New article from Tatton Investment Management: Recession concerns retreat

11 November 2019

Equity markets were in a good mood this week. That is in no small part due to progress in US‑China trade negotiations, in which both sides agreed to the removal of already imposed tariffs in a number of phases. Donald Trump’s trade war against China is among the biggest concerns for global investors (even more so than the all-encompassing Brexit drama here). It seems that recent weakness in the Chinese economy (and possible electoral weakness for the Trump administration) has made a compromise necessary. And as we have written before, with a sluggish global economic backdrop, a positive outcome on trade between the world’s two largest economies will be vital for the health of markets and the economy going forward. Investors are well within their rights to have a little optimism then, albeit with a dash of caution. We discuss this in more depth in a separate article this week.

Sentiment is also being buoyed by a potential turnaround in manufacturing, with new orders showing a recovery from the lows they sank to this year. Not all manufacturers are positive though, with the autos sector still getting to grips with overcapacity in inventories. Peugeot and Fiat have pledged not to close factories in their upcoming merger, but the combined group is expected to have spare production capacity of almost six million vehicles amid slowing demand. We devote another article this week to manufacturers and business sentiment.

Where there certainly seems to be an improvement is in financials. Banks have done well recently, buoyed by optimism over the economic outlook for 2020. That optimism is partly due to resurgent demand for capital in corporate bond markets. This week, the funds raised for European corporate bonds hit €1.28 trillion – the highest ever yearly record. And we still have five weeks of activity left this year. The Bloomberg Barclays Global Corporate Aggregate has been rapidly increasing throughout the year, but the cash has mostly been sitting on the side-lines. With sentiment improving, the likelihood of that cash being put to work in actual investment – to the benefit of the global economy – is high.

What’s more, the demand for capital is strong. That suggests businesses believe there are enough opportunities for profit out there. It may also mean the era of extraordinarily low cost of debt capital is coming to an end. While short maturity yields have remained relatively stable (on the basis that central bank policies will remain accommodative – leaving rates low - even if growth picks up), long maturity yields have risen sharply this week in all developed markets. In the US, the 10-year
 

 
yield has gone back to almost 2%, a rise of 0.5% since the beginning of September. Yield curves – the difference (spread) between government bond yields at different lengths of maturity – are steepening into unambiguously positive slopes. This is a good sign, as the inverted yield curves we saw during the summer suggested a recession could be on the cards. Analysts often use the shape of the yield curve as an indicator of recession probability, and according to JP Morgan Research, on that basis the probability of a US recession in the next 12 months has dropped below
 
 
50%. As the chart above shows, it now matches the probability of recession based on actual economic indicators. Unfortunately, both are still a little too high for comfort.

However, if we take stock markets as our guide, things look a lot calmer. This reflects the improving sentiment we have witnessed in equity markets. Of course, stock markets are not always a good guide to the actual economy. As you can see, market-derived recession probability spiked to over 70% at the beginning of the year; no recession was forthcoming. Markets now are betting that things will improve next year. We happen to agree with them. But current equity levels already have a lot of improvement priced in. At lower levels a month ago, risk markets were resilient to a run of bad news. Now, they need the data to improve just to hold to their current levels.

The current availability of cheap debt (and the fact it may not be around for long) and improving business sentiment should motivate firms to invest more to improve their profitability. As we have written before, profitability is becoming a difficult issue for many businesses, with margins coming under pressure from rising wage costs as low unemployment restrict the availability of labour. This is not particularly concerning for nominal growth, however, and should incentivise investment if sales are forecasted to rise again.

Lastly, let’s turn to the UK. The major parties may not have managed to get their election campaigns off to a particularly smooth start, but with both promising large fiscal expansion in their election manifestos, it is no longer a question of if, but how or where extra public spending will go. For 2020, this should be positive for the economy either way, but the biggest long-term benefit to growth would most likely come from investment in productive public infrastructure, such as physical infrastructure, education and vocational training.

The uncomfortable truth is that public health spending and policing are not likely to add directly to productivity in the short-term and so would inevitably have to be paid for through higher taxes in the long-term. Of course these things may be a necessary public good, but their immediate effect on GDP growth is hard to quantify.  

Given the almost inevitable increase in government spending and borrowing, it is perhaps surprising that the Bank of England struck a dovish (favouring low rates) tone in their latest monetary policy report. Their forecasts for growth and inflation were downgraded, and two members of the Monetary Policy Committee even voted for lower rates. The Bank’s current forecast for inflation two years in the future is below 2%, which suggests an easing bias on their part. No doubt, the new-found strength of £-Sterling is a factor in their dovish move – as are the global developments they acknowledged in their report. The latter suggest they may even be behind the curve, with JP Morgan predicting that the BoE will cut interest rates in January.

Of course, their forecasts lean heavily on their own Brexit expectations. And on this there has been some suggestion that the Bank are concerned that a 2020 Brexit along the lines of Boris Johnson’s deal would not end the uncertainty currently facing businesses and consumers – as trade negotiations with the EU could still take many different directions. It is worth noting that the BoE’s forecasts have already included a number of assumptions that may prove to be a little optimistic: a smooth Brexit transition, a pickup in growth next year, fiscal easing and an orderly transition to a Free Trade Agreement in 2021. All of those are, on balance, reasonable expectations. But none of them is a certainty. Like capital markets, we will have to see significant improvement just to match the current predictions. Returning confidence is a positive; let’s hope it ends up justified.

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