Dave Lafferty

David Lafferty, Chief Market Strategist at Natixis Investment Managers examines the most recent macro data to see if it supports a continued rally in stocks and credit.

The post-Christmas global rally in both equities and corporate credit has everyone wondering, “Is global growth stronger than we expected?” Obviously the Fed’s downshift both on rates (now on hold) and its balance sheet (no longer on autopilot) was a huge boost for risk assets. However, we also can’t help but feel that investors are seeing (or imagining) new spring growth after the fourth quarter’s killing frost.

US GDP head fake

• On the surface, the quarterly real GDP print of +3.2% annualised was more than solid – better than consensus at 2.3% and much better than the 1.0%–1.5% expectation that prevailed from November through February. So much for all that recession talk investors were obsessing over
• Yet unfortunately for the macro bulls, the underlying details of the report were relatively weak. Personal consumption fell by more than half from Q4 (1.2% vs. 2.5%) while business investment was lacklustre, boosted solely by the less tangible “intellectual property” component. Moreover, growth was artificially juiced by an unlikely-to-be-repeated collapse in imports.
• In addition, business inventories, which will eventually have to be liquidated, jumped for the third quarter in a row. All this left “final domestic sales” at a much-less-impressive +1.3% for the quarter. Keep in mind, all this “real” data was further bolstered by the weakest price adjustment in three years
• While we consider 3.2% growth to be a head fake, we still see very little in the data that would imply that growth is stalling or that a recession is imminent
• US manufacturing data has stabilised and the ISM Composite Index at 56.0 would still be associated with real GDP near 3%. In recent years, strength in the ISM data has overestimated GDP, so we doubt 3% is the true long run trajectory. However, even if this remains the case, this level of activity would still justify an economy growing at 1.5%–2.0%
• Conveniently, that coincides with our unchanged view that the US economy is decelerating toward potential GDP near 2%, but not going into recession – at least not in the near term

Is China bouncing back?

• Similar to the US, more recent data coming from China looks significantly better than last year’s second half slowdown. Weakness in Chinese exports appears to be fading while industrial production shot up 1.0% in March – the largest monthly jump in five years
• With this improving data as a backdrop, there should be little surprise that the China Caixin PMI Composite Index rebounded in March to its highest level since last June, to 52.9 from 50.7
• However, like the US head fake, investors should be skeptical of the data coming from Beijing for several reasons:
  • First is the usual caveat – we don’t believe the data is falsified, but it is certainly massaged
  • Second, some of the statistical rebound could be transitory, emanating from timing differences around the Chinese New Year
  • And third, policymakers may be seeking to improve the appearance of macro conditions to strengthen their hand in trade negotiations with the US. We simply can’t know. However, setting aside the overall accuracy of the data, there is a larger concern: Even if the Chinese economy were beginning a resurgence, we have to wonder how much of it is simply more debt-driven stimulus. Stimulus that is unlikely to be sustained in an environment where President Xi is actively trying to wean the economy off of excessive leverage and debt. We suspect the improvement in China’s data is at least partially due to this fiscal accordion, where leverage is unleashed to combat slowing growth and subsequently reined in when growth accelerates

• Ironically, it is precisely this centrally-planned fiscal flexibility that, in the short run, allows policymakers to arrest a slowing economy (as they are doing now), or slow credit creation in a speeding economy. In the long run, however, given the policy mandate to rein in excessive credit growth, China is subject to the same supply-side arithmetic as the rest of the world. This math implies that China’s longer run potential real GDP is somewhere in the 5.0%–6.0% range, just below the current reported GDP trend (low-to-mid 6% range) of the last 3+ years

