As The Tri Polar World Turns - The Year Ahead: Reflation 2020
MACRO THEMES
As we prepare to exit 2019 and enter 2020 it's time to lay out the year ahead outlook - what we at TPWIM are calling: Reflation 2020. We continue to operate in a Lower for Longer Global Growth world and believe such an environment can lead to Higher for Longer Global Stock Prices. Recession fears have led investors to crowd into US equities and Growth/Defensive equities in particular, perhaps marking the tail end of a decade long run of outperformance. In a low growth world one can safely seek yield within the fixed income space, as we have done throughout 2019 and intend to do for the foreseeable future. Low growth & low inflation suggest Central Banks are unlikely to make money more expensive, something Fed Chair Powell recently made clear. The Duration bullies have been cowed; fixed income risk remains on the side of higher long rates in the months and quarters ahead.
Our Big Four Signposts have served us very well this past year; these signposts grew out of our Global Risk Nexus (GRN) work and led to our Fall Risk Asset Rally call & portfolio positioning. We now see this Fall Risk Asset Rally morphing into the case for Reflation 2020. Let’s review the Big Four Signposts:
The Global Easing Cycle continues - JPM expects more rate cuts in Q4 than in Q3.
Global Growth Bottoming is upon us as the Global Manufacturing PMIs bottom, led by the EM in a case of first in, first out.
The US - China Trade Tiff is in the process of stabilizing with a phase one/mini deal likely in the weeks ahead.
Global Earnings Bottoming which is suggested by various measures including revisions and outlook.
We expect the geopolitical overhang, both in trade as well as Brexit terms, to stabilize as we move into 2020 which should support a gradual global growth recovery as the production/inventory restocking cycle picks up. Record low OECD unemployment provides support via consumer spending aided by some prospect of capex spending as geopolitical clarity improves. Continued CB easing coupled with fiscal stimulus in various European and Asian economies, including France, Japan and India among others, provides further support. Earnings skepticism runs deep after several Qs of declining y/y EPS growth in many markets; the outlook for 2020 is for high single digit, low double digit growth in many important equity markets. Earrings upside could stem from any tariff rollback by China or the US which JPM points out is not included in current 2020 estimates.
Sentiment towards risky assets, especially non US equity, remains deeply negative, notwithstanding some positive inflows in the last few weeks. While equities may be overbought on the very short term we see any pullback as a healthy pause & note that ACWI remains at its early 2018 levels, suggesting global equities have basically marked time over the past two years. Flows into money market funds have been huge with estimates of $4T with a T sitting in cash. The real question is whether the nascent moves into non US equity, to Value and into Cyclical sectors of the equity market will be sustained. Sustainability requires catalysts: global growth recovery, trade deal, earnings pick up are all potential candidates.
The environment could be setting up for just such a shift. The rest of the world economy is bottoming now while the US remains in catch down to the globe, slowing into 2020. Defensive vehicles such as Min Volatility ETFs have seen huge inflows in the past year or so and are likely to be used as sources of funds for shifts into more Value and Cyclical market segments. Non US markets are Value by definition, especially non US DM while the linkage between a growth pick up, a backup in long rates and Value outperformance is very well established.
Where could we be wrong? Several places: US - China trade deal could fall apart; a hard Brexit could halt Europe’s nascent pickup; the inflecting up of Manuf PMIs could reverse and relapse, leading to a broader slowdown that encompasses the much larger service segment of the developed economies. Central Banks could stop easing and start raising rates while the mini equity style/sector cycle rotation witnessed the last few months could die out or reverse. Investors could become convinced that a true recession is needed to flush the system and create the grounds for a new bull market with new leadership, both geographically & in terms of style and sector.
We take an optimistic view that Reflation 2020: built upon a global easing cycle, fiscal stimulus & an industrial cycle bottom, will surprise to the upside in terms of global economic growth, earnings growth, stock prices and long rates. An environment where the SPY marks time (flattish) is a great environment for reallocation to the non US markets and that as such Value will outperform Growth and Cyclicals will outperform Defensives. As Chart 1 shows this tends to be how markets perform when the Global Manufacturing PMI inflects up from a sub 50 level as it is now doing.
