Back to school – cram session for the year

The trouble with trying to predict the markets is that the markets are never perfectly predictable. Rather, what we do as the Capital Markets Strategy team at Manulife is try to assess the environment and spot the direction or trend of the markets, identify the risk/reward balance and assess the relative opportunity set – no easy task. To put it bluntly, we try to answer the question – “How do we make money?” It doesn’t happen often, but sometimes, the answer is – “Don’t lose any.” That is what it feels like today.

I have been in the business over 25 years now. I have seen a number of cycles. I have learned a lot – that is to say that I continue to realize that when it comes to the markets the learning never really stops. And I have learned that when all else fails, when the uncertainty feels overwhelming, when there are so many opinions and we start to hear the words, “but this time it’s different,” go back to the basic principles, they rarely steer you wrong. To that end, and to answer the question of what might the investing future hold, we return once again, to the fundamentals to provide the answer.

Global economic conditions continued to deteriorate during the summer months following a slow descent from the peak of the current economic cycle which came early last year. Global central banks having increased interest rates during 2017 and 2018 along with the impact of the ongoing trade dispute between the world’s two largest economies have been the leading cause of the economic slowdown in our opinion. Moving forward, global central banks have pivoted and are in the process of easing credit conditions leaving “trade war” uncertainty as the single largest headwind for the global economy.

What started off in July 2018 with tariffs on a small US$34 billion dollars of Chinese exports into the U.S. has transitioned very quickly to the potential of tariffs on all goods traded between the two economies. In September, the U.S. and China implemented new tariffs on each other escalating the trade war to include, for the first time, a direct impact on the U.S. consumer. Several leading thinktanks have estimated the increase cost to the average American household to be US$1,000 per year.

The challenge is that there is no quick solution especially given that the tone surrounding the negotiations is constantly changing. In the meantime, the tariffs implemented continue to hamper not only the economies of China and the United States, but also Germany, South Korea and Japan that are major trading partners of both. Putting this all together, when we look at the entire fundamental landscape, it is hard for us to be enthusiastic in regard to adding risk in our asset allocation. Below, we highlight some of our thoughts.

We use the JPMorgan Global Manufacturing Purchasing Managers Index (PMI) as an easy gauge of global economic health. And what we are seeing on this front is continued deterioration since the beginning of last year. Globally, manufacturing activity peaked in December 2017 and has slowed materially over the past year and a half.

The JPMorgan Global Manufacturing PMI is a composite index that compiles surveys of prominent manufacturing company executives from across the world. The survey includes a series of questions including hiring expectations, prices, orders from customers and order backlogs, as well as current levels of activity. The responses are limited to a scale of “higher,” “lower” or “the same” for each question. An index reading of 50 indicates no change and levels above 50 indicate an increasing pace of business. The most recent PMI figures indicate that global manufacturing growth continued to slow in August largely reflecting the impact of the United States and China’s trade dispute and its impact on global trade flows.

The headline JPMorgan Global Manufacturing PMI fell further into contraction in August registering 49.5. Global trade volumes highlight this weakness which fell 1.4 per cent in June from a year earlier - it was the single biggest drop since the last recession. This measure tells us that U.S./China trade issues are not isolated to those economies, but given their size and breadth, weakness in those economies will impact global trade volumes. Copper prices which are often viewed as a measure of the health of the global economy have fallen nearly 14% in the past six months. 

No longer are investors overlooking the threat posed by the U.S.-China trade war on the U.S. economy. The U.S. economy grew at 2.1% in the second quarter of 2019 but looking underneath the hood reveals the impacts of the tariffs. Exports slumped 5.2% for the quarter and nonresidential investment, a key metric for business spending, dropped 0.6% for its worst showing since early 2016. According the PWC’s 2019 CEO survey, American CEOs are becoming less optimistic. For 2019 – 30% of CEOs are projecting a decline in global economic growth, up from only 5% last year. With an increasingly uncertain trade environment, this shouldn’t come as a surprise. Policy Uncertainty, Trade Conflicts and Protectionism were ranked 2, 4 and 7 for the Top 10 threats viewed by American executives.

