Economic update: Downside risks still increasing
The outlook for the U.S. and global economy has deteriorated yet again. Unsurprisingly, the culprit behind the outlook downgrade has been news of the coronavirus’ continued spread. To be sure, risk assets sold off this week and financial market volatility increased as concerns about the virus and its potential impact on the global economy dented investors’ up-until-recent euphoric sentiment.
More importantly, worries about the coronavirus come at a time when economic conditions in the U.S. and around the world remain weak and susceptible to unforeseen shocks. Our view remains that the coronavirus outbreak is likely to have a material impact on the global economy and financial markets assuming its spread is not quickly stemmed. Therefore, we believe that households and investors should prepare for economic and market weakness in the coming months, notably as the effects of the coronavirus remain wildly uncertain.
Data pointing to further 2020 weakness
Each month we evaluate a host of quantitative and qualitative factors that help guide our U.S. and global economic and market outlook. Indeed, we utilize econometric models that rely on developments in the labor market, consumer spending, business and household sentiment and rates, among others, to help frame our U.S and global economic views. The result of this work includes forecasts on U.S. gross domestic product (GDP) growth, inflation and employment conditions as well as a view on major currencies and commodities. So, what does our latest work show?
Well, the latest update to our models for February suggests that economic growth in the U.S. is likely to deteriorate further relative to our view in January. More specifically, our quantitative models show that household spending growth is likely to lag behind 2019 even before accounting for the effects of the coronavirus. At the same time, our models suggest that business investment could slow further as global manufacturing remains weak, while a rebound in the U.S. housing market largely supports positive U.S. private investment activity.
Looking abroad, various data releases over the past few weeks have pointed to potentially stabilizing global economic growth. To be sure, the latest reading of the Organization for Economic Cooperation’s and Development (OECD) Composite Leading Indicators (CLIs) are consistent with a potential growth rebound in both developed and emerging market economies. And this improving trend has been supported, in part, by some better than mixed global business sentiment and a broad rally in risk assets, especially U.S. stocks, from the start of the year.
Figure 1: Downward revision to 2020 growth outlook
Coronavirus uncertainties intensify
Taken by itself, the data would lead us to believe that the growth outlook for the U.S. and global economy, while sluggish today, could pick up into the tail end of 2020. This is because broad money printing by the world’s key central banks and a still resilient consumer have underpinned spending activity.
Nevertheless, as we look into the future, we believe that the hard data will begin to reflect renewed weakness in the global economy as coronavirus concerns take hold. And, as they do, this will challenge corporate earnings growth and subsequently the stock market’s ability to charge to new weekly highs.
To be sure, this view was reflected in one of our past writings and comes as the coronavirus is poised to change the way firms do business and the way households spend. For example, just a few weeks ago, as far as market participants were concerned, the coronavirus was largely a China issue as headlines centered on developments in Wuhan.
Today however, virus headlines have taken a dourer tone as cities in Italy deal with quickly growing number of infections and more reports reflect the spread of the coronavirus across the European continent. Adding insult to injury, even leaders from the Centers for Disease Control (CDC) report a heightened risk for a widespread coronavirus outbreak in the U.S. And what does all this mean for the economy and markets?
Figure 2: Pre-coronavirus tentative signs of global economic stabilization
Unforeseen disruptions
We expect discretionary spending among households in the U.S. and abroad to decline should cases of the coronavirus continue to increase globally. This consumption slowdown is likely to come from not only mandatory quarantines, but also from voluntary confinements reflecting a desire among the general public to avoid places where the virus could potentially spread.
This is important because, while eCommerce has increased notably in recent years, spending at brick and mortar stores still accounts for a large portion of retail sales in the U.S. and many developed and developing economies. And, with household spending being a key component of GDP growth, a slowdown in spending could put renewed downward pressure on the overall global economy and hence earnings growth.
Another impact stemming from the coronavirus spread is that of supply chain disruptions. China remains a key supplier of manufactured goods and is integrated into global supply chains that span not just the Asia Pacific region, but also across Europe, the U.S. and other parts of the world. This is important because it only takes the loss of just one critical component to halt the entire production of a key good. Today, some governments are exploring ways to get around such supply chain disruptions, but the fact is that China remains a key global supplier of critical manufacturing components. How do these developments affect our forecasts for the year?
The prospect of a widespread coronavirus outbreak in the U.S. is likely to notably alter of our current estimates of economic growth. That is, assuming a quick resolution to the viral outbreak is not found and coronavirus concerns intensify, economic growth in the U.S. and globally are likely to move from a moderate slowing in 2020 to sharp slowdown with yet to be determined consequences. How bad could it get?
At this point the severity of the slowdown will largely depend on the adaptability of businesses and resilience of consumers to deal with host of uncertainties amidst the threat of a global outbreak. With that said, the virus comes at a time when our quantitative recession risk indicator is pointing to a rising likelihood of an economic downturn in the second half of 2020. What this means is that a sharp decline in business and household spending as a result of the coronavirus could be enough to tip the U.S. and global economy into a recession sooner rather than later.
