As The Tri Polar World Turns - April 2019
MACRO THEMES
The case is growing for a “lower for longer global growth path” which will likely have significant implications for both tactical and strategic asset allocation. Our focus on Potential Growth Rates (PGR) and Neutral Rates of Interest (NRI) within our Global Risk Nexus Scoring System has been very helpful in tracing out this process. We expect to see growth outside the US to bottom this quarter while US growth, still in its catch down process, bottoms in the 2H of the year. Our 3 Step Risk Asset Process (RAP) guides us as markets move from Step 1 Anticipate to Step 2 Confirm and implement Step 3 Reallocate.
Markets are now in Step 2, confirming the bottom in China growth and the subsequent bottom in European growth together with the US - China trade deal. From our point of view, the recent & perhaps fleeting inversion of the 3M-10 year UST curve speaks more to the challenges of monetary policy in a low growth world than it does to an imminent US recession. We remain focused on the consumer and its supportive backdrop of historically low unemployment rates and solid wage gains in the developed economies together with the genesis of a global easing cycle in the emerging economies. We expect these factors, together with a Fed on hold and a stimulating China, to underpin global growth which, while low, will sustain for longer than many expect.
ECONOMICS: While economic data remains patchy it seems clear that growth is bottoming in China and approaching bottom in Europe. Recent China Beige book reports suggest a bottom is forming with every region & sector showing Q/Q improvement. China’s Manufacturing PMI is back above 50 while the Service and Composite PMIs show solid upturns. A strong stock market and further Govt support measures should reinforce both the consumer & the bottoming process.
European data is also picking up with perhaps German manufacturing being the exception. Ex Germany, Manufacturing PMIs have picked up while Service and Composite PMIs remain robust. Europe’s PGR is close to 1% and its deceleration toward trend is intact, supported by a solid jobs market and wage gains in excess of 2% pa. Work by JPMorgan suggests that a new export order bottom in China is typically followed within a few months by a bottom in Europe; therefore we continue to expect Europe’s growth bottom in the current Q.
Yield curve inversion in the US and negative yields in the German 10 year Bund have heightened growth concerns. The yield curve inversion in the US has proved fleeting; the limited number of historical examples suggest a much longer time frame of inversion is necessary to imply elevated recession risk. The Bund’s role as Europe’s safe asset amplifies its moves given the lack of supply from a balanced budget obsessed Germany. Importantly, the global landscape has shifted from one of Fed tightening and China slowing to a Fed on hold and China stimulating. This shift supports the lower for longer growth thesis. JPMorgan makes the point that 2% US growth (its PGR) and 1% in the EU are sufficient to maintain profit margins and hence earnings capacity.
POLITICS: Headline risk remains elevated while its impact on risk asset prices remains muted. If one just read the Brexit headlines for example, one would think British asset prices must be in the toilet but reality shows the opposite. However, it's important to note that a crash out is in no way priced into UK assets. In the US, the Mueller report has been delivered, if not yet made public, and the Democratically controlled House is pressing the President on almost every angle yet US equities approach new all-time highs.
EM political risk does seem to be percolating a bit with Turkey’s local elections creating unease in the lira market while Brazil’s bumpy pension reform process has affected its currency and equity market. Both are isolated to date as opposed to last summer’s EM brush fire; we are focused on Brazil in particular given its solid cyclical economic and earnings story. Our concern is that Pres. Bolsonaro, much like Pres. Trump, is very dependent on others to pass his agenda but unlike Trump, Bolsonaro does not have someone like Sen. McConnell to help him and thus the reform process is more problematic than one would hope.
POLICY: If March was a big month for Central Bank policy action (and it was), Q2 is likely to be important for its trade implications including both the potential finalization of the US - China trade deal & the likely beginning of US - EU trade negotiations. We are arguably in uncharted waters as it pertains to CB policy; the Fed aiming for an “inflation overshoot” amid a long pause which JP Morgan calls “unprecedented”. The case for a global easing cycle led by EM Central Banks has been strengthened by the Fed firmly on hold and ebbing inflation risk, especially in Asia.
Fiscal policy becomes more important as DM monetary policy hits traditional limits on what it can do. EU fiscal stimulus equal to roughly 0.5% of GDP should prove supportive for growth while Japan may also boost its growth prospects by delaying October’s scheduled consumption tax rise. Japan should benefit from the cyclical upturn in the global economy - pushing out the consumption tax could lead to a 2H positive growth surprise.
Trade news coming out of both Beijing and DC seems positive with increased specificity on a deal. Much like Brexit, a no deal scenario is most definitely not priced in. Chinese negotiators and soon perhaps EU negotiators will want to keep an eye on US growth data - the weaker it is, the more pressure Pres. Trump will be under to make deals and not rock the economic boat as the 2020 Presidential election cycle manifests itself.