Several of the metrics that we follow closely have shown a deterioration in the underlying fundamentals in the United States. For example, the Chicago Fed National Activity Index (CFNAI) is a weighted average of 85 existing monthly indicators of national economic activity. As the chart below shows when the CFNAI-MA3 value moves below -0.70 following a period of economic expansion, there is an increasing likelihood that a recession has begun. Conversely, when the CFNAI-MA3 value moves above -0.70 following a period of economic contraction, there is an increasing likelihood that a recession has ended. As of the end of July, the index was -0.26 which highlights the slowing of the U.S. economy.

Another metric that we follow is U.S. Leading Economic Indicators. The index consists of 10 economic components whose changes tend to precede changes in the overall economy including average weekly manufacturing hours, number of new building permits, and consumer sentiment to name a few. As of July, the LEIs registered 1.6, the lowest level in two and a half years. Since 1970, a recession occurs on average six months after the LEIs became negative. A measure of U.S. manufacturing released by the Institute for Supply Management showed U.S. manufacturing contracted in August with a reading of 49.1 (anything reading below 50 indicates contraction). This was the first reading below 50 since 2016.

In our January note, Travel with caution, not fear, we highlighted our view of increased recession risk probability for the US economy at 30% for 2019 and into 2020. However, we did hold that the recessionary risks could increase on the potential for a policy mistake, not by the Federal Reserve, but rather by the current administration. Rising political tensions between the U.S. and China fit that bill, and in our view, have increase the probability for greater global economic weakness through the back half of 2019.

The only thing we can be certain of in this life is that we can be certain of nothing.

— Albert Einstein

While the 10yr/3mth yield curve has been inverted for a few months, we tend to focus on the 10yr/2yr yield curve which only inverted briefly . The yield curve is a much better indicator of a recession once it has inverted for three consecutive months. In 1998 and 2006, the 10/2 year yield curve inverted. However, it proved to be inverted for less than three months which ended up providing a false signal of an upcoming recession. Once it has inverted for more than three months, recession and market peaks typically occur 15 and 11 months after the initial inversion. The key question is whether this metric will be as reliable this time around given the unprecedented amounts of central bank intervention which has resulted record amounts of negative yielding bonds. There are roughly US$13 trillion dollars’ worth of global bonds that are negative yielding. Only 10% of all global bonds are yielding more than three percent. In Europe, 99% of all investment grade bonds are yielding less than three percent with approximately 42% with a negative yield. Perhaps this has driven international fixed income flows into the United States given their relative yield attractiveness exacerbating the flattening of the U.S term structure. Despite some influence on the US yield curve from outside forces, we do not believe that we should dismiss it a caution signal. Although we recognize that negative global yields may be influencing interest rates in the United States, we continue to believe that the bond market is effective in pricing the risks to growth until it is proven otherwise.

It is important to remember that today’s global economic conditions didn’t just happen. This has been an evolution and accumulation of macro-economic risks over the course of the year. The reasons for the risk build-up have been many. In part, it is political policy. In part, perhaps it is simply that the current expansion may have run its course. And perhaps it is other factors not yet realized. Regardless of the reasons, it is important to take a look back and see how much things have changed, and in some cases how they haven’t today vs six months ago, and consider what it might mean for the economy and markets to the end of 2019 and into 2020.

Not everything is trending in the wrong direction in the United States. The U.S. unemployment rate is 3.7%, incomes have been growing, and consumer confidence remains strong. The narrative regarding the economy has recently revolved around the fact that the U.S. economy can stave off recession on the back of a stronger consumer. We agree. The U.S. consumer, as measured by a number of indicators above, remains quite strong, and is the bright spot in an otherwise lackluster global economy.