Figure 3: U.S. recession risk indicator reflects rising likelihood of a 2020 downturn
Preparing for the unexpected
What are households and investors to do in an environment that is charged for more market and economic volatility in the weeks and months ahead? The fact that risk asset prices remain elevated even amidst the coronavirus headlines has given us reason for pause. As we’ve noted in prior reports, we believe that the current rally in risk assets has more to do with the Fed’s unsustainable easy money policies rather than solid economic fundamentals. And this could set the stage for more market pullbacks this year.
While central bank asset purchases have been supportive of lower borrowing rates and a boost to housing market sentiment, we are hard pressed to find positive catalysts that would support a sharp economic rebound this year, particularly as coronavirus risks have yet to be contained and hence challenge the feasibility of a sustained rally in financial markets.
With the economic outlook set to weaken in 2020 and financial market volatility likely to remain elevated, we recommend that households take some constructive steps to prepare for the unexpected. For instance, one way to increase financial preparedness and resilience in a time of uncertainty is to reevaluate big-ticket spending decisions and divert more cash flows toward emergency savings.
This can be accomplished by reducing non-essential spending and refinancing high interest debts in today’s low interest rate environment. We believe that these steps will better prepare households for unexpected life events, particularly as job opportunities have become less plentiful and labor market conditions show signs of continued weakening into the months ahead.
For investors oriented towards asset growth, we recommend maintaining a diversified exposure in investment portfolios. This means not chasing hot stocks or trying to time a market bottom. At the same time, we recommend reevaluating exposure to risky investments to ensure that aggregate portfolio holdings across all investment accounts are in line with long-term goals. This includes rebalancing to target allocations and trimming winning positions to raise cash to keep as dry powder for when market volatility creates favorable buying opportunities.
Finally, for households taking distributions from investment, we recommend rebalancing accounts to long-term investment objectives and reduce unnecessary risk taking. Further, we recommend ensuring that cash positions are adequate to meet 6-12 months of living expenses. This is intended to avoid forced selling at depressed prices, especially as economic and market uncertainties are likely to rise in the coming weeks and months most notably as the overall impacts of the coronavirus remain wildly uncertain.
Are Democratic Candidates' Proposed Economic Policies Disruptive?
The race for the Democratic Presidential nominee remains crowded with eight candidates (as of this writing). Yet, with Super Tuesday just around the corner, the list of candidates is likely to be winnowed quickly. And one deciding factor that could make (or break) the decision for the Democratic Presidential nominee in July is likely to be a candidate’s economic policy.
But what exactly are the candidate’s positions and more importantly, why should they matter to savers and investors? In this week’s post we briefly explore some of the top candidate’s policies and provide an overview of their positions in the context of the current economic environment.
It is our opinion that (regardless of the candidate), the economic policies currently on offer are likely to be disruptive to the U.S. economy and financial markets should a Democrat clinch the presidency in November. Nevertheless, Election Day remains a long way away and we’ll have a better idea of the potential disruption to the economy (and markets) as we get closer to the summer conventions.
Economic policy: why does it matter?
So why should we care about economic policies, particularly as they relate to the election cycle? Well, put simply, political leaders can affect our quality of life through their ability to tax and spend. While the latest enacted key policy (Tax Cuts and Jobs Act of 2017) affected the economy in not so obvious ways, some policies can have more direct effects on our everyday lives, as we pointed out last week in our discussion on the SECURE Act.
The reality is that economic policies can affect the quality of the health care we receive, how much we pay for goods and services we use every day and the extent to which we can find and maintain gainful employment. Today, another generation of voters feel left behind as rising costs of living and debt burdens, notably those related to paying for college, have stifled their ability to get ahead in life financially.
To be sure, while some data suggest that labor markets conditions appear “tight” – with unemployment near multi-year lows and still positive payroll growth – the fact is that wage gains have barely outpaced inflation over the past decade. And simply put, some people feel that the rules have not worked in their favor and this election cycle Democratic politicians are offering up their own solutions to very real problems.
Candidate Economic Policies
It’s important to note that Congress typically is responsible for creating the rules (laws) that affect people’s lives. Nevertheless, the President, in some cases, can help set the legislative agenda and carry the baton on key, highly visible issues. Think the Affordable Care Act. Among many important topics, we believe that issues surrounding student debt, wages and jobs, health care and housing are likely to garner broad based attention from the electorate and the markets in the coming months.
Figure 1: Proposed Student Debt Policies
Student Debt
One issue that has perhaps affected an entire generation’s ability to get ahead in life financially is the burden of borrowing to pay for a college education. To this point, the amount of student loan debt has ballooned from less than $500 billion in 2006 to over $1.6 trillion in 2019. Arguably, this debt has hampered household formations among key demographics, most notably among the Millennial generation. So, what are some of the solutions being offered by Democratic candidates this election season?
