Will the US and/or the global economy fall into recession in 2019–2020?
If you’re pressed for time, you can safely skip the rest of this note. This question is about all that really matters. At this point, our view is “no,” but that is getting to be a trickier call with each passing day. We remain of the belief that much of the developed world is decelerating from “synchronized global growth” (late ’17 – early ’18) toward a slower, but still positive long-run potential growth pattern; in the US near 2%, in Europe closer to 1.5%. Not spectacular, but not recessionary, at least not yet. Chance of recession in the next 18 months? 40% – significant and worrisome, but not yet our base case.
We do see darkening clouds on the horizon. Many activity and confidence metrics have taken an ominous turn in recent months. US-China tensions appear to be weighing on both trade and business investment. Nor can we fully discount the warning sign of inverted yield curves1. However, while the leading economic indicators (LEIs) have stalled, they have not turned negative yet. We continue to think activity is supported by solid employment and consumer spending trends, especially in the US. If we see more compelling evidence that these trends or other forward-looking indicators are faltering, we will become more bearish on the economy.
We should also note that this macro view – deceleration towards potential growth but no recession yet – provides our base-case backdrop for the rest of our Q&A.
What will the US Federal Reserve do?
Our best guess is two 25 basis point cuts through year-end. Doing nothing would run counter to stock market expectations and risk a major market selloff (thus tightening financial conditions). One hike seems unlikely if the Fed believes rate cuts are necessary at all. Three cuts in six months (July–December) would seem like panic and would more likely undermine confidence than support it. Therefore, two cuts is our Goldilocks scenario: enough to show the market the Fed is listening, but not so extreme as to scare investors, consumers, and businesses.
What will the European Central Bank, Bank of England, and Bank of Japan do while the Fed embarks on cutting rates?
There will be plenty of talk of further policy accommodation as needed, but in reality, they probably won’t do much.
The Bank of England is on hold, waiting to see how bad Brexit becomes. The European Central Bank will talk about cutting further into negative territory but doesn’t want to punish their already wobbly banks. Whatever the Bank of Japan decides, we doubt it will matter much.
Will further policy accommodation from the major central banks reignite global growth?
Probably not. Our perspective on so-called “extraordinary monetary policy” is fairly cynical. We believe that negative interest rate policy and quantitative easing (QE)2 can instill confidence and therefore have some ability to blunt the worst case scenario (e.g., a global financial meltdown in 2008–09). However, we have seen little evidence that these unconventional tools can stimulate or sustain economic growth above its longer-run potential. The global recovery and expansion has been historically long, but it has also been historically weak, in spite of unprecedented monetary stimulus in the last decade. This is the classic “pushing on a string” problem that central bankers continue to face.
Does the inversion of the yield curve signal recession?
We don’t know. For those who say “no,” we concede that things are somewhat different this time. Non-US developed market rates are absurdly low, so is the term premium, and $17 trillion of global QE has further suppressed rates artificially. As a result, we doubt the economic signal coming from the curve is 100% accurate. However, investors dismiss this signal at their own peril. An inverted curve isn’t just a sign of oncoming recession. If it lasts long enough, it can be a contributor, as short-term funding costs are higher than longer-term loan rates, resulting in a constriction of bank credit. The longer the curve remains inverted, the more credence we will give its predictive power.
If a recession unfolds, how bad will it be?
Again, recession is not our base case. If we are wrong, there are crosscurrents of factors that will drive its depth and duration. On the downside, it’s been well documented that central banks have less firepower at today’s lower rates. Moreover, we doubt that additional QE will be very helpful, even assuming central banks could continue to find suitable assets to buy. In this sense, the monetary policy response to the next recession will be handicapped.
On the upside, however, we see few if any major imbalances in the real economy and we believe systemic risks3 are better contained.* At worst, some economies show growing inventories of goods. While markets are always focused on the last crisis (equity valuation in 2001, banking/real estate crisis in 2008), we believe the next recession may prove to be a good old-fashioned shallow inventory correction. These typically last a few quarters and cumulative damage to GDP is modest. Yes, central banks have less ammunition, but they may not need that much if the recession is less severe.
