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Recession: For And Against

International | Oct 30 2019

Market analysts put forward their views on the risk of US (and thus global) recession in the near term.

-Fed response too late?
-China feeling the pain
-Earnings must justify valuations
-Stock selection critical

By Greg Peel

The US Federal Reserve’s track record in using rate cuts to avoid a recession is mixed, note the analysts at Guggenheim. And this time around, a combination of limited policy space globally – rates are already historically low – and numerous other headwinds suggest it’s a close call as to whether the Fed has cut early enough (twice this year ahead of this week’s meeting) to help extend the US economic expansion, as is its intent.

The odds of a US recession increased in the September quarter, when the US manufacturing PMI fell into contraction and the US yield curve inverted, while the Chinese economy continued to slow with manufacturing also feeling the pain. Guggenheim’s Recession Probability Model at the time suggested a 58% of recession by mid-2020 and 77% within 24 months. The trend continued at the beginning of the December quarter.

History shows that when this particular model reaches such levels, only aggressive policy action can delay a recession, but not avoid it.

Since Guggenheim published its September report, signs in the US have improved slightly. Manufacturing has crept back and the yield curve has swung back into the positive, albeit mildly. It is important to note that the question of whether or not there will be a recession is always one of when not if. Every period of growth must be followed by a period of contraction at some point.

At this point in history, the defining factor in all economic forecasting is the trade war. If the trade war is to escalate (which could include Trump’s December tranche of new tariffs being implemented) then the chances of a recession increase. If a “deal” can be reached, even a small one, then the opposite is true.

Right now talk is of a small “deal” being reached, as part of a larger process. But we have been here many times before in the past two years. There is little doubt President Trump had expected the war would have been run and won by now when he started the process, even though he did from the outset warn of short term pain for long term gain. But not only is the war ongoing, every attempt by Trump to force a resolution by upping the ante has failed up to now.

Trump blames the Fed for not cutting aggressively. The Fed is now cutting, mostly due to the impact of the trade war. Guggenheim expects Trump to use easier monetary policy as the green light for more aggressive trade policy.

In other words, a dangerous feedback loop may eventuate.

Playing Chicken

However, Trump has an election to win next year, and a failure to secure any sort of trade breakthrough and worst still a recession before November next year will make that task that more difficult. To that end, Russell Investments believes an easing of the trade war seems likely, if only temporary.

It may come down to just how much pain China can bear.

Beijing has come right up to the line on several occasions in the past two years and then baulked, resulting in more or increased tariffs from an incensed Trump. Right from the outset it was assumed Beijing would play a “long game”, attempting to wear down Washington into making concessions that would allow President Xi to “save face”. For some time it has been expected Beijing would try to string things out right up to the election to force Trump into a corner.

Given a “phase one” deal will not be signed until December, if at all, and the critical factor of intellectual property policy is not addressed until phase two and/or phase three, at the pace things are moving it’s hard to see negotiations not running right up to the election. And impeachment proceedings will only have steeled Beijing’s resolve. But they might also backfire, steeling the resolve of wavering Trump supporters.

To date it appears a decidedly left wing candidate may become the Democratic nominee, with the veteran Joe Biden struggling for traction. This may not be sufficiently palatable for US voters, and thus upset Beijing’s “long game” strategy. But moreover, president-for-life Xi does not by default have the support of all of China.

China’s pain threshold may be higher, notes Russell Investments, but job losses and the threat of social instability provide an incentive to de-escalate trade tensions and pursue domestic policy stimulus. Cutting to the chase, trade war escalation will result in more stock market volatility in both camps and this, suggests Russell, may prod both sides into action.

To that end the analysts believe the global economy can recover in 2020 on a balance of trade war resolution and policy stimulus.

Importantly, both will provide a lifeline for the European economy. Otherwise the ECB’s relaunch of QE and cutting of interest rates into ever more negative territory is unlikely to provide any further stimulus, Russell Investments believes.

For the US the outcomes are asymmetrical. Failure on trade would likely lead Wall Street into a bear market. Success provides for limited upside from all-time highs. Russell is thus cautious.

