Head of Equity Strategy
Summary: The US manufacturing sector is headed towards recession with rapid speed following the lead of export-driven economies such as Germany and Sweden. When spillover effects into the services sector are showing their ugly face then equities will begin to ruthlessly reprice to the reality of a recession. However, policies to dampen the impact have already been enacted and more will follow ensuring a mild recession and average drawdown in global equities setting the market up for a rebound in 2020. But for now investors should continue to be underweight equities and tilt towards defensive equity factors such as quality and minimum volatility.
In last month’s Equity Monthly we argued that macro numbers would get worse and indeed they have with yesterday’s shocking ISM Manufacturing figure in September at 47.8 vs. 50.0 expected highlighting a rapidly deteriorating US manufacturing sector. Given the recession seen in Germany’s and Sweden’s manufacturing sector it was not big a surprise. But more worryingly the sub-component on export orders plunged to a reading of 41.0 the lowest since the height of the financial crisis in 2008 (see chart). As we have alluded to in our recent daily equity updates the most important question today is when this weakness will spill over into the services sector that is the most important sector for the overall economy. As we wrote last week the strong consumer narrative holding up equities died with US consumer confidence plunging.
Our main scenario in the current quarter is that companies will begin layoffs and asset write-downs in a kitchen sink operation to lower the baseline so comparable figures become better in 2020. As a result, we expect employment figures to worsen in the fourth quarter and we also expect global earnings growth to go negative causing global equities to sell off. Tactically investors should still be underweight equities and defensive within the equity exposure through equity factors such as minimum volatility and quality. Companies with significant debt leverage on the balance sheet should be avoided at all cost.
As the macro picture deteriorates the USD will continue to strengthen as we have seen in previous weak periods. The incident in the USD repo market is a sign of regulation introduced in the wake of the financial crisis gone wrong. There is a scramble for USD in the global financial system and major US banks are incentivized to lower their balance sheets toward year-end because as global systemically important financial institutions they have a capital surcharged.
As we write in our Q4 Quarterly Outlook (released tomorrow) the USD is killing growth and we expect the next policy move to be actions to prevent the USD from rising more and basically starting a new regime of weaker USD. This will ease financial conditions and help economic growth. The big move towards fiscal policy being more active and resemble modern monetary theory will come later. When we get the signs that the USD is being forced to weaken then investors should consider underweight US equities and overweight global equities ex-US and emerging markets as historically this has been the case whenever the USD weakens in real terms (see table).
Our main scenario is that the global economy is headed for a recession and that the US economy could very well be very close to a recession already. The recession models we are monitoring have US recession probability at between 30-50% within the next 6-12 months. This heightened probability is typically seen just before a recession when it is later defined by NBER. If our thesis is right equities will experience a substantial drawdown close to 20% and thus underweight equities is the most sensible position. But rest assured policy makers have already initiated easing policies, and more will come, so the liquidity and credit support are ready for 2020 to see a rebound in both economic activity and equities. The Trump administration will throw anything at the economy to have the engines running firmly into the US 2020 election. This is Trump’s best ticket for a re-election as US president.
OECD leading indicators on the global economy has been falling for 18 straight months. With the indicators below trend and falling the global economy is in the contraction phase which is typically negative for equities vs bonds. But this time equities have outperformed bonds by wide margin making it a very atypical period for financial markets. However, if we are right in our thesis of significant declines in equities then the relationship could be restored for the business cycle phase before the economy moves into the recovery phase. Based on historical patterns equity markets such as South Korea, Brazil, US, Canada and Australia have been good places to have exposure as these equity markets tend to lead before the business cycle turns (see table).
Japan has led the world in terms of economics and monetary policy by being the first country to hit the wall of ineffective monetary policy coupled with an ageing population. The US and Europe have adopted many of Japan’s policy choices the past 10 years and it will continue with Europe leading as the continent’s economic dynamics resemble most Japan. Another striking feature of Japan’s economy is low growth (1% on average since 1995) and subdued recessions.
Our view is that the developed world is moving towards this equilibrium as well. With financial markets and banks being tamed by regulation the negative feedback loop in credit has been reduced and overall state intervention will produce a low growth environment with milder recessions. This has implications for investing in equities. The next recession will be milder than previously experienced, and the subsequent equity decline tamed around 20% drawdown as this seems to be the threshold for massive policy intervention.
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