Data Source: Bloomberg
May 2019 Market Commentary - Geopolitics Trumps 'Geo-Growth'
Portrait of Sir Ralph Norman Angell, Author of the "Great Illusion". Source: Wikimedia. Labeled for Reuse.
Bear with us as we pen a longer-than-usual monthly commentary, but we believe that the global economy stands at an important crossroads. Readers can skip ahead to the bottom of this commentary for May 2019 market performance highlights.
We here at 3D are big fans of Dan Carlin's Hardcore History podcasts, which are available on most podcast hosting sites. In his four-part series ("Blueprint for Armageddon") covering the military history of World War I, Carlin spends much of Episode 1 discussing the build-up to the Great War.
With respect to Britain's dilemma on whether it should fulfill a 'soft' commitment (Britain was part of the Triple Entente) to support France in the event of a breakout of hostilities with Germany, Carlin references the " Great Illusion," authored by Sir Ralph Norman Angell published in 1909. The general thesis of Angell's book rests on the notion that the economic costs of a continental war among the European powers would be "so great that no one could possibly gain by starting a war the consequences of which would be so disastrous (partial quote from historian James Joll)."
Carlin further expounds upon Angell's thesis by stating that such a conflict poses a threat to Britain's extremely lucrative business interests:
"this war that continually gets threatened…is never going to happen, it can't happen. The world has become too interdependent in that time period; there is too much globalization…Europe was at the heights of its financial power…it was so profitable to simply do business as usual that there was nothing worth going to war over…anything you would gain by launching a war would be dwarfed by what you would lose by destroying the system that was allowing everyone to make so much money."
In other words, it would be against everyone's economic interests (everyone being the continental European powers and Great Britain) for war to break out despite impending signs that Europe was heading into war. According to Carlin, Angell's book was highly influential and convinced many in Britain that war would not happen since it would go against the economic rational interests of those would likely be sucked into this conflict.
Yet, as the tragic events of the Great War unfolded, geopolitics overruled economic interests. In the late 1800s/early 1900s, Germany was a rising colonial power and wanted a seat at the table alongside Great Britain, France, Turkey and Russia. Germany also felt threatened by its encirclement by France from the west and Russia from the east. Russia wanted control over the Dardanelles (the Black Sea gateway into the Mediterranean Sea), which was owned by Turkey. Britain was concerned by Kaiser Wilhelm II's imperial ambitions such as building up Germany's navy that could threaten Britain's naval dominance. Such is the unstable state that a multi-polar political regime can produce. Yes, it was a great time for the European colonial powers, but the system that enabled these powers to prosper rested on a shaky geopolitical foundation.
Now, it would be tempting to draw similarities between the events leading up to the Great War with the events of today in the face of a major breakdown in global trade relations between the U.S. (the great power that emerged from the Cold War) and China (the up-and-coming great power) and Europe (the fading great power(s) which never fully recovered from World War II). China wants to expand its sphere of influence to cover the strategically important South China Seas, a major shipping route, as well as building a technological edge through the expropriation of intellectual property. The U.S. wants to keep China in check while also wrestling with Iran's sphere of influence ambitions in the Middle East and Russia's interests over eastern Europe. This has involved threats from the U.S. over Iranian oil shipments, the use of Chinese telecom equipment (i.e. Huawei), and the natural gas pipelines connections between Russia and Germany.
Angell's book is a good reminder of just how quickly geopolitical interests can overtake economic interests. In hindsight, it should have been obvious to today's investors that U.S. domestic politics (recovering lost manufacturing jobs) and key military strategic interests would, one day, overshadow the multi-decade globalization that many perceive as a hallowing out of U.S. manufacturing and global strategic standing. At the time of this writing, the Trump Administration is potentially expanding its trade tariff imposition on imports from Mexico and India.
Europe and Great Britain are facing something similar with the rise of populist resentment over increased European Union bureaucratic control from Brussels and unchecked flow of migrants from the Middle East. May's European Parliament elections resulted in a greater share of seats held by populist, anti-European establishment parties (including the meteoric rise of the Brexit Party led by Nigel Farage). One would think that the rising Italian/German bond yield ratio would send a signal to both Brussels and coalition League leader, Matteo Salvini, that a collision course over Italy's fiscal deficit will have dire financial consequences.