Both Senators Elizabeth Warren and Bernie Sanders have proposed to eliminate student loan debt. Where their policies differ is that Sanders would do away with all outstanding student loan debt (all $1.6 trillion of it) while Warren would eliminate debt up to a certain limit and phase out the benefit for higher wage earners.
Other candidates like South Bend Mayor Pete Buttigieg would like to see debt eliminated for some borrowers in exchange for government service. Former New York City Mayor Michael Bloomberg and Senator Joe Biden would prefer options that fix existing issues with the student aid system, offering ways to lower borrowing costs but just short of all out-debt forgiveness.
Figure 2: Proposed Jobs and Wages Policies
Wages and Jobs
It has been well over a decade since laws governing the federal minimum wage have been reviewed. In fact, in 2007 Congress raised the federal minimum wage to $7.25 – a rate that is equivalent to a full-time annual salary of $15,080 – and well below the Department of Health and Human Services family of four poverty level of $26,200.
Today, there is broad consensus among Democratic candidates that the federal minimum wage should be at least $15 per hour and many have pledged to pursue legislation that would help increase workers’ earnings. Besides raising the minimum wage, what else have candidates suggested to improve employment opportunities for the American worker?
Well, candidates like Warren and Sanders have each introduced their own versions of a “New Deal”. Warren’s Economic Patriotism is focused on retraining the workforce to compete in a globalized economic environment. This includes scaling up apprenticeship programs and creating incentives for employers to offer other on-the-job training initiatives. Sanders’ Green New Deal meanwhile focuses more specifically on federally funded infrastructure, health care and education initiatives that would directly create jobs.
Bloomberg and Buttigieg have also proposed less-comprehensive programs that would create jobs by improving living circumstances and enhance infrastructure in rural and blighted areas across America. Biden’s focus, meanwhile, is less on introducing new programs than on fine-tuning already implemented policies. This involves focusing on strengthening workers’ ability to organize and generally increase workers’ rights.
Figure 3: Proposed Health Care Policies
Health care
Health care has been the traditional third rail in American politics for decades. This hasn’t changed in today’s election cycle and arguably has become more of a contentious point, especially at a time when health care costs continue to rise and at a considerable pace. This consternation comes as more people participate in the health care marketplace thanks to the Affordable Care Act. Yet, health care costs continue to increase as an aging U.S. population draws on more health care services. So what solutions are some candidates offering?
Well, some of the solutions vary from completely eliminating private insurers and expanding government programs like Medicare (a single payer option). This position is strongly held by candidates like Warren and Sanders. Bloomberg and Biden, on the other hand, oppose the idea of a single payer but would seek to expand coverage for Americans not currently eligible for Medicare. Either way, no one candidate has offered a quick fix to a very complicated (and costly) topic for many Americans.
Figure 4: Proposed Housing Policies
Housing
It has been well over a decade since the housing boom went bust, yet its aftereffects continue to live on. Indeed, housing has become an important issue, notably as home prices continue to move past housing-boom highs and instances of working homelessness continues to increase in different parts of the country.
What’s more, housing costs have risen at a pace faster than inflation over the past five years and have yet to show signs of abating thanks, in part, to the Federal Reserve’s not-QE money printing. Among some of the issues affecting affordability is the fact that quality affordable housing stock has dried up as jaded post-housing-crisis builders refrained from constructing lower priced homes, driving down housing affordability. Democratic candidates across the board agree that something should be done to address the current housing issues.
Solutions offered by candidates include everything from grants that incentivize localities to rehab and improve existing stock to federal funding to build more affordable housing. This camp includes candidates Sanders, Warren and Buttigieg whose plans consist of using federal funds to directly add to the housing stock in one form or another. As for Bloomberg and Biden, while they have expressed a desire to address the housing issue, they have focused their efforts on improving and expanding programs and zoning issues than on building more homes.
Figure 5: Paying for it all
Someone needs to pay for it
Finally, many of the programs proposed by the Democratic candidates require additional spending, some at trillion-dollar rates, over the next decade. This is a problem as the national debt today exceeds $23 trillion dollars and the Federal debt-to-GDP ratio has gone from 59% in 2000 to well over 100% today. What this means is that simply borrowing to pay for these economic policies will become progressively more problematic, especially at a time when growth in the U.S. economy is expected to slow. How would candidates pay for their proposed programs?
Simply put, most candidates have suggested raising taxes as a primary means to pay for their projects. Of note have been Warren and Sanders’ proposals to target the wealthy to fund their programs. Warren, for example, has offered an ultra-millionaire tax on wealth (rather than income) for the wealthiest 75,000 families in the U.S. Sanders similarly has his own Extreme Wealth Tax, that would require CEOs earnings more than 50x their employees to pay higher taxes as a way to fund spending on his social programs.
