Good financial returns may be hard to find

Bob Baur

Bob Baur

“Intensified trade tensions and disappointment with interest rate cuts by the Fed could provoke a relapse in equity markets.”

That’s the view of Principal Global Investors Chief Global Economist, Dr Bob Baur. Writing in his July monthly economic notes, Dr Baur argued that even if world growth picks up as expected, good financial returns might remain very hard to find over the longer-term.

Trump’s tariffs cause ongoing uncertainty, but end of the Asian downturn may be ahead

“Where to find good financial returns depends on the economic environment within which markets will function. The growth slowdown that began in China and migrated around the world continues today. It was exacerbated by uncertainties caused by the Trump administration’s tariffs and trade tensions, which have intensified lately. But there are signals that the end of the downturn might be ahead.

“Leading indicators compiled by the Organization of Economic Cooperation and Development (OECD) for China and a group of five other major non-OECD countries have both moved higher for four months. The OECD leading indicator for all member countries is nearly flat and likely to turn up shortly. Broad commodity price indices seem to be nearer consolidation than further collapse. The Baltic Dry Index of shipping costs surged this year. Recent economic data and business surveys were better than expected in Taiwan, as was June industrial production in South Korea. This suggests the end of the Asian downturn is at hand.

Why U.S. business leaders lack confidence

“Some have wondered why U.S. business leaders lack confidence and convey pessimism, why capital spending has been so lifeless recently. Part of it was uncertainty about trade issues, but, the more likely reason became clear with the sizeable revisions to U.S. NIPA data. That big upsurge in worker income noted above came out of U.S. corporate profits, meaning total earnings have been broadly flat since 2016, rather than rising. A surge in interest costs, rising wage pressures, and a failure of revenue to match. It’s no wonder CEOs are so glum: no profits, no spending, no way.

“The bigger picture is that the lack of profit growth suggests the U.S. may be later in its business cycle than some have thought. Flat or contracting profits is one of three typical long-leading signs that a recession, however mild, may be out there somewhere in the future; now, likely still a ways ahead – We don’t think recession is a worry for this year, nor is it likely next, as these harbingers have a long lead time. But they do herald that the end-cycle is coming.”

No long-term trends, no passive index for investors to jump aboard: why a good long-term return may be hard to find

“The risk of a bit more inflation and higher long-term interest rates may create a challenging environment for investors after 2020. Higher interest rates could bring significant distress in the corporate bond market with prospects of rising defaults. The super-low cost of debt over the last decade has likely kept inefficient companies in business by allowing them to roll over their loans. Higher rates will put the hurt on whatever zombie companies are still operating. Higher mortgage rates will dent housing activity around the world.

“If this milieu comes to pass, good financial returns will be very hard to find. Most financial assets, especially safe-haven government bonds, have very high valuations today, and they are unlikely to become much cheaper into mid-2020. Neither stocks nor corporate bonds will like the environment that could coalesce in 2021, if a bit of inflation returns with higher long-term interest rates. If the worst comes to pass in 2021, cash and safe-haven U.S. or Japanese government bonds would be the place to ride out the lurch. Eventually, this could bring a big rotation to value stocks and real assets (i.e., banks, financials, industrials, materials, real estate, commodities, emerging markets).”

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