Market Outlook

Policy Reversals: Are They Enough?

Mid Quarter Update

By Francis A. Scotland, Director of Global Macro Research
12 September, 2019
Will the most recent policy changes from central banks turn the tide on global growth?

Q: From trade to Brexit, there’s a lot of issues hanging over markets now. Can you update us on your macro outlook, starting with a quick review of the past, in order to put some of these events into context?

A: With all the recent market turbulence it's important to stay focused on the main drivers of capital market trends – global growth and global equity. What's really striking about the most recent macro profile has been the prolonged economic slowdown in the global economy since early 2018. If we use the purchasing managers index as our metric, this has been the longest successive decline since the Great Financial Crisis (GFC) of 2007-2009.
Source: Macrobond (© 2019, Macrobond). Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
In this particular index the global PMI composite has been declining since February of 2018; manufacturing PMI has been in decline since December of 2017 and is now below 50, which would indicate a manufacturing recession.

What I've emphasized in previous outlooks is that the driving factors behind this slowdown have been principally driven by policy. Beginning in 2018, the Federal Reserve tried to normalize interest rates and went too far too fast. A lot of the volatility in the fourth quarter of 2018 was associated with Fed Chair Powell's statement that he believed that the neutral rate was significantly higher than prevailing interest rates. We thought that was a major policy mistake and we still believe the federal funds rate is above our sense of where the neutral rate is.

The second major policy issue involves China. The Chinese reversed course; they'd been stimulating quite aggressively in 2015-2016 and they switched back to focusing on deleveraging. They controlled shadow bank lending, the credit impulse went negative in 2017 and started to really fall sharply in 2018. Even now M1 growth is low. Producer Price Inflation is back below zero.
Sources of the above three charts: Macrobond  (© 2019, Macrobond), Peoples Bank of China, as of 7/31/2019 Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
China is probably the biggest source of beta and global growth. So this slowdown in Chinese economic growth has had a really significant impact on global economic growth.

And the third factor, of course, is the trade war. The trade war has fostered a lack of confidence among business, it's created disruptions in global supply chains and has generally undermined or created a lot of business uncertainty, which manifests mostly in manufacturing and trade.

Q: We’ve had other slowdowns since the 2008-2009 crisis, but those didn’t escalate into a full-blown recession.  Why is there so much concern this time around?

A: This is the third global growth slump that we've seen since the Great Financial Crisis. The first one, in 2012-2013 was associated with the European sovereign debt crisis. The second, in 2015-16 was associated with Chinese deleveraging, the rally in the dollar and the global commodity bust.
Source: Macrobond  (© 2019, Macrobond), annotations by Brandywine Global. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
What got us out of these slumps and created the rising economic momentum following these cycles was a combination of an auto-correcting mechanism in the market and significant policy stimulus.
Source: Macrobond  (© 2019, Macrobond), annotations by Brandywine Global. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
As this chart shows, after the first two down cycles we had the fairly significant rally in bonds, and with a lag of maybe a year and a half to two years, the decline in yields helped support a rebound in the global economy. That in combination with policy stimulus gave us the rebound.
Source: Macrobond  (© 2019, Macrobond), annotations by Brandywine Global. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
In 2012-2013 we had open-ended quantitative easing from the Federal Reserve. We had “Abenomics”, we had European Central Bank (ECB) President Mario Draghi saying he would do “whatever it takes”, and we had a large Chinese credit impulse coming. Then, in 2015-16 we had another major credit and fiscal impulse come out of China. The Federal Reserve went on ice and stopped raising interest rates and we had the European Central Bank embrace large scale asset purchases.

Q: So this time around we’ve had another plunge in global yields, the Fed has retreated from last year’s hawkishness, and other related other policy changes. Isn’t that enough to reverse the current trajectory in the global economy?

A: The problem this time around is so far the comparable moves have been small in scale. Comparing the decline in bond yields with the previous two cycles, the scale of the current move has been too small and too early to expect much of a reflationary response in the global economy. And secondly on the policy front, the Fed's so-called dovish pivot which so far has amounted to one rate cut and suspension of the balance sheet tightening is still lagging behind the economic cycle.
For the two charts above: Source: Macrobond  (© 2019, Macrobond), annotations by Brandywine Global. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
For the U.S. leading economic indicator (LEI), the growth ratehas been slowing now for several months and the level of the index has been flattened over the last couple of months.

And based on current data, the LEI could actually go negative as early as this month, August. And if we look at the Federal Reserve of New York's probability of recession indicator, which is derived from the yield curve, that has now reached a level which in the past has coincided with an economic recession.
Source: Macrobond  (© 2019, Macrobond), annotations by Brandywine Global. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
So what that yield curve is telegraphing is the Federal Reserve needs to cut interest rates significantly and the money market curve is predicting that short term interest rates will be 100 basis points lower by this time next year.  For the Federal Reserve to move that aggressively they would most likely require a need for either some combination of financial market turbulence,  or a start to seeing some weakness in the labor market. So far the labor market looks fairly steady, but a couple of early indicators are warning that there may be some loss of momentum starting to build there as well.

