Crazy like a fox

Summary

• Global update — About as good as the bad news bears.

• Trade update — Too little too late.

• Secular stagnation — Negative earnings may expose the zombies.

• Market dynamics — Stay liquid my friends.

• The week ahead — All eyes on the Fed.

There continues to be no shortage of data supporting the notion of a deteriorating global economic backdrop. Last week I highlighted that Chinese growth was the slowest in nearly 3 decades and flagged some ugly dynamics happening with inflation and producer prices. I also talked about the PBOC (Peoples Bank of China) continuing to play their cards close to their chest, refusing to deliver the liquidity that the market has been demanding. I talk about these dynamics at length in If Monday was a beer. The reality is that anyone betting on China to save the global business cycle is barking up the wrong tree. China is effectively putting downward pressure on already subdued global demand and there’s no sign that that will change. Meanwhile, data out of another regional coal mine canary is also not looking good. South Korea has fallen into deflation for the first time in history despite the Bank of Korea's efforts to create inflation. Exports have also declined for eleven straight months, highlighting how widespread the slowdown has become. In Japan, consumer confidence has plunged since 2018 and the introduction of the twice-delayed consumption tax could tip the economy into a recession. This tax comes at an inopportune time, the manufacturing sector in Japan fell deeper into contractionary territory this week.  In Europe, the latest data painted a similar picture with the number of new orders in the manufacturing sector declining further, marking 13 consecutive months of contraction. Although the Euro bloc isn’t in a recession yet, any hopes that German growth would bounce in the final quarter of the year have no gone up in flames. Europe has been plagued with a widespread manufacturing recession which has come as a result of a combination of an organic slowdown in China and rising geopolitical uncertainty. As such, it came as no surprise that the ECB (European Central Bank) unveiled a new stimulus package at their last meeting in September which was essentially a promise of perpetual liquidity (for those interested please read Russia might be having Turkey for Thanksgiving). At the latest meeting last week, the ECB kept policy rates unchanged. Mario Draghi, the President of the ECB, will now hand the reigns to Christine Lagarde, who is tasked with managing an increasingly controversial set of policies that were aimed at garnering political support for government spending. She has big shoes to fill. On a more micro level, Caterpillar, the construction and machinery company, revealed the first quarterly decline in profits in years. The main driver of the decline was a decrease in inventories and end-user demand — not surprising given the global slowdown in manufacturing. One Bloomberg analyst said that "The best spin it can put on the news is that when the recovery comes, at least dealer lots will be empty leading to a spike in orders” … L-O-L. Meanwhile, on the trade front, a phone call with Beijing on Friday indicated that Chinese officials are pushing for tariff relief in exchange for facilitating the new “phase one” deal. Remember that the so-called “deal” in its current form has China tentatively committing to buying more US farm products and the US delaying a tariff hike. What “more” means is up to the reader's discretion. Reports show that China is willing to ramp up purchases of agricultural products to around US$ 20 billion within one year of a partial trade deal. That seems like a lot until you realize that these additional purchases take China’s imports of farm goods back to 2017 levels (i.e. before the trade war began) — Now that’s the art of the deal! Should a partial deal be struck, that would result in President Trump rolling back the escalations he announced in August, the day after the Federal Reserve meeting, and the enhancement which split the tariffs into 2 tranches and was conveniently put in place after Fed Chair Jerome Powell’s speech in Jackson hole (the same day China announced retaliatory tariffs). As a reminder, the US administration split the tariffs into two tranches to avoid a spike in consumer prices going into the holiday season (read I’ll be seeing you at the zero lower bound bud for more information). What needs to be understood is that President Trump has been engineering rate cuts from the Fed by escalating trade tensions and creating uncertainty — This is the trade war feedback loop mentioned in Canada is not for sale. In many ways, President Trump is crazy like a fox. This is a cunning way to strong-arm the Fed into lowering interest rates despite record low unemployment. The question on my mind and the markets is whether President Trump is willing to give up this leverage in exchange for a partial trade deal. This becomes more of a question of how important an issue trade becomes going into the election next year. At the same time, it wouldn't be uncharacteristic of the President to push through a trade deal and then back out of it right as President Xi is about to sign on the dotted line. For what it’s worth, some banks see a partial trade deal as a good enough reason to cause a large sell of in bonds (this would raise interest rates). A significant spike higher in interest rates could take its toll on consumer spending, especially if that spending has been driven by leverage. Last week I talked about how uncertainty has weighed on business investment, highlighting a survey of CEOs (Chief Executive Officers) and CFOs (Chief Financial Officers) where the majority of participants think the US will be in a recession by next year. This survey is important because it speaks to the collapse in business investment, which has shifted the burden of growth onto consumers. When you take a step back and look at the state of the world, the damage from trade appears to have been done and any progress on a new deal may be too little or too late. The damage from the shift to protectionism away from globalization continues to become more apparent with each passing week culminating in secular stagnation. The IMF (International Monetary Fund) and the OECD (Organization for Economic Co-operation and Development) have repeatedly slashed their global growth over the last several quarters and without a clear end to trade conflicts and/or fiscal stimulus the situation will continue to get worse. Protectionism has unwound the very foundation that modern systems of trade and commerce were built on and, although that system hasn’t crumbled, the very foundation it rests on is getting shakier with each passing week. The world economy is slowing and several of the sources of the slowdown are not being addressed or can not be addressed. This has pushed many market participants and economists to consider secular stagnation as the base case going forward. The reality is, we are one global shock away from a very dark place where monetary policy won’t be able to come to the rescue.  The elephant in the room is China. The fact that China is not rushing to roll out broad-based stimulus, even as growth is slowing, tells me that China is preparing itself for slower growth which will likely result in rising defaults. I’m not entirely sure the world is ready for that. In Zombieland, I talked about how accommodative monetary policy forces investors to search for yield and creates support for companies that would otherwise be cut off from funding. The best example of this is a pension fund, who has to pay out an increasing amount each year because the baby boomer generation is retiring. With interest rates approaching the zero lower bound, these pension funds are running out of safe assets to invest in and, as a result, are forced to take on more risk or “go down the quality ladder”. I talked about this earlier in the year in terms of financial market tourism — the idea that these pension funds are tourists in these higher-risk markets. Tourism in financial markets creates a feedback loop wherein, as investors herd into riskier assets, companies that should default get access to lower interest rates allowing them to continue to produce. These companies are then able to produce, creating excess supply and deflationary pressures that force central banks to then lower interest rates further, creating more search for yield.  I think that there is a real risk of this cycle breaking in the next 5 years and it starts with China — Bloomberg has already run several articles talking about how onshore default rates are expected to hit all-time highs in 2020. Slower growth and rising input prices from tariffs have begun to cripple corporate profits, with the S&P500 earnings growth expected to decline this quarter. With earnings growth starting to roll over, there’s a real risk that these zombie companies get exposed (think about the WeWork IPO if you’re looking for an example). Investors may have more exposure to the business cycle than they'd like to have, with some cyclical stocks dressed as growth stocks. That’s the real risk in the ETF (Exchange Traded Fund) space, particularly with these “smart beta” investment vehicles that give investors exposure to certain factors. The chart below shows the disconnect between the S&P500 and the US government’s measure of corporate earnings. 

