Investing

Uncertainty casts its shadow over the US, Europe, and China

For this edition of Weekly Market Compass, we are going to
take a deeper dive into the issues currently facing the US, Europe, and China.
Guiding us through this “regional roundup” are three of Invesco’s Global Market
Strategists who are on the ground in New York, London, and Hong Kong. While the
details differ in each region, the biggest commonality they report is the heavy
shadow of uncertainty that continues to linger over markets.

Brian Levitt: Can the
US avoid a cycle-ending policy mistake?

For our entire lives we’ve been told that it is always
darkest before the dawn. Alas, it’s not actually true. The brightness of the
night sky varies depending on the moon’s appearance relative to the sunrise. Sometimes
it’s darkest in the middle of the night. Nonetheless, it’s a comforting
sentiment that is often relevant in life and tends to be applicable for
financial markets.

The overarching tone in the economy and the financial
markets this summer has been, well, dark. The uncertainty surrounding US trade
policy with China has eroded US business sentiment meaningfully,1
thereby grinding business investment down.2 The US Treasury yield
curve — in my view as good of an economic and financial market indicator as any
other — inverted, albeit briefly.3 Just last week we learned that
the Institute for Supply Management’s Manufacturing Purchasing Managers Index for
the US had fallen below 50, the demarcation level between expansion and
contraction.4 Services held up better, but manufacturing has tended to
do a better job of capturing the inflection points in the economy.5
Even the headline jobs number showed a hint of weakness, even as wages trended
higher.6

Yet, the broad US market, as represented by the S&P 500
Index, is only 1.16% from its all-time high.7 The late-July to
mid-August peak-to-trough decline of 6% in the broad market was only roughly
half of the median price decline markets have experienced every year since 1980
— and not as bad as the correction in late 2018 or the market downturn in May
2019.8 The spread between the 2-year and 10-year US Treasury rates turned
positive once again.9 The Chicago Board Options Exchange Volatility
Index (VIX) has retreated. Credit spreads have largely behaved.10
What gives?

In my view, the market has endured rolling policy errors
over the past year. In late 2018, it was Federal Reserve (Fed) rate hikes. In
May 2019, it was the prospect of ever-escalating tariffs on Mexican goods. Currently,
it’s about trade policy with China. In the first two instances, policymakers
backed away from the policy mistake: The Fed is now easing and the Trump
administration called off the plans to impose tariffs on Mexico. Now we get
word that the administration plans to meet with China in a month’s time.

Is it possible that we are heading into an environment of
improving policy (note that I didn’t say good, but improving) that will
stabilize business sentiment and reinvigorate economic activity? Figure 1 shows
us that the US stock market has tended to perform very well in the 12 months
following a peak in the US Economic Policy Uncertainty (EPU) Index, which stood
at its most extreme level at the end of August. The lone negative 12-month
period post a spike in the US EPU Index came in the aftermath of the 9/11
terror attacks on the US.

Figure 1: Markets have performed well following spikes in
economic uncertainty

US Economic Policy Uncertainty (EPU) Index

Sources: Baker, Bloom & Davis and Standard & Poor’s, as of Aug. 31, 2019

S&P 500 total return:
12 months following spikes in US EPU Index

Sources: Baker, Bloom & Davis and Standard & Poor’s, as of Aug. 31, 2019

I suspect that it is dawning (pun intended) on policymakers
that in a growth-starved world, the cardinal rule is to do no harm. I believe
that markets would reward them for their lack of efforts. Of course, where you
stand depends on where you sit, and the US has been the brightest star (see
what I did there?) throughout this cycle. I’m looking forward to hearing from Arnab
in the UK and David in Hong Kong.

Arnab Das: Can
politicians find a clear path forward for the UK and Europe?

Moving across the pond to Europe, there’s been an awful lot
of noise and some signal recently in politics that I believe boils down to
kicking the can balanced by continued uncertainty over the longer term. In my
view, the net effect — in line with US developments — is improvement at the
margin, which should help support economic growth and both regional and global
risk assets at some expense to “safe-haven” government bonds. That said, I
believe the continued uncertainty, combined with the somewhat reduced
dovishness of major central banks — especially the European Central Bank (ECB)
and the Fed, is likely to limit the extent of these retracements and keep
market volatility high.

So how to make heads or tails of all the Brexit news and
noise? The good news: Westminster finally found the numbers and the gumption to
seize the UK Parliamentary agenda from the government and pass legislation to
require the recently installed Tory Prime Minister Boris Johnson (or “BoJo” — a
nickname I’ll use just as he does with Brits and world leaders alike) to seek
approval from Brussels for a three-month extension to the current Oct. 31
Brexit date, if no deal is approved by Oct. 19. So, the threat of a no-deal
Brexit is being pushed out into January 2020. The bad news: Procrastination
paves the way to protracted political uncertainty including the potential for a
fourth Brexit extension, a second early general election, and probably even
more troubling political fireworks — and perhaps a no-deal Brexit after all
that, anyway.

