Market report November 2019
Trade wars – may trade power be with you
In 2019, global trade of goods and services is likely to increase at the slowest pace in a decade (+ 1.5%). Globally, exporters are likely to lose USD 420 billion. The trade recession affected mainly China (-67 billion USD), Germany (-62 billion USD) and Hong Kong (-50 billion USD), sectorally it is the electronic sector (-212 billion USD), metal sector (-186 billion USD) and energy (- USD 183 billion).
The “mini-agreement” between the US and China, the slowdown in trade in services and the “politicization of the economic scene” in 2020 are rather not a sign of improvement. Software and IT services (US $ 62 billion), agri-food industry (US $ 41 billion) and chemicals (US $ 37 billion), as well as China (US $ 90 billion) and the US (US $ 87 billion) are likely to see the highest trade profits in 2020 (USD 87 billion and USD 90 billion in 2019, respectively). Trade tensions have taken their toll: export profits make up about half of what they accounted for in 2018. In addition, Germany and the United Kingdom may be subject to US car tariffs.
Phantom trade threat
The trade reconstruction shows that several winners appeared in the structure of world trade, gaining a share in the export market to the USA (Vietnam, France, the Netherlands and Taiwan) and China (Malaysia, Singapore, Russia and Saudi Arabia). Meanwhile, phantom trade, where companies send their goods to a third country market (e.g. Taiwan, Japan) before exporting to a trading partner, reveals customs circumvention mechanisms and artificially inflates the value of trade. In the background we observe Trade Tech preparing the card for a new play: e-commerce platforms and blockchain technology are expected to reduce trade-related costs, and 3D printing can change the cross-border production process by shortening global value chains, reducing operational risk but also reducing the value of trade flows.
Present protectionism (around 1,290 new trade barriers introduced in 2019, the number of regional trade agreements signed is about 30% of the number of contracts signed in the previous year, average US tariffs twice as large as compared to 2017) forced countries to tighten their trading arsenals. We identify countries from the group let’s call them vulnerable to trade war (United States, India, Russia, China, France), countries that are vulnerable, but not equipped with an arsenal of pressure instruments (Japan, Mexico, South Africa) and those that are not susceptible and do not have an arsenal (Australia, South Korea). We expect new rules of the game as part of the transition to more sustainable trade (regulation of commercial transport and issues related to carbon dioxide emissions to the environment from traded products). Considering the Border Carbon Adjustment tax (BCA) as the final tariff for EU imports, we estimate that a 1% tariff may result in a loss of USD 7 billion in exports to the EU, affecting exports from Russia, the US and China.
Chart: World trade in goods and services, increase in volume and value (%, y/y)
Source: IHS Markit
The US-China trade truce (the so-called “Phase 1 Agreement” between the US and China) offers only temporary respite for markets and some postponement when tariffs are introduced. From the point of view of the global economy, it introduces nothing new. What’s more, the politicization of the trade scene, the threat of introducing further duties, the unclear situation in the Middle East (threat of conflict), presidential elections in the US are factors that cause market sentiment change and hamper improvement in the medium term.
Investors benefited from good results in all asset classes in 2019. We believe that risky assets remain attractive and that equities should outweigh the bonds, in fact equity valuations remain attractive to bonds measured by risk premiums around the world. The high level of risk aversion is also positive. However, we are aware that political and economic risks may worsen.
Chart: Trade increase in terms of value and prices of goods
Source: IHS Markit
What caused the markets growth?
Growth in the markets was fueled by the hope that, with solving the problems that hampered growth so far, politicians can reverse or alleviate the downward trend: trade tensions in the US, Brexit in the UK and growing geopolitical tensions, to name a few. Central banks have committed to increasing liquidity injections to maintain growth at the right level. Significant in this context are the words of FED president Jerome Powell: “… we will continue activities that will sustain expansion.”
Looking ahead, we believe that changes in uncertainty in relation to investors’ expectations will continue to cause both periodic optimism and pessimism, fueling volatility. There is a risk that political problems will not be solved and the central bank will not stop the economic slowdown. However, in the perspective of 2020, our underlying scenario is some economic growth, which is still a constructive environment for risky assets.
In a multi-variable environment, we believe that a sound strategy is justified. We are neutral in terms of stocks, conservatively positioned in bonds, adding to the portfolio alternatives that we believe can provide ballast and further diversification. The good news is that we are not alone in our cautious views. Investors withdrew $ 60 billion in shares in the third quarter, the most since 2009. In turn, proceeds on bonds amounted to + 118 billion dollars. A high level of risk aversion can be a positive sign for risky assets.
There are also several reasons for optimism. There are some signs of improving Chinese-US trade negotiations. Although we are skeptical that a full and lasting agreement can be reached, any good news can increase business confidence, which in turn can help with capital expenditure. The Brexit resolution is likely to ensure a proportional rise in business sentiment in the UK and Europe.