Chart 1: Manuf PMI Inflection Leads to Sector/Style Rotation
Source: JPM
As a possible harbinger we note that in the last Global Manufacturing PMI upcycle (2016 – 2018), ACWI rose roughly 50%; we expect a more muted cycle this time around as China is measured in its stimulus, the US is slowing and Europe’s upturn is likely to be subdued. In addition the starting levels are higher both from an actual level as well as from a valuation POV. Nonetheless, better growth means higher rates which mean higher stocks; equity dips should be bought. Chart 2 shows how the current cycle is playing out vs history.
Chart 2: From Fall Risk Rally to Reflation 2020
Source: JPM
ECONOMICS
Global growth appears to be stabilizing with Goldman’s Global Current Activity Indicator (CAI) at 2.6%, roughly in line with where it has been since the spring. China’s CAI of 5.9% is the best since the Spring, suggesting stabilization there as well. We maintain our long standing focus on the service side of the DM economies, responsible for roughly 75% of economic activity, where activity remains robust, with the OECD UER remaining at record lows while wage gains remain above inflation, both of which support consumption.
The consumer has helped keep Germany out of recession with Q3 GDP just released at 0.1% Q/Q and 0.5% y/y. In China the situation is the same with October data suggesting weak industrial and fixed asset investment #s but stable service sector growth of 6.5%. It's a bit of good news, bad news situation though as in Germany’s case growth, while weak, will limit the appetite for aggressive fiscal stimulus while in China weaker than expected industrial activity will generate calls for more stimulus (and raise prospects for a trade deal).
The big news is the growing sense that the Global Manufacturing PMI has bottomed while the Service and Composite PMIs remain above 50 (See Chart 3). There are nascent signs of a turn in the inventory cycle which could jump start the production side as exemplified by a bottoming in autos and semiconductors, two key manufacturing sectors. Europe’s IP has grown for the past two months while the new orders to inventory ratio for example broke above 1 in October for the first time this year.
Chart 3: Global Manufacturing PMIs Finally Turn Up
Source: WSJ, SunTrust
Our outlook remains for the DM economies to stabilize around trend growth rates of 2% for the US and 1% or so for Japan and Europe. China’s L shaped recovery suggests continued growth of around 6% while other emerging economies could see better growth in 2020 aided by lower interest rates (Brazil, Turkey), fiscal easing (India, Indonesia) and an industrial cycle rebound. Inflation remains quiescent absent food related pressures in China (helps push for trade deal).
Lower for Longer Global Growth could end up being seen as quite a favorable environment for financial assets as financial conditions remain benign, CBs are easing or on hold and Govts start to consider a shift from wealth concentration to wealth distribution. How investors respond to such a shift will be worth monitoring… one hopes fear will not be the sole response.
As JPM notes the two key questions to be answered over the coming months are: One, Has the global economy bottomed and two will the growth rebound outside the US be sufficient to visibly narrow the growth gap between the US and the ROW? Clear signs of ex US growth bottom coupled with continued signs of US catch down (ISM, Q4 GDP tracking at 1%) could spur asset allocation shifts.
POLITICS
It is increasingly clear that Pres. Trump will face impeachment in regards to the Ukraine affair. The interesting questions are twofold: one, will it matter to markets and two, will the President serve out his term? To date the answers are no and yes but that may change as we move forward; in the first instance because as President Trump is weakened attention shifts to who might be the next President with the focus on Democratic frontrunner Elizabeth Warren. Leading market mavens have responded with talk about 20-40% declines should she take office.
These worries seem quite overblown given the need for a Democratic sweep (aka Blue Wave) which itself is likely to provide only a slim Senate majority at best and thus not enough to enact her most aggressive redistribution policies. Yet such concerns could serve to put a dampener on relative US equity performance. In the second case, there is some prospect of Republicans telling the President that he needs to resign for the good of the party and the country so they can run someone else for 2020; watch Trump’s support level - now 41% according to respected polling outfit FiveThirtyEight - if it breaks below 40% pressure for Trump to resign could become more likely as there would be less and less Republican need/desire to defend him. A deal for Trump to avoid Federal/state prosecution might be sufficient as recently outlined in the press.
