Section 1: Q4 2019 Outlook

 

Globalization Has Changed the Global Economy. Are We Now in a Period of De-Globalization?

Our investment approach is focused on the expected behavior of asset classes in various economic environments. Our research shows that in addition to five broad economic environments – Growth, Stagnation, Inflation, Recession and Chaos – the global economy also experiences regime shifts, which are temporary, and regime changes, which are permanent. Globalization results in regime change, as does de-globalization. In this Fourth Quarter 2019 Outlook, we take a closer look at the current state of globalization. The recognition of this changing environment is critical in determining our investment positioning in 2020 and beyond.

Economic theory suggests that globalization benefits the world economy. The absence of trade barriers should allow each country to specialize in the production of goods and services in which they are relatively efficient, leading to global productivity gains.

History shows that waves of globalization are driven by both technology and policy, but protectionist shifts tend to end them. In some cases, like in the 1970s, a pushback by policymakers can cause globalization to stall. In more extreme environments like the experience of the 1930s, a sustained policy backlash can push globalization into reverse. So far, the current trade war looks more like a stall but the risk of a de-globalization outcome similar to the 1930s is rising.

 

SOURCE: DEMIG (2015), OUR WORLD IN DATA, CAPITAL ECONOMICS

 

It takes a large and sustained push by policymakers to cause a period of de-globalization. As we begin Q4, the global economy is facing two dangers. The first is that a global economy that is already injured by geopolitical conflicts, including trade wars, endures further negative shocks. The second is that we overestimate resiliency and the feedback loop of slower growth that is occurring in many major economies around the globe.

This is occurring as the U.S. House of Representatives initiates a preliminary inquiry as to whether to proceed with a formal impeachment investigation of President Trump, China potentially delays trade solutions until the 2020 Presidential election, and the deadline for a Brexit decision falls at the end of October. Each of these challenges to the global economy could potentially be prolonged.

Compounding these risks, interest rates worldwide remain low or negative. It is estimated that over 80% of sovereign debt is trading with negative real rates.ⁱ While the U.S. Federal Reserve Bank continues to manipulate the economy with artificially low-interest rates, this policy is likely to backfire as the Federal Reserve’s policies mask the true state of the economy. Without an accurate financial picture, businesses lack the knowledge required to make investments. The resulting inaction could bring about the recession the Fed claims it wants to avoid. In addition, the idea that sub-zero interest rates lower the cost of borrowing has not proven to bring about the anticipated economic stimulus that central banks initially anticipated. Instead of paying banks to hold their money, businesses and individuals will find other sources in which to put their money.

 

Time to Include Gold in our Portfolio Models. Gold is Negatively Correlated with Interest Rates.

Economic events can create structural shifts in the acceptance level of risk. The global financial crisis of 2008-2009 is one example of these structural changes, referred to in our modelling as Chaos. Looking back at events including Black Monday, the LTCM crisis, and the global financial crisis of 2008 – 2009, World Gold Council analysis shows that gold mitigated portfolio losses incurred by investors during almost all tail events under consideration. For example, investors in the U.S., Europe, and the UK, who held a 5% allocation to gold reduced losses by approximately 5% during eight tail risk events.ⁱⁱ

Our Portfolio Models are seeking exposures that offer low correlations among stocks and bonds to mitigate downside risk. In a year marked by noticeable geopolitical unrest, policy uncertainty and the risk of an impending recession, gold becomes a preferred investment to bonds and equities. And while one of the negatives of holding gold is that it does not generate income and has a cost to store it, the periods when bonds have a negative carry momentum become strong periods for gold.

During September, global monetary policy continued to influence gold price performance as many central banks around the world cut rates or expanded quantitative easing measures. The Federal Reserve cut rates by 25 basis points in July, and again in September.ⁱⁱⁱ

Gold has important diversification properties that are evident during periods of systemic risk. Gold has little or no correlation with many other assets, including commodities, during times of stress. In addition, the correlation is dynamic, changing across economic cycles to the benefit of investors. Like other commodities, gold is positively correlated to stocks during periods of economic growth when equity markets tend to rise. Gold is negatively correlated with other assets during risk-off periods, protecting investors against tail risks and other events that can have a significant negative impact on capital or wealth – a protection not always present in other commodities. As a result, gold can enhance portfolio stability and improve risk-adjusted returns.

