The fourth quarter of 2019 kicked off with tumultuous news fanfare that roiled markets and fear of future equity returns but ultimately left us with many of the big questions unanswered. The National Association of Purchasing Managers (NAPM) manufacturing numbers made it clear that US industry is slowing down with production output on a recession trajectory. With the recent yield curve inversion already having set the rather gloomy mood, many expected the worst when it came to the September release of US Non-Farm Payrolls. Fortunately, those data did not provide the recession confirmation that some had feared, and equity markets recovered more of their losses resulting from the earlier manufacturing swoon. Elsewhere, President Trump appeared to provide impeachable evidence against himself on live TV, but also reached a tentative agreement for the “first phase” of a trade deal with China.
Here in Europe, Boris Johnson says he’s got a deal with the EU, but it’s still not clear the Prime Minister has the parliamentary support to get it through. Will the UK leave the EU with a deal, indeed at all? It seems that we are not much better off in knowing the answer to that than we were at the beginning of the year. Meanwhile — is the US heading into recession? Will Trump make it into a second term? Will the unemployment rate keep falling, is inflation dead? The US is enjoying the lowest unemployment levels since the 1960s and yet there are still few answers to the fundamental questions that will have a meaningful impact on future equity returns.
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Brexit is not the only news of the hour
There is no doubt that the US manufacturing sector is slowing down, and one of the likely triggers is the ongoing trade war with China. In the past, the manufacturing sector has been a good barometer of the overall health of the US economy, but it also typically has several mini cycles within a single economic cycle, so prone to providing false signals. The current manufacturing slowdown may well be just another one of those, because the service sector remains in much better health.
That said, consumers are increasingly reluctant to make big purchases, and wage growth seems to have decelerated increasing the risk of a deflation scare. Deflation is plaguing Europe right now, and that is why so many government bond yields there are in negative territory – investors are paying the government for the privilege of loaning it money.
That is not a normal, nor productive environment and the US Federal Reserve is right to be vigilant in that regard. It is also why rate cut expectations have increased again at the beginning of this quarter as a result of these worrying (and somewhat confusing) data.
In that sense. there was something for everyone in the September Non-Farm Payrolls data, with further declines in the unemployment rate, alleviating the near term growth risks highlighted by the manufacturing survey data, but at the same time softer wage growth will undermine the Federal Reserve’s progress in maintaining inflation expectations around the 2% target. Indeed, that was something that Fed Chair Powell spoke recently, reacting to the slowing wage growth from the employment report. Clearly both wage growth and inflation really should be much higher at this stage of the cycle, and these data do nothing to solve that conundrum.
Deflation risk to future equity returns?
Deflation remains a clear and present danger, and the Fed seems to be paving the way to move policy again to addressing those concerns whilst at the same time recognising the overall health and growth in the wider US economy. That is a tough line to tread, and we suspect that the next policy move might be towards further Balance Sheet expansion (quantitative easing) rather than outright rate cuts.
Unfortunately for investors, while the macro risks seem diverse, the ultimate drivers are correlated. Progress towards a resolution to the China trade tension will not only alleviate growth risks in the US manufacturing sector, it will also likely ignite growth in Europe too. Likewise, growth in Europe makes it less likely that the US imports deflation and hence reducing the prospect of further US central bank easing. In the absence of stronger growth in the US, and stronger corporate earnings growth, the prospect of further central bank support is one of the few positive drivers for future equity returns. So, the potential for these now many macro risks to ignite fear in equity markets and motivate a sell-off remains high, but the potential solutions to the many flash points seem relatively small.
China in focus
If the UK were to resolve the BREXIT conundrum one way or another that would remove a large part of the European growth risk and stimulate investment. Even a no-deal outcome, the most painful outcome over the short term, would likely provide the certainty required for investment to resume, and likely be boosted by significant government support in both spending and direct investment in longer term infrastructure build. So, in that sense, a resolution of almost any kind would be better than the stasis that is smothering growth potential presently.
The likelihood of the US and China coming to a lasting resolution of their all-encompassing trade dispute seems unlikely. In a sense, the temporary truce highlights the problem that is likely to plague equity markets through to the end of the cycle. There is so much news flow, but so little news that tells us how things are going to look down the road. Markets are being pulled sharply in one direction and then again in another. One-week good news on growth is bad news for equity markets, and then another time good news on trade is also good for future equity returns. The seemingly schizophrenic digestion of data by equity markets is all about the squeeze on late cycle growth. Don’t expect this to improve before the end of the cycle, nor a resumption of normality.
Things are very far from normal, so this would be a great time to review your portfolio and stress test it against some of these potential shocks. The clock is ticking, the end of the year and decade is drawing ever closer, and we’re still none the wiser as to how the game’s going to finish.