The political runes now point toward an early election,
perhaps in November, centered on Brexit yet encompassing other, even greater
uncertainty. The main opposition Labour Party is lining up a platform of
big-time policy disruption — including higher taxes, salary and bonus caps, and
renationalization plans — that many see as tantamount to expropriation. Many Members
of Parliament and voters would stand shoulder-to-shoulder with Labour on
preventing a no-deal Brexit, yet would oppose such an agenda. They and others
may well prefer BoJo’s version of Brexit Britain (which seems to emphasize
growth and investment through deregulation as well as fiscal loosening financed
with bond issuance) to Labour’s platform (renationalization, re-regulation, and
fiscal loosening financed by taxes on capital and equity, as well as bonds,
which seems to emphasize redistribution at the expense of growth and investment).

The alternative of remaining in the EU might by itself be
market and macro supportive, but if it comes with a Labour government that
increases the chances of a radically redistributive economic policy agenda at
the expense of growth, it would render continued UK alignment with the EU and
US economic models difficult to sustain. I expect the political debate to move
from radicalism to gradualism and toward a US or EU version of capitalism
rather than full-blown socialism. But in the short term, and in short, the only
certainty in the UK seems to be continued uncertainty.

Across the channel in the eurozone (EZ), the political
debate seems like it’s becoming much less fluid and disruptive, but the economy
is still weak, and both monetary and budgetary policy debates are also becoming
somewhat less dovish than hoped even very recently — not unlike the Fed. The
good news is that, at least for the time being, the spillover of Italian
internal political tensions into confrontations with the EU about budget rules
has calmed down as a new, less-disruptive coalition is being formed between the
Five Star Movement and the Democratic Party (PD) in Italy.

That said, it remains to be seen how stable this new
arrangement is. On the face of it, this arrangement may seem more sustainable,
since both partners are from the left, rather than the prior left-right
odd-couple coalition. But hard right-wing League leader Matteo Salvini and his
party are more popular than either the Five Star Movement or the PD;
furthermore, Salvini may well prefer to be an outsider in opposition in order
to snipe at the coalition. Plus, this new coalition will be Italy’s 67th
government in the 75 years since World War II. Rapid political turnover has long
stood in the way of major structural reforms that require taking the long view,
given that the political costs of reform are usually front-loaded and the
economic payoffs longer term.

Moving onto the EZ economy and the ECB, among mixed data,
the trend seems to be going from weakness to weakness in the key sectors of
industry — like autos, machinery, and investment — and in the all-important
German economy. It’s not all bad news as France continues to do somewhat better
than it had during the yellow-vest protests against diesel fuel taxes, which
slowed the economy significantly. But Germany’s export machine for cars, machine
tools, and capital goods continues to suffer from the Brexit noise as well as
the US-China trade war, which is hurting global trade as well as corporate
capex.

Yet the discussion around stimulus, which had been gathering
momentum on both monetary and fiscal policy in recent weeks, seems to have
hardened as policymakers and politicians from EZ Core Creditor countries, like
Germany, push back against hopes that there would be pro-active fiscal and
monetary easing, in contrast to the US in 2018-19. I believe market
expectations and hopes had run too far ahead of reality on both the ECB and
budget policy.

Given the ECB’s limited room for maneuver with rates already
below zero and self-imposed limits on buying government bonds not too far away,
further economic weakness to the point of actual recession may be needed before
the ECB can resume quantitative easing (QE) as well as any significant fiscal
easing. Plus, the latent concern of the creditor countries that QE might
provide disguised money-printing and financing of debtor economies’ budget
deficits probably poses a political constraint to QE — at least pending a more
severe slowdown if not a full-blown recession.

Thus, expectations seem to be coalescing around rate cuts
into even deeper territory, which in my view would not be good for banks as
their capital is already weak and margins very thin. All in all, the bigger
picture is still that EZ banks’ historically important role as credit creation
engines remains highly challenged. Banks account for about three to four times
as much credit funding within the EZ than in the US, where borrowers are much
more reliant on the credit markets than banks. If EZ domestic credit remains
weak at a time when net exports are also weak, it is only reasonable to expect
growth to be weak as well, with stagnation or recession risks remaining
reasonably high.

David Chao: Can new
policy measures in China counteract the effects of uncertainty?

The “uncertainty” theme that Brian and Arnab touched on also
applies to the Chinese market — but there is a difference as to how uncertainty affects market
participants in each region.

Unlike in the US, where market participants are faced with
high levels of economic policy uncertainty, in China there is very little
policy uncertainty because Beijing singularly controls fiscal, monetary, and
industrial policies, and regularly spells out future policy prescription in its
five-year plan. Instead, Chinese market participants have been faced with
political uncertainty since the beginning of the year. Continued protests in
Hong Kong, unabated US-China trade tensions, and a decelerating economy have
caused market volatility. September is an especially important month as the Central
Government gears up to celebrate its 70th anniversary on Oct. 1, and
Beijing has recently come out more forcefully to tackle some of these
challenges.