 

Many Central Banks are Adding to Gold Reserves

Analysis of several factors that are propelling the gold market include central bank gold demand. Physical gold is expected to play an important part as countries shore up their havens, both on the private and official levels. While gold no longer plays a direct role in the international monetary system, central banks and governments still hold extensive gold reserves to preserve national wealth and protect against economic instability. Today, gold is the third largest reserve asset globally, following U.S. dollar and Euro-denominated assets.^iv Gold is increasingly used as collateral in financial transactions, much like other high-quality liquid assets such as government debt.

History shows us that central bankers were net sellers 30 years ago. These same banks have turned to buying gold since 2010, culminating more than 650 tons of bullion bought from the official sector in 2018 with the trend persisting through the first half of 2019.^v This is more than at any time since the end of the gold standard.

We expect that central banks will continue to power gold’s move higher and beyond the current supply and demand dynamics. The October 2019 report from the World Gold Council notes that investors have begun to turn to gold to escape an environment of negative interest rates as treasury yields come under continuing pressure. The U.S. 30-year Treasury acts as a signal here. Should the 30-year U.S. bond fall into negative territory, as has already happened in Germany and France, we expect gold to hit new cycle highs.

 

With rates likely to stay low and geopolitical unrest unlikely to abate, the demand for gold exposure is expected continue.

 

SOURCE: BLOOMBERG, WORLD GOLD COUNCIL

 

SOURCE: BLOOMBERG, WORLD GOLD COUNCIL

 

 

Section 2: 4 Themes

 

Theme 1: Global Trade and GDP are Deteriorating

The multilateral trading system remains the most important global forum for settling differences and providing solutions for the challenges of the 21st century global economy. Trade conflicts heighten uncertainty, leading some businesses to delay the productivity-enhancing investments that are essential to raising living standards. Trade conflicts can also heighten political tensions and occasionally physically aggressive behaviors between countries.

 

The World Trade Organization Lowers Trade Forecast as Tensions Unsettle Global Economy

Escalating trade tensions and a slowing global economy have led WTO economists to sharply downgrade their forecasts for trade growth in 2019 and 2020. World merchandise trade volumes are now expected to rise by only 1.2% in 2019, substantially slower than the 2.6% growth forecast in April.^vi The updated trade forecast is based on consensus estimates of world GDP growth of 2.3% at market exchange rates for both 2019 and 2020, down from 2.6% previously.^vii Slowing economic growth is partly due to rising trade tensions but also reflects country-specific cyclical and structural factors, including the shifting monetary policy stance in developed economies and Brexit-related uncertainty in the European Union.

The projected increase in 2020 is now 2.7%, down from 3.0% previously.^viii The economists caution that downside risks remain high and that the 2020 projection depends on a return to more normal trade relations. Risks to the forecast are heavily weighted to the downside and dominated by trade policy. Further rounds of tariffs and retaliation could produce a destructive cycle of recrimination.

Shifting monetary and fiscal policies could destabilize volatile financial markets. Continued slowing of the global economy could produce an even bigger downturn in trade. In addition, a disorderly Brexit could have a significant regional impact, mostly confined to Europe.

 

US Economy Starting to Feel the Pain

More recently, increased foreign competition has been blamed for U.S. manufacturing job losses over the past twenty years. In practice, while the integration of several billion workers into the global economy has contributed to both a loss of manufacturing jobs and a more general squeeze on labour’s share of income in the developed world, most academics agree that other factors, including technological change, have played a bigger role.

The U.S. economy posted strong gains in the first half of 2019, although some measures were negative. Consumer spending surged in the second quarter, supported by the strong labour market. The decline in interest rates over the summer tees up for U.S. consumers to be the key driver of activity in the second half of the year. Companies continue to hire, and the unemployment rate recently hit a 50-year low.^ix Labour market tightness is finally translating into a pickup in wages. Business sentiment has deteriorated amid unrelenting uncertainty about trade. Business investment fell in the second quarter for the first time in three years and exports sagged with the weakness concentrated in the manufacturing sector. While fundamentals are still positive for the consumer, the government’s protectionist policies pose risks to the outlook. The persistence of healthy labour-market conditions, as well as efforts by several central banks to shore up an expansion that’s already passed the 10-year mark, will provide support to the global economy. Another tranche of tariffs on Chinese imports coming into effect in mid-December will hit U.S. consumers.

Open borders tend to boost productivity at a global and national level (particularly for developing countries). However, globalization has distributive consequences within economies. Workers and capital owners in competitive export-orientated industries tend to gain, while consumers’ purchasing power rises from access to cheaper imports. But relatively inefficient domestic industries can lose out to more productive foreign competition.

