The Outlook: September 2019 economic commentary

With all this talk of recession, how could equity markets possibly move higher?

There is certainly a lot for investors to be gloomy about these days. The global economy is slowing. The US-China trade war continues to take its toll on business investment and this, along with weakness in the global autos sector, has caused global manufacturing output to contract. In Europe, the negativity has been compounded by the ongoing Brexit fiasco. In the US, a so-called inversion of the yield curve (a development which has preceded every downturn of the last 50 years) has sparked fears that the world’s largest economy is heading for a fall.

Against this backdrop, how could equity markets possibly move higher during the coming months?

Brexit weighs on growth and makes investors wary

Let’s consider Europe first. Of all the major developed market economies, those that are closest to experiencing a technical recession – defined as two consecutive quarters of negative growth - are probably Germany and the UK, which saw contractions in Q2 GDP of 0.1% and 0.2% respectively. Germany’s export-dependent economy has been particularly vulnerable to two key trends over the last 18 months: a deterioration in business confidence which has hit demand for investment goods, and weak demand for motor vehicles, notably in Asia and Europe. In addition, Brexit uncertainty has taken its toll on sentiment and produced output volatility in both countries, as inventory building ahead of the original March departure date gave way to output cuts in Q2. A continued slide in industrial data suggests Germany will enter a mild technical recession during Q3, although firmer activity during July has raised hopes that the UK will avoid such a fate, at least for now. 

Needless to say, the near-term economic outlook for the UK and its main European trading partners hinges crucially on how and when the UK will leave the EU – a factor on which there remains little clarity. The stepping up of the government’s no-deal Brexit planning in recent months should soften the blow from a disruptive departure. However, most mainstream forecasters still expect a significant hit under such a scenario. The Bank of England currently anticipates a peak to trough decline in GDP of 5.5% under a worst-case scenario, compared to the 8% decline anticipated previously.

However, as investors, it is important to remember that the UK economy is not the same as the UK stock market. A no-deal Brexit recession in the UK would take its toll on the earnings of domestically-focused businesses. However, as is well known, around 70% of UK FTSE 100 earnings originate from overseas, with much of it outside the EU. With a no-deal Brexit likely to result in a significant depreciation of sterling, overseas earnings will get a boost when translated back into sterling.

Moreover, as global investors have generally steered clear of UK equities over the last few years due to Brexit uncertainty, the asset class is attractively valued on some metrics relative to other markets. For example, the MSCI UK equity index has a forward price-earnings ratio of around 12, compared to an average of the MSCI World index of over 15. Against this backdrop, an eventual deal with Brussels could trigger a reallocation of capital to UK equity markets, as uncertainty dissipates. Such a turn of events could see both UK equities and the pound rise in tandem.

US consumer still strong, but yield curve raises concerns

Clearly, the bigger question for global financial markets is whether the world’s largest economy, the United States, goes into recession. Growth in the US economy has cooled, as manufacturing output and business investment has been hit by the ongoing trade war, and the impulse from the 2018 tax cuts has faded. However, the narrative from the hard data so far is of an economy slowing to a trend-like 2% or thereabouts, rather than one on the brink of imminent contraction. Consumer spending - which makes up around two-thirds of GDP - continues to prop up the economy, and is being supported by rising wages, plentiful jobs and low mortgage interest rates. Importantly, US consumers have not overextended themselves as they did prior to the 2008-09 recession, and household finances are in pretty good shape. Although employment growth has slowed in recent months, the number of job openings, or vacancies, continues to exceed the number of unemployed.

Concerns about a pending US recession have been heightened by the so-called inversion of the yield curve, as yields on longer-term US government bonds have fallen below those on short-dated paper. Such an inversion has occurred prior to every US recession of the last 50 years. As a result, models based on the yield curve have shown a rise in near-term recession probabilities. One such model from the Federal Reserve Bank of New York puts the probability of a recession during the next 12 months at close to 38% - its highest level since the financial crisis.

This sounds worryingly high. However, there are good reasons why the US yield curve might not be as reliable an indicator of pending recession as in the past. Various factors, including increased risk aversion, quantitative easing, and negative central bank policy rates in Japan and the eurozone have pulled down US long-term bond yields, arguably making the yield curve flatter than it ordinarily would be. Moreover, yield curve inversions in the past have tended to occur when the Federal Reserve has raised interest rates too high and choked off growth. However, real interest rates (i.e. after accounting for inflation) are currently close to zero and well below levels that have triggered recessions in the past.

Moreover, yield curve inversions provide a poor guide to when exactly the next recession will hit, and more importantly for investors, when equity markets will peak. JP Morgan notes that looking at data from 1967, the average time between a yield curve inversion and the economy going into recession has been 18 months. However, the lag has been as short as eight months and as long as 24 months. Importantly for investors, the main US equity market index - the S&P500, which tends to set the tone for global equity markets - typically continues to rise on average 8% during the 12 months following a yield curve inversion.