Bloomberg, Biden and Buttigieg have focused more on broadly increasing existing taxes rather than singling out any one social class or taxpayer. Bloomberg, for example, would like to roll back some of the TCJA benefits, raising the corporate tax rate back up to 35% from current levels of 21%. Biden would also like to increase revenues by taxing capital gains as ordinary income, raising the corporate tax rate and ending stepped-up basis rules.
Potential economic disruption?
The solutions offered by some of the Democratic candidates are in many ways a departure from current policy and certainly have the potential to be disruptive to the financial markets and economy. Why? On the one hand, an elimination of student debt could act as a massive form of fiscal stimulus, in some cases substantially increasing the amount of disposable income available to younger households who have a greater propensity to spend. Increased certainty over health care, employment and housing could also give households the confidence they need to make long-term spending and saving decisions.
On the other hand, someone will need to pay for the additional costs associated with some of the proposed programs. And while financial markets cheered the TCJA, its effects on the economy, notably as they related to tax cuts, have yet to show major benefits to the overall economy. Nevertheless, reversing some of these benefits, particularly raising corporate taxes, could be perceived negatively by the financial markets as corporate earnings decline as taxes increase. What’s more, business hiring and investment activity could slow in the short-run as business leaders put off spending decisions as policy uncertainties linger.
Assuming a Democrat wins the White House, over the long-run, the outcomes will further depend on a number of factors, including the composition of Congress following elections and the political will to implement some of the large-scale projects. Make no mistake, topics like housing, health care, wages and paying for college are issues that are likely to remain relevant for years and will need to be addressed sooner rather than later.
As for the degree to which candidates’ policies will disrupt the U.S. economy, we believe that the outlook will become clearer as we move past conventions in the summer. Even so, some of the same policies that have gotten us to this point will need to at least be addressed by our political leaders, regardless of whether a Republican or Democratic president is at the helm post-November.
Economic update: Recession risks on the rise
U.S. Growth
Our latest estimates continue to suggest that economic growth in the U.S. will weaken in the coming year while the risk of a recession remains elevated. We expect growth to come in around 2.1% YoY in 2020, slightly weaker than our expectation of 2.2% for 2019.
International Growth
Globally, World GDP is likely to accelerate as emerging market economies (ex China) rebound from markedly low levels of growth in 2019. We expect China’s economy to slow further in 2020 (5.8% YoY) as policymakers balance easy credit conditions with allowing market forces to curb certain lending excesses. Growth in developed market economies is expected to remain soft in 2020 as weaker growth in China and the U.S. put downward pressure on eurozone (1.1% YoY) and Japanese (0.6% YoY) exports.
U.S. Employment
Incoming data show that labor market conditions remain weak and continue to deteriorate, as evidenced in the November double digit job opening decline. These figures continue to support our expectation of a rise in employed workers (3.8% in 2020 vs. 3.7% in 2019) as nonfarm payrolls growth continues to slow and the number of people reporting full-time employment falls.
U.S. Inflation
Inflation is likely to remain soft as a decline in home prices through the first half of 2020 is offset by a rise in transportation costs off of 2019’s low base. Core PCE is likely to fall further in 2020, led on by housing weakness. Decelerating inflationary pressures coupled with slowing economic growth are likely to prompt two further rate cuts by the Fed in 2020.
Click here to download our latest economic forecasts.
Figure 1: January economic outlook
Acute threat: a looming U.S. recession
-
The threat of a U.S. recession will add to a number of looming issues contributing to heightened financial market and economic complexities and uncertainties in 2020.
-
While some of the latest economic data suggest that growth in the U.S. economy remains steady, some key market and economic indicators are more consistent with a downturn, like the inverted yield curve.
-
The health of the U.S. consumer is likely to hold the key to the health of the U.S. economy and the potential timing of a U.S. recession.
In addition to the financial market distortions, debt overhangs and democratic challenges to getting ahead financially over the long term, lies the increasingly real potential for a U.S. recession in the near term. The reason an economic downturn is important is because of its immediate and acute effects on households, particularly as it relates to its potential to derail life transitions as emergency savings are put to the test, opportunities to get ahead are stalled by lending and labor market tightness and financial market volatility further complicate aforementioned retirement insecurity.
The making of an economic downturn
What is a recession? On the one hand, a commonly cited definition of a recession is two consecutive quarterly declines in GDP growth. The National Bureau of Economic Research, a highly regarded business cycle dating group, on the other hand, broadly defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales".
Put in simpler terms, a recession is a crisis of confidence experienced by businesses and consumers that is preceded by a set of events or circumstances (inflation shock, financial market disruption, war, social unrest) leading to a broad slowdown in economic activity. More than ten years have passed since the U.S. experienced its last recession and comes at a time when downturns tend to happen once every 5-7 years[1]. Does this mean that a recession is imminent?
