Per Stirling Capital Outlook – September 2019
The major global economies and markets remain mired in a “Catch 22” macroeconomic environment. The term “Catch 22” first became a part of the American lexicon in 1961 thanks to the Joseph Heller novel of the same name, in which a disillusioned American bombardier fighting in World War II desperately seeks to avoid flying future missions by trying to convince the army psychiatrist to declare him insane, only to find that the very fact that he does not want to expose himself to the risks of such dangerous missions is, in and of itself, proof of his sanity, and thus the very reason why he must continue to fly.
Merriam Webster offers several definitions of “Catch 22”, two of which offer a very pragmatic backdrop against which to view the prospects for and impacts of current global monetary, trade and fiscal policies.
The first definition, “a problematic situation for which the only solution is denied by a circumstance inherent in the problem or by a rule” applies beautifully to the ongoing U.S./China trade negotiations. A second definition: “a measure or policy whose effect is the opposite of what was intended”, is increasingly relevant to global monetary policy in general, negative interest rates in particular, and even, to a lesser extent, U.S. fiscal policy.
We have seen the first definition play out time after time in the Trump administration’s trade negotiations with China. Every time that there are signs of trade progress, the markets rally, economic indicators edge upwards, and measures of investor and consumer sentiment improve. However, every time that these improvements manifest themselves, President Trump seems to be emboldened by the gains, and therefore motivated to become even more hawkish and more demanding in his negotiating stance.
Indeed, this phenomenon just played out again on September 20th, when President Trump, presumably encouraged by the stock market’s attempt at new highs and favorable polling results regarding trade, hardened his stance, dismissed the possibility of an interim agreement, reinforced his desire for what he called a “big win”, and countered recent Chinese concessions with threats of escalation, an approach not likely to be well received in China given how the country views the traditional foreign powers in light of its “Century of Humiliation” (1839-1949), when it was subject to European and Japanese colonialism.
As Chinese state-run media Xinhua proudly pronounced on August 27th, when both the U.S. and China were denying that they had made the phone call that ultimately catalyzed the most recent, albeit potentially only temporary, improvement in trade relations, “China did not and will not surrender”. China is an emerging economic superpower and nationalism is an important part of current Chinese culture, as is the concept of “saving face”. As a result, we believe that China would ultimately rather have their economy suffer great harm due to ever-increasing tariffs than to ever be perceived as capitulating to anyone.
In addition, there is a mistrust of President Trump on the part of Chinese leadership, at least partially due to the fact that Trump threatened to use tariffs against Mexico to force them to be more vigilant regarding illegal immigration into the U.S., despite the fact that the threatened tariffs would violate the very trade agreement that Mexico had reached with the U.S. only weeks earlier.
As noted, this scenario has just played out again in the days since August 27th, when the aforementioned phone call reopened a seemingly productive dialogue between the two countries. China announced that it would delay any retaliation against Trump’s latest tariffs, Trump deferred for two weeks some of his planned tariff increases, and mid-level negotiations began, in anticipation of an October Trump/Xi summit. China even restarted purchases of U.S. agricultural products and scheduled for a trade delegation to meet with American farmers.
There was even talk that Trump would settle for a more modest, interim trade agreement that would at least stop a further escalation of the trade war. There were growing reasons for modest optimism, and this optimism manifested itself in the capital markets, which reacted dramatically to the perception of improving prospects for a trade deal, with seemingly almost every established trend in the global stock, bond and commodity market reversing in their entirety.
Interest rates moved sharply higher and equity market leadership changed entirely, with small cap and value stocks suddenly taking on the mantle of leadership and the previous leadership sectors (large-cap growth, income-oriented and safe-haven stocks like gold miners) selling off or at least dramatically underperforming, in the face of a broad market advance.
However, that optimism-driven reversal in the markets seemed to reverse yet again when President Trump’s senior advisor on China, Michael Pillsbury, pronounced on September 19th that, if a trade deal is not reached soon, “tariffs can be raised higher. These are low level tariffs that could go to 50 per cent or 100 per cent.” He also noted that Trump’s critics were wrong to assume the president was “just bluffing when he threatened an all-out trade war.”, and that “There are other options involving the financial markets, Wall Street, you know, the president has a whole range of options.”
President Trump doubled down on that hawkish commentary the very next day when, during a joint press conference with the Prime Minister of Australia, he said that China is a “threat to the world”, that he was going to hold out for “the big deal”, that he does not need to get a deal before the election, and that he can afford to wait because “China’s being affected very badly. We’re not, we’re not being affected.”