Our current outlook does not see any material improvement over the next twelve months.

 

Theme 2: Brexit and the EU: Deal or No-Deal?

The prolonged and twisted saga of Brexit has been a weight overhanging global markets since 2016. UK growth was synchronized with its main trading partners in 2015 but slowed following the 2016 Brexit vote from a range of 2.0- 2.5% to around 1.5-2.0% in 2017.^x This occurred despite a clear strengthening in global activity. Throughout the latest phase the labor market has held strong and helped consumers to keep the economy from stagnating. The realistic prospect of no-deal since the change in prime minister has combined with a regional growth slowdown to produce a collapse in business confidence and signs in some of the leading surveys that the labor market is about to weaken. The domestic drag began to stabilize in 2018 after the initial purchasing power shock from the weaker currency peaked. Later in 2018, growth among the UK’s main trading partners slowed and growing complications in the Brexit negotiations prompted a phase of outright decline in UK business spending. Since the referendum UK business investment has weakened by almost 10% compared to capex in other developed markets. Given that UK investment was growing faster than elsewhere prior to the vote.

In a major blow to Prime Minister Boris Johnson, Britain’s highest court ruled in early October that his decision to suspend parliament for five weeks in the crucial countdown to the country’s Brexit deadline was illegal. And unresolved is a legal and operational solution including the Irish border backstop. Currently, there are no border posts or physical barriers between Northern Ireland and the Republic of Ireland. The backstop is designed to ensure that this continues after the UK leaves the EU. The backstop would only be needed if a permanent solution to avoid border checks could not be found. If it was needed, the backstop would keep the UK in a close trading relationship with the EU to avoid checks altogether.

If the sides fail to reach a deal, Mr. Johnson could be forced to seek a third Brexit extension. That’s because MPs have passed a law – known as the Benn Act – that requires Mr. Johnson to ask for a Brexit delay by October 19. This will push the deadline back from October 31 to January 31, 2020. MPs say the law is necessary in order to prevent a no-deal Brexit.

These events unfolding in the UK have the potential to impact European markets and beyond. Regardless of the outcome of Brexit, there is no doubt that the trading relationship between the EU and Great Briton has changed While many Dutch politicians say they dread the economic repercussions of the looming Oct. 31 Brexit deadline, the Netherlands is working to minimize the damage, in part by attracting some of the organizations and businesses that have already fled the United Kingdom.^xi

 

SOURCE: NETHERLANDS FOREIGN INVESTMENT AGENCY

 

Theme 3: Low and Negative Interest Rates: A Dilemma for Central Banks and the Aging Population

Many central banks reduced policy interest rates to zero during the global financial crisis to boost growth. Ten years later, interest rates remain low in most countries. Core inflation has been low and stable for 15 years and shows no signs of acceleration anytime soon.

The U.S. Federal Reserve cut rates on July 31 for the first time since the Great Recession, and the ECB committed to a range of policy steps to fuel growth and get inflation to levels closer to its stated target. The minutes to the September FOMC meeting show that the Committee held a range of views with respect to both the appropriateness of the September rate cut and to what the Committee should communicate about the future direction of rates. The majority who wanted a cut last month cited trade policy uncertainty, slowing global growth, low inflation, and risk management as motivating considerations. Several participants favored leaving policy rates unchanged and argued policy should respond more to the data than to risks. Some argued that cutting too much now would leave monetary policy with less scope to boost aggregate demand if such shocks materialized.

The two major central banks were among a dozen that eased policy rates to combat the negative spinoff from rising trade tensions and political turmoil. The Bank of Canada was an outlier, staying on the sidelines as Canada emerged from a six-month slump in economic activity. And there is still no firm line of sight on how the UK will leave the European Union. Given these tensions, it will once again fall to extraordinarily stimulative monetary policy to sustain global growth, as few governments have committed to providing fiscal support.

 

Savings Gluts Provide Fuel for Low Rates

From the demand side, as populations age, they have a propensity to save. Prior to 2005, the global saving rate was never above 24.5%. Since then it has only been lower during the panic of 2009. The rate equaled its record high of 26.7% in 2018. This works out to roughly $21 trillion saved every year.^xii Since many seek to match the investments in their savings to their life expectancies, they tend buy bonds.