[1] National Bureau of Economic Research, Business Cycle Dating, December 2019
Figure 1: Yield curve inversions lead recessions by 18-24 months
What the recession indicators are saying
While some of the latest economic data suggest that growth in the U.S. economy remains steady, some key market and economic indicators are more consistent with a downturn, like the inverted yield curve. More specifically, the spread, or difference between the yield on 10-year and 3-month U.S. Treasurys is historically consistent with a recession beginning 18 to 24 months after the spread turns negative.
Using history as our guide, an inversion of the yield curve in 2019 suggests that the risk of a recession is likely to increase in mid-to-late 2020. Nevertheless, no one measure can accurately predict a downturn in the economy and so it is important to look to other economic indicators for more confirmation of a likely downturn.
Figure 2: U.S. business confidence in decline on trade uncertainties
To be sure, measures of business and household sentiment are another statistically significant indicator of a potential recession. And lately, business confidence in the U.S. and globally has weakened from its peak in 2018. This comes as the positive effects of the U.S. Tax Cuts and Jobs Act have faded, and the U.S. has raised tariffs on important economic and trading partners like Canada, Mexico, China and Europe.
At the same time, China’s credit-fueled growth continues to slow, putting downward pressure on economic activity at home and among its important trading partners, including the U.S. Taken together, these and other financial market complexities and geopolitical uncertainties are contributing to a greater level of caution among business leaders.
This is important because as businesses lose confidence, they tend to cut back on discretionary spending activity like replacing aging equipment, expanding facilities or adding new jobs. At the same time, businesses tend to pare back on the amount of inventory held in storerooms, putting downward pressure on factory orders and manufacturing activity. Indeed, recent surveys of corporate executives suggest plans to curb capital expenditure and hiring activity in the coming year as corporate earnings growth are expected to slow.[2]
[2] Duke Fuqua School of Business, “Duke CFO Global Business Outlook”, September 2019
Figure 3: Economic growth forecasts downwardly revised
A slowdown is coming, consumers may hold the key
Recession or not, economists have ratcheted down their expectations of global growth and largely expect economic activity to weaken in 2020. Most notably, the International Monetary Fund in October 2019 published revisions to its World Economic Outlook that suggest global GDP growth will slow to levels not seen since the 2008-2009 global financial crisis. And while slower economic growth does not necessarily portend a recession, it does increase an economy’s susceptibility to a downturn, particularly at a time when a few recession indicators are flashing amber.
One factor underpinning positive economic growth and arguably staving off an economic downturn has been the resilience of household spending. U.S. retail spending growth has largely surprised to the upside in 2019. And this followed a rebound in global equity markets and the prospect of falling interest rates earlier in the year, which likely buoyed household sentiment and underpinned household consumption in major economies. A key question today, however, is whether this virtuous trend in spending can continue amidst a host of uncertainties, particularly as elections and trade uncertainties loom in 2020.
Moreover, the buoyancy of consumer sentiment is likely to remain tied to developments in the business sector. As business uncertainties grow, employers are likely to further curb hiring activity. This means that the current slowing pace of job gains is likely to be exacerbated by falling sentiment, making it harder for some people to find work and leaving others worried about their own job prospects and potentially feeding into a cycle of falling discretionary spending and hiring activity.
Either way, with government spending constrained and business spending expected to slow, a decline in household spending could tip the U.S. economy into a recession, leading to a period of heightened economic and financial market volatility and challenging households’ ability to get ahead financially.
In our final post in this series, we discuss how households can get ahead, financially, despite growing financial market and economic complexities and uncertainties.
This post is an excerpt from our report, Getting Ahead Financially in 2020. You can download this report in its entirety by visiting franklinmadisonadvisors.com.
Important Disclosures
Broadview Macro Research is a division of Franklin Madison Advisors, Inc (“FMA”). The commentary provided on this website is limited to the dissemination of general information pertaining to Franklin Madison Advisors’ investment advisory services and general economic market conditions and are subject to change without notice. The information contained herein is not intended to be personal legal, investment or tax advice or a solicitation to buy or sell any security or engage in a particular investment strategy. For additional information about FMA, including fees and services, please contact FMA or refer to the Investment Adviser public disclosures.
Franklin Madison Advisors, Inc., is registered investment adviser firm with its registration and principal place of business in the Commonwealth of Pennsylvania. Registration of an investment adviser does not imply a certain level of skill or training. FMA is in compliance with the current notice filing requirements imposed upon registered investment advisers by those states in which FMA maintains clients. FMA may only transact business in those states in which it is notice filed or qualifies for an exemption or exclusion from notice filing requirements. Any subsequent, direct communication by FMA with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For additional information about FMA, including fees and services, please contact FMA or refer to the Investment Adviser Public disclosures. Please read the disclosure statement carefully before you invest or send money.
To learn more, visit us at http://www.franklinmadisonadvisors.com
Brace for more uncertainties in 2020
-
An undercurrent of seemingly benign financial market and political developments are poised to move both prepared and unprepared households further away from their financial goals in the coming years.