Predictably, with their recent “signs of good faith” being met with perceived threats by the Trump administration, the Chinese trade delegation terminated their negotiations early, cancelled their trade mission to America’s farmland (supposedly at the request of Treasury Secretary Mnuchin) and returned to China. Welcome to “Catch 22”.
That is not to suggest an end to negotiations, or that Trump and Xi won’t meet next month to continue their discussions, but it does illustrate one of the major reasons why a trade deal may not be agreed to, even if it is to both sides’ economic advantage.
That said, we do believe that there are still a variety of reasons why the ground is more fertile for a potential trade deal than it has been in the past, starting with growing evidence that it is dragging on economies across the globe, including both the U.S. and China, and is even primarily responsible for what is now a global manufacturing recession (as illustrated by readings below 50).
Ironically, one of the reasons why the markets are reportedly giving additional credibility to the current set of negotiations is because the potential for progress was this time reported by Chinese state media instead of the White House (a revealing but notably sad commentary).
As noted, there are a variety of headwinds to economic growth that are being caused by the ongoing trade war, but the first casualty has clearly been the manufacturing sector on a global basis. The U.S. still remains as an island of relative economic stability, as opposed to its foreign peers, as 70% of the domestic economy is based upon consumer spending, and the consumer remains very strong due to an exceptionally robust jobs market and a significant acceleration in wages.
However, it is also very important to keep in mind that the domestic consumer has thus far been largely sheltered from the trade war, as almost all tariffs on consumer-related goods are being deferred until later in the year. If, as expected, the upcoming tariffs have a deleterious effect on consumer spending, the outlook for the domestic economy should change dramatically. Indeed, even with the consumer being largely protected to-date, we are already seeing an array of econometric recession models indicate a rising risk of recession for 2020.
One of the most well-respected of those is run by the New York Federal Reserve Bank. That model is now predicting a 38% likelihood of a U.S. recession within the next twelve months, which may not seem particularly worrisome until you realize that there has only been one instance in history when probabilities were this high and a recession (shown by grey shaded areas) did not follow in short order.
Ironically 38% is also the percent of the 235 fund managers in the September Bank of America Merrill Lynch Fund Manager Survey who expect a recession over the next twelve months (the highest risk of recession by this measure since 2009).
Corporate executives are even more pessimistic, with 53% of U.S. Chief Financial Officers (CFOs) polled in the just-released Duke University/CFO Global Business Outlook survey expecting a recession before next year’s elections and two-thirds predicting a recession by the end of next year (a three-year low in corporate optimism). Surveys taken outside of the U.S. were even more pessimistic, with 81% of African CFOs, 68% of Canadian CFOs, 69% of European CFOs, 72% of Asian CFOs and 65% of Latin American CFOs expecting for a recession to start by the third quarter of 2020. Of note, Presidents are almost never re-elected in the midst of a recession, which could potentially incentivize President Trump to seek a trade deal sooner rather than later.
At the same time, it is noteworthy that, in the just-released September NBC News/Wall Street Journal poll, 46% of Americans give President Trump credit for “an improving economy”. This is the highest reading of his presidency, and potentially very important, as people tend to, as the saying goes “vote their pocketbook”.
Will President Trump take this news as evidence that he should play hardball and hold out for an even more comprehensive deal, or will he make the political decision to strike a deal over the intermediate term, particularly now that China also has political reasons for seeking rapprochement sooner rather than later?
First of all, with the Democratic presidential candidates sounding as hawkish on China-related trade issues as the President is, and a recent Harvard CAPS/Harris Poll survey showing that more than two-thirds of American voters want the U.S. to confront China over its trade policies despite believing that Americans are suffering more from tariffs than China is, there is much less motivation for China to wait until after the elections to seek a deal.
Even more importantly, China is in desperate need of U.S. agricultural products (particularly pork), as swine flu is wiping out live hog inventories in both Japan and China, where pork prices have soared 47% over the past year, and they have a dire need for protein.
Similarly, the potential of an impeachment may increase President Trump’s desire for a more immediate deal, before the process potentially weakens his negotiating position, and as a means of increasing his popularity and distracting the public from his political woes.
We also suspect that Trump’s inability to effectively bully the Fed to “get our interest rates down to ZERO, or less”, as the President put it, may motivate the President to seek a deal, as we believe that he was counting on his ability to force U.S. rates down to European and Japanese levels as a means of offsetting the negative effects of the trade war.