We would also suggest that the consumer can be influenced by the macro forces. And strong confidence today can give way to weakness that would fail to provide the backstop that the US economy needs. Historically a significant drop in confidence, as measured by the University of Michigan Consumer Sentiment Index, has led to a drop in consumption. Today however, consumption growth year-over-year is already trending near the 5-year low at 2.5% year over year. A shock to sentiment may send an already tepid consumption rate even lower. What might shatter consumer confidence you ask? Oh, say perhaps a trade war between the world’s two largest economies in the world being played out in the Twitter-verse.

The bond markets have been pricing in greater risk while the equity markets have remained somewhat complacent to the global economic environment. We would say the equity markets have also remained complacent to the earnings environment. The second quarter earnings season is coming to a conclusion and as the chart below illustrates, the trend is clear with a slowdown in both revenue and earnings relative to last year across the world.

We don’t believe investors are fully appreciating the change in the earnings growth rate globally for the current quarter on a year-over-year basis and more importantly where we are headed. We can only assume that increased trade tensions will lead to lower demand and manufacturing; and will only have a negative effect on the forward earnings outlook. Having the equity markets move higher on weaker earnings growth isn’t often the highest quality market gains. Call us old fashioned but we prefer the majority of our equity market gains to come because companies are generating higher profits.

Across a number of macro indicators the recent trend has been weaker: manufacturing, new orders, exports, copper prices, earnings, etc. From the manufacturing side globally, manufacturing activity peaked in December 2017 with the JPMorgan Global Purchasing Manager’s Index (PMI) reaching 54.5 (an index level above 50 indicates expansion). As of August the global PMI has fallen into contraction at 49.5. Another indicator of the health of the manufacturing economy that we pay attention to is the price of copper. It is the old adage of “Dr. Copper” and the red metal’s ability to foreshadow changes in the global economy. Over the last six months copper prices have fallen 14%. This would also coincide with what we are seeing in terms of the New Orders and Backlog of New Orders component of the Institute for Supply Management Purchasing Manager’s Index at 47.2 and 46.3 respectively. Our work suggests, as the chart below highlights, that the headline Institute for Supply Management Index leads S&P 500 earnings by approximately 6 months. July’s headline reading of 49.1 indicates flat to slightly negative earnings growth for the S&P 500 leading into the second quarter of 2020. Business is slowing and given the trade uncertainty it may be a while yet before we see a bottom.

Internationally, we expect similar weakness in earnings. A reliable predictor for MSCI World Earnings Growth is the three-month moving average in semi-conductor sales. Given that the United States and China are two of the larger users of semi-conductors, their current trade dispute is also impacting South Korea, Taiwan and Japan. It’s not hard to envision how a continued trade spat will continue to drag down semi-conductor sales.

About seven years ago, our team went looking for a reliable predictor for both U.S. corporate earnings and MSCI EAFE earnings and we found it in an unlikely place, some 7,000 miles away in South Korea. What we found was that earnings closely track the path of South Korea’s exports, going back as far as two decades. Why such a strong relationship? South Korea is a good bellwether for the global economy. Case in point, Korea’s exports dipped in late 2014 to early 2015, suggesting that the global economy was losing its momentum. South Korea’s gross domestic product is the 11th-biggest in the world, with exports accounting for roughly 25%. The critical role that exports play in the country’s economy also gives South Korea an outsized role in international trade. In 2017, South Korea’s exports totaled US$577.4 billion. But it’s not just sheer volume that makes it a weather vane for international commerce. It is diversity as well as the importance of its trading partners — about 60% of its exports are to the four largest economies in the world. Its manufacturing sector is also an essential part of the global production chain and it supplies key parts that go into finished goods exported by other countries, such as China. The current data would suggest that future earnings will continue along with the weakness seen in South Korea exports. 

Canada will not be spared by a weaker earnings outlook. Historically, the S&P / TSX earnings growth is tied closely to the price of energy. As of time of writing, oil as measured by WTI (West Texas Intermediate) is approximately $55. At $55 which is our base case for oil for the remainder of the year, S&P TSX earnings will be flat to negative.