-
These issues include monetary policy-related financial market distortions, a drag from excessive global debt and the rise of geopolitical uncertainties.
-
Households attempting to financially prepare for the future will need to contend with financial market distortions that induce greater risk taking, debt constrained growth that lead to increasingly more expensive investment options and weaker economic activity and political developments that have the potential to batter financial assets.
An undercurrent of seemingly benign financial market and political developments are poised to move both prepared and unprepared households further away from their financial goals in the coming years. Contributing to this outlook includes the fact that the global economic ties that had in recent years contributed to higher standards of living for millions of people globally are at risk of unwinding with the rise of populist politics and social unrest. At the same time, policy responses are forcing some savers into riskier investments and creating unsustainable excesses in debt and equity markets.
How financial market distortions make it easier to lose money
Central banks, in a bid to reverse slower economic growth and weak inflation, have maintained unconventional monetary policies since the height of the Global Financial Crisis. Doing so has nevertheless led to certain distortions in the global financial system, like extremely low interest rates (negative in places like Europe and Japan), excess liquidity in some corners of the financial system and liquidity shortages in others.
And these policies aren’t likely to go away anytime soon as gross domestic product (GDP) and inflation in the U.S., Europe, Japan and China remain weak, prompting policymakers to remain committed to unconventional monetary policies for the long term.
Figure 1: Major government bond yields remain in decline
This has two important implications for both savers and retirees when it comes to asset accumulation and distribution strategies. First, lower central bank interest rates have put downward pressure on traditional fixed income asset yields. What this means is that individuals and institutions setting aside funds to meet long term obligations will either need to put away more money today to boost saving levels or allocate their savings to high yielding (and often riskier) financial assets to generate higher investment growth rates.
There is no such thing as a free lunch and so the cost associated with higher returns is either the increased time need for more investment due diligence on riskier assets or the need for greater investor risk tolerance for inevitable swings in market prices. Either way, these central bank policies have effectively made it easier for unprepared savers to lose money by incentivizing higher allocations riskier investments.
Figure 2: A notch above junk: BBB rated corporate bonds a key market risk
At the same time, the number of firms rated as financially risky has increased as lower borrowing costs provide a support to otherwise structurally uncompetitive firms. Typically, rising interest rates late in the business cycle has the natural effect of weeding out weak firms as revenues typical with selling goods and services dry up and increased borrowing becomes prohibitive. Yet, lower rated firms have been given an artificial lifeline as central banks maintain extremely accommodative policies, keeping borrowing costs lower than usual.
Further, lower rates have pushed up valuations of riskier investments like stocks even as corporate earnings growth has weakened recently. The implications here is that valuations for some stocks and bonds, particularly those of lower quality issues, may become susceptible to outsized price swings when political or economic concerns inevitably lead to bouts of increased market volatility. Lower interest rates have also contributed to a notable rise in the amount of debt outstanding globally.
Figure 3: A rise in global debt will challenge growth for years to come
Debt and when a rising tide does not lift all ships
According to the Institute for International Finance, total public and private debt outstanding globally was $246 trillion at the start of 2019, which is 50% higher compared to a decade ago and nearly three times the annual output of the global economy. At some point this debt must be paid back, which becomes increasingly problematic and a rising source of financial market volatility when economic growth rates for major global economies are expected to remain subdued in the near term.
Closer to home, the cost to service debt is actually below where they were prior to the Great Recession in the U.S. Yet, lower interest rates have created an incentive for households to borrow more money, pushing up the value of non-financial assets like home prices and contributed to the ballooning cost of education, crowding out other discretionary spending and in some cases making important life transitions harder to attain.
And while lower interest rates have reduced government debt service costs, Washington has only increased debt-fueled deficit spending and hindering its ability to invest in important growth-oriented infrastructure projects. Taken together, what this means is that households and governments alike increasingly remain constrained in their ability to spend on growth-oriented ventures as balance sheets remain hampered by ballooning debt piles.
Therefore, potential economic growth rates (and rates of corporate earnings growth) are likely to remain subdued in the coming year, further challenging firms’ ability to service growing stockpiles of debt and potentially leading savers to buy investments at a time when asset prices are becoming more expensive and economic and market risks are increasing.
Figure 4: A rise in global policy uncertainties has challenged growth
Reasons to be worried: geopolitics and Main Street uncertainty
And if low interest rates and a debt overhang didn’t already complicate financial strategies for preparing for the future, a rise in geopolitical tensions has contributed to a rise in economic and financial market concerns. This comes as the U.S.’s Trade War with Canada, Mexico, the European Union and China has led to higher prices paid for goods by some households and a simultaneous decline in business confidence. What’s more, the unclear outcome of the 2020 U.S. presidential election is likely to intensify political uncertainties that markets, businesses and households have already contended with in the past year.
