Climbing the Wall of Worry

It is said that equity bull markets “climb the Wall of Worry”.. The third quarter of 2019 is an excellent example of exactly that. As the wisdom also goes, “there are decades where nothing happens, and weeks wherein decades happen”.

In looking back on the 3^rd quarter of 2019, investors should have sympathy with this sentiment, having endured an extremely volatile quarter that saw another escalation of the US/China trade war, a synchronised collapse in global bond yields, sustained public disorder in Hong Kong, the biggest intra-day surge in oil prices on record, a spike in overnight repo rates, US recent IPO’s falling sharply, an equity market factor rotation and never-ending political drama in both Washington and London. The table below gives some context by providing the trading ranges – peak to trough – for several major global indices over the quarter.

Against this backdrop, the actual outcome – global markets ending marginally higher in USD, barring some substantial currency moves – underlines the extent to which noise and volatility dominates the market news cycle between reporting seasons. There’s not much to be done about the noise, unfortunately – the 24-hour news cycle needs headlines, and there is currently no shortage of supply.

Despite daily negative headlines, developed equity markets were either flat or edged marginally higher in the quarter. If you had ignored Twitter and done nothing with your equity portfolio you would have seen little change in the quarter.

You may ask yourself, how can bad headline news be good news for equities??

The simple answer is Central Banks.

In the quarter we saw the worlds Central Banks, including the RBA, act swiftly to get in front of deteriorating near-term economic data. This included the ECB re-starting QE and the FED increasing the size of its balance sheet via heavy intervention in the overnight repo market.

I have to say though, even though I believed in structurally low interest rates I actually never thought I’d see the Australian cash rate with a “0” in front of it and an Australian 10yr bond also with a “0” in front of it. A 0.75% cash rate and 0.96% AGB 10yr yield may well be both on their way to zero or even negative. Chatter about Australian QE is now not far-fetched as monetary policy reaches the limits of its usefulness. In fact, you could argue Australian cash rate settings are at the “reversal rate” where further rate cuts actually become contractionary.

The big question from here becomes, how much more can Central Banks do? Conventional monetary policy is close to “pushing on a string”. The only effect I can see monetary policy having is on the Australian Dollar due to interest rate differentials with the US. If anything, Australian households are using record low interest rates to accelerate debt reduction. They aren’t going out and buying new cars etc and that is why GDP growth remains around +1% despite the windfall of high iron ore prices (which won’t last).

If the Australian Government continues to bask in the glory of its “budget surplus”, and refuses to use fiscal policy to increase aggregate demand, then there’s every chance we eventually see ZIRP and unconventional monetary policy (QE) in Australia in 2020. Under that scenario the AUD will have a 5 in front of it and the best returns Australian investors will generate will be via being invested in unhedged global equity funds

The US Yield Curve Inversion

Of all the headlines in Q3, none caused more consternation to investors than the US yield curve inverting. Inversion – the term used to describe the phenomenon when bonds with longer maturities yield less than those with shorter maturities – normally signals that investors are concerned about a material slowdown in future economic growth, and are willing to accept a lower yield for the certainty of a future return. A yield curve inversion has preceded every US recession since 1950 – though a recession has not followed every instance of an inversion. In the cases where a recession did occur, it usually took longer than a year – and in some instances, closer to two years – to materialise.

The flattening of the US yield curve should be viewed against the backdrop of the ongoing extraordinary monetary policy settings in place around the world. Research done by the Federal Reserve itself suggests that the last decade of quantitative easing has likely depressed the long end of the yield curve by approximately 1%.

With central banks still actively buying bonds and policy rates at or below zero in Japan and large parts of Europe, the relative appeal of earning a positive coupon on a 10-year US treasury bond fuelled the extraordinary buying seen August. Even the US 30-year yield briefly traded below 2% – not that outlandish a notion when the alternative is to own a negative-yielding 20-year German government bond and pay 0.40% every year for the privilege of lending the government money.

As we have said before, we do not think owning fixed income assets at these levels are likely to provide attractive real returns to investors over time, particularly given the risk of capital loss far outpacing the interest earned if rates move even modestly higher.

However, a yield curve inversion against a backdrop of slowing global growth is a shot across the bow of US central bankers, politicians and investors alike. Unlike during past yield curve inversions, the Fed has already reversed course and cut rates. Whether this is enough to extend the economic expansion remains to be seen, but is certainly preferable to the alternative of continuing on the path of rate increases. 

Perhaps more instructive than only watching for a yield curve inversion is to consider the real interest rate. Defined as the difference between the Fed Funds rate and core CPI, real rates have peaked at substantially higher levels prior to past recessions.

It can be argued – likely with some merit – that the Fed shrinking its balance sheet has imposed additional monetary tightening not fully captured by the real interest rate. Given a higher public and corporate quantum of debt, it also stands to reason the threshold for real rates to negatively impact demand will be lower than in the past. However, with the real rate close to zero at present, it does not yet seem like a problem, and to our minds does not imply the certainty of a US recession as a foregone conclusion within the next twelve months. The big unknown is the confidence-sapping impact of the trade war: were that to materially escalate, the likelihood of a US slowdown would increase substantially.

A Question of Confidence

In looking at the current sources of economic drag, a manufacturing slowdown is evident around the world, with Manufacturing PMI’s trending down from late 2017/early 2018 peaks.

This slowdown has more recently been exacerbated by the increasingly volatile global trade landscape, which has had the effect of negatively impacting business confidence and the willingness of management teams to invest.

However, in the US, manufacturing accounts for only ~11% of GDP, while consumer spending is much more meaningful at ~70% of GDP. US consumers – possibly remembering the extraordinary pain experienced during the global financial crisis – have chosen to deleverage their balance sheet over the last decade, with household debt now at ~85% of GDP compared to a peak of ~94% in 2008/2009. This combination of lower leverage, ongoing jobs growth (translating to lower unemployment) and steadily growing hourly wages over the last few years has seen consumer spending hold up well, even in the face of worsening corporate sentiment. 

The salient question now is whether a further weakening of business confidence starts to materially impact hiring and wages. If this were to occur, the transmission to weaker consumer confidence would likely be swift.

We believe business confidence is the missing ingredient (US ISM manufacturing PMI worst since 2009), and any positive developments leading to more visibility on the business landscape will likely underpin a sharp restoration in capital investment, both in the US and elsewhere.

These missing “positive developments” are in the hands of the political class. They include a trade war resolution, Brexit deal and coordinated fiscal stimulus to name the three key ones.
Either way, I continue believe this tug of war between monetary policy (extreme), fiscal policy (current lack thereof) and political uncertainty (extreme) will continue to drive equity market volatility

Inside that volatility however, there will be clear stock specific investment opportunities. 

Invest with conviction, not momentum

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