Waiting on Karl to get up outta here...

Summary

• Global dynamics — Looking at the forest from the trees.

• Market dynamics — Bond yields could move too far too fast.

• The week ahead — Europe in the tariff crosshairs.

Growth fears dominated headlines throughout the week, offsetting any positive news from Brexit and trade. The week kicked off with the IMF (International Monetary Fund) issuing their quarterly doom and gloom report, highlighting that global growth is expected to fall to 3 percent this year — the lowest since the financial crisis. If you’re looking to assign blame for such a weak growth profile, the Fund will point you to the usual suspects; rising trade barriers, geopolitical uncertainty, idiosyncratic problems in emerging markets and broader structural problems such as low productivity and aging demographics. None of this is “news” per se. The Fund has been pounding the table on these issues for years but, I think there's value in going over some of these broader dynamics to rationalize the moves we're seeing in markets. 

For starters let's talk about China. Data out on Friday showed that the Chinese economy grew by 6 percent year over year last quarter — the slowest in 27 and a half years. On its own, that is not surprising. China has been grappling with leverage to transition into a more sustainable growth model (I have talked about this at length in If Monday was a beer). The Chinese economy was expected to slow before any of this trade war rhetoric entered into play. The trade war on its own has hurt China but, more importantly, has weighed on business sentiment globally. The widespread manufacturing slowdown is largely being driven by economic and trade policy uncertainty given that many businesses would rather postpone investments until a trade deal is made. As a result, business investment has collapsed, shifting most of the burden of growth onto the consumer. For the most part, this has not been a problem. Falling bond yields and further central bank accommodation have helped spur credit growth and has provided support for consumers. However, this kind of growth is unsustainable. Interest rates can only go so low and consumers will only spend if they believe the best days aren't behind them. Sure, central banks can do their best to control that narrative but eventually, things will run their course. This brings us back to China. In the past, China was willing to spur loan growth which would sturdy up demand for commodities and kickstart the global economy. This is exactly what happened in 2015 but, this time is different. Beijing doesn't want to undo years of deleveraging. The market has been waiting for Beijing to throw everything at the economy, including the kitchen sink, but policymakers have been reluctant to do so. In short, we can't expect China to come to the rescue on this time. 

What's more concerning is that some ugly dynamics are rearing their heads within China. Producer prices have fallen into deflation while consumer prices have been on the rise, particularly in food (25 percent of Chinese pork production has been wiped out due to African swine fever). Deflating producer prices in the world's second-largest economy will undermine the global push from central banks to reflate the economy while rising consumer prices have the potential to knock out a key pillar of growth. Although retail sales in China have remained buoyant, in the US, retail sales contracted the second time this year. If recession fears cause consumers to save, it's very likely the US will slip into a recession, taking the rest of the world with it. That is why the plunge in consumer confidence back in August caught so many headlines at the time. I can not emphasize enough how important the US consumer is to keeping growth positive. Businesses are convinced a recession is coming, a survey of CEOs shows that CEO confidence is the lowest since 2008. The Duke University CFO survey paints a similar picture, with two-thirds of CFOs thinking the US will be in a recession by next year. That tells me that management teams are going to be exercising extreme caution, making it even less likely that business investment will come to the rescue in the face of decades-high economic policy uncertainty. 

Despite the growth backdrop being nothing to write home about, the combination of the US yield curve being no longer inverted and trade optimism helped push equities higher while bond yields remained flat. A comprehensive trade deal between the US and China remains elusive however, the “mini deal” struck a week ago reduces the risk of further escalation. As I mentioned last week, markets were generally expecting a crash and as such were positioned for one. When the good news started to hit the wire, all of the hedges market participants had taken out were being lit on fire causing a massive sell-off in crash protection. That carried through to this week with the VIX selling off until Friday when the Chinese GDP numbers came out and reasserted the growth fears. The chart below shows the 1-month implied volatility of S&P500 options — the VIX Index.

CTAs, momentum trading hedge funds, were also likely buying following the melt-up in equities — The chart below shows the S&P500 with the moving averages I explained from Everybody has a few bars to play in this song. 