From a trade policy perspective, leaders on both sides of the political aisle remain energized to address economic issues caused by past trade policies, particularly as it relates to the U.S.’s seemingly unbalanced relationship with China. And so, the implication here is that while a partial trade deal between the U.S. and China may be secured at some point, tensions between the U.S. and China are likely to remain elevated for years to come irrespective of the 2020 election outcome.
Meanwhile, some U.S. presidential candidates have proposed tax and spend policies that are likely unfavorable for some families and complicate long-term estate planning considerations. Moreover, financial markets – abhorring uncertainty – are likely to become increasingly choppy heading into the 2020 U.S. elections as the potential for notable shifts in trade or economic policies brought about by shifts in the executive or legislative branches are likely to buffet risk asset prices and dampen near term business and consumer confidence.
Taken together, households attempting to financially prepare for the future will need to contend with financial market distortions that induce greater risk taking, debt constrained growth that lead to increasingly more expensive investment options and weaker economic activity and political developments that have the potential to batter financial assets.
Above all, these developments have the potential to raise the risks of a U.S. recession which we cover in our next post.
This post is an excerpt from our report, Getting Ahead Financially in 2020. You can download this report in its entirety by visiting franklinmadisonadvisors.com.
Important Disclosures
Broadview Macro Research is a division of Franklin Madison Advisors, Inc (“FMA”). The commentary provided on this website is limited to the dissemination of general information pertaining to Franklin Madison Advisors’ investment advisory services and general economic market conditions and are subject to change without notice. The information contained herein is not intended to be personal legal, investment or tax advice or a solicitation to buy or sell any security or engage in a particular investment strategy. For additional information about FMA, including fees and services, please contact FMA or refer to the Investment Adviser public disclosures.
Franklin Madison Advisors, Inc., is registered investment adviser firm with its registration and principal place of business in the Commonwealth of Pennsylvania. Registration of an investment adviser does not imply a certain level of skill or training. FMA is in compliance with the current notice filing requirements imposed upon registered investment advisers by those states in which FMA maintains clients. FMA may only transact business in those states in which it is notice filed or qualifies for an exemption or exclusion from notice filing requirements. Any subsequent, direct communication by FMA with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For additional information about FMA, including fees and services, please contact FMA or refer to the Investment Adviser Public disclosures. Please read the disclosure statement carefully before you invest or send money.
To learn more, visit us at http://www.franklinmadisonadvisors.com
Are Markets Getting the COVID-19 Recovery Wrong?
Various earnings reports, data releases and the IMF’s World Economic Outlook have served investors notice not to get ahead of themselves. Truly, global risk assets have moved lower this week in response to historically disappointing corporate earnings and economic reports. It’s certain that the stay-at-home orders in 42 states have essentially shut down the national economy.
And so, markets shouldn’t be surprised by the weak data, right? In other words, this week’s bad news should have been taken in stride. Well, market moves are typically about expectations. And the market response to this week’s data suggest that investors’ expectations of a post-COVID19 economic recovery may have been wrong.
Figure 1: March industrial production drop worst since 2008
Misplaced expectations?
Indeed, market expectations in recent weeks have shifted from panic selling in March on COVID-19 related uncertainties to renewed optimism on policymakers’ fiscal and monetary responses in April. Large cap stocks being up well over 20% from March lows is one indicator of this change in sentiment. And a rise in the price of riskier assets like small cap and emerging market equities proved the renewed optimism as well.
One reason for the recent market bounce is that some market participants expect the negative effects from the quarantine to be short-lived. This goes back to the u-shared vs. v-shared recovery debate that we’ve written about before. To be certain, various wire house strategists are already calling a bottom in this year’s market lows. And some are even advocating that people add risk to their investment portfolios right now as headline coronavirus concerns dissipate.
But, this market view assumes that a few things need to go right in order for a v-shaped recovery to take place. This includes a rapid end to quarantine efforts, a back-to-normal mentality for households and businesses operating pre-coronavirus capacity. Market moves lower this week suggests that such assumptions could in fact not hold out in the near term.
Coronavirus: NYC seeing progress, national response still lagging
To the first point, in order to have a v-shared recovery you need the U.S. economy to reopen quickly. Some policymakers and pundits are certainly pulling for this outcome, setting May 1st as a soft deadline to begin allowing non-essential businesses to restart. This assumes, however, that “flattening the curve” efforts have been effective enough to prevent a renewed surge in COVID-19 infections.
For instance, some people are looking at the positive developments in New York as a litmus test for the broader U.S. economy. And this could be a problem. With a key reason being that many other states are just now beginning to see a rise in new COVID-19 cases weeks after New York started its quarantine efforts.
Other issues come up as well. Like state-level coordination and the ability to test the U.S. population for the coronavirus broadly, frequently and consistently with states at varying outbreak phases. Therefore, looking at what’s happening in one state may not be the best measure of how the COVID-19 outbreak will play out nationally. Put differently, other state economies could remain closed even as New York reopens for business. The longer people stay at home, the fewer businesses they will frequent. This increases the likelihood that more businesses may simply remain shutter and not reopen.