The savings glut is leading to massive bond buying that is resulting in yields dropping below the inflation rate nearly everywhere in the developed world. Only two countries in the developed world have real 10-year yields above zero: Portugal and Italy.^xiii Everywhere else, older people are buying bonds and driving yields below the inflation rate. Demographics tells us the developed world is not running out of old people anytime soon. The savings glut will continue.

While the global economy has been recovering, future downturns are inevitable. Severe recessions have historically required 3–6 percentage points cut in policy rates. If another crisis happens, few countries would have that kind of room for monetary policy to respond.

 

Theme 4: ETFs have a Positive Role in Market Volatility and Liquidity

Passive investing has historically attracted criticism, typically focused on illiquidity. The liquidity of ETFs varies due to characteristics determined by their underlying markets and indexes. The underlying markets for equity ETFs and credit ETFs are fundamentally different. In addition, apart from the underlying securities in an ETF, there are multiple layers of liquidity in the primary and secondary ETF markets, and the liquidity should never be less than that of the ETF’s underlying holdings. This is a superior feature compared to mutual funds.

ETF market makers and authorized participants looking for arbitrage opportunities trade dynamically to balance the supply and demand for ETF shares and their underlying assets. One of the key features of ETFs is that the supply of shares is flexible. Shares can be created or redeemed to offset the changes in demand. This structure has two important functions: it creates liquidity for the ETF shares by meeting the supply-and-demand needs of investors who trade on an exchange; and it helps keep an ETF’s price per share close to the ETF’s net asset value (NAV).

Index vehicles may be price takers at a microeconomic level but help to set prices at a macroeconomic level. The arbitrage mechanism allows for authorized participants to factor into the price the impact of macro and geopolitical events that may not yet be reflected in the underlying securities when these events occur while the primary markets are closed due to time zones and holidays. Historical evidence is consistent with the idea that higher correlations today are not the result of passive indexing, but rather reflect the macro environment and common factor risks.^xiv

Recently there have been liquidity events that have tested the mechanisms behind ETFs. A number of credible studies have concluded that the arbitrage mechanism associated with the create and redeem feature of ETFs in fact helps, rather than hinders market liquidity in these extreme events.^{xv xvi}

 

 

Section 3. Investment Outlook

 

Slowing Global Growth and Inverted Yield Curves Leads Us to a Stagnation Forecast for the Next Twelve Months

SOURCE: FRAME GLOBAL ASSET MANAGEMENT

 

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

 

Section 4. September 2019 Portfolio Models

We have maintained our Stagnation outlook for the U.S. economy as growth is capped over our forecast time horizon of twelve months. While geopolitical developments have always played a role in economies and markets, their scale and impact has been steadily rising since the 2008 financial crisis. Against a hostile trade backdrop, the global economy is losing momentum. Forecasts for world GDP growth this year have fallen to 3.2% from the 3.9% economists expected a year ago. Inverted yield curves and slumping manufacturing activity that are traditional recession predictors are contributing to a cautious business mood. Few governments have committed to providing fiscal support, leaving extraordinary stimulative monetary policy as the tool of choice to combat the recession threat. Our concern is that central banks in several countries are operating at the limits of what monetary policy can do. This has negative feedback implications for fiscal policy and financial markets.

We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

October 14, 2019

 

ⁱWorld Gold Council. Global Gold-backed ETF Flows. October 8, 2019.
ⁱⁱWorld Gold Council. Gold and Tail-risk Hedging. January 2013.
ⁱⁱⁱTrading Economics. U.S. Fed Funds Rate. September 19, 2019.
^ivWorld Gold Council. Gold Versus Commodities. October 2019.
^vWorld Gold Council. Gold Versus Commodities. October 2019.
^viWorld Trade Organization. Press Release. October 1, 2019.
^viiWorld Trade Organization. Press Release. October 1, 2019.
^viiiWorld Trade Organization. Press Release. October 1, 2019.
^ixTrading Economics. U.S. Unemployment Rate. October 4, 2019.
^xJ.P. Morgan. Global Data Watch. October 11, 2019.
^xiNetherlands Foreign Investment Agency (NFIA). More Brexit-impacted companies choose the Netherlands due to ongoing uncertainty. August 26, 2019.
^xiiNational Accounts of OECD Data. Household Savings. 2019.
^xiiiTrading Economics. Ten Year Yields. October 15, 2019.
^xivMadhavan, A. and Morillo, D. “The Impact of Exchange Traded Funds: Volumes and Correlations.” The Journal of Portfolio Management. Summer 2018, 44 (7) 96-107.
^xvMSCI. “Have High-Yield ETFs Created Liquidity Risk?” Reka Janosik. March 27, 2019.
^xviAquilina, M., Croxson, K., Valentini, G. “Fixed income ETFs: primary market participation and resilience of liquidity during periods of stress.” Financial Conduct Authority. Research Note. August 2019.

