As The Tri Polar World Turns - The Clouds Are Parting

MACRO THEMES

As we approach 2020 the geopolitical clouds appear to be parting. Brexit visibility has improved (post Tory election landslide) while US - China trade talks appear (stress appear) to have reached a phase one deal. More importantly, the global economic outlook is brightening, led by a growing sense that the industrial cycle has bottomed, especially outside the US. These perspectives lead us to suggest that the key foci of 2019, Central Bank easing and geopolitics, will fade into the background as 2020 unfolds & the prospects for a global growth upswing take center stage. What we call: Reflation 2020 (2020 Outlook Piece).

We continue to be guided by our Big Four signposts - work that emanates from TPWIM's Global Risk Nexus (GRN) scoring system. The signposts remain constructive:

1. The most aggressive Global Easing cycle since 2008-9.

2. A Global Growth bottom coming into place as the industrial cycle bottoms and a new inventory cycle begins.

3. US - China Trade talks appear to have reached a deal - we are past peak tariff threat.

4. An upturn in the Global Earnings cycle seems imminent with forecasted sequential increases tracking the global growth upswing - tariff rollback offers upside.

Chart 1: Earnings Recession Ends, Sequential Pick Up Ahead

Source: JPM

Thus, the debate has shifted from the likelihood of a global growth bottom to the shape and velocity of the rebound. We remain on the Lower for Longer Global Growth Path and have added a corollary - that such a path can lead to Higher for Longer Global Stock Prices. A U shaped recovery as opposed to a V shaped growth pickup reinforces this likelihood. Inflation remains quiescent & economies are unlikely to either overheat or sink into recession. Such an environment provides Central Banks with lots of operating room to let inflation run hot in an effort to make up for its persistent undershoot.

The global equity supply/demand picture remains favorable & while many 2020 forecasts strike a positive note, investment flow data suggests that both retail and fast money positioning is light. The pain path is higher; we continue to suggest any pullbacks are opportunities to allocate. Risk assets have priced out the downside risk of another leg down in the manufacturing cycle or an increase in tariffs but have yet to price in the growth upside of Reflation 2020.

ECONOMICS

OECD Q3 GDP came in at 1.6% Y/Y, stable and close to DM trend growth. Germany barely avoided a recession as inventory drag weighed, something that should reverse in 2020. Europe’s trifecta of shocks: Brexit, US - China trade and the auto sector slowdown should ebb as 2020 progresses, allowing growth to recover. Europe and China’s PMIs have started to pick up, joining EM, while the US continues its catch down process. Back to back improvements in Germany's investor sentiment surveys suggest nascent service sector concerns are misplaced.

Chart 2: Global Growth Bottoms as Industrial Cycle Turns

Source: Markit Economics

The next few months will be important to ensure the industrial cycle bottom forestalls further decline in the more important Service sector. Data is supportive with the Economic Surprise Indices (ESI) for Europe, China, and the US all in positive territory for the first time since Q1 2018, suggesting a possible shift from synchronized downturn to an upturn. A robust DM employment picture, continued consumer confidence (7 month high in US) & a turn in the inventory cycle should all be supportive. A recent research note on China stated that “inventories across all industries have been cut to the bone” and need to be rebuilt. Given the length of the global manufacturing downturn, over 18 months, such an inventory cycle could be quite supportive of growth to and thru 2020.

JPM’s two key questions from last month remain important: 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? The answer to the first Q seems to be yes; MS expects global GDP growth to pick up from 2.9% in Q4 2019 to 3.4% in Q4 2020 (Chart 3). The 2nd question remains outstanding; we expect clarity to be forthcoming in the coming quarters.

Chart 3: U Shaped Global Growth Rebound Ahead

Source: Haver Analytics, CEIC, IMF, national sources, Morgan Stanley Research

Inflation remains quiescent around the globe which should allow for continued easing of monetary policy while growth stabilizes and starts to pick up, an environment that would seem to bode well for equity and credit if not duration (most forecasts call for 10 yr UST to end 2020 at 2.2% and around zero for the BUND). The case for reflation 2020 is building: 2019’s easing cycle should start to filter through and underpin growth, fiscal stimulus is being brought to bear, the industrial cycle is turning & inflation will be allowed to run hot. All of which should lead to positive surprises across global economic growth, earnings growth, and stock prices.