Figure 2: Behavior changes post 9/11
Expect a change in consumer behavior
Another argument being made for a rapid economic recovery is the concept of pent up demand. Proponents of this belief suggest that once the stay-at-home orders are lifted, people will simply flock to non-essential businesses after having been cooped up at home for weeks. While intuitive, such a view assumes that a large part of the U.S. population will frequent businesses that still exist and consume in a manner consistent with how they had at the end of 2019.
Some may certainly go out and spend on the things they have long wanted. Yet, back to normal consumption is likely to take some time to return. More specifically, we expect the COVID-19 outbreak to change the way people interact with each other and businesses once the threat is gone.
One example of how consumer behavior can change is found in the aftermath of the 9/11 World Trade Center attacks. At the time, air travel in the U.S. was halted until leaders were certain that the terrorist threats were contained. While the grounding lasted only two days, we find that flights getting back to normal took even longer. For instance, government data show that it took well over a year for people to begin flying at pre-crisis levels again.
It’s also worth noting that it wasn’t just a fear of renewed terrorist attacks that changed people’s behavior and ability to fly. Before 9/11, TSA checkpoints didn’t exist like they do today. In fact, the early days of its operations were hampered by fits and starts, and long lines made flying simply unbearable. Certainly, we’ve adapted, but it didn’t happen overnight. As reports from China show, the COVID-19 outbreak could have lingering effects on our daily lives once the stay-at-home restrictions are lifted.
Figure 3: COVID-19 downturn worse than Great Recession
Business coming back online will take time
There’s also this expectation that businesses will simply pick up where they left off before the stay-at-home orders took hold. Indeed, the IMF reported this week that the global economy is likely to face prolonged sluggishness due to the COVID-19 containment efforts. Analysts at the Fund expect the global economy to contract sharply this year, experiencing its worst decline in over a century. The dour forecasts represent more than people simply not shopping or visiting restaurants. Consider supply shock.
Stories abound of growers upending crops and chicken farmers destroying thousands of eggs because of demand and logistic challenges. Truly, the supply shock issue shows that it’s hard to flip a switch and bring back lost produce and livestock overnight. Also consider the way downstream processors, distributors and wholesalers depended on agricultural supply available to them that is now gone.
Quote: While timing the market bottom is interesting, what should be of more concern for investors right now is whether market prices accurately reflect risk expectations.
This concept can also be applied to restaurants, retail spaces and the myriad support businesses that will struggle to restart once the U.S. economy broadly reopens. Adding insult to injury, there is a real risk of a renewed COVID-19 outbreak so long as we do not have a vaccine for the virus. Even then, getting a vaccine produced and distributed throughout the U.S. and globally will yet take even more time. Certainly, there is a strong argument to be made that getting back to normal won’t happen overnight.
Reframing expectations
While timing the market bottom is interesting, what should be of more concern for investors right now is whether market prices accurately reflect outstanding risks. We believe that this may not be the case today. Indeed, all of the knock-on effects from the global economic shutdown are still not fully understood. And this could open the door for more downward market moves as data releases, like those from this week, surprise in the months ahead. We’ll take just one more example from history to crystalize our point.
The 1906 San Francisco earthquake nearly decimated the city. While the earthquake took only minutes, the fire that ensued lasted for days and destroyed thousands of buildings. Now imagine local leaders back then having discussions about how much of the city would need to be rebuilt just hours into the inferno breaking out – well before it was even contained. We believe that, right now, we’re still in the early days of trying to understand the present and future consequences of the COVID-19 pandemic.
Figure 4: Market sentiment still in risk-off territory
Positioning for more market uncertainty
Therefore, making high conviction calls in one direction or another at the present time could be a setup for investor disappointment. Make no mistake, we will get a handle on this outbreak. Our economy and markets will recover. The challenge for market participants right now is whether their expectations are misplaced. So, what should investors be doing right now during this time of uncertainty?
For now, we believe that the best course of action is for investors to remain disciplined and committed to their long-term investment process. Stick with your systematic investment savings contributions and allocate new capital in a manner consistent with your long-term asset allocation framework. It certainly is tempting to look for deep value opportunities in the markets today. For sure, use this time to create a wish list of high-quality names that you would like to own, but give it time.
Our risk-on/risk-off indicator shows that we remain well into risk off territory. Using the October 2008 lows in risk sentiment as our guide, it wasn’t until March 2009 that the markets broadly bottomed and a new bull market took hold.
Volatility may increase in the coming weeks as market participants begin repricing the likelihood of a longer, deeper protracted recovery. Therefore, we believe that investors should hold off on taking unnecessary risk in their portfolio. From this vantage point, we will likely need the balance of news to lean net positive in the coming weeks before we gain further conviction on shifting more favorably towards value/cyclical opportunities. Until then, stay focused on the long-term opportunities.