A Tale of Two Global Economies

Positive global equity returns in July and tighter spreads in the credit markets reflected investor optimism that the global economic expansion would live to fight another day supported by the powerful tailwind of loose monetary policy.

Here are five key takeaways for the month:

1

Market Pulse

Bated Breath

Global markets, both Risk and Risk Control, spent the month of July anticipating a series of central bank actions around the world. Global sovereign bond markets rallied, expecting the easing bias to turn into action, sending yields in several important developed markets below zero. The U.S. 10-year ended the month at 2.03%, clearly reflecting the expectation that the Fed would cut rates several times over the next 12-16 months. Optimism was not driven by an improving economic or corporate earnings outlook, as both appear strained under the continued pressure of trade conflict.

As we enter August, the trade conflict appears to be deepening with U.S. President Trump’s announcement that the US would proceed with a 10% tariff on the remaining $300B of Chinese imports and Beijing promising to retaliate. Coming on the heels of disappointing global growth data, slowing global trade volumes and a global manufacturing recession, these announcements have driven a “risk off” mood, with global equity bourses facing significant losses. Global sovereign bond markets have rallied sharply, taking the U.S. 10-year U.S. Treasury yield to 1.75% and inverting the yield curve at 3, 6, and 12 months against that yield.

The odds of a more protracted trade conflict between the U.S. and China have increased, however, another détente later this year still remains likely. The changing global growth dynamic, tightening market conditions and equity market decline will not go unnoticed by central bankers, and we believe resolve will be strengthened to ease policy.

2

Macro View

Mixed Messages

The global growth slowdown continues, but it seems to be a tale of two global economies:

  • The global services sector continues to hum along under the power of strong trends in consumption. Reinforced by recent data from the U.S., consumer confidence rose to an eight-month high, according to The Conference Board survey. Although coming off the boil, U.S., European and Chinese Non-Manufacturing Purchasing Manager’s Index (PMI) readings remain above 50.

  • In stark contrast, global manufacturing remains in contraction, and the pace of contraction appears to be gaining speed, thanks in large part to ongoing trade conflicts. The Global Manufacturing PMI sits below 50, at the lowest level in nearly seven years.

It is unusual to have a prolonged period of services strength and manufacturing weakness. Fear is growing that the weak manufacturing backdrop could creep into the services sector, stem employment growth and send a negative feedback loop through the consumer. We continue to forecast slow growth, with the global economy avoiding a recession.

3

Policy Front

Oops, He Did it Again

Following an ECB statement all but committing to easier policy in September, all eyes were on the U.S. Federal Reserve – and in particular to messaging, given a myriad of previous communication gaffes by Powell as well as other committee members. Hence, you could almost hear the collective face palming around trading desks as Fed Chair Powell presented a confusing message at the July meeting. Words matter and Powell introduced some new ones to an audience prepared to parse every sentence. Many interpreted the “mid cycle rate action” as a hawkish hike, assuming based on some of Powell’s comments that this cut may be “one and done,” clearly out of line with the market expectation for several cuts over the next year. Powell was able to walk back some of his comments, but the damage was done, particularly in the currency market where the U.S. dollar hit an eight-year high. With dollar strength cited as a meaningful headwind by many corporate CEOs during the 2Q earnings calls, and in the midst of ongoing trade negotiations, this strength is unwelcome.

4

Fundamentals Focus

Weak Earnings, Strong Markets?

The return of a stock, or the market as a whole, is the sum of growth in earnings per share, the dividend yield, and change in valuation. The change in valuation can either be a headwind, as investors reduce the multiple they are willing to pay for a stock’s future earnings, or it can be a tailwind, as they may increase the price they will pay for each dollar of earnings. Theoretically, an interest rate decline is supportive of price-earnings multiple expansion, as future earnings are discounted at lower rates revealing higher present values. This does not always hold, and can be dependent on the overall economic backdrop.

The 2018 earnings growth rate for the S&P 500 was over 20%, yet the market ended the year in the red. The reason? Multiples contracted. The contraction in multiples more than offset the growth in earnings for the year, and in fact, also offset the dividend, leaving investors with a total return of -4.75%. Conversely, this year we have seen a notable multiple expansion driven by the expectation of increasingly dovish Fed policy and in the face of flat earnings.

So here we sit, with valuations above historical ranges on arguably depressed earnings. The market is already pricing in several rate cuts, which leaves little if any room for further valuation expansion, and may in fact suggest a reversion toward the average. Logic would suggest that future equity returns will be more directly a function of earnings growth and dividend yield.

5

Segment Spotlight

Dude, Where’s My Brexit?

Boris Johnson has been elected as the new head of the Conservative Party in the U.K., and will serve as the new prime minister, succeeding Teresa May. His platform sits on a foundation of “Deliver, Unite, Defeat and Energize,” or DUDE. Johnson is well-known for his position on Brexit, and “one way or another” has vowed that the U.K. will leave the European Union on the October 31 deadline. Amid a meaningful reshuffling of his cabinet, PM Johnson delivered a fiery speech to the House of Commons indicating that he would seek to remove the Irish backstop provision from the Brexit deal, which details what will happen on the border between Northern Ireland and the Republic of Ireland. This provision has been a critical sticking point on both sides and has increased the odds of a “no deal” Brexit, which would throw the U.K. and EU economies into turmoil.

Time is running short, and we are monitoring the situation closely, with our base case remaining that a deal will get done but perhaps not by the deadline. The risk case, however, has increased significantly and is manifesting in the currency market where the pound sterling has tumbled.

The Currency Market Reflects Growing Hard Brexit Concern

$ per £

Source: Refinitiv (formerly Thomson Reuters)

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