There are plenty of macro catalysts on the horizon and market liquidity may very well play a crucial role in the coming months. The world's most liquid market appears to be far less liquid than it was earlier this year. That’s right, the US Treasury market has been thinning according to the CME’s liquidity tool. The chart below comes from Bank of America’s Carol Zhang and shows the market depth of US Treasury bonds and the 3-month 10-year swaption volatility. 

What this means is that fewer people are participating in the market, implying that it has become easier for the price to move (which is why the swaption volatility has risen). This is in many ways the same chart like the one below from JP Morgan which I have used in the past to explain the same dynamics in the equity market. 

The idea here is that as fewer people partake in the market, the volatility in the price increases as there are fewer buyers and fewer sellers. This was one of the main issues that caused such a nasty sell-off last year in December. This is very much the case of the Chicken and the egg — market volatility feeds off of market depth and vice versa. This story made sense in the equity market as investors were reducing their risk and positioning themselves in bonds (due to fears of recession etc). That same story doesn’t make as much sense for bonds. There’s always the case of High-Frequency Traders (HFT’s) who now represent a larger portion of the market than in the past. The key thing with HFTs is that their presence is dependent on volatility — as volatility rises they are less willing to participate, reducing liquidity. The chart below shows HFT presence in the Treasury market. 

Some participants are tying this to the latest string of “good vibes” that have hit the market. These include some progress on the US-China trade deal, Brexit and the US yield curve going back to “normal”. The idea is that investors are starting to take on more risk and going out of US bonds — I’m not sure I buy that. There’s something else going on here and I’ll let you know once I’ve cracked the case. In the meantime, I wouldn’t be chasing any risk/illiquidity premiums going into year-end. The Fed will be the main event next week although there will be plenty of other macro catalysts to keep an eye on. Starting in the US, the Fed will almost surely cut interest rates by 25 bps on Wednesday. The Fed has been keen to describe the latest easing cycle as a mid-cycle adjustment and with the latest string of good news from the trade front, this meeting seems like a good time to convey that message. Of course, things can change depending on how the data evolve this week. This week we have US Q3 GDP, manufacturing data and, more importantly, the US non-farm payrolls for October. The US economy is expected to decelerate to 1.6 percent, the slowest in 2019 and nearly half of what the US administration is targeting. The Labour market is expected to continue to cool in the US and, while a rebound in manufacturing would be welcome, it seems unlikely. The data could reinforce the mid-cycle adjustment narrative or undermine this week so there is plenty of macro risk over the next 5 trading sessions. The Bank of Canada is also up this week and is expected to remain on hold following the Federal election where the Liberals won a minority over the Conservatives. Monthly GDP will also be released in Canada. Europe will report Q3 GDP with market consensus showing a 0.1 percent gain. Bank of Japan will also meet this week and there are no changes expected. There will be some data out of South Korea and New Zealand as well as some manufacturing data in emerging markets. In Argentina and Uruguay, voters are going to the polls and the results should start to come in later tonight. Tiago Figueiredo