What is your outlook for global growth and potential for a recession in the next 6–18 months?
I remain optimistic on the outlook for global growth in the coming quarters. Central banks around the world have supplied the global economy with plenty of liquidity through balance sheet expansion and accommodative interest rate policies. Interest rate policy acts with a lag which could start to manifest during 4Q19 in terms of an improved growth backdrop.
In my view, the world is not facing an aggregate demand problem – but rather a confidence shock. Lowering the cost of capital will not have the impact that it once did, but the signaling effect – that central banks are not willing to simply stand idle and let the economic malaise get worse – can help to support risk appetite, which can seep into the real economy over time.
We are seeing signs that the global economy may be bottoming. The US economy may very well lag this bottoming process, as the Trump tax cuts extended the US expansion several quarters longer while the global economy had begun to downshift. While there is evidence of a global troughing, the US is likely several quarters behind the cycle and will likely be playing follow-the-leader in terms of the path going forward.
China appears to be doing just enough policy stimulus to stabilize their growth outlook – while not looking for a marked reacceleration – as the Chinese government is loath to use credit to support the backdrop.
I would highlight two key risks to this outlook: a Fed policy error and a President Trump miscalculation. The Fed appears to have thus far orchestrated a soft landing regarding their recent “mid-cycle adjustment.” Importantly, the guidance associated with Fed Chairman Jerome Powell’s October policy decision certainly raised the bar for a rate hike in the next few quarters, indicating that a policy mistake in the near future would likely be a low probability event.
What is your expected outcome for US/China trade relations and its impact on the global economy?
China/US trade tensions remain a wild card and difficult to handicap. Escalation would certainly change the sentiment and increase the risk of recession. However, this possibility must be paired with the 2020 presidential election cycle – we all know that voters vote with their wallet.
My expectations are for a series of small deals regarding the negotiation process but no “grand solution.” I believe the trade war should be viewed as a clash of two very different economic models driven by political systems that do not see eye-to-eye. As result, US/China tensions are likely to continue to linger for years to come as both economic heavyweights vie to be the dominant global power from an economic, political, technological and military standpoint.
The demands set out by the Trump administration – closing the trade deficit, improved intellectual property rights and limiting state support for corporate champions – are difficult asks. While the trade deficit can be easily addressed through increased spending, the latter two issues would require a change in the long-term Chinese economic model. This will be a very difficult hurdle to overcome. Meanwhile, the markets are most concerned about escalation and uncertainty. The uncertainty thus far has had a measured adverse impact on corporate earnings, but escalation from current levels would certainly change that backdrop. And this is key: Further escalation from current levels would add to increased uncertainty, which would certainly trigger a downward revision in the economic outlook. Again, it’s important to consider the impact of the upcoming presidential primaries and 2020 presidential election when formulating an outlook here. It may be in Trump’s best interest to maintain a firm stance regarding China policies – which resonates with his base – but not so firm as to weigh on the economic outlook for the US economy. It should be noted that Elizabeth Warren, seen by many as a front runner for the Democratic presidential nomination as of mid-November, appears to be just as hawkish regarding Chinese policy. The idea of waiting out Trump for the 2020 elections may not prove to be as tactically advantageous as China once considered should Warren earn the Democratic presidential nomination.
Will additional stimulus from central banks reignite global growth?
The ability for central banks to cut rates and stimulate growth remains challenged. However, there is still room for rate cuts to remain an effective policy tool for stimulating growth in the US, as well as in emerging market countries.
In the US, I believe the impact of lower rates would be marginal because stimulating aggregate demand is not the issue holding back growth, it’s political uncertainty. Nevertheless, signaling power still remains important for risk appetite. Central banks demonstrating that they will not sit idly by sends an important message to investors and helps to support risk appetite. Risk appetite in this case may support asset price inflation and not necessarily the real economy. But without support from higher asset prices, sentiment in the real economy would face even greater headwinds and prove more susceptible to sentiment and headline shocks.
In Europe and Japan, central bank stimulus is close to its limits. We have seen central banks pointing to the need for fiscal stimulus to take the reins. This has been highlighted by former European Central Bank (ECB) President Mario Draghi, as well as his replacement, Christine Lagarde. While many of the European governments have been constrained or loath to expand their fiscal balances, it has nonetheless become a critical topic. In my view, Germany remains the key here. Given the size of its economy and its outsized fiscal and trade surplus, it has the capacity to act. Political undertones in Germany may be shifting, evidenced by the defeat of Chancellor Angela Merkel’s Christian Democratic Union (CDU) party in September 2019 regional elections, which highlighted voter frustration with the trajectory of the economy. Fiscal spending will need to supplant monetary action in Europe as the driver of growth. This will be critical to follow should Europe be expected to regain lasting economic traction.
Can you explain the current asymmetric return profile of equities?
This is a very important question in terms of framing an overall view of risk appetite and how we reconcile this through the prism of portfolio construction. Boom/bust cycles are a product of excesses in risk taking. We spend a lot of time looking at risk appetite in order to assess when those excesses might be problematic. Currently, we don’t really see any excesses in risk taking. If anything, we see just the opposite – a pervasive consternation.
