Investors’ Outlook July/August 2019

Jerome Powell has the right golf clubs to do the job

Enjoying a game of golf may be one of the few things Jerome Powell and Donald Trump have in common. We don’t know whether they have ever met on a golf course. But it’s fair to assume that there, as in real life, the President of the United States would gladly offer advice on each of the US Federal Reserve Chairman’s actions. We believe “Jay” Powell has practiced his swing long enough to do what’s right – and perhaps deliver the hoped-for crowd pleaser. Regardless of any US rate cut, the environment for global financial markets is generally favorable.

Not long ago, Donald Trump likened the Fed to “a powerful golfer who […] can’t putt!” Mid-June, he called it “very disruptive”. The POTUS regularly slams the central bank’s slow transition from last year’s “tightening bias” to a more “neutral bias” in recent times. What he doesn’t mention is that the US central bank may now be just about able to lower interest rates again. In any case, Jerome Powell is enough of a pro to strictly follow the Fed’s dual mandate of maximizing employment while controlling inflation.

With inflation threats all but disappearing in the brush beyond the golf course, Powell is now groping for a softer “wood” rather than an “iron”. Next in line is European Central Bank President Mario Draghi, whose choice of clubs seems more limited. Mr. Trump has a strong opinion on his game too. The ECB chief’s recent dovish statement, which put the euro under pressure, is giving Europe an unfair advantage over the US economy, according to the “tweeter-in-chief”.

Hooked on liquidity

The markets, eagerly awaiting a crowd-pleasing shot, are beginning to aggressively price in rate cuts. It matters little that in the US, such moves may occur for the wrong reasons as the trade war is beginning to bite – the next round of tariffs might hit a wider range of US consumer goods.

The US yield curve, i.e. the yields of short to long-term government bonds plotted on a graph, has come down to a very low level again. It is currently inverted, reflecting expectations of low growth and marginal inflation. Should the priced-in cuts materialize, the curve could get back to normal, i.e. slope upwards. European interest rates are being pushed further towards or even deeper into negative territory amid signals from Frankfurt that a more generous monetary policy for the euro zone is on the cards (see chart). It remains to be seen if the effect of further cuts will have the same stimulating effect as in the past. Lower policy rates influence lending rates in a non-linear way. The impact wears off with each additional cut, in particular if surveys point to companies’ restrained demand for funding.

Nearly all asset classes are currently benefiting from the big central banks’ renewed taste for liquidity injections. The flip side of extremely low interest rates is that they imply dismal economic prospects and lead to capital misallocation. However, that hasn’t really sunk in given the still well-oiled wheels in the US.

The bearable burden of corporate debt

Let’s take a deeper look at a few asset classes, especially the riskier ones. Has the increased probability of recession stoked default fears in the corporate bond sector? It has not. We see the default rate remaining at around zero for investment-grade US and euro zone paper, while some analysts expect a default rate of around 2.5% for US high-yield issues (versus less than 1% today). Euro zone high-yield bonds are likely to do better than their US counterparts. Given the still generous lending practices on both sides of the Atlantic, companies should be able to service and repay debt over the next 12 months.

One of the biggest risks of a pronounced economic slowdown is that US companies, which today use a record share of their earnings for dividends and share buybacks (more than 60% of US companies’ 2018 earnings), might see their earning fall. This would lead to a significantly lower debt coverage ratio.

More cash is a share’s best friend

What about stocks? Equity investors agree with their fixed income counterparts in predicting decelerating growth and lower-than-expected inflation. This gives them reason to hope for central banks turning on their money taps. When comparing equity earnings yields and bond yields, relative valuation clearly speaks for equities.

Naturally, there are risks. Equity markets presently shrug off the US-Chinese trade war. If it escalates, the “fear index” VIX would spike up from the current low level. In such a scenario, defensive stocks would outperform cyclicals again, and “value” could beat “growth”. There are opportunities as well. The US and China may continue efforts to settle their differences, re-enter trade talks and stop levying new tariffs. This at least is what transpired from a meeting on June 28 at the G-20 summit in Osaka, Japan. The minimum expectations haven thus been met.

Not yet time to start looking at risky assets

Low but steady global economic growth and more dovish central banks would put risky assets on investors’ radars. This could last some time until central banks change tack again or a Goldilocks-graced summer pushes these assets into overpriced territory – in which case stronger earnings and economic growth would have to compensate for higher refinancing costs. By contrast, an absence of supporting factors would justify an equities underweight. Retaining a neutral stance therefore seems reasonable. As in golf, you may pull off a rare “hole in one” occasionally, but it’s safer to hit the ball from the putting green.