USD strength fueling the new normal of slower growth and lower rates
The drumbeat of negativity and ubiquitous uncertainty resounded through markets over the summer as the trade war escalated, PMIs collapsed, and multiple geopolitical flashpoints came to a head. The USD, meanwhile, remained strong — breaking out to its highest level in over 20 years —tightening financial conditions globally, killing any green shoots and cementing the path for weaker economic growth. This culminated in the global “race to the bottom” dominating the narrative over summer and resultant highly correlated price moves across a whole host of assets.
This narrative may be taking a late summer sojourn, but will no doubt return once confidence in central banks’ magic wand lapses again, meaning this quarter will be turbulent.
Elevated uncertainties have led to larger forecast ranges, less reliable prediction intervals and an inherent negative skew as uncertainty stymies investment and consumption decisions for all economic actors. As pessimism peaked in August and investors sat on the negative end of that forecast range — with extreme positioning across safe havens anticipating economic armageddon — a temporary reprieve on the trade front, and a run of data no longer surprising as dismally to the downside, has seen a sharp reversal in sentiment.
The unwinding of this extreme negative skew and poor positioning for any positive news drove notable consolidation across safe havens and culminated in a seismic rotation under the markets’ surface as the Momentum factor plunged (and with it, low beta/minimum volatility) and Value rebounded sharply. This leaves room for a temporary reprieve on the “race to zero” tape action throughout September while the policy responses aimed at counteracting fading growth steal the limelight in driving price action, particularly as rising geopolitical tensions pause in the run up to China’s Golden Week celebrations and the Central Committee's fourth plenary session. Citigroup's global surprise index has broken its record-setting 524 calendar days of negative surprises and is now on the up, supporting risk sentiment as the narrative that nothing is getting any worse takes hold.
However, the balance of probabilities lies with these moves being part of a temporary countertrend bounce. Political discontent remains unresolved, and slower growth and lower interest rates will persist throughout an extended period of economic underperformance. In Australia the RBA cut the cash rate again in early October, and in the US the FOMC will deliver another 25 base point rate cut by year end as US growth catches down to the rest of the world.
Don’t be fooled by the can kicking on the geopolitical front: tensions remain high. The reality is modern geopolitics continues to fray as issues are not solved, just postponed. The long list of flashpoints cannot be swept back under the rug and 2019 is becoming influential in shaping the decades to come. This is one factor that leads us to believe that in the period ahead active investment strategies are likely to outperform passive strategies.
In valuing a company, we estimate cash flows forever (or at least for very long time periods) and then discount the future cash flows to present value. Lower interest rates have kept valuations high until now, because when rates are lower, the market values future growth more richly. And if the risk-free rate falls while risk premiums and cash flows remain the same, then the effect on valuation is explicitly positive. However, we cannot ignore the impact from the forces that are pushing interest rates down on other valuation inputs. As the economic cycle slows and growth momentum wains, the effect on valuations from lower rates is countered by falling profits/margin degradation. So there comes a point where lower yields no longer translate to higher multiples.
This outcome will be dependent on the nature and competitive strengths of the individual companies. The risk to valuations then arises from overly optimistic assumptions for expected growth, particularly for highly cyclical businesses masked as secular growth stories or profitless companies for which future cashflows and adoption curves may be overstated. Therefore, equity investors must become more discriminating and focus on companies with strong balance sheets and resilient earnings duration and growth.
Once valuation models are recalibrated with lower long-term rates, then sticking with defensive positioning across bond proxies with consistent and growing low-risk earnings streams, minimum volatility and quality factor exposures remains justified — as we have maintained since our Q1 outlook.
While the USD remains strong and liquidity tight, macro data globally continues to decelerate and earnings growth evaporates. This will remove the buyback bid, meaning the back up in yields and corresponding rotation into cyclicals and reflation trades will be short-lived: particularly while the Fed remains behind the curve and divided on the path for future rate cuts. For value to continue outperforming quality we need to see a reacceleration in economic growth as we did in the second half of 2016 or, alternatively, an imminent recession spurring rotation into cyclicals in anticipation of the recovery post-recession.
