Multi-Asset

There’s politics and then there’s everything else

We believe the direct market impact from impeachment is low but the secondary implications could cascade into trade discussions and the 2020 election field.
October 2019

Politics upstaged the global economy, monetary policy and even trade tensions late in the third quarter as House Democrats began an impeachment inquiry against President Trump. The inquiry followed a whistleblower complaint concerning phone calls between Trump and Ukrainian President Volodymyr Zelensky. These proceedings are likely to dominate the U.S. media, consume Washington and seriously impede progress on bipartisan legislation, but we expect the immediate effects on financial markets to be less dramatic.

Other storylines remain relevant even if they are elbowed out of the spotlight by political drama. As we note below, the U.S. economy has showed resiliency despite the slowdown in global growth, a trade war with China and a volatile political environment. We expect this dynamic to continue and have maintained our overweight to U.S. equities as a result.

Slowing global growth: Should we be scared yet?

The specter of recession continued to haunt investors in the third quarter as economic growth indicators weakened further. Survey data showed manufacturing slowing across multiple economies including Europe, the U.S. and emerging markets. In September, the Organization for Economic Cooperation and Development downgraded its expectations for global growth across the G20 countries and emerging markets to the lowest levels since the financial crisis. China’s fiscal stimulus, slowly rolled out over the last year, has not improved the situation as many had hoped, with manufacturing there continuing to contract and the economy slowing further.

Yet the U.S. economy showed resiliency in this environment, in part because of the large role played by consumer spending. Though President Trump has promised to restore America’s prominence as a manufacturer, the reality is that manufacturing currently accounts for a relatively small percentage (~11%) of U.S. output compared to countries like Germany (~30%). Consumption drives growth in the U.S., and U.S. consumer spending remains strong.

Contribution to percent change in real GDP

Source: Bureau of Economic Analysis

In addition, purchasing managers’ indexes in the U.S. service sector have held up well, as they are less vulnerable to trade tensions versus the manufacturing sector. With the housing market showing signs of life due in part to lower mortgage rates, we expect U.S. leadership of the global economy to continue. U.S. resiliency supports our position that fears of a major recession are overdone.

U.S. housing starts

Source: U.S. Census Bureau

The Fed hedges while the ECB goes all in

In September, the Federal Reserve (Fed) cut interest rates for the second time this year. In an effort to temper market reaction to the cut, the much-maligned phrase “mid-cycle adjustment” was removed from the Fed’s official statement, though the commitment to “sustain the expansion” remained. While the immediate response of the market was more muted, investors remain divided on interpreting the latter comment, with a majority still anticipating two more cuts this year. The Fed itself is increasingly fractured, with dissenters to the 25-basis-point September cut coming from both hawkish and dovish perspectives. In part to illustrate the challenges in the current environment, Chairman Powell alluded to the Fed’s laundry list of “reaction” functions, or global crosscurrents to which the central bank responds. Some of these external factors are driving dissent within the Fed, as some members are more concerned about Brexit risk and the manufacturing slowdown in Europe. Our expectation is that the Fed will be a bit more U.S.-data dependent in the fourth quarter, with just one more rate cut unless U.S. indicators take a sharp negative turn.

Our expectation is that the Fed will be a bit more U.S.-data dependent in the fourth quarter, with just one more rate cut unless U.S. indicators take a sharp negative turn.

Meanwhile, the European Central Bank (ECB) held little back in Mario Draghi’s swan song as ECB president, announcing new quantitative easing, a cut to its main deposit rate and a tiered rate system to help banks whose profits have been pinched by low interest rates. Emptying the toolkit surely made it easier for Draghi to urge Europe’s governments to enact fiscal stimulus. His successor, Christine Lagarde, is also on the record calling for fiscal stimulus. We expect Lagarde to continue along the monetary-policy path Draghi has established; however, fiscal easing does not appear imminent from the eurozone. Germany appears the most logical source of fiscal stimulus due to their struggling economy coinciding with a fiscal surplus. However, Angela Merkel and her centrist coalition have proposed only mildly stimulative measures primarily focused on green energy projects and minor tax cuts. Contrary to the wishes of Mr. Draghi and Ms. Lagarde, it will likely take a deeper downturn before larger-scale fiscal stimulus comes to the eurozone.

Percent of global negative yielding debt

Percent of global negative yielding debt

Source: Bloomberg

U.S. politics: Halloween horror show or just the usual circus?

The probability of impeachment spiked toward the end of the quarter as details around President Trump’s call with the Ukrainian president hit the headlines. We expect impeachment hearings to bring Congress to a virtual standstill, with the parties polarized and unlikely to pass bipartisan legislation during the coming months. We believe the direct market impact from impeachment is low but the secondary implications could cascade into trade discussions and the 2020 election field.

Odds of President Trump impeachment in 2019

Odds of President Trump impeachment in 2019

Source: PredictIt

Trade: Roadwork ahead but at least the car is moving

The U.S.-China trade war continues to loom over markets and the global economy. Market participants seem so anxious for progress that they continue to overreact to any developments. This has led to a volatile environment in which streaks of clarity alternate with a cloudier picture. In August, both countries were in a retaliatory mood and announced new rounds of tariffs. Then China dialed back the rhetoric and announced a desire to collaborate with a “calm attitude.” In September, the U.S. exempted a slew of Chinese goods from tariffs imposed in 2018 as the Trump administration acceded to exclusion requests from U.S. entities. The administration continues, however, to play a high-risk game with tariffs as the effects of the policy creep closer to U.S. consumers. As we noted above, consumer spending drives U.S. growth and is one of the few remaining bright spots in the global economy. Despite positive signs such as the tariff exemptions and China’s agreement to increase agricultural purchases, we do not yet see any genuine progress toward resolving the significant points of contention between the two countries such as intellectual property issues and forced technology transfer. Our base case remains further de-escalation ahead of the 2020 U.S. election but with little progress toward a large-scale deal that would address these issues.

While the heavyweight fight between the world’s two largest economies continues to dominate the headlines, some other trade policy areas progressed in a more positive manner. There was genuine momentum behind the effort to ratify the U.S.-Mexico-Canada (USMCA) trade agreement in the U.S. and Canada, though the odds of near-term U.S. passage fell as impeachment gripped Washington. Risks around U.S.-European trade tensions remain in the market — in particular around auto tariffs — but notably both sides have carefully avoided escalation over the prior months.

An in-person meeting between President Trump and Indian Prime Minister Narendra Modi at the end of September also brought some optimism for progress on trade policy. A smaller-scale deal with India, perhaps focused mostly on agricultural products, would help the Trump administration argue that it is taking the steps necessary to eventually reach large-scale deals (i.e., in a second term).

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Positioning

In the third quarter, we removed our underweight duration position as the team’s expectations for Fed rate cuts have shifted closer to market consensus. Combined with slowing economic growth, recession fears, a lack of inflationary pressures and trade tensions, the Fed’s actions have made cash less attractive and provided support for core fixed income. In terms of equities, we remain underweight international developed market stocks due in part to weak manufacturing data and Brexit uncertainty. It is difficult to see a rebound for these markets in the near term. We expect U.S. equity earnings to strengthen over the remainder of the year and exceed consensus expectations, which have set a relatively low bar. An accommodative Fed and strong consumer further support our overweight to U.S. equities.

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Purchasing managers’ indexes (PMIs) are based on monthly surveys sent to senior executives at companies in key industries. The surveys include questions regarding business conditions and whether conditions are improving, deteriorating or holding steady.

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