POLITICS

By the time December is over one can expect to have articles of impeachment for Pres Trump, greater Brexit clarity and further insight on US - China trade. 2019’s strong risk asset returns remind one not to invest on headlines but it seems fair to expect that clarity would be asset price positive. It's also a reminder that what markets hate are surprises and by now none of these issues are a surprise - thus they are in the price.

More broadly and perhaps more worrisome, politics seems to have turned into a blood sport with violent protests breaking out in Asia, the Middle East and South America. Research firms such as 13D and others have suggested that we are moving from a lengthy period of wealth concentration to one of wealth distribution - they may be right. In the US the clear choice of the billionaire class as enemies by both Sen. Sanders & Warren suggest that a major element of the Democratic Party supports this thesis. Numerous assertions that a Warren presidency will lead to 30% type declines in the S&P reflect fears of wealth distribution.

Others argue the Warren economic plan could be growth supportive while also noting that full imposition of her plans would require Democratic control of the Senate which at this point seems unlikely. However, the broader point about wealth distribution does resonate with Millennials who are now the biggest voting cohort in the US. Millennials are also much poorer, deeper in debt, and sicker than prior generations at the same age point while those 55 and older have 3x more wealth than younger generations. Millennials also grew up around 9/11, the Iraq and Afghanistan wars and of course the Great Financial Crisis, helping one understand why the geopolitics and economics of the past 20 years or so don't resonate. Clarity around the Democratic candidate race is unlikely before Super Tuesday (early March) which gives us several months to think it through.

For the most part these events have yet to dramatically impact financial asset prices with even Hong Kong’s equity market close to flat since the protests began. Impeachment worries have yet to dent the US bull market (no real policy issues at stake), while Brexit has not precluded UK - EU stocks from rising. Risk assets should respond positively to any clarity given the high degree of uncertainty still in place. It's also worth noting that the S&P tends to rise in the year prior to US Pres elections.

POLICY

The Fed and other Central Banks (CB) are likely to spend 2020 in observation mode, watching the effect of their 2019 about face. The 3 cut insurance policy approach, similar to 1995 and 1998, seems to be the Fed’s playbook. As we go to print both the Fed and ECB have met and made no change - something we are likely to see more of in 2020. The global rate cutting cycle continues, with more cuts expected in Q4 than occurred in Q3, but this should start to taper off in 2020.

The more important point here is that Central Banks are likely to allow inflation to run hot and above target to offset the lengthy period of below target inflation. This point has been made by both the Fed and the ECB but it seems markets have not fully thought through the implications - bullish equity, bearish bonds, especially long duration (Chart 4).

Chart 4: History Suggests Long Bond Risk in 2020

Source: JPM

Fiscal policy is also starting to manifest itself across the globe. The US is running a trillion dollar budget deficit, Japan just announced its biggest fiscal stimulus since 2016 while the UK Conservatives election manifesto touts an aggressive spending policy. Europe is debating a Green New Deal that could spur significant spending in the coming years while multiple EM economies are stimulating including India, Indonesia and others.

Thus, the center of policy attention is shifting to the fiscal realm; the clear sense that monetary policy is limited and the rising recognition of the need to combat climate change coupled with the capacity to borrow at generational low rates implies a policy handoff in the years ahead.

Trade policy finally got a W with the USMCA (NAFTA 2.0) agreement but that is a sideshow to the main event where clarity remains elusive. Press reports suggest the US & China have reached a deal with US tariffs rolled back and China ag purchases increased. From an equity market perspective this could lead to some EPS upgrades if tariffs are quickly rolled back.

A deal makes sense - both sides would benefit from a more stable 2020 given the still decelerating US economy and a Chinese economy that needs to hit some important growth markers in 2020. Should press reports be wrong and the additional tariffs put in place several banks have suggested 5-7% downside for global equities - given our view that the growth upswing counts more than tariffs we would suggest being buyers on the dip.

Bottom line: Policy makers remain focused on shoring up global growth, providing liquidity to financial markets and ensuring easy financial conditions. Inflation is to be allowed to run hot. The surprise continues to feel like better than expected global growth/earnings and Reflation 2020.

MARKETS

Markets have displayed a two steps forward, one step back dynamic over the past few months, especially as it relates to US vs ROW and to the Growth/Value and Cyclical/Defensive debates. BofA and others have noted significant shifts from fear to euphoria, sharp cash drawdowns, sudden moves into Cyclical and Value segments of the markets etc. Most also suggest these style and sector rotations are in their infancy with JPM noting markets are only 20% thru the shift from Momo to Value while MS suggests that hedge fund Cyclical vs Defensive exposure is only in the 5th percentile since 2010.