Synchronised monetary easing and the hope of fiscal stimulus

Looser monetary policy is a key reason why it might be premature for investors to sell down equities. The US Federal Reserve (or Fed) turned more dovish at the beginning of the year and has since cut interest rates twice, in July and September. Importantly, it appears that the Fed is easing policy pre-emptively, cutting interest rates before the current weakness in manufacturing permeates the broader economy and job layoffs start to rise. Indeed, recent US economic data has come in stronger than markets were generally expecting.

A more dovish Fed has also facilitated looser monetary policy in several emerging market economies in recent months, including China, Russia, Brazil, India and Indonesia. Synchronised global central bank easing holds out the prospect that the downturn in global manufacturing will bottom out during the coming months and a global recession will be avoided. Some leading indicators of economic activity, including a pick-up in money supply growth, support such optimism.

There is understandable scepticism that further monetary stimulus in countries where interest rates are already low will have much impact. Even the European Central Bank (ECB), which recently announced a cut in its deposit rate further into negative territory and plans to restart its quantitative easing (QE or buying bonds) programme, is not anticipating much of a pick-up in growth in 2020. Negative interest rates threaten to become counter-productive, not least due to the impact on commercial banks’ profitability (although the ECB is trying to mitigate this risk). However, from a global perspective, the ECB’s pledge to keep buying bonds and not raise interest rates until inflation ‘robustly’ converges on the 2% level should serve to anchor global bond yields going forward, helping keep real interest rates low. Lower for longer bond yields should enhance the relative attractiveness of risk assets, which will also be supported by increased liquidity, as the ECB ‘prints’ money to buy bonds.

In turn, slowing growth and low borrowing costs are creating an incentive for governments to expand fiscal policy, i.e. increase public spending and/or cut taxes. In his September press conference, ECB President Mario Draghi stated that it was “high time…for the fiscal policy to take charge” in supporting the economy. In Germany, there are political and cultural barriers to a big increase in government spending (see our March 2019 commentary), but there are signs that the government is moving towards adopting more stimulus, albeit slowly. Elsewhere, significant fiscal easing in China has served to cushion the negative impact of the trade war, and expansionary budgets have also been introduced in India and South Korea.

In the UK, the government has outlined plans to increase government spending next year, and more expansionary policy seems likely whatever the outcome of any forthcoming election. Given concerns regarding the capacity of monetary policy alone to reinvigorate economic activity, the push towards greater fiscal stimulus is likely to grow across the globe, a factor which should ultimately support risk markets.

A rethink from the president?

Of course, the ultimate direction for risk assets going forward remains highly dependent on US-China trade relations. Although a new wave of tariffs was introduced at the beginning of September and the conflict has broadened to encompass a technology war, markets have taken heart from the news that trade talks will resume in October. Given signs that China is unwilling to make fundamental changes to its economic model, a comprehensive deal between the two countries is looking increasingly unlikely before the November 2020 US presidential election. However, with the dispute taking its toll on US manufacturers, employment growth slowing and tariffs increasingly targeting consumer goods (and therefore likely to hurt US households) there is a growing incentive for President Trump not to escalate the conflict.

Survey data suggests that consumers and businesses are becoming increasingly worried about a pending recession, and President Trump will be aware that if the economy does turn down during the next 12 months, his chances of re-election will be much reduced. And yet, the likelihood of a recession in 2020 largely hinges on the President’s own trade policy.

The US economy has slowed over the last 18 months mainly because business confidence has suffered due to trade uncertainty, not because of credit conditions, which are generally loose.Although monetary policy easing is likely to cushion the slowdown, it is doubtful that rate cuts alone could offset a lurch down in business and consumer sentiment in the event of a marked escalation in the trade conflict. All of this puts the onus on the President to de-escalate tensions and push for some kind of interim deal during the coming months. Some press reports suggest the president is warming to such an idea. A decision not to follow through with tariff increases currently planned for 15 October and 15 December would, if it happened, be welcomed by investors.

Scope for upside surprises

A slowing global economy clearly faces many challenges going forward. Geopolitical risks are elevated and political decisions, be they regarding US-China trade, Brexit or tensions in the middle east, will play a large role in shaping market performance during the coming months. Recession risks are rising, and although early warning signals such as the yield curve might be distorted, they cannot be ignored completely. It is easy to be gloomy, and sentiment surveys suggest that many investors are. However, against this backdrop, it is not difficult to envisage a situation where economic data and political outcomes surprise on the upside during the coming months, triggering an improvement in risk appetite that pushes equity markets higher.

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.