Macro Reflections #2

Which direction for the markets at the end of 2019?

Before thinking about our year-end outlook, we first need to go back to the summer of 2019 in order to really appreciate the magnitude that this series of events brought to markets:

July 31 – Fed: While caving to market pressures demanding rate cuts, Jerome Powell called off future hopes of additional measures by calling the 25bp cut a “mid-cycle adjustment”.
August 1st – US: President Trump raises the US-China trade stakes by announcing that new tariffs of up to 10% on $ 300 million of Chinese products would be effective September 1st.
August 5 – China (1) announces a halt to its US soybean purchases and (2) lets the RMB devalue below the symbolic 7RMB mark. The RMB loses 3% in total over the month, its worst month since November 1990
August 8 – Italy: Matteo Salvini, strengthened by the European Parliament elections, seeks an early election in an attempt to consolidate powers and end his party’s alliance with Di Maio’s 5-star party.
11 August – Argentina: Following the primary elections (PASO) won by a landslide by Alberto Fernandez, Argentinian assets plunge and the country prints the second largest daily stock market drawdown in the last 70 years
August 24 – Jackson Hole: While Jerome Powell is about to deliver a speech, China imposes additional tariffs. Following the announcement, Trump “compels” US companies to repatriate their production facilities back to the US right away
Throughout the month of August – HK: Intensification of protests related to Carrie Lam’s extradition law. Images of the People’s Army of China (PLA) suggest an imminent Chinese intervention is likely.

These events led the bond market to reach the world record of $ 17T in negative yielding debt at the end of August.

As these events faded going into September, the relaxation observed and pick up in risky assets resembled an early ‘Santa Claus rally‘, a welcomed development for investors that had to shorten their summer vacation.

Although the fourth quarter of 2018 is still fresh in the minds of investors, the context is obviously different with a Fed having “pivoted” in January 2019 from a restrictive monetary policy (ie on “autopilot”), towards an accommodative trajectory, while the American economy started to show strong signs of a slowdown.

Here is the review of the major elements which developments we follow closely.

(1) The United States joins the rest of the world, with services and industrial indexes both deteriorating

The manufacturing and service indexes both disappointed in September. The ISM services, down for its 4th month in a row is at its lowest level in 37 months (the same for new orders). The US manufacturing index – printing at 47.8 – has just fallen below the average of developed market PMIs of 48.8. The US deceleration, which has been more pronounced in the manufacturing sector in the previous months, is now reflected in services, which are themselves on the verge of entering a contraction zone and casting doubt on the idea that the service sector is immune from any weakness felt by its manufacturing counterpart.

Source: Bloomberg

The export component, showing a sharp decline in growth, gives us an anticipated view of the US equity market that could consolidate sharply in the coming months.

Strengthening the idea of a deceleration and countering the idea of a well-functioning labor market, the employment component seems to be deteriorating on both indexes: services employment fell to its lowest point in 67 months, while manufacturing employment fell to its lowest point in 44 months.

To this was added a new revision of the US Labor Office (-500K over the year 2019), a disappointment on the ADP index for the month of September coupled with an August revision and a drop in consumer confidence as well as future hiring intentions. Although the latter was not confirmed by the Non-Farm Payrolls (NFP) index, this variable could continue to decelerate in view of the overall reduction in the non-share of labor(3.5% unemployment rate = at the lowest since the 1970s).

Source: Bloomberg

In Europe, the contraction has been deepening. Sweden’s manufacturing index, due to its high exposure to global trade and export sensitivity, has recorded its worst contraction since 2012. The long-awaited German manufacturing rebound has not yet arrived: the contraction that started in January is now at its lowest for the year 2019 at 41.7.

Source: Bloomberg

PMI Suède vs Euro Composite

Source: Nordea

Sweden’s Asian equivalent – South Korea – has equally weak export growth, an indicator strongly correlated with US equity performance.

Source: Hedgeye

It should be noted that, unlike their developed markets counterparts, which have been in a contraction zone since January 2019, emerging countries are showing some resilience.

Source: Bloomberg

(2) Central banks in full cacophony, rising inflationary pressures?

In the United States, would a 3rd rate cut at the Fed’s October meeting support further the markets?

The stakes will be high for the Fed: despite a potential reduction in its key rate on October 30, a press conference considered as “too hawkish” would exacerbate this slowdown with a dollar that would appreciate and constrain the ability of other central banks to put in place effective stimulus packages. In this regard, the comments made by some members of the Fed committee, such as Richard Clarida (Vice-President) or Charles Evans (Chicago Fed), contrast with the comments of James Bullard (St Louis Fed) in favor of “aggressive intervention” and suggest that the debates will be lively.

Nevertheless, following the publication of the US services and manufacturing indicators reflecting a contraction of the market, markets have re-adjusted their probability of a 25bp cut from 39.6% to 75.4% at the meeting of the Fed on October 30th. The expectations for the month of December have also been revised upward (37.8% vs. 17.5% the previous week) with an additional reduction of 25bp, bringing the number of cuts to 4 for the year 2019.

Source: CMEGroup.com

Note the rising inflationary pressures that could constrain the actions of the Fed in its dual mandate of price stabilization and support for the labor market. These end-of-cycle dynamics related to wages are found in Europe, while in Asia certain countries are hit by idiosyncratic factors (swine flu pandemic far from contained in China and increase of a consumption tax in Japan). In this context we remain open to a scenario of “Stagflation” (rising Inflation + Decline in growth).

Source: Hedgeye

(3) Potential for a disappointing US earnings season, partly due to wage pressures

Even if the best case for the markets was to happen – a combination of (1) a resolutely accommodating Fed (2) a relaxation of US-China tensions and (3) an effective Chinese recovery – the US labor market would still be approaching saturation. This dynamic should be felt in the compression of the margins of American companies. Indeed, at the end of the cycle:

Wage pressures grow as the labor market approaches full employment
Lack of employment opportunities leads to increased wages and squeezed corporate margins
Profits fall due to squeezed margins and wage pressures are automatically reflected in a limited future hiring capacity, leading to a decline in employment growth.
US employment at this stage may continue to deteriorate, while margin pressures should continue to increase.

US jobs growth vs wage growth

Source: Hedgeye, Bloomberg
Wage growth vs GDP growth: Increased pressure on margins

Source: Hedgeye, Bloomberg

In addition to wages, a relatively strong dollar and falling demand, the ingredients are all coming together to post a sharp drop in future US results.

Lastly, share buybacks that have recently reached new records will be gone during the announcement period, due to the associated blackout that does not allow for the repurchase of shares.

Source: Bank of America

To these macroeconomic considerations can be added other idiosyncratic risks that we will develop in future notes, among others: the risks related to future IPOs, the “impeachment” procedure of President Trump and geopolitical developments.

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Etienne de Marsac – Head of Absolute Return Strategies – https://twitter.com/etiennedemarsac

Jonathan Rejaud – Global Macro Analyst – https://twitter.com/jonathan_rejaud