China, on the other hand, needs globalization more than the developed world needs to trade with China. China is starting to see cracks in its highly levered banking system (whose total commercial assets comprise ~45% of World GDP), presenting a threat to China's 13 trillion bond market. Despite rising to become the world's 2 nd largest economy, China is more vulnerable to a breakdown in trade relations with the U.S. as it faces an exodus of supply chain manufacturing to Southeast Asian competitors like Vietnam. The reality is that China is a much poorer country with more fragile political institutions versus other developed markets. Increasing trade with Europe may also prove to be problematic as Europe has not ruled out adopting protectionist measures of its own. And China will increasingly need foreign direct investment (FDI) to fund future economic growth as it sees its current account trade balance trending from surplus to deficit (see " Speaker Highlights from the Grant's Conference, Part 1").
For now, it appears China is digging in their heels based on this policy response issued by China's State Council Information Office, whereby, unsurprisingly, "China will not compromise on major issues of principle." China insists on the U.S. lifting existing tariffs and that the U.S. not dictate to China matters that require legislative changes such as intellectual property protection.
All this is not to suggest that another 'Great War' is about to break out, but that we could be entering into a new global standoff characterized by a Cold War between the U.S. and China over technology advantages and spheres of influence. If the two do not engage each other directly (that's what makes it a Cold War), then a détente of some sort can be formed until the strategic interests of a closer trade relationship outweigh the geopolitical advantages gained from a breakdown in the trade relationship.
In 2019, It's All About Global Trade
The current (and sudden) downward trend in global economic growth can be sourced to the Trump Administration's hawkish stance on global trade going back to the 1 st Quarter 2018. With the latest breakdown in U.S./China trade relations in early May and the negative rhetoric growing between both sides, investors are adopting a base case scenario that the U.S. will impose 25% tariffs on all of China's $775 billion imports, representing 1.4% of 2017 U.S. GDP (Figure 1).
Figure 1: China Import Tariffs - Estimated Impact to U.S. GDP
And whatever economic goodwill that was created from cuts in the U.S. corporate tax rate have been largely offset by the prospects of a protracted trade conflict (Figure 2).
Figure 2 - U.S. Import Tariffs Will Likely Weigh on Global Business Confidence, Export Growth, and Earnings Growth
The imposition of additional U.S. tariffs would also bring U.S. tariff levels well above emerging market levels (Figure 3).
And as of the time of this writing, the Trump Administration is threatening to impose tariffs on imports from Mexico due to the unchecked migration flow from Central America. This could be potentially more disruptive to U.S. business supply chains than tariffs imposed on China (Figure 4).
Figure 4 - U.S. Trade Composition with Mexico
It's also interesting to note that when we reference global trade ex-China with the U.S., we're primarily talking about automobiles and auto parts (Figure 5).
Figure 5 - Outside of China, U.S. Trade Is Primarily About Autos
Up to this point the U.S. Economy has held up well despite the ongoing trade conflicts and slowdown in global trade, but there are telltale signs of weakness. Figure 6 displays announced layoffs in industries (autos, retail) directly impact by the trade conflict.
Figure 6 - Announced Layoffs from Industries Impacted by the Trade Conflict
There are few doubts that global manufacturing sentiment (Figure 7) is taking a hit on top of a weakening trend that started last year, but a larger question surrounds the impact on the U.S. economy where 2Q2019 growth estimates have dropped to just over 1% growth (Figure 8).
Figure 7 - Global Manufacturing Sentiment Continues to Slump (Propped Up by the U.S., but How Long Will that Remain?)
Figure 8 - Atlanta Fed GDPNow Estimates 1.2% for 2Q2019 U.S. GDP Growth (Below the Lower End of Consensus Forecasts)
For now, the U.S. continues to enjoy both safe haven status (via strong dollar) and one of a handful of markets expected to generate positive earnings growth (Figure 9). The 5/31/2019 edition of Factset Earnings Insight still points to positive earnings growth in 2019 with consensus expectations of 3.2% earnings growth on top of 4.6% revenue growth (much of this growth back-end loaded to the fourth quarter). Europe earnings growth estimates have started to pull back while Japan and Emerging Markets are expected to experience negative earnings growth.
Figure 9 - Positive Earnings Growth (White Lines) Still Expected for U.S. and Europe but Not Japan and Emerging Markets
So, to sum up the U.S. macro environment, it remains one of pullback rather than contraction. One could argue that May's stock market correction is discounting this pullback but is also discounting help from the Federal Reserve in the form of 2-3 rate cuts for this year as well as an extended lower rate environment through 2020 (Figure 10).