 

 

 

Section 1: Q3 2019 Outlook

 

The Danger of Politicizing the Central Bank

As we enter the third quarter of 2019, we review recent global monetary policy and question how it has changed the traditional ways that we use it to detect risk in markets and the global economy.

The global economy is expected to continue to slow in the coming quarters resulting in lower inflation and downward pressure on interest rates. Central banks in developed and emerging markets are now generally cutting rates and quantitative easing (QE) is making a comeback. Weak economic data versus central bank activism remains the key theme.

Recently global markets have been encouraged by a truce in the trade war between the U.S. and China as President Trump and Chinese President Xi Jinping agreed to return to talks late in June. While the truce is encouraging following decades of growing trade flows and cooperation, the process of global trade integration faces risk of stalling or going in reverse. And while the U.S. has proven successful in securing a trade deal with Canada and Mexico (that has not yet been signed off on) and extracting some concessions from China, uncertainty remains due to the growing, rather than shrinking trade deficit in the U.S.

Trade contributed 0.94 percentage points to the U.S. economy’s 3.1% annualized growth pace in the first quarter. ⁱ Building on that trend, the U.S. trade deficit jumped to a five-month high in May, widening to USD 55.5 billion from a revised USD 51.2 billion in April. Imports surged 3.3% and exports rose 2%. The politically sensitive goods trade deficit with China increased 12.2% to USD 30.2 billion despite the recent increase in import tariffs on Chinese goods. Imports increased, likely as businesses restocked ahead of an increase in tariffs on Chinese merchandise. Data for April was also revised higher to show the trade gap widening to $51.2 billion instead of the previously reported $50.8 billion. ⁱⁱ

Many economists highlight that the most important role of the U.S. economy, as the largest economy in the world and the globally recognized main reserve currency, is in providing liquidity to the global economy and driving demand around the world. Contrary to current Trump trade policy, this implies that the U.S. trade deficit is central to global economic stability. The dollar’s role as the global reserve currency and primary tool for global transactions means that many other countries rely on holding dollar reserves, creating massive demand for U.S. financial assets. This means that the U.S. pays little for its foreign borrowing, allowing it to finance its high consumption at low cost, which boosts global demand.

The IMF Working Paper on Tariffs from May 2019 found that U.S. GDP would decline in scenarios that include retaliation on Chinese trade tariffs imposed by the U.S., but also that U.S. output would decline in the case where China only limits exports of selected goods to the United States. ⁱⁱⁱ This is because those foreign goods (electronics and other manufacturing goods) are particularly difficult to substitute with domestic production, and thus tend to be replaced by additional imports from other countries.

The risk that the Trump trade standoff will unwittingly destabilize the entire global economy and thus have dire consequences for the U.S. economy itself is the greatest current risk to equity markets and the broader global economy.

 

 

Global Fundamentals and the Limits on Central Bank Action

After the June FOMC meeting Chair Powell signaled a strong easing bias but indicated a desire to learn more about upcoming policy and data developments. Since then the two main events – the G20 summit and June payrolls – have been positive. U.S. data show that growth has been solid for the first half of the year, supported by a strong labor market and strong financial markets. Inflation remains subdued, and inflation expectations have fallen such that they are no longer consistent with the Fed’s 2.0% target.

But the global picture has deteriorated, and business sentiment has fallen, suggesting that the outlook for the U.S. has also deteriorated. The ECB is expected to ease policy again as the euro area is heavily exposed to a further slowdown in global growth because it has much less policy flexibility. The shift in global policy bias toward easing has also affected the debate around likely Bank of Japan action too, prompted in part when Japanese government bond yields fell further into negative territory.

The gap that has opened between the U.S. manufacturing and non-manufacturing sectors makes clear that trade policy uncertainty is the primary driver of the slowdown. The case for an “insurance” ease remains strong as global growth momentum is slipping and the latest declines in U.S. and global business confidence have yet to be felt.

