Market View - 1st Quarter 2020
“The yield curve – specifically, the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill – is a valuable forecasting tool. It is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six quarters ahead.” Arturo Estrella and Frederic S. Mishkin, authors of the June 1996 Federal Reserve Bank of New York paper titled “The Yield Curve as a Predictor of US Recessions”
LAST QUARTER REVIEW
The Federal Reserve (Fed) left the target range for its federal funds rate unchanged at 1.5-1.75 percent on December 11th 2019, and suggested there are no plans to change rates in 2020. The Federal Open Market Committee (FOMC) press release of the meeting advised that, “the labor market remains strong and that economic activity has been rising at a moderate rate. Job gains have been solid, on average, in recent months, and the unemployment rate has remained low. Although household spending has been rising at a strong pace, business fixed investment and exports remain weak. On a 12‑month basis, overall inflation and inflation for items other than food and energy are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed.”
Meanwhile the Fed’s battle to ensure no recurrence of the “repo market” interest rate spike that occurred in September meant it has continued to add to its balance sheet throughout the last quarter with a likely continuation for the foreseeable future. The repo marker ordinarily operates smoothly without the Fed’s involvement via the big commercial banks and broker dealers, but on December 12th the New York Fed announced additional repo money injections that will amount to at least another $425 billion to ensure a trouble free market into the year end, and beginning of 2020!
Wall Street appeared unperturbed by what many are calling additional quantitative easing (QE) to suppress the problematic repo market, as the benchmark S&P 500 closed the year just shy of its record high of 3240 set a few days earlier and up almost 29% during 2019! The promise of a potential settlement early in January to China US trade talks added to the seasonal goodwill in stock markets, while the interest rate on the benchmark 10 year US Treasury rose again during the quarter, from 1.68% to 1.92%, suggesting that just maybe inflationary pressures could be a consideration in the New Year!
In the UK, the main focus of markets was on the National Election held in December in which Prime Minister Boris Johnson and his Conservative party won a resounding victory with an increased majority after winning 365 seats of the 650 total. The landslide result was seen as a conclusive vote by the British electorate to finally end the three and a half year Brexit saga, as the Prime Minister campaigned with the slogan, “Let’s Get Brexit Done”, pledging to finally take the UK out of the EU by the end of January this year.
Meanwhile, at its meeting ending on 18 December 2019, the Monetary Policy Committee (MPC) voted by a majority of 7-2 to maintain the UK base interest rate at 0.75%. The Committee voted unanimously both to maintain the stock of sterling non-financial investment-grade corporate bond purchases, financed by the issuance of central bank reserves, at £10 billion, and to maintain the stock of UK government bond purchases, financed by the issuance of central bank reserves, at £435 billion.
The election result and possible resolution of the Brexit indecision resulted in sterling surging against most currencies, including the US dollar as the exchange rate improved from $1.23 to $1.33 during the quarter. The UK economic news was also much brighter as the third quarter GDP data showed the economy grew at 0.4% following the shock 0.2% fall recorded for the second quarter, and ensuring that a recession (officially recognised as two consecutive falling quarters) in the UK has been averted.
The UK Stock market, as measured by the benchmark FTSE 100 index provided solid returns rising 1.81% for the quarter, and just over 12% for calendar 2019. Its poor relative return compared to Wall Street and other international equity markets was likely due to a combination of factors including companies that make up the FTSE 100 earn more than half their earning overseas, while the continuing uncertainty surrounding the US China trade deal and Brexit negotiations were also a factor. The UK bond market, as in the US and elsewhere gave up some of the gains made earlier in 2019, as the interest rate on the 10 year benchmark gilt rose during the quarter from 0.48% to 0.83%.
The European Central Bank (ECB) left its key interest rates and stimulus package (bond purchases at a monthly pace of €20 billion as from November 1st, 2019) unchanged during Christine Lagarde’s first policy meeting in charge on December 12th, with the main refinancing rate remaining at 0 percent and the deposit rate at -0.5 percent. Policymakers said they expect interest rates to remain at their present or lower levels until the inflation outlook converges to their aim.
The ECB also cut its growth forecast for 2020, due to weak trade growth, while inflation is seen below the 2% target through at least 2022. Meanwhile European stock markets had another positive quarter and proved a rewarding sector for investors over the calendar year, with for example the EuroStoxx 50 index rising almost 25%!
The Chinese economy expanded by a seasonally adjusted 1.5% during the third quarter, while interest rates remained largely unchanged, albeit The People’s Bank of China (PBOC) decided on December 28th 2019 to start using the key loan prime rate (LPR) as a new benchmark for pricing outstanding floating-rate loans from January 1st 2020. The one-year LPR is at 4.15% and the 5-year LPR, generally used for new mortgage loans, at 4.8%. The central bank last cut the two rates by 0.05% each last month, aiming to reduce lending costs and boost a slowing economy.