Figure 10 - Lower Interest Rates for the Foreseeable Future?
Finally, a couple of telltale 'canaries' are starting to flash recessionary signals for the U.S. economy. Figure 11 displays Semiconductor Sales against U.S. Manufacturing Sentiment (PMI) lagged 3 months. Although semiconductor sales have contracted twice since the 2008 Great Recession, this latest pullback could be the straw that collapses this well-worn economic cycle.
Figure 11 - Does a Drop in Semiconductor Sales Indicate an Impending U.S. Recession?
Another worrisome sign may be emerging from consumer credit (recall that U.S. consumption contributes ~70% to U.S. GDP). We're now starting to see a meaningful upturn in consumer loan delinquencies which could weigh on future employment conditions. Figure 12 displays the delinquency rate on consumer loans against the unemployment rate lagged 12 months.
Figure 12 - Does a Rise in Consumer Loan Delinquencies Foretell U.S. Labor Weakness?
So, it appears that the Trump administration is willing to sacrifice near-term growth and market stability to (re)gain longer-term strategic advantages to reinforce our sovereign interests whether those interests lie with a secured border or ensuring other great powers don't obtain strong enough footholds to challenge U.S. geopolitical authority. It will be interesting to see how the rest of the year plays out.
May 2019 Recap
Global stocks (MSCI All-Country World Index or ACWI) returned -5.9% led by MSCI Japan and MSCI Europe (-4.0% and -5.5%, respectively) while the U.S. (S&P 500), MSCI Asia-ex-Japan, and MSCI Emerging Markets underperformed (-6.4%, -7.0%, -7.3%, respectively) (Figure 13). It was a tough month for global markets with U.S. and China/broader Asia bearing the brunt of the trade stand-off.
Figure 13 - Japan and Europe Led in May While the U.S., Broader Asia, and Emerging Markets Lagged
The S&P 500 dropped 6.4% in May, as investors fled to the safety of rate-sensitive defensive sectors (Real Estate, Utilities, Healthcare, Staples) while Cyclicals and Financials underperformed (Figure 14). The energy sector was hardest hit with spot oil prices dropping to $53.5/barrel from $63.9/barrel at the beginning of the month.
Figure 14 - Risk-Off Flight to Defensive Sectors
Small caps underperformed large caps, as is generally expected during risk-off periods, while value underperformed growth, primarily due to the underperformance of financials (lower interest rates hurt margins) and industrial cyclicals (Figure 15).
Figure 15 - Small Caps Underperform Large Caps and Value Underperformed Growth
Risk-Off behavior was also evident across U.S. thematic, risk-based factors (Figure 16); Quality, High Dividend and Value underperformed while defensive factors such as Minimum Volatility and Momentum benefited from defensive position. Incidentally, the May month-end index rebalance of MSCI Momentum produced a basket heavily weighted towards growth technology, so it will not directly track Minimum Volatility as it has done throughout this year.
Figure 16 - Low Volatility and Momentum Capture Risk-Off Sentiment
U.S. fixed income benefited from the flight-to-safety as investors flocked to long maturity U.S. Treasuries which helped the Bloomberg Barclays Aggregate Bond Index return 1.8%. U.S. High Yield underperformed as investors sold off corporate credits alongside equities. (Figure 17). Despite the sell-off in Emerging Market equities, local Emerging Market debt held up posting a flat return in May.
Figure 17 - Investors Seek Shelter in Fixed Income During Risk-Off Month
The 10-Year U.S. Treasury Yield dropped to 2.13% at month-end, levels not seen since 2017 (Figure 18). The 2-10 Year Term structure remains marginally positive, but this is due to the significant inversion of the curve at the short-to-intermediate end.
Figure 18 - The 10-Year U.S. Treasury Yield Has Dropped to Levels Not Seen Since 2017
Corporate credit spreads widened as investors start pricing in more economic slowdown risk (Figure 19); however, they remain well below the wide levels reached in 4Q2018.
Figure 19 - U.S. Credit Spreads Widen Reflecting Macro Uncertainty
Interest-Sensitive Real Estate and Precious Metals both benefited from defensive positioning while commodities are being weighed down from the poor performance of oil and industrial metals (Figure 20).
Figure 20 - Real Estate and Precious Metals Benefit from Risk-Off Flight
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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