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July Investment Strategy - Prevent horizon: US sidesteps recession for now

Key points

  • The US economic slowdown remains modest – the world’s largest economy looks set to avoid a recession in the next 12 months, thanks to the Fed’s monetary easing
  • Eurozone macro data and easing in the US, should lead the ECB to cut its deposit rate
  • (No deal) Brexit worries are back
  • China’s June rebound is likely temporary with further softness and policy support ahead – other emerging markets are also posting lacklustre numbers
  • Given the vulnerability of the macro environment, we are keeping a cautious allocation stance, with a preference for high-carrying fixed income

US economic vulnerability in need of modest support

The US economy has unsurprisingly kept slowing down following 2018’s fiscal-fuelled 12-year record-high growth. With US/China trade tensions easing a notch at the Osaka G20 Summit in late June, monthly “hard” data remains relatively healthy while business surveys are holding up, especially in the services sector. Even the internationally exposed manufacturing industry endured a milder slowdown than witnessed in the late-2012 and late-2015 downturns. Altogether, we forecast US GDP growth of 2.4% this year and 1.6% in 2020, thereby avoiding recession in the next 12 months.

Building up on our previous research and mindful that macroeconomic indicators often lag market signals, we cross-checked with our spread-augmented yield curve recession model. This analysis confirmed our macroeconomic assessment of a vulnerable US economy, like where it was 1989 – when Iraq invaded Kuwait, oil prices spiked, and a recession started in 1990 – and then in 1998, there was another three years of expansion.

Fortunately, the Federal Reserve (Fed) hasn’t much to do, to provide meaningful support. Indeed, the current policy stance is neutral. Cutting by 50 basis points (bps) in the second half of 2019 – our baseline expectation – would be sufficient to bring it into unambiguously easy territory, enough in our view to avoid a recession. The risk though is that such an approach from the Fed emboldens Donald Trump on his aggressive trade policy, fuelling more global tension – with adverse ramifications for Europe in particular. Another issue is that we end up in a “Greenspanian loop” with markets counting too much on automatic support from the Fed, leading to excessive exuberance in some financial markets’ segments.

Eurozone: Less support, more vulnerability

Meanwhile, Eurozone macroeconomic data has been mixed in terms of indicators and countries. Whilst the Composite Purchasing Managers Index (PMI) for the whole region hit an eight-month high, German manufacturing indicators keep falling and the labour market is registering its first cracks with lower hiring intentions and rising unemployment. Whether Germany will fall into recession is a close call, but we believe the Eurozone will avoid one thanks to domestic demand, especially in France and Spain. Conversely, net trade and the industrial sector will keep weighing on Eurozone growth, as China’s recovery is not yet on a solid footing. Indeed, we doubt June’s rebound, with both retail sales and industrial production accelerating beyond expectations, will be sustained despite renewed policy support.

This economic slowdown coupled with the Fed’s summer easing is putting mounting pressure on the European Central Bank (ECB) to also deliver some sort of monetary support. We expect a – already fully priced in – 10bp deposit cut to be delivered in September and announced in July. We are however more cautious on the prospect of the ECB relaunching quantitative easing soon. We believe this would require further economic deterioration going forward, not just a lack of improvement.

Back to the Brexit countdown

On 23 July, Brexit campaigner and former Foreign Secretary Boris Johnson became the leader of the Tory party, and therefore, the UK’s new Prime Minister. In his successful attempt to convince the ≈160,000 members of the Conservative Party, Johnson promised to uncompromisingly leave the European Union (EU) on 31 October, whether a new deal is reached or not. Such a political pledge and adamant tone had observers and markets worried, as no alternative deal seems reasonably in sight in such a short period of time. The UK Parliament has repeatedly expressed having a majority against an exit without a deal and the House of Commons passed an amendment last week, requiring it to regularly meet between 9 October and 18 December to avoid an explicitly threatened suspension. This Parliamentary determination is however of little reassurance, as no deal is not an active, Parliamentary-approved choice but simply the default outcome if nothing is proactively done by 31 October. Of similarly little weight, is the insistence of Ursula Von der Leyen, the new President of the EU Commission, to offer another postponement of the Brexit deadline and make sure to avoid no deal. But while you can lead a horse to water, you can’t make it drink.

Time for panic? Well, we have been here before; the inexorable dead-end, the lack of compromise, another countdown to Brexit and a country sleepwalking into a no deal exit. Once again, we believe the UK will avoid such an outcome. General elections may well be ahead, albeit with unforeseeable results – remember June 2017 – and yet-to-define campaigns. The Brexit show will go on.

Cautious asset allocation favouring carry

With forecasts for global earnings stabilising at 4%, overall equity valuations are not particularly stretched (with multiples close to long-term averages). We nevertheless maintain our cautious stance on equities, for several reasons. First, fragile investor sentiment seems sensitive to the erratic (geo)political environment. Second, although the “Fed put” is well in place, we believe market pricing offers room for disappointment in communication. Third, and on a relative basis, we maintain our preference to allocate our modest risk appetite to credit, especially high-yielding and emerging debt, with a goldilocks backdrop of modest but resilient growth, low inflation and monetary easing.

In the fixed income space, we maintain a constructive view on duration risk in the medium to longer term, as the Fed embarks on its ‘insurance’ easing cycle (with the ECB to follow) and material inflationary pressures are few and far between. That said, given the ultra-low level of yields globally, we are conscious of the near-term risk for a mini correction in rates, accompanied by a limited correction in in risky assets – a mini ‘rate tantrum’. A catalyst to that could be an effort by the Fed to deliver a hawkish cut to wean the market off the expected five rate cuts over the next 18 months. In any case, we would view such a correction as an opportunity to add spread risk at cheaper levels, as the macro backdrop for spread carry remains very conducive.

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