By Francis P. Rybinski, CFA, Chief Macro Strategist & D. Harris Kere, CFA, Investment Strategist
As we come down the homestretch, the main themes from an economic growth perspective have been deceleration and lower expectations as consensus growth expectations were trimmed for both 2019 and 2020. While this recalibration process can often set a dour mood, it also sets a more realistic launch pad for 2020 economic comparisons. For those keeping score at home, our base case continues to call for growth in '20 to be a trend-like, sub-2% year, but no outright recession (Exhibit 1). However, we continue to believe that because of trade uncertainty, the distribution of risks around our forecast remains to the downside.
Exhibit 1: Aegon AM US Economic Forecasts
|GDP (Real %, YoY)||2.3||2.9||2.25||1.8||1.6|
|Fed Funds (%)||1.50||2.50||1.75||1.25||1.25|
Sources: Aegon AM US as of November 17, 2019. Includes historical data sources from Bureau of Economic Analysis, Congressional Budget Office, Haver Analytics.
Trade War Soap Opera—No End In Sight
We've been using the analogy that the trade situation resembles a soap opera —a daily drama where the narrative oscillates constantly between positive and negative. Due to political influences, we see this continuing for the foreseeable future. In economic terms, the pall of uncertainty is not going away anytime soon and, thus, capital expenditures (a key factor of cyclical growth) are likely to remain subdued as well (Exhibit 2).
Exhibit 2: Index of global trade volumes (three-month moving average)
Source: CBP World Trade Monitor, AAM. As of August 1, 2019.
Can a "phase one" deal reverse all that? We don't think so. To us, it remains an issue of symbolism vs. substance. China agreeing to buy some agriculture products in exchange for a lowering of some tariffs does not signal an all clear. Rather, it is analogous to the mid-2017 'early harvest' agreement between the US and China, which was more of an optical deal than anything else. Yes, optics are important, especially when they deal with the trade relations of the two largest economies. However, optics don't relieve underlying issues that stem from substantive policy dispute (i.e., intellectual property, forced technology transfer, etc.).
Can the consumer hold everything together?
It depends how the labor markets play out. Our base case is that aggregate hours continue to moderate. When combined with stable wage gains +/- 3%, then the labor income proxy (i.e., fuel for the consumer) grows at a slower pace than previous years. This translates into slower growth in aggregate consumption versus prior quarters, especially service consumption which is the largest part of consumer expenditures (Exhibit 3).
Exhibit 3: Labor income proxy versus service consumption
Sources: BEA, Haver. As of September 30, 2019.
If perception ultimately becomes reality, another way to look at the consumer is by sentiment surveys that compare expectations of today versus the future. As you get late in the cycle, this tends to reach extremes— consumers become very upbeat about the present, but less so about the future (Exhibit 4).
Exhibit 4: Consumer confidence: Present situation versus expectations gap
Sources: Conference Board, Bloomberg. As of October 31, 2019.
Any outlook would be incomplete without mentioning what we see as the Federal Reserve's (Fed) path for monetary policy. Given the softening in aggregate output, combined with modest inflationary pressure, we believe that the Fed will trim its fed funds rate two more times in 2020, bringing the terminal rate of the upper bound to 1.25%. As we have opined, we believe that the real neutral rate is zero to negative and thus further cuts are warranted to support a moderating growth picture.
The US Election – the '21 Wildcard
On November 3, 2020, the US will have its next election cycle which could witness shifts in none, some, or all of the Executive office (President) and control of the House and Senate. Given the vast contrast of the political platforms, the policy picture for '21 could look substantially different depending on which party holds or wins power. While our base case calls for a status quo, we readily acknowledge a dense fog around this prognostication. In economic terms, this means there is a wide distribution around the base case forecast.
Asset Allocation – Not Time to Be a Hero
When we talk about asset allocation, we always refer to risk-adjusted returns, e.g., which assets maximize their return per unit of risk. As we've commented on in previous pieces, as the curve flattens late cycle, it is typically a time when lower-quality assets tend to underperform higher-quality assets. So far, this is exactly what we have seen since December 2018 when the Treasury 10/3-month curve went below 50 basis points (Exhibit 5). In fact, within the major credit indices risk-adjusted return has been maximized in the BBB/BB range. With that in mind, we continue to believe the best balance is offered in mid-tier credit.
Exhibit 5: Return since Treasury 10/3-month curve < 50 bps
|Tsy Index||US IG||US HY||S&P 500|
Source: Bloomberg.As of November 22, 2019.
- While Treasurys have had a great run, our rates strategist sees them mostly as a coupon clip from here, yet with a potential for an upswing in volatility on geopolitical events. The best case for Treasury is the possibility of the downside skew to our economic forecasts materializing, creating a flight to quality.
- Low quality credit assets benefit from rapid nominal growth to grow into their balance sheets, a low probability event in our mind. We would be very selective in positioning risk here based on idiosyncratic credit analysis.
- In mid-tier credit, we believe there is a much more balanced risk-reward given our outlook for modest economic growth.
- Equities – Earnings growth will be challenged to meet the roughly 10% consensus bar for '20 given slower nominal growth (affects top line) and continued margin pressure (affects bottom line). Baring multiple expansion, that puts returns in the mid-single digits for '20. However, volatility from trade tensions will likely drag on the risk-adjusted returns.
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