And let’s not forget Brexit. Even after the developments of the past couple of weeks it appears a Never Ending Story that will ensure uncertainty and investment constraint for some time. Russell is tipping another referendum.

The trade war has also led other central banks around the Asia-Pacific region to cut rates, which should provide some support, Russell believes. But while easier monetary policy from the Reserve Bank of Australia has provided a boost to the Australian equity market, the analysts suggest any upside is limited given soft fundamentals.

The analysts at investment manager Loomis Sayles are expecting a further weakening in global economic data in the near term but expect the manufacturing-driven slowdown to reverse course later in the December quarter without recession.

Loomis expects the Fed to cut this week and in December, while the ECB and Bank of Japan have indicated signs of continued easing until growth and inflation approach targets. Global growth forecasts have begun to stabilise and absolute levels of real GDP look “decent” for 2020-21. The analysts see labour market strength and rising wages but do not believe these will lead to a blowout in CPI inflation as has been the case in past expansion cycles.

One risk highlighted by Guggenheim is the possibility of US core inflation reaching back up to 2%, leading some FOMC members to forcefully resist any further policy easing.

Loomis does fear the risk of recent weakness in manufacturing bleeding through to service-oriented sectors, but for now notes limited indications of such an outcome.

Earnings Critical

As for the US stock market, the issue here is that any further strength will need to come from earnings, given price/earnings multiples have already expanded over 2019 from very low levels, when the Fed was tightening, to levels which many see as “expensive” today, regardless of the implications of low interest rates on discounted cash flow valuations. To justify high PEs, earnings must rise in accordance. The outlook for corporate earnings and global growth remain critical, Loomis suggests, in helping to drive equity market performance.

Loomis was writing ahead of this month’s US earnings season which to date has proven positive, in the sense that forecasts already deemed to be too pessimistic heading into the season are being beaten by (at the time of writing) around 80% of S&P500 companies. The S&P has hit a new all-time high as a result, along with ongoing confidence in a trade deal if at least some sort.

But most agree, as Loomis believes, any resolution on trade, however small, would be an upside catalyst, while escalation would evoke downside risk.

Possibly severe downside risk, one assumes.

Of course, the trade war is not the only geopolitical hotspot at present. There’s Brexit, and US conflicts with Iran and other nations. Plenty of scope elsewhere for downside risk.

But put it all together and Loomis believes US economic expansion should continue through 2020.

Choose Wisely

American Century Investments nevertheless advises, and is not alone, that given expectations for ongoing volatility investors should take a more defensive stance without deviating from their long term strategic asset allocations. However, beware of crowded trades, the analysts warn, especially in traditionally low volatility sectors that may have become risky due to lofty valuations.

Into this group we can place the likes of utilities, REITs and consumer staples – the traditional “defensives” – which have been bought up heavily in the US in particular but also in Australia.

Adopting a defensive posture in equity portfolios could mean complementing growth-oriented holdings with higher-quality companies with histories of paying dividends, American Century suggests. The late stage of the economic cycle continues to favour companies that can use their competitive advantages to drive profit growth regardless of economic conditions.

In the case of utilities, REITs and other bond proxy-type asset (infrastructure funds, toll roads, airports…), the allure has not just been “defensiveness” but yield in a little-to-no yield paying environment. Aside from having been pushed beyond typical valuations due to demand, these assets are at risk of any decision by central banks to hold off on or even reverse further easing.

Which might be the case, say, were the trade war to be resolved.

Consumer staples tend to pay reliable if not as spectacular yields but are truly “defensive” in that even in a recession consumers will still have to eat, drink, wash etc. The big US names have been the go-to trades for most of this year but unfortunately for Australia it is the same US labels that grace our supermarket shelves, leaving the supermarkets themselves as the mega-cap staples, which are far from a risk-free proposition in Australia’s supermarket wars.

This leaves “companies that can use their competitive advantages to drive profit growth regardless of economic conditions” as a rather select group locally. In Australia’s case, “size” is not the simple answer, particularly when the ASX top 20 represents over half of total market capitalisation and is dominated by banks/insurers and resource companies.

But that is not to dismiss all large caps.

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