While it is understood that the unique position of the U.S. in the global economy warrants a central bank that considers the global economy, recent comments by President Trump suggest that his political motives for seeing a continuation of strong equity markets are an attempt to influence the central bank and Chair Powell. Trump’s call for rate cuts while reminding everyone that the American economy is the best it has ever been leads us to this conclusion and has distorted the ability of market participants to detect actual underlying risk.

Central banks in most modern economies are designed to be insulated from the short-term whims of politicians. The goal is to give central bankers the freedom to snuff out inflation, even if that hurts political leaders at election time. Since the global meltdown of 2008, central banks, in the name of protecting the economy, have reacted to sharp market falls by easing policy. Investors have been placated into seeing the stock market as a roller-coaster ride backed by engineers. This creates a false sense of confidence in those markets that can lead to larger negative shocks.

How long can bad news, by going to lower interest rates, be good news for equity prices? Signs that central banks have abandoned monetary policy normalization and are ready to provide additional policy stimulus have encouraged markets as we enter the third quarter of 2019.

Fed rate cuts may happen with the intent to reassure economic actors that the ongoing expansion will continue. But slowing economies and soft inflation imply lower revenue growth, excess capacity, and competitive pricing pressures. The risk is that monetary policy may delay the correction but not prevent it. Given the deterioration in the global economy and policy uncertainty at home, when the correction does come, it will be all the more unanticipated.

Market skepticism, asset purchase limitations, and the potential adverse effects of greater negative yields on banks are all issues we see challenging risk assets. We continue to hope that the U.S. will develop policies that jointly address the U.S.’s need for strong demand and full employment and the rest of the world’s need for dollars by channeling foreign capital into productive, job-creating domestic investment.

 

 

Section 2: 4 Themes

 

Theme 1: Slowing Global Growth

The pace of global growth is slowing this year as policy uncertainty takes its toll on the world’s economy. Data points to the global economy expanding by 3.3% this year, slower than 2018’s 3.6% pace, with trade volumes declining and business sentiment deteriorating. ^v

Economic and market risks are elevated as a result of the U.S. administration’s use of tariffs at a time when global growth is slowing. The prospect of a prolonged U.S.-China trade war, the lack of clarity around Brexit, and political and economic upheaval in countries like Venezuela have combined to generate downside risks to the outlook.

The stakes are high for this year’s European Parliamentary elections where the populists are likely to continue gaining ground, while lingering tensions and a lack of progress in Brexit negotiations raise the odds of a “hard Brexit” scenario. Another near-term risk, which was cited in the November FSR (Federal Reserve Financial Stability Report, May 2019) is elevated tensions between the European Commission and Italy over Italy’s budget plan, which had raised the country’s borrowing costs and prompted worries about its long-term fiscal sustainability. ^vi These concerns have been deferred for now, as Italy and the European Commission agreed on a budget plan for 2019, but Italy still faces longer-run fiscal challenges.

European economies have notable international financial and economic linkages, and a sharp economic downturn in Europe would affect banks, markets, and the global economy. Financial market volatility in Europe could spill over to global markets, including the United States, leading to a pullback of investors and financial institutions from riskier assets, which could amplify declines in equity prices and increases in credit spreads. In addition, spillover effects from banks in Europe could be transmitted to the U.S. financial system directly through credit exposures as well as indirectly through the common participation of globally active banks in a broad range of activities and markets. The consequent U.S. dollar appreciation and weaker global demand in such a scenario would depress the U.S. economy through trade channels, which could reduce earnings of some U.S. businesses, particularly exporters. Such effects could harm the creditworthiness of affected U.S. businesses, particularly those that already have high levels of debt.

Amid the uncertainty, global central banks have moved to the sidelines. Even with the economic expansion in its tenth year, contained inflation pressures have removed any urgency for central banks to act.

 

Theme 2: China’s Non-Financial Sector is Dangerously Over Leveraged

In China, the pace of economic growth has been slowing over the past several years, and a long period of rapid credit expansion has left the non-financial sector highly indebted and lenders more exposed in the event of a further slowdown.

