Quarterly Outlook
Equity outlook: The high cost of global fragmentation for US portfolios
Charu Chanana
Chief Investment Strategist
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Equity Monthly: Light at the end of the tunnel?
Peter Garnry
Chief Investment Strategist
Summary: A dovish Federal Reserve and a stimulus-pushing Beijing are leading equities higher, but the key outstanding thing remains a trade deal between China and the US.
January was a big comeback month for global equities, which rose 7.8% in the wake of Federal Reserve chair Jerome Powell's significant U-turn on January 4, when he acknowledged that the Fed was open to ending quantitative tightening faster than anticipated and stated that the current interest rate trajectory was put on hold.
Immediately thereafter, the Chinese government enacted several key stimulus programmes, from cutting taxes to cutting interest rates and banks’ reserve requirements. While global equities have responded positively to these events, Chinese investors are still holding back. Key levels in the CSI 300 Index (China’s leading stock market index), however, may soon be broken to the upside which could change the dynamics altogether. From our sources in China, sentiment has changed for the positive lately which will likely drive risk-on sentiment in equities but hard economic data will not show the change until as late as Q4 this year.
The crucial thing required if the economy is to avoid slipping into recession is more monetary stimulus (most likely to come) and a comprehensive US-China trade deal. We use the USDCNH exchange rate as the best proxy for estimating the probability of a trade deal, and the signal here is clear: a trade deal is coming. We put the probabilities at 25% (no trade deal) and 75% (trade deal). But what's more important is the nature of the deal. Will it be comprehensive or not? If it is not comprehensive, the market's reaction will likely amount to a short-lived rally and then a fade. If it is comprehensive and China has responded forcefully enough against its economic slowdown then equities could fight back to new all-time-highs.
What we hear from sources in China is that the two parties (US/China) are moving closer to each other but some key bottlenecks remain in place. Ultimately, however, the process is most likely so advanced that the deal will be extended (the current deadline is March 1). Two things stand out: first, the US wants China to close the trade deficit gap much faster than China can accept given the impact on its economy. Second, this trade deal is highly bilateral, circumventing the World Trade Organisation and in this way potentially representing a new chapter in globalisation. It could potentially represent a new chapter in the globalisation process, and one based more on national interest than is the contemporary norm.
Immediately thereafter, the Chinese government enacted several key stimulus programmes, from cutting taxes to cutting interest rates and banks’ reserve requirements. While global equities have responded positively to these events, Chinese investors are still holding back. Key levels in the CSI 300 Index (China’s leading stock market index), however, may soon be broken to the upside which could change the dynamics altogether. From our sources in China, sentiment has changed for the positive lately which will likely drive risk-on sentiment in equities but hard economic data will not show the change until as late as Q4 this year.
The crucial thing required if the economy is to avoid slipping into recession is more monetary stimulus (most likely to come) and a comprehensive US-China trade deal. We use the USDCNH exchange rate as the best proxy for estimating the probability of a trade deal, and the signal here is clear: a trade deal is coming. We put the probabilities at 25% (no trade deal) and 75% (trade deal). But what's more important is the nature of the deal. Will it be comprehensive or not? If it is not comprehensive, the market's reaction will likely amount to a short-lived rally and then a fade. If it is comprehensive and China has responded forcefully enough against its economic slowdown then equities could fight back to new all-time-highs.
What we hear from sources in China is that the two parties (US/China) are moving closer to each other but some key bottlenecks remain in place. Ultimately, however, the process is most likely so advanced that the deal will be extended (the current deadline is March 1). Two things stand out: first, the US wants China to close the trade deficit gap much faster than China can accept given the impact on its economy. Second, this trade deal is highly bilateral, circumventing the World Trade Organisation and in this way potentially representing a new chapter in globalisation. It could potentially represent a new chapter in the globalisation process, and one based more on national interest than is the contemporary norm.
Where is the business cycle?
Using the OECD’s Composite Leading Indicators, we see that the the data suggest the OECD countries are currently growing below trend and contracting. This is the most difficult phase in the business cycle because this is when policymakers realise that the economy is quickly losing steam and enact measures to remedy the slowdown. The question then becomes whether policymakers responded quickly and severely enough to avoid deviating further from trend growth and slipping into a recession.
This is exactly the situation facing the global economy right now and also the key driver behind why investors and companies are worried about the future.
The OECD’s data cover until November, but December’s figures are just around the corner and the interesting question is whether the contraction has accelerated or decelerated. The print will most likely reveal the worst business cycle dynamics since late 2009. If the Fed’s U-turn came fast enough and China did its par, then the economy might take a 2012-style path where recession is avoided and global growth is resumed.
Using the OECD’s Composite Leading Indicators, we see that the the data suggest the OECD countries are currently growing below trend and contracting. This is the most difficult phase in the business cycle because this is when policymakers realise that the economy is quickly losing steam and enact measures to remedy the slowdown. The question then becomes whether policymakers responded quickly and severely enough to avoid deviating further from trend growth and slipping into a recession.
This is exactly the situation facing the global economy right now and also the key driver behind why investors and companies are worried about the future.
The OECD’s data cover until November, but December’s figures are just around the corner and the interesting question is whether the contraction has accelerated or decelerated. The print will most likely reveal the worst business cycle dynamics since late 2009. If the Fed’s U-turn came fast enough and China did its par, then the economy might take a 2012-style path where recession is avoided and global growth is resumed.
What does the current business cycle mean for sector exposure?
Based on data going back to 1995, business cycle phases with contracting growth (both above- and below-trend growth) are the most negative ones, and correlate to declines in the equity market. This fits very well with what we have observed as the global economy went from a boom cycle to a downswing in February 2018 and then shifted into a “recessionary” phase in August 2018. This period saw equities down globally and feature great downside volatility, scaring investors.
In the current phase, the preferred sectors are communication services, information technology and healthcare, and the least preferred are financials, energy and materials. When the business cycle turns into the recovery phase, the best sectors to be exposed to are real estate, financials and industrials while the underweight sectors should be communication services, utilities and materials.
Based on data going back to 1995, business cycle phases with contracting growth (both above- and below-trend growth) are the most negative ones, and correlate to declines in the equity market. This fits very well with what we have observed as the global economy went from a boom cycle to a downswing in February 2018 and then shifted into a “recessionary” phase in August 2018. This period saw equities down globally and feature great downside volatility, scaring investors.
In the current phase, the preferred sectors are communication services, information technology and healthcare, and the least preferred are financials, energy and materials. When the business cycle turns into the recovery phase, the best sectors to be exposed to are real estate, financials and industrials while the underweight sectors should be communication services, utilities and materials.
These months are the most important ones for investors since the euro area crisis in 2011/12 and the great financial crisis of 2008-9, so we recommend investors be more active and stay alert to changing conditions. In our next Equity Monthly we will give an updated picture on the business cycle and hopefully more clarity on the US-China trade deal.
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