given the size of its economy and its contribution to global growth. However, it remains to be seen whether the improving trend in new export orders will be sustained.
Areas of Resilience in Europe
If a US-China trade agreement is reached in the coming months, we could also see some relief for European economies that have been hurt by slowing Chinese and global demand given their higher exposure to external demand. Growth weakened significantly, especially in Italy and Germany during the second half of 2018, a development only belatedly fully acknowledged by the European Central Bank (ECB). Indeed, despite intensifying weakness in high-frequency data over the past six months, it was only in January 2019 that the ECB shifted its assessment of risks from “balanced” to “to the downside”. PMIs continue to shrink, most notably in France where political tensions are mounting thanks to the “Gilets Jaunes” movement. And yet, even as the headline industrial data disappoints, we see some areas of resilience within the European economy. Stronger labour incomes (wages and salaries plus supplemental labour income), in particular, should support private consumption and with inflation currently subdued, interest rates could remain supportive for some time.
US Economy Still Humming Beneath the Surface
In the US, the picture appears more stable than what some negative data headlines might suggest. Consumer confidence appeared to collapse in January, but in fact it was only the expectations portion of the metric that declined; the assessment of present conditions was little changed. We think this is likely to have been a response to the US shutdown which triggered a rise in part-time employment as well as hurting sentiment. In our view, the chances of a second shutdown appear slim, but cannot be ruled out. Meanwhile, the housing market, one of the worst performing areas in 2018, could benefit from lower mortgage rates and a more patient Fed.
In our Global Market Outlook late last year, we anticipated that capital expenditure would continue to support US economic growth this year. Recent survey data raise some concerns here as capex intentions have retreated from the highs seen a few months ago. We attribute this to the probability that many companies are holding off making big investment decisions until economic policy uncertainty (shutdown, trade, etc.) subsides. And it is worth noting that policy uncertainty rarely persists at the sort of extreme elevated levels seen at present; as it recedes, risks assets often benefit.
Jobs data, meanwhile, suggests companies are still hiring to meet demand. Manufacturing employment in particular remains strong, which historically has not been the case when an economy is on the cusp of recession. We also note that the Fed’s own Recession Risk monitor fell back in January from a spike at the end of 2018.
We interpret this to mean that while headline growth has slowed in the US, the economy continues to hum beneath the surface. Indeed, unemployment remains near historic lows and the labour force participation rate has improved. US wage inflation is also higher than it was six months ago when inflation fears provoked a sell-off in bonds and then equity markets. Recent minimum wage increases will likely keep wage inflation from slowing too much. Thus, we think the Fed has paused to facilitate the extension of the economic cycle, not because the cycle has come to an end.
Headline inflation is lower thanks to lower oil prices, but once through this period of uncertainty, we would expect stronger US data to shift the Fed away from its current risk management stance and back towards policy tightening. We currently anticipate at least one hike in the second half of the year, but it could come as soon as June.
Earnings Not As Bad As Feared
Moreover, almost half way through the earnings season, most of the companies that have reported appear to have had a good Q4 2018: not as stellar as last year, but definitely not as bad as analysts forecasted at the end of 2018 and market pricing suggested. With over 500 companies globally having reported at the time of writing, 57% have exceeded expectations. As expected, this has mainly been driven by the US, where over 70% of companies have reported a positive earnings surprise. This is only slightly below the 5-year average of 71%. The blended earnings growth rate for the S&P 500 so far remains in double digits.
While analysts are now forecasting negative earnings growth for the first quarter of 2019, we think this could prove to be overly pessimistic. Earnings growth rates may have peaked but they remain positive. The quality of earnings growth is also encouraging as return on equity and margins are improving and revenues are still growing. This should allow the companies to withstand any short term shocks and support their dividend and payback programs. Within the US market, Energy and Materials are seeing the largest downgrades despite a profitable quarter for many of the energy majors. Health Care and Utilities, however, are seeing an increase in their 1Q19 forecasts.1
Taking a Defensive Stance
This sector view and the likelihood that volatility will remain elevated support the case for being defensively positioned for 2019. While we have been advocating the weatherproofing of portfolios for some time, it remains important to assess what you own. Opting for certain low-volatility strategies that over-allocate to bond proxies may expose investors to higher interest rate risk. Given we think the Fed could resume tightening at some stage this year, if the US administration’s disputes at home and abroad are resolved and growth stabilizes, investors may want to ensure their defensive portfolios account for this risk. Finally, as we approach the end of this prolonged cycle, it is important to identify areas that have become more sensitive to riskier types of debt and the possibility of widening spreads.
1Source: FactSet, February 1, 2019
Capital expenditure (“capex”) – company funds used to acquire, improve and maintain physical assets, including property, buildings and equipment.
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