Developments that significantly strain the repayment capacity of Chinese borrowers and financial intermediaries, including a further slowdown in growth or a collapse in Chinese real estate prices, could trigger a collapse in this market. If problems arise in China, spill¬overs could trigger a domino effect with a broader pullback from risk-taking, declines in world trade and commodity prices, and U.S. dollar appreciation resulting. Such an event would tighten conditions in U.S. financial markets and affect the creditworthiness of U.S. firms, particularly exporters and commodity producers facing weaker demand and lower prices. ^vii

In the recently released book “Crash” by Adam Tooze, China’s credit boom is compared with other credit bubbles that ended badly. ^viii Tooze highlights that the U.K. banking sector has by far the heaviest exposure to Hong Kong and China in general — much more than the United States, Japan, or Europe. Although the Chinese have not slowed their credit bubble, they have shown an ability to restructure their banking sector in the past – in 1998 to 2005, for example – and more recently to shrink their shadow banking segment. The outlook for the global economy rides on how China manages its current credit situation. Trade-related uncertainty has made Chinese capex expansion less likely. On the monetary side, the ability to cut the reserve requirement ratio (RRR), or the benchmark interest rate and on the fiscal side, the government can issue more special local government bonds are both available. If the Chinese economy does stabilize this year, China’s currency could become a global currency stabilizer.

 

 

Theme 3: The U.S. Economy Balancing Act Between Slowing Manufacturing Growth and Strong Markets

The U.S. economy continued to grow at a solid clip in the first quarter of 2019 on the back of net exports and inventory building. ^ix Growth is likely to be somewhat weaker in Q2. Despite an uneven quarterly pattern, the key driver of the U.S. economy remains the consumer. Strong demand for labour pushed the unemployment rate to a 50-year low in early 2019 and wage growth accelerated. Non-farm employment increased by 224,000 jobs in June, handily beating expectations. The resilience of business hiring is in strong contrast to the recent business surveys’ generally downbeat message. In June, the unemployment rate edged up from 3.62% to 3.67%, and average hourly earnings increased only 0.2%. ^x

With more people working and wages rising faster than inflation, we expect consumer spending to increase this year. Business investment is also forecast to contribute to the economy as companies take advantage of last year’s cut in the corporate income tax rate and other supportive policies.

On trade policy, the U.S. is the instigator and the perpetuator. The recent removal of tariffs on steel and aluminum imports and the Trump Administration’s desire to ratify the new trade agreement with Canada and Mexico had dampened some of the pressures within North America. Unfortunately, the positive sentiment was crushed in late May when the U.S. threatened to levy tariffs on Mexican imports in order to force its southern neighbor to stem the flow of migrants. Tensions between the U.S. and China, meanwhile, have become increasingly heated after the U.S. bumped up tariff rates and made threats to expand the list of products affected.

The Fed can claim mission accomplished on getting the economy to full employment with most inflation measures at or slightly below the 2% target. Maintaining these conditions is the challenge now facing U.S. policymakers. The FOMC appears content to hold the fed funds rate at a slightly below neutral level as a nod to the risks to the economic outlook coming from an unpredictable presidency.

 

Theme 4: Canada Is Not an Island

Were Canada an island insulated from global developments, there would be little reason for concern about the economy. Growth is solid, the labor market is strong, and there is no sign of imbalances. But Canada is not an island, and global economic developments matter for its economy. With the global outlook having darkened in recent months, it is fair to say that downside risks prevail in Canada at this point, even if the domestic economy looks fine.

Falling oil prices and a deepening in the housing-market correction saw Canada’s economy grow at just a 0.3% annualized rate in the last quarter of 2018 and contributed to the economy growing at a similar pace in the first quarter of this year. ^xi A recovery in oil production, easing of pressure in the housing market and the end of an unseasonably cold winter saw the economy post a solid increase in March, paving the way for stronger gains ahead.

Canada’s own tensions with the U.S. have eased with the removal of U.S. steel and aluminum tariffs along with Canadian retaliatory measures. But the ongoing close integration of cross-border production chains means that anything that hurts the U.S. industrial sector will have spillovers to Canada. Concerns about a slowing in global growth could also spill over to Canada’s resource-producing regions via lower commodity prices.

Canadian business confidence has weakened with the manufacturing sentiment index slipping into negative territory in April for the first time in more than three years. ^xii Global policy uncertainty, frictions with the U.S., and the Chinese government’s banning of Canadian canola all played into the decline.

Although the recent removal of tariffs on steel and aluminum by both the Canadian and U.S. governments and renewed efforts to ratify the updated NAFTA set up to restore confidence, the impact will be limited by the persistence of tensions between the U.S., China, Europe, and Mexico, Canada’s top trading partners. We view the Bank of Canada as more likely to cut rates later this year than not, but we expect those cuts to arrive after the Fed cuts. The difference in timing and magnitude may give the Canadian dollar a slight upward bias relative to its southern neighbor but likely not a large enough one to pose economic danger.