Across the pond, headway is being made in the Brexit saga with another UK election next month to determine how to move forward. Clarity would be supportive for UK and EU; the EU could use the breathing space to deepen its own integration under its new (EC, ECB) leadership. Recent comments by French president Macron about the need for “European sovereignty” to preserve and build Europe’s geopolitical leadership reinforce the idea of European integration within our Tri Polar World (TPW) framework.
US - China trade remains an open item with occasional flare ups regarding US investment in China or AI blacklisting etc, etc. The big focus is on whether a phase one or mini deal gets signed in 2019 & whether as part of that deal some of the existing tariffs are rolled back. Both sides need a win but the cancellation of the APEC Summit seems to have cooled any sense of urgency. The US ask for numerical targets on agricultural imports has been met with China’s desire for phased tariff rollbacks. The scheduled Dec 15th tariffs (main focus on consumer, computer goods & thus politically sensitive) will provide the next clue on the road map.
Given the importance of both the US consumer & C-suite capex plans it makes a lot of sense for Pres. Trump to move in a positive direction. That the recent Conference Board’s CEO confidence survey came in at lows not seen since the depths of the GFC is a data point that is unlikely to be lost on the Trump team. Should a deal happen, investors are likely to respond positively as many remain very defensively positioned, wanting to see the ink dry on the page before committing themselves.
POLICY
Having now cut three times, the Fed is likely to go on hold to assess the situation, confident that it has reversed the yield curve inversion & sent the duration bullies packing. It's interesting to note how little attention the yield curve reversal has received vs how much the original inversion received a few months back. One must conclude a decent economy is not as good a story as an economy going in the toilet. Similarly, Brazil passed its pension reform and while markets celebrated the amount of press has been pretty minimal. Further Brazilian reforms are expected on both the tax & governance side.
Mario Draghi has left the (ECB) building in Frankfurt replaced by Ms. Lagarde who seems well suited to continue the fiscal push in Europe. As noted there is some fiscal spending across Europe but it is state by state and Germany is dragging its feet. This will be Ms. Lagarde’s big battle - not the monetary bazooka fired by her predecessor but to restore fiscal stimulus as part of the EC tool box.
In Asia, Japan has both raised its VAT & said it plans a supplementary budget to support the economy - its first fiscal stimulus in three years. China continues to move slowly in stabilizing its economy, sending a clear message that it will neither save nor sink the global economy.
Bottom line: after all the growth fear mongering over the summer, policy makers across the globe, including those wearing both fiscal and monetary uniforms, are on the case providing liquidity and easy financial conditions to global financial markets. 2020 reflation could be the surprise that lifts markets and sparks a violent rotation.
MARKETS
Financial markets have morphed from being Teflon like in their ability to handle negative headline risk through the worst seasonal period to now moving up and in some case clearly breaking out as seasonality turns positive, earnings beat, geopolitical clouds part and economic data shows signs of improvement. Non US equity is leading, Value is starting to OP Growth and Cyclicals are beating Defensives. Commodities have seen a lift while FI, especially long duration Sovereigns on both sides of the Atlantic, have brought up the rear.
The moves to date are in line with past cycles suggesting further room for stocks to rally and bonds to sell off. Yet it's important to note that upside may be more limited than in prior cycles given that the growth and asset prices are not at historical extremes. The fear that Q4 2019 would repeat Q4 2018 has been squashed though investors remain very cautious with Barron's Big Money poll showing only 27% bullish equity investors over the next 12M vs 56% a year ago - the lowest level in over 20 years! Q3 Earnings are coming in better than expected and 2020 estimates suggest a sequential pick up as Chart 4 shows. US Industrials seem to be signaling an imminent low in the production cycle while semiconductors are doing the same. While overbought in the very short term equity technicals look pretty good with many holdings well above their 200 day support levels, a first for many months of what in hindsight has been a roller coaster of a global equity market.