Dead flowers

• Based on the above data, we return to our original question: Should investors get excited that global growth is about to bloom? That’s a bit too optimistic in our view. Yes, there are some positive signs, but we see the improvement, such as it is, to be both modest and a bit transitory. However, at the margin, the global economy certainly hasn’t gone dormant and we think any oncoming recession may be pushed a bit further into the future
• While the data is somewhat better, we believe the underlying trajectory of the global economy has changed very little. Growth is at worst slowing toward its long run potential, and at best, not booming but merely showing signs of stabilising. Absent an inflation surprise (in either direction), neither outlook is extreme enough to move the US Fed to tighten or loosen policy in the near term
• With the Fed on hold for now, and consistent with our view for several quarters, slow but positive growth should be supportive of stocks and credit. Broad economic growth, however, is not strong enough to warrant more aggressive risk taking. With apologies to the Rolling Stones, we don’t see “dead flowers every morning”, but be careful not “to put roses on your grave.”

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Dave Lafferty

What could go wrong for investors this year?

In late November we produced our 2019 Outlook for the global economy and capital markets. In December, we highlighted five trends that would likely reverse in the coming year (growth, rates, monetary policy, the US dollar, and rising volatility). This month we itemise seven risks we see on the investment horizon – and offer our best guesses about the probability that they will come to pass.

1)  Slowdown or recession

The global economy is clearly decelerating, but in the wake of the Q4 selloff, markets should be set to move higher again if this is just a mid-cycle return to slow-but-positive growth. However, if the slowdown devolves into recession, markets are not prepared for this shock as neither investor sentiment nor asset prices appropriately reflect this risk.

For this reason, recession risk could be categorised as “all that matters” as future returns could probably withstand any of our other risk scenarios provided the economy doesn’t fall off a cliff. Conversely, the absence of those risks will not save markets if the economy does falter significantly. Based on current data, we estimate the likelihood of a global recession in 2019 at 25%. For the subplots, we think the risk of a 2019 recession in the US is 20% while in Europe it’s closer to 35%. China has virtually no chance of recession this year, but that isn’t the correct yardstick. For China, the risk is a sub-6% real GDP print for the year, which we think is about 30% likely.

2)  US/China trade tensions

This risk seems to rise to the top of everyone’s list, but we’re a bit less worried, primarily because we think the market has (at least partially) already priced it in. First, as US/China relations got trickier in 2H:2018, global stock markets discounted much of this bad news. Second, businesses have already begun taking steps to adjust production, build inventory, and develop new supply chains.

The most likely scenario (55%) is that US/China trade negotiations bumble along throughout 2019 with no definitive success or failure. This makes trade tensions look more like a “risk in progress” than a specific event. In the short run, we believe equities will be buoyant on days that see trade progress and deflated on days that see setbacks. Don’t read too much into it. Even a “final” trade deal will be inherently inconclusive as monitoring and verification will prove challenging. 

3)  A Central Bank mistake

Given the weakness in Q4, the Fed has turned sufficiently dovish that forward action (raising rates and/or balance sheet roll-off) is unlikely to bring recession. So we rate the risk of the Fed inducing a recession this year at 10%. But here’s the rub: As everyone knows, monetary policy changes have a long lag time. It may actually be just as likely (10%) that the Fed has already overtightened, “winter is coming”, and we just don’t know it yet. The die may already have been cast.

4)  A messy Brexit

While the situation is very fluid, for now it remains our highest probability risk. A delay in the withdrawal process – walking back Article 50 or a second referendum – is still more likely (60%). However, as the situation has deteriorated in recent weeks, our hope that the unthinkable would be avoided may be clouding our judgment

5# US policy gridlock-shutdown & debt ceiling

Having endured the first 35-day shutdown, we doubt Republicans in Congress are looking for any more bad publicity. We expect that budget resolutions will pass in mid-February to keep the US government functioning and that the economic fallout from the Dec-Jan shutdown will be modest. Probability of another material shutdown in February? About 15%.