Last week, China’s State Council — the chief administrative
body of the central government — sent a very strong monetary loosening and
fiscal stimulus signal to the market. Most of the measures listed aim to
support growth via fixed asset investment. Three important measures to be aware
of:

  1. An unspecified increase in this year’s municipal
    bond quota for infrastructure investments.
  2. A near-term cut in the risk reserve requirement (the
    amount of cash that banks must hold in reserve) to inject liquidity.
  3. Near-term interest rate cuts to the medium-term
    lending facility to financial institutions, and possible cuts to the loan prime
    rate to spur lending to state-owned enterprises.

Although I don’t expect the stimulus package to be as strong
as the one instituted in the latter part of 2018 and into the first quarter of
this year, this package is still significant and the strongest economic policy
signal that has been issued so far this year.

I believe these policy measures should provide enough
buffering against any dramatic economic slowdown brought on by recent events. Political
uncertainty is countered by economic policy certainty, and I continue to expect
gross domestic product (GDP) growth for 2019 to be within the government’s 6.0%–6.5%
target. Chinese equities — both onshore A shares and offshore H shares — have
been at discounted valuations. As Beijing starts to loosen its monetary policy
and stimulate the economy ahead of Oct. 1, I believe Chinese risk assets should
benefit.   

Conclusion

Taking a step back and surveying the world as a whole, we
see the need to take the good news of short-term improvements in stride with
the longer-term challenges and underlying uncertainties. The thorny issues of
the US-China trade war, of Brexit, of restoring vim and vigor in Europe’s
growth cycle, and of EU and EZ integration will persist. China is moving to
shore up its economy, but seems unlikely to provide the worldwide lift that it
did in 2009-2010 or in 2015-2016.

We also expect uncertainty to persist, offset by the efforts
of policymakers and politicians to prevent downside risks from materializing.
We therefore expect a narrower range of potential outcomes in the economy —
neither a strong rebound nor a surge in recession risk — but more trundling along
at an acceptable pace with risks shifting up and down with the passage of time
and persistence of uncertainty.

The portfolio proposition we take from this worldview is to
maintain diversification across asset classes and preserve room to maneuver as
more clarity emerges. This approach stands in sharp contrast to heavily shifting
into bonds (as many investors seemed to do very recently, and which we believe would
be more appropriate in a recessionary scenario such as 2010-2012 or 2015-2016)
or heavily shifting into riskier assets (as might make more sense for the type
of synchronized global rebound scenario we saw in 2017).

1 Source: Chief Executive Magazine CEO Confidence Index: Confidence in the Economy 1 Year From Now, Aug. 31, 2019
2 Source: US Census Bureau Capital Goods Orders, Aug. 31, 2019
3 Source: Bloomberg, L.P. US yield curve is represented as the spread between the 10-year US Treasury rate and the 2-year US Treasury rate.
4 Source: Institute for Supply Management, Aug. 31, 2019
5 Source: Institute for Supply Management Non-Manufacturing Purchasing Managers Index, Aug. 31, 2019
6 Source: Bureau of Labor Statistics US Employees on Nonfarm Payrolls, Aug. 31, 2019
7 Source: Standard & Poor’s, Sept. 6, 2019
8 Sources: Bloomberg, L.P.; Standard & Poor’s.
9 Source: Bloomberg, L.P. US yield curve is represented as the spread between the 10-year US Treasury rate and the 2-year US Treasury rate.
10 Source: Chicago Board Options Exchange

Important information

Diversification
does not guarantee a profit or eliminate the risk of loss.

An inverted yield
curve is one in which shorter-term bonds have a higher yield than longer-term
bonds of the same credit quality. In a normal yield curve, longer-term bonds
have a higher yield.

The US Manufacturing PMI® (Purchasing
Managers’ Index®) is produced by IHS Markit based on data collected from a
panel representing the entire US manufacturing economy. IHS Markit’s total US
Manufacturing PMI survey panel comprises over 600 companies.

The S&P 500®
Index is an unmanaged index considered representative of the US stock market.

The CBOE Volatility Index® (VIX®)
is a key measure of market expectations of near-term volatility conveyed by
S&P 500 stock index option prices. VIX is the ticker symbol for the Chicago
Board Options Exchange (CBOE) Volatility Index, which shows the market’s
expectation of 30-day volatility.

The Economic Policy Uncertainty
Index is compiled from three underlying components that quantify newspaper
coverage of policy-related economic uncertainty, reflect the number of federal
tax code provisions set to expire in future years, and use disagreement among
economic forecasters as a proxy for uncertainty.

Safe havens are investments that
are expected to hold or increase their value in volatile markets.

In a “no-deal” Brexit, the UK would leave the
EU with no formal agreement outlining the terms of their relationship.

Quantitative easing (QE) is a monetary policy used by
central banks to stimulate the economy when standard monetary policy has become
ineffective.

Risk assets are generally described as
any financial security or instrument, such as equities, commodities, high-yield
bonds, and other financial products that carry risk and are likely to fluctuate
in price.

The opinions referenced above are those of the
authors as of Sept. 9, 2019. These
comments should not be construed as recommendations, but as an illustration of
broader themes. Forward-looking statements are not guarantees of future
results. They involve risks, uncertainties and assumptions; there can be no
assurance that actual results will not differ materially from expectations.

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