As 2019 draws to a close, market expectations on forward growth are inextricably shaped by the economic drag from intractable trade wars, political uncertainty, negative yields and, consequently, the pullback of capital investment. With interest rates hovering about zero bound in much of the advanced world, central banks find themselves largely outgunned in any outbreak of recession using traditional tools of old. By necessity, central banks will be forced to look toward fiscal policy and governments, rather than monetary policy, to soldier the attack on future economic downturns - as problematic such a thought might be.
Renewed commitment to monetary easing in Europe and Japan as well as in the repo markets by the Federal Reserve in the name of promoting growth for the former and liquidity in the overnight markets for the latter, works to keep a ceiling on upward yield growth. Further, renewed asset buying by central banks is a clear signal to markets and investors alike that ultra-low rates are here to stay for the foreseeable future. With the yield of the US 10-year Treasury note at 1.91% juxtaposed against most of Japanese and the entirety of German government debt languishing in negative territory, the incentives are strong for global companies to issue euro- and yen-denominated bond issues, if for no other reason than to lower their overall borrowing cost and servicing balance sheet debt.
North American corporate borrowers have sold about $129 billion in euro-denominated debt year to date, more than double last year’s tally. Similarly, the issue of yen-denominated bonds by non-Japanese corporations has also doubled through the first nine months of the year to $80.8 billion. Persistent excess savings in countries like Germany mixed with an estimated $12 trillion of negative yielding debt outstanding, will continue to apply downward pressure on both bond yields and price inflation across the economies of the developed world.
Short-term horizons of share buyback programs have largely taken the place of long-term investment in growth. Tariffs have weaponized international trade on national security grounds, while the Trump administration’s short-sided disdain for multilateral governance of international commerce idles the Appellate Body of the World Trade Organization for want of a quorum. All told, it leaves little to the imagination as to why the International Monetary Fund downgraded global growth rates to 3% last month from January’s 3.7% projection. The Fund’s new estimate on global growth is the lowest growth projection since the financial crisis.
The economic data of 2019 certainly presents its share of explanatory challenges. Capital investment has largely collapsed with corporate sentiment indicators hitting lows last seen in July 2009. The statement appears to fly in the face of November’s unemployment post of 3.5%. The long-term natural rate of unemployment is currently estimated to hit 4.381% through the end of 2029. While November’s labor participation at 63.2% remains well below the peak 67.3% rate in May of 2000, the whole concept of a natural rate of unemployment appears beyond current theory as core PCE inflation appears quiet at 1.61% for the month.
Corporate profits before taxes peaked in 2014 at $2.26 trillion have now fallen just under 9% to $2.06 trillion through the end of 2018, one of the biggest drops since WWII outside of a recession. Profits are even lower for domestic companies beyond the pale of foreign currency fluctuations and international tax havens. Estimates from the Federal Reserve Bank of Minneapolis have US companies shifting about $280 billion in profits offshore in 2012, a loss of about $100 billion in federal, state and local tax revenues. The corporate tax cuts in December 2017 have cushioned the blow, driving earnings per share to record highs, a quirk that is expected to continue in a more muted fashion in 2020. The widening gap between weak profits and record EPS, however, could spell potential trouble should tax policy change under a new administration.
Meanwhile, portfolios have for the most part reaped outsized benefit across a broad cross-section of asset classes. Technology and financial issues had banner years, delivering performances in excess of 46% and 31%, respectively. Base metals have also turned in strong performances to date on pent-up demand for materials, an outgrowth of large-scale infrastructural projects approved by China’s National Development and Reform Commission for an estimated Rmb764 billion ($107 billion) in the first nine months of the year.
The S&P 500 is up over 28% at Friday’s market close (20 Dec). To date, the S&P 500 is within 1.2 percentage points of a previous record year in 2013 post with 5 ½ days of trading left in the calendar year. Internationally, the MSCI All-Country World Index is up just shy of 29%, the Nikkei 225 Index is up 23% while the German DAX is up just under 22% for the period.
Figure 1: Vanguard Total Bond Market against the 10-year Treasury Yield
Not to be outdone, the US investment grade fixed income space staged a strong rally year-to-date, up just over 14%, chalking up its first double-digit performance since 2009 (see Figure 1, above). Improving economic fundamentals, speculation on a phase one trade deal with China, low inflation, accommodative monetary policy are all factors that have contributed to the bond rally. Double B issues at the top of the speculative grade, have posted returns of about 14%. The resulting rally on the price side has sent the yield of the 10-year Treasury in the opposite direction (black dotted line in Figure 1, above).
The yield spread between corporate bonds and risk-free Treasury debt speaks volumes to potential economic trouble around the bend - just 354 basis points separates corporate debt from risk-free Treasury debt through Friday’s market close for the lowest post since October 2018. That spread was 537 b/p in December of 2018 and 854 b/p in 2016. Unsurprisingly, corporate debt quality has been in a slow, declining spiral for decades. In the 1990s, the median corporate debt rating score was solidly investment grade. Today, that median rating clings precariously to a position of just one notch above junk.