The Bank of Japan held its key short-term interest rate at -0.1% during its December meeting, while keeping the target for the 10-year Japanese government bond yield at around 0%. Japan’s economy grew by a better than expected 0.4% during the third quarter, thanks to private consumption and capital expenditure increasing faster than initially thought, while net external demand contributed negatively to the expansion.
|Q3 GDP||Annual GDP||Base Interest Rate||Equities Last Quarter||Equities Last 12 Months||Bonds Last 12 Months|
GDP Data shown are to the 30th September 2019; Interest Rate, Equity & Bond Index Data are to the 31st December 2019; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.
Surveying the economic data three months ago, as we headed into the last quarter of 2019, it was relatively easy to be concerned, and conclude that the slowing growth numbers appeared to be confirming that the recession warning given by the US Treasury yield curve inverting during the summer was going to be proven an accurate market predictor once more. The data from the last quarter however is much more promising and suggest that just maybe global central banks and most especially the Fed have done enough to have averted a recession in the US and in most other developed economies.
The latest estimate (27th December) from the Atlanta Federal Reserve’s “GDP Now” economic monitor is that the US economy will have grown by 2.3% in the fourth quarter, which if proven accurate will mean growth is even stronger than quarters two and three (2.0% and 2.1% respectively). However, the latest data (November 2019) from the Institute for Supply Management (ISM) is less reassuring, and showed that while the overall economy grew for the 127th consecutive month, the headline Purchasing Managers Index (PMI) slowed for the fourth consecutive month from 48.3 in October to 48.1.
Key numbers in the November PMI report included the following which all fell compared to October, “the New Orders Index at 47.2% (-1.9%), the Backlog of Orders Index at 43% (-1.1%), the Employment Index at 46.6% (-1.1%), the Inventories Index at 45.5% (-3.4%), and the New Export Orders Index at 47.9% (-2.5%). Meanwhile the following key data all registered gains compared to October, the Production Index at 49.1% (+2.9%), the Supplier Deliveries Index at 52% (+2.5%), the Prices Index at 46.7% (+1.2%) , and the Imports Index at 48.3% (+3%).
Perhaps more importantly, the omens look better than for some time that President Trump and President Xi may at last be able to resolve the US China trade war that has been going on for almost two years and has severely impacted upon global trade. Following an announcement from the White House in early December that President Trump would not be increasing tariffs on some $200 billion worth of goods from the current 10% to a proposed 25% in the New Year as previously intended, the US President delighted markets on the last day of the year when he advised that he will sign a long-awaited trade agreement with China on 15 January 2020.
When the US Treasury yield curve inverted during May this year before then un-inverting in October, we, like most professional investment managers and advisers, took the signal very seriously following the comprehensive research undertaken by the two Fed economists in 1996, whom we have been quoted at the beginning of this Market View. Based on their key recession prediction signal, the bond market has inverted ten times since 1953 and US recessions followed in nine of those instances, with 1966 the one exception when the Fed managed to somehow get back in front of the yield curve, and keep the growth expansion going!
With the US Treasury yield curve having now un-inverted and no recession having yet occurred, some commentators have suggested that Jay Powell and the Fed have also managed to avert a recession this time, but the resulting curve steepener is the real harbinger of a potential forthcoming recession, which typically occurs between two and six quarters after the original inversion. Based on this history, a recession is highly likely to begin in any quarter of 2020.
We covered the mechanics of the yield curve inversion in the Q1 2019 Market View, and the “curve steepener” occurs when the US Treasury yield curve responds unexpectedly post-inversion if a recession has not yet occurred. This time the Fed’s action of easing monetary policy by reducing interest rates three times during 2019 resulting in the US base interest rate falling from 2.50% to the current 1.75% appears to have been the steepener catalyst.
A steepening yield curve can be a bullish sign for the economy, suggesting that economic growth and inflation are set to rise in coming months. However, the curve steepening is usually a warning sign if the interest rates on US Treasuries of differing maturities have previously inverted as happened in 2019.
Similarly if investors in the US bond market believe a recession has been averted and economic growth is set to continue, then, in theory, the yield or interest rate at the longer end of the curve ought to come down at a similar rate to the short end as more investors sell short dated Treasury holdings (bills) for longer dated ones (notes and bonds), as the interest rates on offer are better. This in turn will push down yields (or interest rates) on longer dated bonds as more and more people buy them.
However, the yields at the long end of the curve have remained stubbornly high resulting in the steepening, as the majority of investors appear to be anticipating a recession and a Fed panic in response, as it is forced to potentially return to a zero interest rate policy (ZIRP). Accordingly, these investors continue to front run the central bank in anticipation of this, by selling at the longer end and buying short dated Treasuries.
Only time will tell whether a recession is on the horizon; being prepared for any eventuality is, however, key to wealth preservation. Another area we shall be watching closely is the notoriously opaque and shadowy offshore eurodollar market. The term eurodollar in this sense does not refer to the foreign exchange market for converting dollars into euros or vice-versa, but to the global reserve currency greenbacks that have been created outside the mainland US, and for which the American policymakers including the Fed appear to have little knowledge of, and even less control over.
There has been endless speculation post the Lehman collapse of 2008 that the dollar would eventually lose its hegemony and cease to be the global reserve currency. The dollar’s primary competitor appeared to be the Chinese yuan as an increasing amount of trade between China and its Asian neighbours as well as many parts of South America and Africa would supposedly migrate to the yuan (potentially backed by, and convertible into gold along the lines of the old dollar gold standard).