Many clients will point out that we are in the longest expansion in history. They point out that stocks are at all-time highs and that we are likely in the 8th inning of the business cycle. There’s a belief that we will have to see a market correction or a bear market in the near term. Much of this, I think, links back to the behavioral aspects of loss aversion and the trauma suffered by investors during the Global Financial Crisis. It’s easy to say that we are late in the expansion cycle. And as a result, many investors are looking over their shoulder, worried that the next equity downturn is just one step behind them. Any economic soft patch then gets extrapolated into a recession – often a recession equivalent to the 2008 equity market drawdown.
We see these anxieties borne out in terms of investor positioning and investor sentiment. Portfolios are far from being extended regarding equity exposure, especially when compared to the traditional 60/40 portfolio. We see it in the investor flow data as well. Equities are in net redemptions, while money continues to pile into bonds. Money market flows are almost back to 2008 levels, which is certainly not an indicator of bullish sentiment. Yet this investor psyche is exactly why we find the asymmetric return profile to be interesting and favorable. Without excessive risk sentiment in the marketplace, it’s hard to envision a significant equity market selloff given that there is no need to unwind excessive risk. If anything, we see the risk in the backdrop improving and investors remaining under-allocated to markets and having to chase returns higher. Because of this “2008itis” or “end-of-cycleitis,” I believe we could easily see this expansion cycle run much farther than most expect. And if we are wrong about our economic outlook, the downside to our view seems to be somewhat buffered, given the lack of equity overweights that would need to be de-risked in a full-blown bear market or recession. This asymmetric risk outlook leaves us leaning bullish for risk assets in 2020.
What’s your outlook for emerging markets?
Emerging market equities and debt are some of our favorite ideas for 2020. While the market continues to focus on China as the key driver of global growth, I believe emerging markets in general are not getting the full credit they deserve. Many emerging market economies are seeing rate cuts coupled with fiscal expansion, which has historically proven to be growth supportive. At the margin, emerging market countries will prove stimulative for the growth backdrop and should not be discounted. We see a list of supportive themes driving this outlook:
- Global growth is bottoming and we expect it to inflect higher. Improving global growth is supportive for risk sentiment.
- Emerging market growth has already been turning higher. When emerging market growth is increasing at a faster pace than developed market growth, emerging market equities tend to perform better than developed markets.
- Dollar interest rates are expected to remain range-bound. The Fed has signaled an extended pause and the bar for a hike appears to be set very high. This will help keep funding costs low and supportive for emerging market borrowers.
- The US dollar appears to be topping out. Our near-term outlook is for the dollar to remain range-bound to weaker. Growth differentials remain the key driver for US dollar trends. As the US economy slows relative to the troughing global economy, that growth differential could tilt in favor of global growth. This tends to be supportive of US dollar weakness. US dollar weakness is supportive for easier financial conditions, as well as an added benefit to total return in local currency-based assets.
- Emerging markets have seen steady redemption over the past two quarters. This is evidence of poor sentiment and an under-allocated asset class.
- Emerging market countries have the room to cut domestic interest rates further and expand fiscal policy, and we are currently seeing both from many of the largest economies in the emerging market theater. This should be supportive for emerging market growth.
- Obviously, the key risk remains US/China trade tensions. All bets are off if the rhetoric gets dialed up. Not our base case, but still a risk worth monitoring.
A key point that we continue to remind investors of is not to forget the purpose of fixed income in your portfolio. With rates at 1.90% on the benchmark US Treasury bond, it’s easy to question the need for safe haven assets. While we do not expect a repeat of the bull market and spread compression that we witnessed throughout 2019, we do expect a more benign backdrop where yields and carry are the primary driver of returns in fixed income. Equities will still be the significant driver of returns in a portfolio. Bonds will provide a sliver to that contribution to total return.
With that framework in mind, fixed income needs to provide some utility. That utility is portfolio insurance. Otherwise, why own it? If the US and global economy were to face a shock and slip into recession, bond yields would drop, providing some cushion against a drop in equity prices. With yields hovering at low levels relative to history, investors may have to look to extend some duration in Treasuries and higher-rated credits in order to provide some reasonable downside protection in an equity market selloff.
Investors need to be willing to sacrifice some upside in order to own some protection in a downside/risk-off scenario. In my view, they should be willing to trade marginal upside in spread product for downside protection in safe haven assets like Treasuries within the portfolio construct that equities will be the primary driver of portfolio returns.
Alpha: A measure of the difference between a portfolio's actual returns and its expected performance, given its level of systematic market risk. A positive alpha indicates outperformance and negative alpha indicates underperformance relative to the portfolio's level of systematic risk.
Diversification does not guarantee a profit or protect against a loss.
Duration risk measures a bond's price sensitivity to interest rate changes. Bond funds and individual bonds with a longer duration (a measure of the expected life of a security) tend to be more sensitive to changes in interest rates, usually making them more volatile than securities with shorter durations.
Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.
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