Markets are morphing from Fall Risk Asset Rally to Reflation 2020; catalysts are needed for the next leg higher - growth bottom, trade truce etc. JPM’s case for retail flows to really support equity in 2020 is also a possible catalyst (Chart 5). 2019 was the worst year for equity outflows since 2008 with $215B taken out while roughly $850B of bond funds were bought. The shift in 2020 could see up to $500B in equity fund buying if history repeats, what JPM is calling Great Rotation II after the 2013 original. A more bullish Wall St could also help, Bloomberg’s 2020 average SPY return forecast is roughly 4%, the least optimistic outlook in 15 years.

Chart 5: Sometimes it’s that Simple: Equity Supply & Demand

Source: JPM

Such a SPY return profile is also perfect for non US outperformance, much better than a down US equity market. We continue to favor the non US DM equity markets with Europe, in particular, showing significant improvement in EPS revisions vs the US while the prospects for Europe’s first sustained equity fund inflows since Q1 2018 could provide kindling for the fire. We continue to like the EU banks and note their first push to share buybacks. Japan, very exposed to an industrial upswing, has likewise been all but forgotten by global investors. Our EM equity exposure remains limited to China and North Asia together with Brazil and Mexico. Brazil’s inflation collapse and subsequent rate cut cycle (real rates at 1%) has opened the door to potential economic expansion, earnings growth & multiple expansion.

The two steps forward, one step back dynamic has also been visible in global Govt bond markets. Yield curves have started to steepen as bond markets slowly price in a global growth bottom and muted pick up. The clear risk is to higher yields as markets price in the new CB mantra: let inflation run hot. TPWIM’s Lower for Longer Global Growth outlook supports our Search for Yield thesis as growth picks up and Central Banks sit & observe.

The global FX low volatility realm remains intact. USD risk is to the downside but there is little to suggest a sharp move unless that growth divide really swings in the ROW favor (See Chart 6). USD-Yen 109 and USD - CNY 7 remain key levels while the Euro continues to back and fill around 1.10-1.11. EMFX remains a mixed bag with some high real yield currencies likely to remain attractive.

Chart 6: USD Downside Risk

Source: Variant Perception

Oil has rallied sharply over the past month or so helped by a growing capital preservation focus in the US shale patch coupled with OPEC+ agreeing to cut production further. While a slow pick up in global economic activity does not seem to bode overly well for base metals risk is clearly to the upside. Commodities have been tricky all year (at least for us); should conviction build on the inflation overshoot some precious metal exposure would seem worth a look.

Potential remains for risk assets to rally significantly led by a robust rotation across geographies, sectors and styles as laid out in our 2020 Outlook.

PORTFOLIO STRATEGY AND ASSET ALLOCATION (GMMA)

We made limited changes to our portfolios this month with our main objective being to add Small Cap exposure in both the US and Europe together with consolidating our commodity exposure 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. Both will benefit from a shift to Value.

Our EM equity exposure remains focused on China, N Asia and Latin America; earnings growth, the semi cycle & 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 initiated Small Cap positions in the US and Europe.

In Fixed Income we exited our European HY position and added a US TIPS position as we expect the Fed to let inflation run above target.

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.

In the ALTs space we exited our MLP position and added to our broad commodity position. We continue to maintain a Silver position.

GLOBAL MACRO SUITE PORTFOLIO CHANGES

Global Macro Multi Asset (GMMA)

• Within equities, we exited our US Oil Services position and our broad European equity position while reducing our US Transports position. We added a US Small Cap position and a US Financials position together with a European Small Cap position.

• In Fixed Income we exited our European HY position and replaced it with a US TIPS position.

• In ALTs, we exited our MLP position and added to our broad Commodity position.

Global Macro Income (GMI)

• No Changes.

Global Macro Equity (GME)

• As in our GMMA equity sleeve we exited our US Oil Services position and reduced our US Transport position while adding a US Small Cap position.

• In Europe we reduced our broad European equity position to fund a Small Cap position.

I hope you find this year end piece of value and look forward to engaging with you on a monthly basis as we approach 2020 & a new decade.

Jay Pelosky, CIO & Co-Founder
TPW Investment Management

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