However, the political gridlock that triggered the shutdown has far graver implications for the US debt ceiling limit which is fast approaching. As with Brexit, the unthinkable – a breach of the debt ceiling causing a “technical” default – could only be classified as a colossal policy accident. Historically, partisan brinksmanship over the debt ceiling has been standard operating procedure, so it inevitably creates short-term market noise but never comes to pass. However, with the precedent of the longest shutdown in history, we’re less certain that raising debt ceiling is a non-event. Is the risk low? Yes – maybe 5%–10%, but it’s not 0%. They’re called “accidents” for a reason.

6)   US constitutional crisis

As 2019 rolls on and the findings of the Mueller investigation eventually surface, we have no idea how serious the damage to the Trump administration could be. Given the record of convictions and pleas exacted by the special counsel, we suspect there is at least some fire to accompany all the smoke. The chance of impeachment by Democrat-controlled US House of Representatives is at least 50%. However, conviction (and removal) by the Republican majority in the Senate is far less likely – again depending on what Mueller actually finds.

7)  Data Privacy and Regulation

2019 may be the year that governments begin cracking down on the use of personal data. US congressional inquiries along with the EU’s General Data Protection Regulation (GDPR) illustrate how seriously countries are taking this issue. “Big data” only has value if you can monetize it, either by selling personal information or using it to micro-target advertising dollars. Increasing government scrutiny may make it harder for businesses to profit from this data in the future. 

While the probability is low that regulators would stifle the big data bonanza, maybe 20%, the impact would be significant. This risk is under-appreciated because data privacy issues apply to nearly all companies in the major indexes, extending well beyond just the biggest names in the tech sector.

By Dave Lafferty

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Dave Lafferty

Chief Market Strategist, Dave Lafferty discusses what lessons Investors might have learnt 10 Years after the collapse of Lehman Brothers.

It’s often said that you should never let a good crisis go to waste. As we approach the 10 year anniversary of the seminal event of the Global Financial Crisis – the collapse of Lehman Brothers – investors may wonder if we’ve learned anything from past mistakes. Through the varying lenses of policymakers, investors, and markets, the answer is decidedly mixed.

Without question, policymakers around the globe have made some headway, particularly in the area of bank vulnerability. While concentration risk among the major global banks has actually grown since the crisis, broadly speaking, leverage and trading risk are down while equity and capital ratios are up. Large bank failures remain a risk, particularly in the European periphery and emerging markets, but the gradual de-risking of banks should make the system less vulnerable to contagion in the next Lehman-like crisis.
Where policymakers have made less progress is on the monetary front. Other than the US Fed, the other major central banks remain in crisis mode today, unable to lift rates or unwind their massive quantitative easing programs. Balance sheets are bloated to the tune of $15 trillion with still close to $8 trillion in negative-yielding sovereign bonds, reducing the stimulative firepower of the major central banks to counteract the next recession or crisis. In the end, it may be fortunate that banks have ramped up their ability to absorb losses because central banks certainly have less power to prevent them.

Coming on the heels of the tech & telecom bust of 2000-2001, the plunge in risk assets during the GFC represented the second bear market in eight years for many investors. In addition to rethinking their equity expectations, Lehman’s collapse highlighted a new risk: that systemically important institutions might be too big, too interconnected, or too complex to save. Millennial investors coming of age in the 2000s may never look at equities the way the baby boomers did growing up in the bull market of the 1980s and 90s. The common refrain in the wake of Lehman was that investors cared more about the “return of their capital, not the return on their capital.” While some scar tissue has built up, investors have been forever altered. Ten years of Zero Interest Rate Policy and Negative Interest Rate Policy have pushed them grudgingly out the risk spectrum and back into equities, but there is little doubt investor risk tolerance has been fundamentally altered. Investors are more skittish and therefore more likely to bail when volatility rears its head again. “Buy and hold” has gone from a trusted maxim to a sad platitude that many investors can no longer embrace.

