Who will win?
Financial markets are caught in a tug of war between fears of slowing global growth and hopes for further central bank stimulus. Judging which side will emerge victorious will be a critical determinant of returns for investors over the coming months. So which viewpoint is likely to prevail?
There can be little doubt that global growth has slowed markedly, particularly in the manufacturing sector, as can be seen from the chart below.
Manufacturing PMI indices
Economic activity is expected to slow further over the coming months, potentially dragged down by numerous geopolitical risks including Brexit and Iran. Expectations of slower growth are manifest in the shape of the US yield curve, which has now inverted.
US yield curve: 10 year – 3 month yields
Such yield curve inversion worries some equity investors as it has historically been a strong signal of impending recession. To demonstrate this point, we have plotted previous recessions as red boxes on the chart. As can be seen, however, this presents a problem. While inverted yield curves have been useful predictors of recession, they typically precede the downturn by 12-18 months, with strong equity gains often achieved in the meantime. This suggests that investors could be foregoing significant positive returns by turning defensive too early.
A more fundamental issue with using the inverted yield curve as a sign of imminent recession is that years of easy monetary policy since the Global Financial Crisis have distorted markets beyond all recognition and created some truly bizarre side effects. For example, an astonishing 30% of bonds in the most widely followed global bond index now have a negative yield. If US bonds are excluded, this number rises to 44%. Moreover, not all of this negative yielding debt is short-maturity bonds issued by the world’s “safest” governments. Bond investors are guaranteeing losses (in nominal terms) on 10-year bonds held to maturity from countries such as Ireland, Latvia and Slovenia – hardly traditionally harbours of safety in a storm. The lack of yield, particularly in Europe and Japan, has almost certainly depressed US 10-year yields and exaggerated the flatness of the US yield curve. This undermines the utility of the US yield curve as a signal of imminent recession, which may in turn weaken the bear case for financial assets such as equities.
The proliferation of negative yielding bonds has resulted in the coining of a new acronym: ‘TINA’ - there is no alternative. That is to say, yield-starved investors have not only been forced down the quality spectrum in credit, but also into riskier assets such as equities. To take an example, Swiss pension funds facing a yield of -88 basis points on 10-year bonds could be forgiven for preferring to buy shares in Nestle, which currently offer a dividend yield of 2.3%. This helps to explain the fact that many equity markets are near all-time highs, yet remain cheap relative to bonds, with the S&P dividend yield now exceeding that on 10-year Treasuries. By pushing bonds deeper down the rabbit hole of negative yields, the argument goes that additional monetary easing should be bullish for equities as it will further intensify the search for alternatives. At the same time, several other signals have begun to turn more favourable for equities. For example, the economic surprise index has bounced, albeit off low levels.
Global Economic Surprise Index
Meanwhile, financial conditions have become more supportive of growth.
US Financial Conditions Index
Source: Goldman Sachs
Finally, the Bank of America Merrill Lynch Bull & Bear Indicator has just moved into “extreme bearish” territory, triggering a contrarian “buy” signal. This is the 17th time this has happened since 2000. On each of the 16 previous occasions, 10-year Treasury yields rose in the ensuing three months, by an average of 50 basis points. On ten occasions, global stocks rose in the following quarter, with a median return of 6.3%.
However, we are not overly convinced by these arguments. While equities are attractively valued versus bonds, this is due to the fact that bonds are richly priced rather than because equities are particularly cheap. Indeed, global equities are trading slightly above their long-term median on a price/earnings basis.
ACWI prospective P/E
More importantly, while the economic surprises index has bounced from low levels, the reality is that macro momentum is still decelerating. Central banks are now scrambling to cut rates in order to arrest the slowdown. However, interest rates are already very low in the developed world and central bank balance sheets are bloated, meaning they have far less scope to ease than they did in the past. This lack of firepower is compounded by a growing body of evidence which suggests that when interest rates are already very low, cutting them further or engaging in other forms of monetary easing becomes less effective in stimulating economic growth. For example, a 2017 research paper from the Reserve Bank of Australia noted:
“The empirical evidence relating to these questions is rather scant. That said, what is available suggests that monetary policy transmission is indeed weaker when interest rates are persistently low. The economic context appears to matter, making it more likely that policy may push on the proverbial string as headwinds blow.”
Unfortunately, just as the marginal benefit of further rate cuts diminishes, so the risk of unintended consequences rises. For example, sustained low rates impair bank profitability, which is problematic because a healthy banking sector is vital for driving economic growth. A period of very low or even negative rates may also create the impression of an abnormal and uncertain environment that actually undermines the confidence of consumers and businesses.
We may therefore be approaching the moment where an intensifying global slowdown cannot be prevented by yet more rate cuts and quantitative easing. There are many potential catalysts for such a slowdown, from a hard Brexit to a deterioration in geopolitical tensions in the Middle East and Hong Kong. This would clearly be a challenging backdrop for equities.
While any news of additional central bank stimulus may initially lead to rallies, particularly in cyclical, Value stocks, we do not think these rallies are sustainable. In our view, chasing these market moves by significantly increasing exposure to cyclical stocks raises the risk of being caught offside when the slowdown intensifies, as we believe it inevitably will. Consequently, we remain defensively positioned in our Global, EAFE, European and UK portfolios.
However, we believe that the risk/reward dynamic is more evenly balanced in the developing world. Positioning in our Emerging Markets, Asia and China strategies is reflective of this. Unlike the developed world, real rates are generally high in Emerging Markets. Rate cuts from increasingly dovish central banks are therefore likely to be far more effective in boosting growth. This comes at a time when relative growth momentum is already skewed in favour of Emerging Markets, given the late-cycle slowdown in the US and a nascent recovery in China as previous policy easing gains traction. Moreover, unlike developed world equities, Emerging Market equities are not just cheap versus richly priced bonds, they are cheap versus their own history. For example, around 30% of stocks in the MSCI EM index now trade below their book value. This is the most distressed valuation for a decade and the lowest level ever outside a US recession. Clearly we are not arguing that Emerging Markets would avoid a sell-off if global growth slowed and central banks were found wanting. However, we do believe there is significant downside protection in the form of positive relative growth momentum, scope for substantial central bank easing, and attractive valuations that in many cases already price in a slowdown akin to the Global Financial Crisis. Furthermore, there is the potential for a positive surprise from thawing trade tensions. While this is far from certain, any major breakthrough could have an outsized impact on EM equities, given their valuations. The impact would be magnified by the fact that the EM equity index has a 73% weighting to Asia – the most trade-sensitive EM region. We have been pessimistic about the trade war for some time, believing that many of the issues are intractable. However, our network of experts and politicians is becoming more constructive, arguing that both the US and China want a deal more than they are letting on.
As can be seen below, Trump’s approval ratings are suffering from incremental tariffs.
Trump’s trade war is increasingly unpopular
Source: PollingReport.com, RealClearPolitics, Goldman Sachs
The President will be keenly aware that to appeal beyond his core support base, the economy will be key. Perhaps he will pivot back to issues such as the economy and immigration that are more powerful vote winners for him. Given investors’ widespread pessimism and associated negative positioning, any meaningful breakthrough in the trade war should be a significant positive catalyst, particularly for EM equities.
Thus, while we are generally positioned defensively in anticipation of an intensifying global slowdown, positioning in our Emerging Markets, Asia and China strategies is more balanced. This reflects the favourable relative growth momentum, potential for positive surprises, and the fact that we can already find what we deem to be truly world class companies in sectors such as Financials that are trading on distressed valuations.