Should significant problems arise in China, spill¬over effects could include a broader pullback from risk-taking, declines in world trade and commodity prices, and U.S. dollar appreciation. The effects on global markets could be exacerbated if they deepen the stresses in already vulnerable EMEs. These dynamics could tighten conditions in U.S. financial markets and affect the creditworthiness of U.S. firms, particularly exporters and commodity producers facing weaker demand and lower prices.

 

 

Section 3. Investment Outlook

 

Slowing Global Growth While the U.S. Fed Pulls Back on Tightening Leads Us to a Stagnation Forecast for the Next Twelve Months

SOURCE: FRAME GLOBAL ASSET MANAGEMENT

 

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

 

Section 4. June 2019 Portfolio Models

Our outlook is focused on tension between politics, policy, and the positioning of the corporate sector. The world economy remains vulnerable to the U.S-China power play. If tariffs persist or are ramped up further, already-weak world trade volumes will struggle to gain traction. In addition, rising political conflict (Brexit and Italy) and uncertainty have weighed on business sentiment over the past year and global capex is stalling. The dovish stance by central banks supports our Stagnation outlook for the U.S. economy as growth is capped over our forecast time horizon of twelve months.

China is committed to maintaining 6% growth and will respond to any slowing with further easing. ^xiii The U.S. and China have each raised tariffs and appear to be broadening the conflict to their respective tech sectors. The results of the European Parliament elections showed a significant step up in support for populist parties, who now control 28% of total seats in Parliament, up from 22% before. Turnout in the elections was low at 37%, some 30%-35% lower than may be expected in a general election or second referendum. ^xiv The Brexit Party’s win (mostly at the expense of the Conservatives) sent the message that many voters are willing to support a no-deal.

We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

July 14, 2019

 

ⁱTrading Economics, U.S. Balance of Trade. July 3, 2019.
ⁱⁱTrading Economics, U.S. Balance of Trade. July 3, 2019.
ⁱⁱⁱCaceres, C., and Cerdeiro, D. A., 2019. IMF Working Paper. Strategy, Policy, and Review Department and Western Hemisphere Department. Trade Wars and Trade Deals: Estimated Effects using a Multi-Sector Model.

^ivAhir, H., Bloom, N., Furceri, D. Caution: Trade uncertainty is rising and can harm the global economy. 4 July 2019. The source for the data on key dates in the U.S.-China trade negotiations comes from Bown and Kolb (2019). Item #6 comes from the BBC (2019). Note 1: The font in blue indicates the tariff measure taken, and the font in black indicates the narrative of the World Trade Uncertainty index. The WTU index is computed by counting the frequency of uncertain (or the variant) that are near the following words: protectionism, North American Free Trade Agreement (NAFTA), tariff, trade, United Nations Conference on Trade and Development (UNCTAD) and World Trade Organization (WTO) in EIU country reports. The WUI is then normalized by total number of words and rescaled by multiplying by 100,000. A higher number means higher trade uncertainty and vice versa. Note 2: The WUI is computed by counting the frequency of uncertain (or the variant) in Economist Intelligence Unit country reports. The WUI is then normalized by total number of words and rescaled by multiplying by 1,000. The WUI is then normalized by total number of words, rescaled by multiplying by 1,000, and using the average of 1996Q1 to 2010Q4 such that 1996Q1-2010Q4 = 100. A higher number means higher uncertainty and vice versa. While the latest spike is the result of uncertainty over Brexit and US trade policy, trade uncertainty explains more than 70% of the increase in uncertainty since the first quarter of 2018.

^vIMF. World Economic Outlook. Growth Slowdown, Precarious Recovery. April 2019.
^viFederal Reserve Financial Stability Report. Near-Term Risks to the Financial System. May 2019.
^viiFederal Reserve Financial Stability Report. Near-Term Risks to the Financial System. May 2019.
^viiiTooze, A., “Health of the Global Banking Sector: Differences by Region.” Columbia University.
^ixTrading Economics, U.S. GDP. June 27, 2019.
^xBureau of Labor Statistics. Economic News Release. Employment Situation Summary. July 5, 2019.
^xiTrading Economics, Canada GDP. July 11, 2019.
^xiiTrading Economics, Canada GDP. July 11, 2019.
^xiiiSouth China Morning Post. China lowers 2019 GDP growth target to 6-6.5 per cent range. March 5, 2019.
^xivJ.P. Morgan Economic Research. Global Data Watch. May 31, 2019.