The biggest risk to this view is that monetary stimulus has one last kicker left and policy makers have acted quickly enough to successfully pivot the economic cycle, reminiscent of the reacceleration in growth that we saw in 2016 post Shanghai Accord. We doubt this and have long lamented that monetary stimulus is ineffective in remedying the structural challenges economies endure. Worse, it exacerbates those structural problems inhibiting growth.
Meanwhile, China’s stimulus package continues to be targeted and hampered by transmission problems so will not be the reflationary impulse that saves the globe this time around. And when it comes to the drag on growth from the trade war, central bankers are ill-equipped to deal with the fallout. This means growth is likely to remain subdued for a prolonged period and a US recession remains a very real risk.
If we are on the cusp of an imminent upturn in the business cycle, then the current downdraft in momentum and unwind of the long growth and quality stocks vs. short value and cyclicals would continue in a painful manner. At present we maintain that this is a low probability outcome and view the current rotation as a temporary correction rather than a structural regime shift. Particularly as we begin to approach Q3 earnings season where consensus estimates remain optimistic against a backdrop of elevated uncertainties, margin degradation and the lagged effect of tariffs hikes.
Without real game changers such as a weaker USD, a comprehensive and finalised “real” trade deal reigniting animal spirits or a coordinated fiscal stimulus package from global policy makers there is little reason to retreat from cautious and defensive positioning regardless of tactical bounces in sentiment. While there are whispers of fiscal stimulus being floated, proposals to date fall short of the extensive fiscal stimulus which would be necessary to reignite growth and buy into the value rotation with confidence.
Australia is the poster child of this dynamic, whereby the tax cuts already implemented have done little to spur consumer spending or confidence. The propensity to spend extra cash has been reduced as Australian consumers remain overleveraged and devoid of any pick up in wage growth while economic uncertainty is on the rise. More substantial fiscal stimulus will be needed as monetary stimulus loses its potency in order to boost productivity and reignite the private sector.
As global economic data resumes its downdraft and the lagged effect of the September tariff materialises, the retracement across safe havens and defensive positioning will run its course. This represents a buying opportunity at better entry levels for those assets which outperform against the backdrop of lower growth and lower rates.
With respect to trade, the real problems are still unresolved and President Trump still has a Twitter account ready to unleash of volatility. Despite the temporary ceasefire, tariffs have been hiked in May and September and uncertainty is rife. This weighs on confidence and capital spending decisions and accelerates the bifurcation of global trade and technology.
An interim deal addressing the trade deficit could be reached but there appears to have been no progress made on key issues such as IP reforms, technology transfer practices or enforcement of any deal. The underlying dynamics which reach far beyond trade call for continued escalation in tensions, despite any intermittent off ramps, which means that over the medium-term pressure on risk assets lingers.
The relationship between the US and China has fundamentally changed. We have crossed the Rubicon in terms of the potential for these ructions to trigger a broad economic dislocation. Equities remain in a precarious position, near all-time highs as the business cycle continues to slow, earnings growth fades against consensus estimates remain too optimistic. Dollar liquidity is tight, and the risks of a bleed of recessionary dynamics in the manufacturing and industrial sector into services, jobs and the consumer are building. Monetary stimulus, meanwhile, provides less of a cushion than in previous cycles.
As yet, the ongoing retrenchment in capital expenditures and recessionary dynamics in the manufacturing sector has yet to fully permeate the services sector or the consumer. But this is a very real risk — and one to be avoided as private consumption continues to underpin the economic expansion in the US.
The manufacturing sector represents a smaller part of the economy so growth can continue even while that subsector exhibits recessionary dynamics. The problem is that the manufacturing sector typically leads the services sector lower, which represents a larger part of the economy and is where the bulk of employment sits.
Consumers are carrying the US economy and the Fed must move to arrest the bleed into the consumer and outlook for private consumption, which would accelerate the end of cycle undercurrents and significantly raise recession risk. At present, the Fed has been clear in its intention to extend economic expansion. But they have leant against dovish market pricing in their rhetoric and remain behind the curve. This is a problem, because as trade uncertainty looms and the economy continues to deteriorate, neutral rates will also track lower, meaning the Fed will have to move aggressively in order to provide relief and ward off a sharper slowdown. Without being well and truly ahead of the curve, the Fed will also not be able to engender dollar weakness: which will continue to be a significant hinderance to any reflation.