What I am getting at here is that what we are seeing in the market is not a rational response to, what essentially is, an agreement between Washington and Beijing to continue talking. Interestingly, the trade dispute has been on the Federal reserves mind since its inception and the recent string of positive news has taken some pressure off of the Fed to ease policy later in the year. This makes for a shallower easing cycle than was originally expected, playing right into the narrative that Fed Chair Powell was pushing to the market back in July about a “mid-cycle adjustment”. Indeed, market participants continue to expect a 25 bps cut at the end of October but after that, market pricing shows nearly a 70 percent chance of a hold in December. We can see this optimism materializing in US real yields, aka TIPS (Treasury Inflation-Protected Securities), which represent the portion of a yield that is driven by growth prospects. The bounce in real yields in the US shows the first sign that the market may be seeing growth bottoming. 

Of course, real yields are closely tied to trade developments, which makes sense given that trade uncertainty is what has been clouding the global outlook. The hope is that once a trade deal is reached, business investment will pick up. Now that seems problematic given that CEO’s and CFO’s are convinced that a recession will be coming. The progress we’ve seen on the trade front fails to address key sticking points in the negotiations, making the “progress” not that significant. President Trump would also lose leverage over the Fed if a deal is reached, given that he has been using the trade war as a way to engineer rate cuts. Although real yields are reacting to trade news, I’m not convinced that any developments on trade have been material enough to shift underlying sentiment within the market. That’s not to say bond yields can’t rise — They can rise on trade optimism but without better growth prospects, higher bond yields can quickly tighten financial conditions as we saw in 2018. For bond yields to rise in a “healthy” manner, they need to be accompanied by inflation expectations and a broader rotation away from defensive sectors into cyclical sectors. This could come as a result of fiscal stimulus, like the tax cuts in the US in 2016, but for the time being that seems unlikely. The reality is, this trade dispute goes far deeper than just economic issues, something I had highlighted in my previous email. Geopolitical uncertainty will continue to fog the outlook, just like Karl in San Francisco.

Many market participants noted that the yield curve in the US is back to “normal”, where normal implies an upward sloping curve. Although true, this shouldn’t come as a surprise. In my last email, I highlighted that with the Fed launching a new round of asset purchases on the front end of the curve, that should cause the US yield curve to steepen — Pushing front end rates lower while keeping long rates the same. Yields did rise across the curve throughout the week, reflecting the string of good news on trade and Brexit, but, they rose by less on the front end, likely being held down by the new string of asset purchases from the Fed. As for what a steeper yield curve implies after an inversion, generally speaking, once the yield curve starts to steepen, a recession is typically on its way. The chart below shows the past few inversions of the 10-year 3-month and 10-year 2-year spread with the green bars showing recessions. We can see that the curve steepens ahead of each recession (red circles).

This typically happens because the front end falls as the market begins to price more rate cuts. That’s different from what we are seeing this time around, so I wouldn’t raise the alarms quiet yet. There is far more to this indicator than what it appears and I will elaborate more on this as I see fit. For those in need of a refresher on why the yield curve matters, Vox has a great video that explains things to the simple man.

The week ahead will bring us some interesting dynamics in Europe, the Canadian election and a potential rate cut in China. US Tariffs on European imports that were sanctioned by the WTO will go into effect this week for the improper subsidies that were given to Airbus. Europe has threatened to retaliate but nothing has been made official yet. We will also see the latest string of manufacturing data from the Euro area, expectations are bleak. Mario Draghi will also hold his last press conference as the head of the ECB on Thursday — Draghi will likely be asked on the self-imposed limits on the asset purchases which are expected to go on in perpetuity. Work from UBS shows that the ECB, at its current pace, will only hit the limit in mid-2021. Meanwhile, risks of a hard Brexit have fallen following Boris Johnson’s official request for an extension to negotiations to the European Union. In Canada, Canadians will be hitting the polls on Monday in what appears to be a neck-and-neck race between the Liberals and the Conservatives. The Canadian dollar has been one of the stronger currencies this year, holding its ground well against the USD. Emerging markets are expected to perform well in the coming week should trade optimism persist. The USD has been taking a beating in the last few weeks, which is positive for emerging markets. The Turkish and Indonesian central banks are meeting on Thursday and are expected to cut rates. In China, the PBOC is expected to announce it’s new prime loan facility and deliver a 5 bps cut — a small and largely meaningless cut. The US equity market remains slightly long gamma.

Tiago Figueiredo