On that point, as investors, strategists and economists are all starting to appreciate, Chairman Powell’s ability to withstand President Trump’s verbal abuse and jawboning is proving to be very important, and provides the perfect segue to the second definition of “Catch 22”: “a measure or policy whose effect is the opposite of what was intended”.
Negative interest rates are an anomaly, and they can not (for a variety of reasons that are beyond the scope of this report) persist over the longer term in a capitalistic system. They are based upon the premise that, if low interest rates provide stimulus by encouraging borrowing and consumption, then negative interest rates should be stimulus on steroids.
However, rather than being stimulative, it now appears that negative interest rates literally weaken the banking system so severely that banks are simply too weak to lend and, as a result, negative interest rates are actually proving to be a drag on economic growth.
This is the finding of the research released on August 29th by the University of Bath (England), which reports that “following the introduction of negative interest rates, bank lending was weaker than in countries that did not adopt the policy”…and “that negative interest rates also appear to have cancelled out the stimulus impact of other forms of unconventional monetary policy such as quantitative easing”. The research team found “robust” evidence that bank lending growth was weaker in countries with negative rates.
Moreover, a just-released report by the European Central Bank also questions the benefits of negative rates, and estimates that all that negative interest rates have produced is a one-tenth of 1% increase in European inflation and a similarly minute increase in European economic growth.
It is also noteworthy that there are nine central banks that have lowered their target rate to 0% or below. Each has since tried to raise rates, and each is now back to rates of 0% or below. While never touching 0%, the Fed also tried raising rates, and has since reversed course and lowered them twice.
To wit, the global economy was saved by the central banks, who used extraordinary measures to keep the financial crisis from turning into a global depression, and it has left the global economy addicted to monetary stimulus, while also trying to service record levels of debt. The world is just starting to understand the longer-term ramifications of these macroeconomic factors.
For example, in a CNBC interview on September 19th, renowned investor Leon Cooperman made the very insightful point that the significant economic slowdown that the U.S. experienced in the fourth quarter of last year was catalyzed by a very modest increase in interest rates, and that such an outsized economic reaction is an indication that the U.S. economy is overburdened by soaring levels of debt. This raises the important question of what will happen to the economy when rates head higher in earnest?
Similarly, the recent spikes in the short-term repo rate (at which banks borrow to meet their short-term liquidity needs), and the Fed’s resulting difficulty in controlling short-term rates (its primary policy tool) illustrate the significant challenges associated with trying to shrink the Fed’s balance sheet from its incredibly bloated levels via quantitative tightening.
If anything, a renewed expansion of the Fed’s balance sheet is the most likely solution to this repo rate issue, which would officially reverse the Fed’s attempts to partially “normalize” monetary policy by shrinking their balance sheet (yet another example of how hard it will be to return to anything even remotely resembling normal/traditional monetary policy).
The Fed is offering assurances that, unlike the conditions that existed at the onset of the financial crisis, the current issue is purely one of liquidity rather than credit quality, and that it is being caused by the confluence of quarterly tax payments, unusually large treasury auctions, and previous quantitative tightening programs, each of which drained unexpectedly large amounts of cash out of the banking system.
While the Fed’s explanation does make sense to us on the surface, the world has never before seen the economic and expansive monetary conditions that exist today, and there is no playbook for how this is likely to ultimately impact the world’s economies and markets, particularly when interest rates do eventually move higher (as we have seen over recent weeks). As such, it bears close watching.
Warren Buffett famously noted that “only when the tide goes out do you discover who’s been swimming naked.” In this instance, it is the withdrawal of monetary liquidity and a resulting climb in interest rates that will eventually expose virtually every economy, market, company or investor who is over-leveraged.
Ultimately, we believe that the experience of the last several weeks served to reaffirm that the trade war is the single most important variable to both the financial markets and the world economy as a whole, and its potential resolution is probably the key determinant as to both whether or not the U.S. experiences a recession in 2020, and whether or not interest rates finally return to something even remotely resembling more normal levels.
The period’s violent sector rotation also provided what could be potentially important insight into how markets will react when and if a trade deal with China is ultimately successfully negotiated, and where the greatest opportunities (and risks) lie if and when the current trade conflict is finally settled.
As noted previously, there is virtually no historic precedent for many of today’s economic conditions, and therefore no time-tested “playbook” for how things might ultimately be resolved. However, there is still the sage advice offered long ago by Mark Twain, whose words remind us that “History does not repeat itself, but it oftentimes rhymes”.