Secondly, the Chinese have undertaken a lot of policy initiatives, including the combined influence on the credit impulse and property sales, which are the primary conduit through which Chinese savings make their way into the Chinese economy.
Source: Macrobond  (© 2019, Macrobond), annotations by Brandywine Global. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
By comparison with the previous two cycles, shadow bank lending continues to contract. Some of the bank failures that we've been reading about recently are related to this contraction. The Chinese stock market has been a great coincident indicator momentum in the Chinese economy over the last couple of years. But since March, both the stock market has been falling and the economy weakening as stimulus measures have been reduced.

And the third factor of course which has weighed on global growth this time around has been the trade war. There's been no improvement, there's been only escalation. The most recent escalation came on August 1st with President Trump's tweet that an additional 300 billion dollars of Chinese imports would be targeted with a 10 percent tariff on September 1st. That was followed by the U.S. Treasury Department designating China as a currency manipulator a few days later. All of this has conjured up the impression of an all out trade war reminiscent of the Smoot-Hawley tarrifs, which played out in the 1930s and which many financial historians believe contributed to the Great Depression of that era.

Q: Where do things currently stand?

A: Capital markets have reached pretty critical levels in recent days. We really are at a fork in the road. If we look at the level of European bank stocks they're now starting to sink below levels which contained this index since the Great Financial Crisis.

If we look at the price of copper, an industrial commodity which has done a pretty good job of tracking the ebb and flow of the global economy it's back to where it was in 2016.

If we look at the break even inflation rates in the United States they're breaking to new lows. If we look at the global bond market, bond yields have plunged in recent weeks. Some of that in response to President Trump's latest tweets, which have escalated the trade war but more generally the global bond market is reacting in sympathy with the global economic cycle.

If we want to expect to see stabilization of global bond yields, we need to start to look for stabilization in the global economic cycle. We're at a fork in the road – we either get enough policy stimulus to pave the way for slow but sustainable economic growth and a global soft landing or we don't. And if we don’t, we get something worse – a global economic recession.

Q: How does this affect your outlook for global markets and the economy?

A: There's already a lot of economic pessimism built into asset prices. Stocks are generally holding a bid, but the equity risk premium is rising as bond yields tank. The bond market is projecting a pretty pessimistic economic outlook, but at the same time projecting enough policy stimulus in order to avoid an absolute contraction in the economy and an absolute contraction in earnings.

So, for the moment we're on the same page. Our expectation is there's going to be a significant amount of stimulus come through the pipeline over the course of the next six to nine months; that'll be enough to achieve a soft landing. That’ what seems to be the view embedded in in asset prices as well, judging from the U.S. money market curve and the recent breakout of the price of gold.

So if we look at a number of objective indicators there's clearly an interest rate easing cycle that has started around the world. In countries like Brazil, India, Thailand, parts of Latin America, Australia, and New Zealand there have already been cuts in interest rates. The Federal Reserve has cut interest rates by 25 basis points. As I've already said we expect more to come. The European Central Bank is preparing a large package of extra stimulus. We've got the People's Bank of China as well as the Bank of Japan making public statements about new stimulus measures.

If we look at global M0 and M1 one measured in U.S. dollars, there’s clearly been an inflection.

In general, China's approach to stimulus has been successive approximation via selective measures. They still have tremendous firepower available to them if they wish to take additional steps.

[On the trade front, the latest iteration was when the White House announced that some portion of the 300 billion Chinese imports that had been designated for a 10 percent tariffs in September might be deferred until later in December, while at the same time announcing new negotiations.]

In the United States we know that the White House is very sensitive to what happens in the stock market and the economic outlook. And we know that the odds of President Trump being re-elected in the November 2020 elections would be a lot lower if the economy is in a recession or in bad shape.

Our base case is that we think enough policy stimulus is going to come through between now and early 2020 to produce a global soft-slow-but a global soft landing for the end of the year.

Definitions:

Credit Impulse is defined as the change in new credit issued as a percent of gross domestic product (GDP).

Shadow banking refers to financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight.

M0 and M1 are measures of the supply of money in an economy. Each country’s central bank may use its own definitions of what constitutes money for its purposes. M0 often refers to the amount of physical cash (bills, coins), while M1 includes M0 along with checking account balances. Both are also called narrow money.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The federal funds rate (fed funds rate, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.

Purchasing Managers Indexes (PMI) measure the manufacturing and services sectors in an economy, based on survey data collected from a representative panel of manufacturing and services firms. PMI greater than 50 indicated economic expansion; below 50, contraction.

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