Central banks around the world have gone into the accommodative phase, with market easing expected by the market. The US Federal Reserve (FED) introduced rate cuts in August and September. The Fed also suspended the quantitative tightening and instead introduced measures to increase the liquidity reserve. In Europe, the European Central Bank reduced rates to -0.5% and resumed the open quantitative easing (QE) program. The Chinese People’s Bank continues to ease its monetary policy, and the Chinese government increased infrastructure spending and reduced taxes to support growth.
Jest też kilka powodów do optymizmu. Istnieją pewne oznaki poprawy relacji chińsko-amerykańskich negocjacji handlowych. Chociaż jesteśmy sceptyczni, że można osiągnąć pełne i trwałe porozumienie, każda dobra wiadomość może zwiększyć zaufanie biznesu, co z kolei może pomóc w wydatkach inwestycyjnych. Rezolucja Brexit prawdopodobnie zapewni proporcjonalny wzrost nastrojów biznesowych w Wielkiej Brytanii i Europie.
Banki centralne na całym świecie przeszły do fazy akomodacyjnej, z oczekiwanym przez rynek dalszym łagodzeniem stosowanej polityki. Rezerwa Federalna USA (FED) wprowadziła obniżki stóp w sierpniu i wrześniu. FED wstrzymał również zaostrzenie ilościowe i zamiast tego wprowadził środki mające na celu zwiększenie rezerwy płynności. W Europie Europejski Bank Centralny obniżył stopy do -0,5% i wznowił otwarty program luzowania ilościowego (QE). Chiński Bank Ludowy nadal łagodzi politykę pieniężną, a rząd Chin zwiększył wydatki na infrastrukturę i obniżył podatki, aby wesprzeć wzrost.
We see more hope that governments will use fiscal leverage to boost growth.
In the United Kingdom, both Conservative and Labor parties are geared to increasing spending, and since 2020 is the year of US presidential elections, there may also be some information about the fiscal front. Both Republicans and Democrats agree on the need to increase investment in infrastructure. In Europe, the next German government may be more open to giving up the “black zero” (legal requirement for budget surpluses), which will enable a more expansive fiscal policy in the euro area. Negative interest rates in Europe give more room for maneuver, because interest costs are part of the structural deficit. If some or all of these measures are implemented effectively, growth should accelerate in 2020. Then the fear of recession will disappear. However, persistent uncertainty will keep investors on the brink and will likely cause continuous bouts of market volatility.
The upward market is relatively narrow, which carries risks.
Another feature of 2019 is the better performance of shares with strong growth characteristics (high long-term earnings growth forecasts) compared to shares with value characteristics (less reliable growth, with less demanding valuations). There are two reasons for this. First, at a time when global growth is weaker, investors are more likely to pay premiums on shares that have good structural growth features because global growth slows down preventing growth in the broad market. Secondly, in times of falling interest rates and profitability, the discount rates used for valuation are also falling. The lower cost of capital means that the current value of future earnings is worth more today (so shares with a high increase in long-term profits justify higher valuations).
What are the implications of this dynamics?
One of the results is that market leadership is narrow – investors mostly have their own sectors and shares that have the characteristics of growth described above, while exposure to cyclical shares remains underweighted. Another is the fact that a higher percentage of returns than usual has been achieved through repeated expansion – investors are valuing a certain amount of company profits higher and higher – not necessarily in the face of an increase in retained or paid by companies profits.
Chart: Components of a total return.
Source: Bloomberg Finance L.P.
This makes the growth shares more sensitive if they are not profitable. It also means that there is a risk of sector rotation if economic growth significantly improves and investors reallocate funds to more cyclical parts of the market.
What should investors expect in the last months of 2019 and the first months of 2020? Are we heading towards recession or are there signs of improvement in economic data? What impact will this have on asset markets?
As the results remain uncertain, we advise you to be cautious until you see real evidence that political uncertainty has disappeared and economic data is improving as a result. Any improvement in production, trade and business investment would be a sign of imminent growth and further development. However, in this scenario, we also bear in mind that any improvement in economic growth may result in an increase in bond yields, which would not be beneficial for long-term positioning. Bonds with longer maturities and lower coupons are most sensitive to such movements.
Conversely, if trade tensions continue and production weakness begins to affect economic services, the risk of recession may increase. Central banks will do everything in their power to prevent this. We must be aware that the global slowdown can have self-regulating negative effects. Is it possible that monetary policy is becoming less effective at the low interest rates we have today?
Given this uncertainty, we like the barbell investment approach, remaining with exposure to market areas that can benefit from recovery or growth improvement, while balancing this exposure with assets that will work well in more turbulent or receding markets. This has different implications for asset classes.