MARKETS: Q1 proved to be quite the recovery quarter for global risk assets with all three main assets: equity, bonds and commodities up, led by commodities. Of course this follows 2018’s awful 4th Quarter leaving global equities down slightly over the past 6 months. DM bond yields have fallen substantially during that period while Commodities, led by oil, are still down roughly 12% over the past 6 months.
As noted, markets in our 3 Step Risk Asset Process (RAP) sit on Step 2, the confirmation of the global growth bottom. Equities remain robust and any weakness seems to be bought. The upcoming earnings season with its negative y/y forecasts should be a good test. An equity market pause/slight pullback would be healthy; downside risk seems limited given light positioning and elevated cash levels (Bloomberg reports US MM funds hold $3T, the highest amount since 2010). It has been a buy the rumor, sell the news type of market suggesting some caution around possible positive announcements re Q1 Earnings, Brexit or the US - China trade deal.
In fixed income land, rather than selling off and confirming growth bottoms, long rates have rallied suggesting growth fears in Europe where Bunds flutter around zero, China where the 10 year yields roughly 3.20% down from a high of 3.7% last Fall or in the US where the 10 yr UST crashed to 2.35% (now back at roughly 2.5%). Yet US and European credit had a great quarter, suggesting little concern over growth (See Chart 5).
Commodities also display little concern over growth as supply concerns remain supportive and demand remains solid. If growth picks up, commodities should remain attractive. FX has been quiet; we do have growing concerns about the US twin deficits & note that the US fiscal deficit has soared 40% y/y while real rates have fallen sharply. Once the growth bottom in the ROW is confirmed the case for USD weakness would seem to be a good one on both a tactical (US assets are overbought) and strategic (twin deficits) basis.
Chart 5: Credit Shows No (Recession) Fear
Source: WSJ
A lower for longer global growth path would seem to be a reasonably good one for risk assets, by trading potential lower earnings growth for less risk of a death by Fed. Such a path would suggest markets with potential for multiple expansion (EU, Japan, parts of EM) and those assets with attractive yields (EM debt, US - EU HY, European peripheral debt, preferred securities etc) would remain well bid. It's worth noting that the US equity market is up over 10% in the past year and sits only ~2% off it's all time high, while ROW (ACWX) is down ~2% over the past year and sits roughly 15% below its recent high.
Confirmation of growth bottoms is key; investors should be preparing for Step 3, Reallocation to the non US markets as confidence grows. Focus should be on the DM ex US markets; Q1 flows highlight the opportunity: flows out of EAFE related funds totaled over $5B while Japan (EWJ) alone had outflows of $2.6B. When the flows reverse it is likely to be a bit of a feeding frenzy. It's worth noting that China, a top performer ytd, remains down roughly 5% over the past year and roughly 20% off its recent highs while Lat Am is down close to 10% over the past year and remains roughly 25% off its highs of the past several years. There would seem to be much more equity upside outside the US.
PORTFOLIO STRATEGY AND ASSET ALLOCATION
We have made limited portfolio changes this month given our view that markets were extended and due to pause. We remain slightly overweight equity, underweight bonds and overweight alternatives & cash.
Within equities, we remain OW the non US equity markets. We exited our US Financials position believing that the current rate structure will make it difficult for banks to outperform. We reallocated that position into US Industrials taking advantage of the Boeing related selloff and anticipating both a US - China trade deal and a global growth bottom.
In Fixed Income we maintained our positions in the US: OW credit with a preference for the belly of the UST curve. We exited our EM LC debt position and added it to our EM USD debt position expecting the lower for longer global growth path to support continued interest in EM USD debt with its yield pickup. We added a position in US Mortgages as a yield play and continue to hold a position in European HY believing Europe’s imminent growth bottom will prove supportive.
We remain overweight Alternatives with a position in broad commodity exposure and a tilt to energy via a MLPs position. We have high conviction in OPEC, specifically Saudi, desire to maintain production cuts to ensure higher oil prices (Saudi Arabia’s 2019 budget has a $80 avg price estimate). We continue to expect both supply concerns and demand pickup based on growth bottoms to support our commodity overweight. We maintain cash positions as we await the economic & political signals noted above to add to our preferred risk positions.
GLOBAL MACRO SUITE PORTFOLIO CHANGES
Global Macro Multi Asset (GMMA)
Within equities, we sold our US Financials position, replacing it with a US Industrials position.
On the fixed income side we exited our EM LC debt position, rolling it into our existing EM USD debt position.
Global Macro Income (GMI)
As in the GMMA portfolio, we reduced our EM LC debt position and added to our EM USD debt position.
We reduced cash and added a position in US Mortgages.
Global Macro Equity (GME)
As in the GMMA portfolio, we exited our US Financials position and added a US Industrials position.
We also exited our Gold position and replaced it with a Base Metal position as a way to participate in the expected global growth bottom.
We hope you find this monthly piece of value and look forward to engaging with you on a monthly and quarterly basis as we go thru 2019.
Jay Pelosky, CIO & Co-Founder
TPW Investment Management
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