Finally, as investors have changed, so have the markets. Because the failure of Lehman was equal parts credit crisis and liquidity crisis, investors have come to demand both better protection and more liquidity in their investments. Wall Street, asset managers, and global banks have been more than willing to develop new products and strategies promising to reduce volatility, manage downside exposure, or reduce correlation to falling markets. Assets in these products number in the trillions and include all manner of strategies that either use volatility as an input to reduce exposure or short volatility outright. The common theme of these strategies, to one degree or another, is to reduce risk into falling markets which may exacerbate the sell-off – as seen in February’s volatility tantrum. While we believe these strategies play an important role in tailoring appropriate client portfolios, it represents a modern-day tragedy of the commons whereby investors’ demands for better downside protection actually creates more selling pressure and downside volatility when the crisis finally comes.

Historical analysis of any crisis is likely to be inconclusive and provide few solutions. There can only be so much learned from looking back when every new crisis is sewn from different seeds. All participants and policymakers can do is hope that the system is more flexible and therefore less fragile when the next crisis hits. On this score, we can only conclude that things have changed very little from the days of Lehman. While consumers are in no worse shape, corporate and sovereign debt levels have only risen since the crisis, sustained solely by artificially low interest rates.  Banks have found some religion with respect to building equity capital, but much of the leverage has simply moved to the bond markets. Meanwhile, old fashioned value investors who were willing to catch the falling knife are few and far between, replaced by quants and algos who will sell (or go short) at the first sign of trouble. The Lehman collapse brought about many positive changes, but in the end, the global financial system appears no less brittle today than a decade ago.

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Dave Lafferty

Dave Lafferty, Chief Market Strategist at Natixis Investment Managers examines why a “recession is imminent”…

A Recession is Coming

Economic forecasting is a tough business, not to mention incredibly imprecise. However, we can say with nearly 100% certainty that a US (and/or global) recession is coming – at some point. For investors, of course, the timing is all- important. Given current valuations and strong growth expectations, it is highly unlikely that equities could bear an economic downturn unscathed. This month we consider the path for the economy, coming headwinds to growth, and the possible timing of the next recession.

As Good as It Gets?

There is little doubt that the global economy has been strengthening in the last two years. As we’ve noted several times, most countries and regions saw a significant improvement in GDP starting in mid-2016 versus their previous 2010–2015 run rates. In many cases, this was corroborated by the strongest post-GFC economic levels, as measured by metrics like the ISM or PMI composites.

This strength was also exhibited by global equities. From mid- 2016 to the peak in late January this year, the S&P 500® rose nearly 37% in price terms alone (excluding dividends and reinvestment). Non-US stocks were up nearly as much, with the MSCI World Ex US gaining 36% during that period in local currency terms. The global economy was humming along and equity gains reflected it. But it’s during exuberant times like this that investors should begin to consider what the downside might look like.

Global Headwinds

While we expect global economic momentum to carry through 2018, we see growing headwinds affecting the global growth story starting in 2019, specifically:

• Higher short-term interest rates from the Fed, ECB, and BOE. Why is this different? Because until now, Fed rate hikes only generated real rates that were less negative. But as the fed funds rate breaches 2%, near the level of core inflation, real rates will actually move into positive territory. Simply put, until now, money has been more- than-free. That is set to end in 2019 as real rates turn positive.
• A yield curve that may continue to flatten/invert putting pressure on banks. The risk is that lending becomes less profitable, constricting credit expansion, which is the lifeblood of economic growth.
• Significantly more restrictive trade policy as countries retaliate and global supply chains are interrupted.
• US fiscal stimulus fades as tax-cut benefits wane. While some positive secondary effects will remain, without a kickstart to productivity, the tax cut’s impact will dwindle in 2019–20.
• Moreover, we see much less fiscal latitude in the face of massive budget deficits, particularly if the Democrats retake the House of Representatives in November.
• A very messy Brexit. The UK’s bumbling withdrawal from the EU is likely to trigger more uncertainty for businesses and consumers that will further stunt growth.
• Slowing credit growth in China will likely limit capital investment in the world’s most dynamic economy.
• Risk of higher oil prices. While we see the global oil market as roughly in balance near $60–$65/barrel on WTI, geopolitical risks in the Mideast are likely to ramp up, pushing oil prices higher – historically not a good sign for global growth.