With such little leeway between investment and speculative bond grades, an economic downturn could precipitate a torrent of corporate debt falling out of investment grade. The current projection for downgrades is about 1.86 for each upgrade, well above the 1.32 to one quarterly median on data back to 1986. Without a noticeable increase in earnings in the speculative space, the spread with risk-free comparables will likely widen in the New Year. Further, the watering down of covenant protections over the last decade makes such a cascade a looming crisis of confidence while persistently low yields force retail and institutional fixed income investors into taking more risk to meet long-term investment targets.
And then there is all the red ink that continues to spill forth in the developing world. Fueled by uber-low interest rates in the developed world, total debt in the EM space has soared 170% of total GDP to $55 trillion through the end of last year, a 54 percentage point increase since 2010, according to World Bank data. China owns much of this debt rise with a debt-to-GDP ratio now at 255% over the same period. Developing countries, particularly those with current account deficits and corporate debt denominated in foreign currencies, could quickly become unsustainable in an economic downturn.
Prevailing long-term interest rates in the advanced world only make sense if the global economy remains in a low-growth, low inflation scenario for the intermediate- and long-term future. The US ten-year Treasury note carries a yield of 1.91% at Friday’s market close, up from a September low of 1.46% but well below its post of 3.24% in November of 2018. Upside movement on yields in anticipation of a phase one agreement to lessen US-China trade tensions and the first step in solving the Brexit quagmire - are both positive developments. Rising yields are reflective of rising investor confidence, manifested by investors' assuming more risk in the greater market. Yet with the equivalent yield in Britain being 0.785%, in Japan 0.011% and in Germany -0.25% through Friday's market close, US fixed assets will continue to rally for the foreseeable future.
Monetary policy across the developed space has attempted to capture myriad vagaries of time and place: retiring post-WWII boomers, excess savings, weak worker productivity, historically low inflation and declining corporate investment in the future. Trade wars and subsequent dislocation of global supply chains have squeezed manufacturing, prompting copious predictions of the end of the current decade-long bull market which reached shrill levels this past summer, triggering the Fed to begin a series of rate cuts in its July, September and October FOMC meetings. Unsurprisingly, equity markets responded favorably. The purchasing of US fixed income assets by foreigner investors escaping negative yields prevailing in European and Japanese fixed income markets continue to push US yields to the downside. Central banks have done well in lowering the risk of recession for the moment. Supplying a fix for low growth remains more elusive.
Accommodating monetary policy has been a boon for the corporate sector for much of the past decade. Borrowing costs remain at historic lows - and will continue to remain at historic lows through 2020 and likely beyond. The threshold to cut rates remains significantly lower than the threshold to raise rates. Core PCE inflation would have to hit and sustain itself well above the 2% target for the better part of six months before the Fed would consider raising the federal funds rate. Core PCE hasn’t breached that target since the inauguration of the measure in 2012.
The last time core PCE was above 2% for a sustained period of time was in 2008 during the heat of the Great Recession of 2007. Core PCE slipped to 1.6% YoY during the month while the market-based 10-year break-even measure settled at 1.79% at Friday’s market close. Contextually, China’s economy was then growing at a 12% annual clip - twice its current rate of growth. The buildup to the Chinese expansion saw global base metal prices rise fourfold. The price of agricultural commodities such as soybeans and corn rose twofold. Oil prices hit $145/barrel in world markets, taking gasoline, jet fuel and transportation costs into the stratosphere. Food prices soared. At the same time, US housing prices entered a bubble, fueled by out of control lending practices. The Great Recession of 2007 was upon us.
Few of the economic particulars leading up to the Great Recession of 2007 are likely to be repeated in the near term or beyond - quite the contrary. US oil production is now above 12 million b/d, doubling over the last ten years. Since the end of 2016, US oil production is for export to countries around the world, rather than being limited to a New Brunswick refinery that serviced the New England and Mid-Atlantic states with refined energy products. With the price differential between West Texas Intermediate and global Brent benchmarks, US oil production maintains sizable a price advantage in world markets.
The fact limits OPEC's ability to determine world price structures - a driving force for the US and global inflation since the 1970s. Other checks on inflation include the greater penetration of technology in the purchase of goods by consumers, about 70% of total US GDP. Consumer spending rose 0.4% through the end of November on a 0.5% increase in personal income. Spending was up 2.4% YoY. The further extension of global economic integration means less price sensitivity in local markets from wages, productivity or productive capacity. Add in ever-declining birth rate, aging demographics and low (anemic) inflation, a predictable canvas of slow, single-digit equity growth for 2020 emerges.
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