Achtung! German GDP & Ugly Europe/China Industrial Data Sends Yields & Stocks Lower

Stocks in Asia join the global rout after US equities were hammered overnight in what was the broadest sell off since February 2018. Every sector of the SP500 finished in the red and 94% of volume on the NYSE was in declining stocks, again the highest level since February 2018. 

The last 48 hours have been a rollercoaster for investors as trade optimism briefly stoked risk sentiment knee jerking stocks up, but ongoing global economic growth concerns provide an oppositional force. The tariff delay positivity was quickly outweighed as evidence that the cyclical slowdown in global growth, which predates the trade war, is taking a firmer grip came to the forefront of investor concerns.

The slew of poor data including negative Q2 German GDP, weak Eurozone industrial production and ubiquitously ugly China industrial data confirmed what is fast becoming a synchronised global slowdown. This stoked haven demand which saw yields curves across developed markets invert and set the risk-off tone in the markets. Bond markets flashing alert sent a warning signal about the rising risk of recession as the 10-year Treasury rate slid below the two-year for the first time since 2007 and the 30-year yield fell to the lowest on record. The escalating trade tensions have become akin to pouring kerosene on a pre-existing cyclical slowdown, increasing the probability of recession.

The bond market sniffed this growth slowdown out sometime ago as global PMIs collapsed, the manufacturing sector crumbled, and global demand dampened. But equity markets, cushioned by complacency and misplaced trade optimism, have been placing unrelenting faith in the ability for central banks to pivot the cycle. It is only a matter of time until the equity market surrenders to what the bond market has been screaming. Equities have been priced for a perfect execution of FY2020 uplift in earnings growth and have largely ignored the deteriorating growth outlook to focus on central bank easing, with multiple expansion driving the year to date rally. Against the current economic backdrop with a myriad of factors weighing on revenue growth the v-shaped recovery in earnings growth through to FY2020 looks far too optimistic.

Bond yields globally have collapsed as ongoing economic growth concerns have driven haven demand since Q42018, both the 2-year and 10-year yield peaked in November last year. To date a large proportion of the decline in yields has come from collapsing real rates, signalling growth concerns have been the major factor driving yields lower.

Even following the 25bps rate cut from the Fed in July bond yields continued to aggressively drop and the curve flattened as growth concerns took centre stage and trade tensions escalated. The yield curve has been telling us for some time that monetary policy is too restrictive, and the Feds forward guidance accompanying the July rate cut was not dovish enough. The market interpreted this as a potential policy error, with short end rates too high, therefore raising the risk of recession and pressuring inflation expectations. The bond market has no faith in Powell's “mid-cycle adjustment” narrative, and nor should they. For one mid-cycle is optimistic (and that’s being polite!), and two, US growth is slowing more than consensus believes and will continue to do so.

Market pricing has been indicating monetary stimulus will fail to engender a re-acceleration in growth or inflation, and the Fed are increasingly behind the curve and are not providing relief. This means more “mid- cycle adjustments” are coming from Chairman Powell, and the Fed will move to aggressively cut policy rates in September.

Meanwhile the combination of falling producer prices as China PPI contracts for first time since 2016, along with the CNY depreciation, is indicative of mounting global deflationary pressures. Add in the continued slide in oil prices, iron ore prices collapsing as the supply shock rally recalibrates given global demand is faltering and a copper chart that looks ready to break and it is clear disinflationary forces loom large. In this this environment as a synchronised global slowdown takes effect there is no reason that bond yields should be heading higher and there is a good chance Fed must cut by more than the market is currently implying. Race to the bottom anyone?

Another reason the Fed will move to cut rates stems from the yield curve inversion which historically signals that the risk of a recession is increasing, an indicator which the Fed should heed. The yield curve is the best forecasting tool for recessions, having inverted before each of the last seven recessions. This inversion means that the interest rate (or yield) on 2-year US Government treasury bonds is higher than the interest rate on 10-year Government bonds. Signalling that investors believe current growth is stronger than future growth and interest rates will be lower in the future. Banks borrow short and lend long, thus when the yield curve is inverted the ability to lend profitability is less and hence the incentive to lend can be reduced, these expectations of slowing growth also cause businesses and investors to slow spending.