* We believe there are few imbalances in the real economy. The capital markets are a different story. In markets, imbalances are much easier to find in a world dominated by QE and negative interest rate policies.
What is the outlook for US/China trade relations?
There is no long-lasting grand deal on the horizon. US threats have hardened the Chinese position and the Fed’s dovish U-turn has emboldened President Trump. Through the summer and fall, we expect some positive gestures, but a significant trade breakthrough will remain elusive. Both sides may tone down the rhetoric as the global economy stumbles along, but unless there is a flare-up in recessionary pressures, we don’t see anything that forces Trump or Xi to buckle. Investors should expect the on-again/off-again trade war with China to remain on-again/off-again.
Where does this leave the stock market?
The holy trinity of equity gains includes changes in:
1) Top-line revenue growth
2) Profit margins – which translate top-line growth to bottom-line earnings
3) Valuations – as measured by price multiple expansion or contraction.
Looking ahead to the next few years, top-line growth is likely to be positive, but below average in our decelerating but non-recessionary base case. With most equity markets showing elevated profit margins, we doubt bottom-line earnings will be much better than top-line revenues. Consensus earnings growth rates for 2020–2021 (annualized) are approximately 10% and 8% for the S&P 500®4 and the STOXX® Europe 600,5 respectively. That will prove to be somewhat optimistic – probably closer to mid-single digits.
Lastly, price-to-earnings (P/E)6 multiples are generally elevated, but not extreme. We think investors should expect little in the way of P/E expansion as the economy slows, in spite of easier monetary policy. This calculus implies positive but sub-par returns over the intermediate term. If we move away from this base case, we see the risks as asymmetrically skewed with more downside than upside – another reasons to be cautious even though we think stocks will eke out gains.
What about interest rates and bonds?
Our call last November was for rates to be range bound to somewhat lower. The US 10-year Treasury is now more than 100 bps lower since that call with the bonds rallying far more than we anticipated. (The 10-year German Bund is over 60 bps lower since that time.) Given this rally in bonds, we see more asymmetry in upside vs. downside. Again, unless recessionary and/or deflationary forces win out, rates have more room to rise than fall. Near-benchmark positioning seems appropriate.
Are we on the edge of a corporate credit bubble?
While corporate debt outstanding is up significantly since the Great Financial Crisis, the coupon/yield associated with that debt has fallen significantly. By our back-of-the-envelope calculation, these two effects nearly cancel out, leaving the debt service burden of US and European investment grade companies up only slightly. Recession – again, not our base case – would almost certainly bring a close to this credit cycle, but that is hardly news. At these levels of indebtedness, our credit concern is more about market access and the ability to roll over maturities than it is about debt service itself.
What keeps us up at night?
Stagflation. There seems to be almost universal agreement that inflation is well contained. We agree. That’s why it worries us so much. Neither stocks nor bonds are priced for an inflationary surprise, especially if it is accompanied by slower growth. Significantly higher inflation could tie the hands of central bankers who previously have supplied most of the bull market’s mojo.
2 Quantitative Easing (QE) refers to the U.S. government's program that was in place from December 2008 through October 2014. QE involves the purchase of Treasury bonds and agency mortgage-backed securities by the central bank to help keep interest rates low.
3 Systemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy.
4 The S&P (Standard & Poor’s) 500 Index is an index of 500 stocks often used to represent the US stock market. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large-cap segment of the US equities market.
5 The STOXX® Europe 600 Index is derived from the STOXX® Europe Total Market Index (TMI) and is a subset of the STOXX® Global 1800 Index. With a fixed number of 600 components, the STOXX® Europe 600 Index represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom. You may not invest directly in an index.
6 The price-to-earnings ratio (P/E) indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company's earnings.
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