To be clear, none of these dynamics are new, but each appears to be approaching a more painful inflection point. These headwinds have many market watchers forecasting the beginning of a global recession late in 2019 or in 2020.

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Dave Lafferty, Natixis IM provides some insights into how the ongoing trade war will play out and the knock on effect as we head towards US mid-term elections in early November.

Tariffs become a reality

Until 5 or 6 weeks ago, I viewed Trump’s tough trade talk as mostly rhetoric designed to be an opening gambit for getting modest trade concessions. Underneath the bluster, surely his pro-business instincts would recognize that upending the global trading system would be bad for the US and global economy, not to mention, potentially undermine the benefits of his hard-fought tax cuts. Ultimately, I believed Trump wanted some “small wins” that he could take back to his populist base in the Midwest, but he wasn’t looking to do any real damage.

Today, I’m less sanguine. Trump’s trade talk has taken a darker turn in recent weeks.  Trump is doubling down on tariffs and proposing restrictions of Chinese investment (CFIUS) and tariffs have moved from the “proposal” stage to reality. The latest leaked story, that Trump is actively considering withdrawing from the WTO, is troubling. It would be almost impossible to do (business and Congressional blow-back would be HUGE), but the fact that it’s even been discussed is scary enough. It highlights how little this president understands the value of global trading system.

Trump famously quipped that “Trade wars are easy to win.”  That’s nonsense. Nobody wins a trade war. Moreover, while the Chinese are more export dependent than the US, they also have more levers to pull. They have command of the RMB value, over $3 trillion of foreign currency reserves, and Xi is effectively president for life.  (Trump’s mandate may die as early as the November mid-term elections if the Democrats take the House of Representatives, which is probably a 60% chance right now).

Is Trump playing by the rules?

Trump is correct that the Chinese have not played by the rules, largely ignoring intellectual property rights and effectively stealing technology. However, there are better ways to hit back than tariffs, which hurt everyone.  This is a key distinction between the China fight and the NAFTA fight. In the case of China, they aren’t “playing by the rules.” In the case of Mexico and Canada, Trump just doesn’t like the rules. (i.e., the NAFTA agreement).

Almost as evidence that Trump has turned even more combative on trade, there are now small factions within congress who are looking to limit his trade authority. House and Senate members feel the heat when businesses start talking about leaving or laying off workers, Harley Davidson for example.   This morning, the US Chamber of Commerce (the largest business lobby in the US) began a campaign against Trump’s tariff policies. Trade talk, which is now becoming trade action, is creating uncertainty and starting to hurt business.

Inflation and higher prices are the least of my worries. In the past 20+ years, supply chains have become globally integrated. Trump represents the biggest threat to global trade since the creation of the WTO. Manufacturers source parts and labor from all over the world. Services (like banking, asset management, consulting, etc.) are globally integrated. Disrupting these global supply chains is a bigger risk than the dollar value of the tariffs themselves. The US simply can’t back away from the global trading system in some misguided attempt to reduce our current account deficit.

Will China go on a Treasury buying strike?

The larger, but more remote (less likely), risk is that trade arguments spill over into the capital markets. The current account (imports vs. exports) is mirrored by the capital account (portfolio flows and foreign direct investment – FDI) which has currency and interest rate implications. Yes, the Chinese sell a lot more goods to the US than they buy from the US, but they also buy a lot of US Treasury debt that keeps our interest rates in check.  The Chinese are unlikely to go on a Treasury “buying strike” – it would cause their currency to appreciate too much, but it highlights how this can spill over into rates and FX values which may have an even larger effect on US growth.