Based on previous instances where the 2/10 curve inverted, the economy peaked an average 16 months later. The stock market, however, peaked on average 5 months before the economy topped out. Whilst this inversion creates concern, and significantly raises the risk of a recession it is not a foregone conclusion. Although if you still believe in a business cycle, a recession is eventually inevitable. Typically, the magnitude of inversion preceding a recession is deeper than current levels and more persistent. And it is the subsequent re-steepening that signals the impending recession. That is not to say we won’t see a continued and more pronounced inversion, but before sounding the alarm bells of imminent recession, it is prudent to wait for an improved signal (a deeper inversion, and subsequent re-steepening).

Together with other measures we are probably sitting at around a 50% probability of a US recession in the next 12 months and it’s better to look at it like that – in probabilities NOT certainties. You don’t need to make a big call right now as we are probably not going to know until after the fact anyway. We don’t need to know whether this a recession or severe slowdown in growth followed by a reacceleration to know if we should position more defensively. The market is vulnerable either way, we are late cycle and a more defensive and conservative asset allocation would be prudent.

In terms of monetary policy, an inverted yield curve has deep implications as it led all the past 6 Fed easing cycles of the past 3 decades and is likely to lead this “mid-cycle adjustment” to become a full Fed easing cycle as well.

But the real root of the problem, for central banks, monetary policy is no panacea for economic ills. Their ammunition is already limited, and there is little a lower cost of capital can do to pivot the economic cycle at this stage. Demand for credit is also being dampened by uncertainty as the trade war weighs on confidence. The uncertainty paralyses decision making for multinational companies, burdens capex intentions and forces supply chains to be unravelled in order to remove risk. This spills through to the real economy via reduced business investment and ultimately the labour market through hiring decisions. Which is where the real trouble lies, to date the consumer is propping up the economic expansion, but if the jobs market is hit and confidence wanes this will not be the case. Global central banks will move to provide additional stimulus, but whilst political risk remains ubiquitous and the trade war uncertainty remains central banks can only manage downside risks, not pivot the economic cycle.

Against a deteriorating global backdrop where geopolitical constructs that have upheld the global order as it has stood since World War II are ailing, policy rates fast approaching the zero-lower bound render monetary stimulus akin to feebly pushing on a string. As such, a coordinated policy response is necessary. Up next should be a real focus on pro-growth productivity reforms, infrastructure spending and other fiscal measures in order to reignite confidence and a self-sustaining recovery in economic growth. Already policymakers are behind the curve on policy settings and risk a further disruption in confidence and persistent below trend growth if confidence is not restored.

Our view remains that until we see a more robust macro environment and confirmation of a self-sustaining re-acceleration in economic growth, it’s time to move into capital preservation mode with an underweight allocation to equities. In volatile times, another way to slice and dice the equity market and add defensiveness to a portfolio is to look at style/factor exposure rather than sectors. We look to maintain exposure to low beta/minimum volatility and quality in terms of factor exposure as an indirect portfolio hedge, while staying clear of momentum and high beta factor exposure. Global markets remain vulnerable to a continued deceleration in economic growth and a fragile geopolitical environment could well be the straw that breaks the camel’s back.

Risk sentiment will continue to gyrate with trade headlines and growth concerns, thus volatility will remain part of the picture. When volatility picks up larger trading ranges are driven by falling liquidity and the expansion in trading ranges is not only to the downside, but to the upside as well. So even falling markets can witness fierce upside rallies.

Precious metals and gold miners will continue to outperform as investors seek out safe havens to protect against volatility. Heightened geopolitical risks and trade tensions set to weigh on global growth combined with an aggressive easing cycle from the US Fed, with a further rate cut set for September spurs demand from gold and dividend paying gold miners as a store of value. In an environment of cheap money against a backdrop of the return of central bank largesse where the purchasing power of currencies is persistently eroded and real rates continue their collapse, gold remains attractive.

There is also no reason to lean against current bond market dynamics as yet. Looking at the continued slide in oil prices, iron ore prices collapsing as the supply shock rally recalibrates given global demand is faltering and a copper chart that looks ready to break and it is clear disinflationary forces loom large. In this this environment as a synchronised global slowdown takes effect there is no reason that bond yields should be heading higher and there is a good chance Fed must cut by more than the market is currently implying.