The reality as we enter 2020 is very different, and overwhelmingly favours the greenback remaining the most important global currency for the foreseeable future. According to the latest Bank for International Settlements (BIS) triennial survey, the dollar is still used as one side in 88% of all the world’s foreign exchange (FX) transactions. The yuan or renminbi meanwhile accounts for just 4%!
The likely reason the yuan has failed to challenge the dollar as an alternative in trade and FX transactions during the last decade is probably not too dissimilar to why Japan failed to do likewise with the yen in the seventies and eighties, namely the fact that China cannot create enough offshore yuan in the way that dollars have been created for decades via the eurodollar system. This is enormously frustrating for China and its trade partners, particularly in emerging economies as whenever there is a shortage of offshore dollars, the price of the reserve currency spikes upwards, and adversely affects their economies as they desperately seek to acquire more greenbacks for financial and FX transactions etc, often via the Hong Kong market in China’s case.
Data from the BIS shows that “the dollar reigns supreme in FX swaps and forwards. Its share is no less than 90%, and 96% among dealers. Both exceed its share in denominating global trade (about half) or in holdings of official FX reserves (two thirds). In fact, the dollar is the main currency in swaps/forwards against every currency.”
For another country to attain global reserve currency status, they would need to somehow square the circle of Triffin’s Dilemma or Paradox. Economist Robert Triffin during the 1960’s suggested that no national currency would be able to perform essentially two roles: creating enough for the demands of a globalising world, while at the same time maintaining the confidence in it while so much of it was being printed from nothing.
Many market commentators have suggested that the eurodollar system, albeit probably by accident, has solved this problem by operating in the shadows offshore where officially it doesn’t even exist! The eurodollar system conveniently resolved Triffin’s Dilemma by allowing “enough dollars” to be created for a world that needed more and more and more of this intermediating middle currency.
The problem for investors is that the eurodollar market has become increasingly more volatile and unstable since the 2008 credit crisis, with some analysts and strategists even suggesting that the US mortgage subprime crisis was simply a catalyst for an accident waiting to happen as bank lending and inter-dealing ceased completely for a time, because nobody could know for sure what off-balance sheet eurodollar liability counter-party risks they were taking in the markets. The Fed was able to finally resolve the global market’s “plumbing crisis” by injecting enough money to shore up the system through several doses of QE, but the jury remains out as to whether this will be successful the next time the system seizes up, and indeed, there is speculation that the recent repo rate spikes are the continuing symptoms of the same long term problem.
There can be no denying that the shadowy offshore eurodollar market is a potential concern. As the longest economic expansion in US history continues, we are also conscious that unless a genuine new paradigm has somehow been created, then a recession will eventually occur. Were this to coincide with another seizing up of the eurodollar plumbing system that keeps global markets ticking over, a serious equity bear market could ensue.
For now we remain sanguine that the (mainly) encouraging economic data both in the US and elsewhere has at least delayed, if not totally avoided a full blown recession in 2020. However, with a US presidential election at the end of the year, we shall be keeping a watchful eye on political, geopolitical and market developments, and advising on portfolio adjustments as necessary.
With valuations in both US blue chips and many global growth companies at record levels, we shall be looking to gradually shift portfolios into more defensive value sectors of the market. As ever, maintaining liquidity will remain a key consideration when evaluating investment options.
We believe it likely that the regulators will increasingly try to encourage investors to invest a portion of their portfolios into companies that qualify under the environmentally, social and governance (ESG) criteria. We are mindful however, that while there are undoubtedly some attractive opportunities in this sector, there are as always, likely to be many that prove poor value.
During 2019, we saw medium sized UK companies as represented by the FTSE 250 perform better than blue chips, with the index growing around 25%. Smaller companies did not fare as well rising just 15% over the twelve months, however, with Prime Minister Boris Johnson promise to finally end the long running Brexit fiasco on the 31st January 2020, perhaps this will be the year when confidence in British companies, earning most of their revenues here in the UK, might be restored.
Of course a final Brexit settlement will benefit UK companies of all sizes and likely result in sterling being much stronger in 2020, which will somewhat dilute any potential gains from foreign stocks. Accordingly we shall look to have a larger UK representation across any new global funds we invest in and also selectively seek dedicated UK focused funds where appropriate.
We continue to believe that the equity asset class offers investment portfolios the best relative risk reward potential, and in particular value and income stocks. At the same time, we recommend maintaining exposure to other defensive asset classes including fixed income, property (notwithstanding the liquidity issue) and lower risk alternative investment options.
As always, appropriate investment risk is key and, whilst it is often necessary to undertake adjustments in portfolio allocations in order to maintain individual preferences, we are confident that our advised portfolios remain well placed in meeting our clients’ needs. On behalf of all of us here at Ash-Ridge Asset Management, we would like to wish you and your loved ones a Happy, Healthy and Prosperous 2020!
Copyright © Ash-Ridge Asset Management 2nd January 2020.
Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; Hoisington Investment Management; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.
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