The threat to global supply chains

To the point above, we already see the Chinese managing the RMB lower.  In the last 3 months, since all the trade rhetoric has picked up momentum, the Chinese have managed the RMB almost 6.5% lower in what is certainly a “stealth devaluation” – that’s more than twice the 3.0% explicit devaluation that rocked markets in August of 2015.

Global trade has been slowly improving after faltering a bit in 2014-2016. This is another headwind the global economy doesn’t need, particularly as we see signs of an interim slowdown in Europe, England, Japan, and China. The uncertainly of trade wars will continue to create volatility for the capital markets. Having pushed the issue this far, and really taking a hit on the “family separation” issue, Trump is going to become more combative, not less, heading into the midterm election.

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As the global economy gained steam in Q2 through Q4 last year in a more synchronized fashion, the UK seemed to be only major economy that was getting left behind. Firms have opening offices and shifted workers into the EU, real estate prices are under pressure, and the initial competitive boost of sterling weakness has faded as the currency stabilized. Two years in, the economic fall-out of the referendum is clearly being felt. Moreover, with only a provisional agreement on the transition period, and virtually no progress on other important issues like financial services or the Irish border, the UK is at risk of stagnating even further.

While the journey toward withdrawal remains in progress, some clear lessons have emerged in the negotiating process that might help Britain in the latter stages – or at least serve as a cautionary tale to the remaining EU members contemplating life outside the union. One, have a clear objective entering the process. Throughout the negotiation, the UK goals have vacillated too frequently between getting a good deal, avoiding a bad deal, or a compromise withdrawal deal that might have rendered the vote meaningless. To paraphrase Seneca, no wind is favorable if you don’t know which port you’re sailing to. Two, present a unified front.

Undoubtedly, the UK’s position in these negotiations has been weakened by infighting: Leave vs. Remain, Tory vs. Labor, Tory vs. Tory, Lords vs. Commons. Prime Minister May has been fighting with both hands tied. Third, know your line-in-the-sand. Without a real willingness to walk away, you have little credibility in the eyes of your counterparty. Hard Brexiteers were willing to accept those painful consequences (and may still get the chance), but constant backsliding by the UK has emboldened EU negotiators. The UK’s unclear withdrawal strategy has created uncertainty, and that uncertainty ultimately has real downside economic consequences.

Philippe Waechter, Chief Economist, Ostrum Asset Management

The most striking impact of the Brexit is the lower growth momentum seen in the UK since the referendum. The dynamics has faltered and the UK has not taken advantage of the strong growth improvement of the Euro Area in 2017.

A very simple calculation can translate this remark. I have calculated a trend on the real GDP level from the beginning of the recovery in 2013 to the second quarter of 2016 (referendum) and extended it to the first quarter of 2018. I did the same for France, Germany and the Euro Area. In the first quarter of 2018, the French GDP is 1.8% above its trend, Germany is +1% and the Euro Area +1.4% while the UK is 2% below it.

The UK is disconnected from the rest of Europe while the Euro Area is its main trade partner. In other words, despite the European recovery there was no positive contagion to the UK.

Expectations about the UK have dramatically changed and the domestic market is not strong enough to drive a strong growth trajectory. The uncertainty will remain, implying less capital inflows, people outflows leading to lower human capital and lower capital expenditures. The adjustment process is just at its beginning.

It means that the Bank of England will not rapidly normalize its monetary policy. The inflation rate is converging to the BoE target at 2% and the economic momentum is low. Taking the risk of a normalization would be another source of weakness for the UK.

The main effort is to reduce uncertainty for everyone, from households to companies and foreign investors. That would be key for a recovery. But the current negotiation with the European Commission and the weakness of Theresa May and her Parliament do not remove the risk of a hard Brexit and a situation that would have a persistent negative impact on the UK economy.

By Dave Lafferty, Chief Market Strategist

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