In the case of shares, this means that we will remain close to a neutral, more cautious position in 2020 than this year, but we will still be able to benefit from positive surprises regarding policy and growth. We favor high-quality US growth companies that have achieved very good results, but also maintain exposure to Europe and emerging markets, areas that would be more attractive if trade tensions were resolved and production growth improved.
We are cautious about Great Britain because Brexit and its solution are still unclear. It is possible that we are approaching the final phase of the “Brexit game”, which is why we can consider an increase in exposure to Great Britain, which should take advantage of any reduction in uncertainty and possible fiscal support for the British economy.
Regarding bonds, we are still underweight and we are still favoring investment grade short-term corporate bonds in which we can still find attractive rates of return with less interest rate risk than long-term public debt. This conservative positioning means that we have the flexibility to respond to changes in interest rates if growth and the economic picture in the coming months and quarters improve.
Three segments we currently prefer for exposure to alternatives:
- For commodities, we currently like precious metals that can provide security against political and geopolitical risks;
- Absolute return strategies that have little or no correlation with shares and therefore can offer a solid return with low volatility;
- Asset-backed instruments and funds, which aim to provide a solid income of around 4-5%, can often be protected against inflation by investing in tangible assets.
We believe that these assets may still offer diversifying benefits to customer portfolios at a time when there is both a noticeable fall risk and growth potential for both, bond and equity markets.
Low interest rates in Europe matter, but their impact on individual countries varies.
The current debate about zero and negative interest rates is increasingly focusing on long-term negative effects: inequalities, poverty of an aging society, zombie companies and financial market bubbles.
* We calculate the direct impact of changes in interest rates in the European Union (EU) for each economic sector, using net interest income (interest payments received minus interest payments made) – in particular, we accumulate annual changes since 2008, when the current easing cycle began The European Central Bank (ECB) – until 2018
* The results are surprising: the overall benefit of low interest rates is not equally distributed nor compatible with the North-South divide. The main beneficiaries include not only Spain (+ 16.5% of GDP or EUR 181 billion) and Portugal (+ 10.4% or EUR 19 billion) – as expected – but also the Netherlands (+ 12.7% or EUR 87 billion ) and, to a lesser extent, Italy (+ 5.9% or EUR 99 billion) and Germany (+ 3.9% or EUR 114 billion). On the other hand, Finland (-6.4% or -13 billion EUR), Belgium (-3.0% or -15 billion EUR) and France (-2.9% or -63 billion EUR) lose unexpectedly.
In addition, the development of net interest income varies considerably from sector to sector. Three observations are particularly striking:
- Only non-financial companies consistently use the low interest rate environment. Especially indebted enterprises in Southern Europe have seen particularly large positive effects, from 13.5% of GDP in Portugal (EUR 25 billion) and 18% in Italy (EUR 299 billion) to 34.5% in Spain (EUR 378 billion).
- Not all governments have been able to take advantage of falling interest rates. Rising levels of debt in some countries have absorbed savings from lower interest rates. Germany has improved its (negative) net interest income (+ 6% of GDP or EUR 184 billion) the most because the reduction in interest rates is accompanied by a reduction in debt. At the other end of the spectrum is Spain: its net interest income has fallen by 12.7% (-EUR 138 billion) because public debt has tripled.
- The situation of private households is very heterogeneous. This is caused by changes in behavior, the proportion of households’ savings and debt, and the translation of interest rate cuts on the credit side of households’ financing. All these factors led to German households suffering from low interest rates – 4.2% of GDP (-EUR 123 billion) – while Spanish (+ 14.1% or EUR 153 billion) and Portuguese households (+ 20% or EUR 36 billion) benefited the most.
A few words about what is already included in the long-term yields of US Treasury bonds.
Long-term nominal bond income reflects expectations about future interest rates. However, regardless of whether these expectations are adaptive or rational, the matter is centered on looking to the past or the future. Although there is solid evidence that long-term adaptation expectations come first, it appears that short-term rational expectations contribute to fluctuations around the trend.
We are in the phase of analyzing a model that combines these two types of expectations and allows us to assess what is already valued in long-term bond yields. As at November 26, the estimated fair value of 10-year US Treasury bonds is 1.79%. The analyzed model shows that 0.62% of this amount comes from the current federal funds rate, 1.24% from its perceived value and -0.07% from the expected short-term change (against -0.50% at the beginning of September). In other words, long-term adaptation expectations about interest rates maintain short-term expectations on a leash. This was evident in early September, when the US bond market heard rumors that rate cuts were coming, and then sold news when the FOMC actually lowered the federal funds target. Expectations for subsequent FOMC moves are now suppressed. From the valuation point of view, the model confirms that the distribution of potential portfolio results is not currently skewed enough to justify aggressive positioning of portfolios in terms of duration.
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The views expressed in this document do not constitute research, are not investment or commercial advice and do not necessarily reflect the views of all management teams. They change over time.