A potential sign of weaker earnings ahead may be the selling of shares by U.S. executives. Corporate insiders sold an average of US$600 million of stock per day in August. August was the fifth month of the year in which insider selling topped US$10 billion. The only other times that has happened was 2006 and 2007, the period before the last bear market in stocks. It may not be fair to compare today with 2007 since the market capitalization today is much larger, but we believe selling of shares is indicative of concerns by executives of obstacles faced by corporate America moving forward. Another sign of corporate Americas lack of confidence is share buybacks. U.S. companies announced US$2 billion of buybacks per day during earnings season, that's the weakest pace in two years. Completed buybacks by S&P 500 companies declined 13% during the second quarter to US$165.7 billion. However, buybacks remain above the pace of 2017, the final year before the Republican tax law that created a huge windfall for companies. We believe that the amount of insider selling and the decline in share buybacks is reflective of the uncertainty that lies ahead for U.S. corporations.

With profit margins rolling off historically high levels and a buildup of inventories over the past couple of quarters while manufacturing has slowed, it is likely that earnings growth and profit margins have peaked for this cycle. Additionally, our work would suggest that the contributing factors to a change in profit margins are output volume, wage growth and credit costs. While interest rate cuts would support profit margins the gains in wages and declines in production volumes would suggest overall downward pressure on margins. The flat trend in profits and the long slide in margins have important economic consequences as both have always preceded recessions in years past. We continue to believe the odds of a recession are low but the profit and margin data shows how vulnerable the economy is at the present time, especially with business leverage at record highs. President Trump’s federal tax law change helped boost year over year profits and cash flow on an after-tax basis but this was a one-time benefit, and going forward operating earnings on the bottom line should track the top line.

Another interesting bit of information is that S&P 500 earnings are reported on an after-tax basis and are presented on a per share basis. Not only did the federal tax law provide a large boost to after-tax earnings, but also companies used the tax windfall to buy back stock (nearly US$1.2 trillion since the new tax law went into effect). According to various estimates the outstanding share count for the S&P 500 declined by over 5% in the past 12 months or so. The reduction in the share count made the year-on-year earnings per share gains paint a more optimistic picture. With the benefit of the tax reduction in the rear-view mirror and corporate buybacks slowing S&P earnings will now be more aligned with the current state of the economy. That creates the potential for an increasing number of corporate earnings reports disappointing relative to market expectations given the continued slowdown of the U.S. economy. Also, of interest is that the new tax law limits the deductibility on corporate debt—increasing the effective cost of interest payments despite low interest rates. That is likely to put an additional strain on highly leveraged businesses. A "true" earnings recession appears to be in train, with the potential to trigger cuts in investment, inventories, employment and then consumer spending. That’s the standard sequence of events following a downturn in corporate profits.

As the charts below illustrate, valuations today, based on trailing price/earnings ratio, remind us of a goldilocks environment where it’s not too hot nor too cold. Despite markets being close to all-time highs, valuations are not stretched. With the exception of the United States and MSCI Asia x Japan, which are perhaps fairly valued, all major investable regions in the world are trading below their five-year averages. Herein lies the challenge facing investors today looking solely at valuations. We have clear signs that the global growth environment is slowing and it’s having an impact on company earnings. As such, we believe valuations today do not compensate us enough for the risks given the current weakness in global fundamentals and earnings.

As we return to the fundamentals we ask ourselves, over the next twelve months, is the destination worth the journey? Is the reward, worth the risk? Over the long-term we acknowledge that stocks have outperformed bonds. And this is likely going to be the case over the next 20 years. However, we also have to acknowledge that if the return over the next 6-12 months isn’t worth the risk, then why take the risk? Perhaps it would be better to respect what the fundamentals are telling us, and pare back some risk for a better day. This is where our defense comes in.

One of my favourite sayings (and one that I am sure my children are sick of) is that it is better to have something and not need it than to need it and not have it. When it comes to leaning more defensively within our portfolios today, while I hope we don’t need it, I will be glad to have it should the need arise. To that end, we continue to emphasize a balanced approach to asset allocation with a skew to the defensive until better clarity, greater certainty, and an improved opportunity set arises.