Chart 4: Earnings Recession Ends, Sequential Pick Up Ahead
Source: JPM
Should a trade deal be signed, Brexit agreed upon, &/or clear evidence of Manuf PMI bottom the potential exists for equities to rally significantly led by a robust rotation across geographies, sectors and styles as we have laid out. Many sell side firms have joined us on the ex US equity OW through flow analysis suggest investors remain hesitant. Citi notes for example that November inflows into non US equity funds represent the first inflow in over two years! Both Japan and Europe are cheap; European equity for example trades at a 30 yr wide discount to the US on a P/BV basis. Given 7% up moves by ACWI over the past three months some pause/pullback is to be expected - the question is what to do about it? Our view is a pause is likely to be one that refreshes and investors should buy the dips.
On the FI side duration got a bloody nose over the past month with the US 10 yr pressing 1.9%, on its way perhaps to Fair Value at 2% while the 10 year BUND has retraced from -.80% to -.30%. JPM analysis of past cycles (1995,1998) suggests room for further backup in yields given long bonds have priced in more recession risk than equities, and that balanced investors are OW bonds vs the past decade history. Credit has continued to outperform and our FI positioning in credit, EM $ debt and preferred has continued to pay off. In fact, we own everything north of the 5% yield line shown in Chart 5.
Chart 5: Low Growth, Low Inflation = Search For Yield Continues
Source: JPM
The USD has weakened a bit but given the shallow nature of the growth pullback and the likely lack of a V shaped recovery USD weakness might not be as pronounced as one might have expected. EMFX has pulled back sharply in the past few weeks - we remain cautious given a slow global growth pick up may not support the EM rallies of old. DXY has broken below its 200d support level & we continue to watch the 109 level on the $/Yen; as sentiment improves the Yen could weaken further helping equities. As the US China news flow improved so did the Yuan/$ rate - should a deal get signed look for the Yuan to rally back under 7 & stay there.
On the Alts side results have been mixed - silver has done well while energy has been a very poor performer. Net long bets on WTI are back to Jan 19 lows & OPEC continues to restrain supply but even the Aramco offering seems unable to boost oil prices. Base metals have had a bounce but given the lack of faith in a V shaped growth rebound upside would seem limited. A visible catalyst like a trade deal or more aggressive Chinese stimulus is probably necessary for base metals to do well.
PORTFOLIO STRATEGY AND ASSET ALLOCATION (GMMA)
We made limited changes to our portfolios this month with our main objective being to add Value exposure in both the US and globally while further reducing our Min Vol positions in order to better position the portfolios for a growth bottom. We remain overweight equities, underweight bonds, alternatives & cash.
We remain overweight the non US equity markets with a focus on Europe and Japan given our belief that those markets offer greater room for appreciation based on ownership, valuation and currency upside. As the shift to Value takes hold both will benefit.
Our EM equity exposure remains focused on China and Latin America; earnings growth, positive policy momentum in China & Brazil together with room for rate cuts in Mexico support those positions. A trade deal would propel China assets higher.
On a Factor basis, we expanded our Value positions and reduced our Min Vol positions.
In Fixed Income we replaced our Global Min Vol position with a non US Value position.
We expect USD weakness based on massive twin deficits and a clear bottom in non US economic growth. The Euro screens very cheap relative to its history.
We made no changes in the alternative space & maintain a position in Silver. We continue to favor energy via our MLP position.
GLOBAL MACRO SUITE PORTFOLIO CHANGES
Global Macro Multi Asset (GMMA)
Within equities, we reduced our US Min Vol position and increased our US Value position while also exiting our Global Min Vol position and replacing it with a non US Value position.
Global Macro Income (GMI)
We exited our Global Min Vol position and replaced it with a non US Value position & an enhanced cash position.
Global Macro Equity (GME)
As in our GMMA equity sleeve we reduced our US Min Vol position and added to our US Value position while also exiting our Global Min Vol position and replacing it with a non US Value position. We also exited our US Software and Health positions while adding to our US Financials position.
In Europe we added to our broad European exposure.
I hope you find this year ahead outlook piece of value and look forward to engaging with you on a monthly basis as we round out 2019.
Jay Pelosky, CIO & Co-Founder
TPW Investment Management
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