Trade Troubles Persist as Central Banks Resist Recession

Paul Zemsky

Paul Zemsky, CFA

Chief Investment Officer, Multi-Asset Strategies and Solutions

Barbara Reinhard

Barbara Reinhard, CFA

Head of Asset Allocation

We view stocks as more attractive than fixed income given our outlook for low, slow, but still positive economic growth.

Global equities rose in September, recapturing some of August’s losses. By contrast, so-called “safe-haven” fixed income asset classes, such as long-maturity U.S. Treasurys, declined, giving back a small portion of their prior month returns. The advance in stocks was led by the UK and Japan; additionally, U.S. value stocks outperformed growth stocks. The shift from defensive to cyclical stock leadership came alongside a short-lived lift in long-end U.S. interest rates. The temporary jump in term premium and yields followed the first increase of the global PMI index in 16 months, as the bond market began pricing a potential end to the cyclical slowdown. Unfortunately, subsequent data would show that an end has not yet come.

U.S. ISM manufacturing PMI’s recent print of 47.8 was a 10-year low. New orders and exports continued to ebb, pointing to further weakness likely in 4Q19. This coincides with a drop in manufacturing employment growth. Eurozone economic data also remain soft, though consumer confidence may be firming. This comes on the heels of the better September employment report, which showed the region’s unemployment rate continued its six year fall. The German unemployment rate is down to 5%, much improved from the peak of 12.1% in 2005.

Against this backdrop of softening economic growth, monetary policies are easing. For the second straight month, the Federal Reserve lowered its benchmark rate by 25 basis points (bp) in September on a weakening outlook and below target inflation. Outgoing European Central Bank President Mario Draghi, whose term officially concludes at the end of October, finished his tenure with a fresh round of stimulus, including a modest rate cut and a new open-ended asset buying program. He urged European governments to increase fiscal spending to take pressure off monetary supports. Emerging market central banks are cutting rates aggressively. While global monetary policy is generally expected to become more accommodative in the ensuing months, much of the prospective rate cuts may already be priced into asset markets.

Tactical Indicators
Tactical Indicators

Figure 1. U.S. labor market conditions remain strong

PMIs are leading indicators of economic growth
Figure 1. U.S. labor market conditions remain strong

Source: JP Morgan, Bloomberg, Voya Investment Management, as of 9/30/19

Figure 2. Present and future confidence remain high despite their divergence\

Conference Board: future versus present confidence
Figure 2. Present and future confidence remain high despite their divergence

Source: Atlanta Federal Reserve, Bloomberg, Voya Investment Management, as of 9/30/19

Figure 3. If you want to know where bond yields are going, look at Germany

Indexed 10-year yields: U.S. Treasury versus German Bund, October 2013 = 100
Figure 3. If you want to know where bond yields are going, look at Germany

Source: Bloomberg, Voya Investment Management, as of 10/3/19

Portfolio Positioning

Investment Outlook

The industrial slowdown in global activity, which began in 2018 (Figure 1) as China started rebalancing toward a more consumer oriented economy, has been exacerbated by trade tensions and is threatening to induce a recession. Industrial activity is a prominent leading indicator that often acts as a swing factor for global growth. As a result, it frequently provides the thrust for equity market performance, which can flow through into the services sector and personal consumption. Although the Conference Board’s Consumer Confidence survey shows that consumers’ assessments of their present situations are still solid, these headwinds are weighing on the expectations component (Figure 2). Still, we are cautiously optimistic and watch closely the trends in labor income and hours worked for signs of consumer wellbeing.

Despite the challenges and assuming no significant escalation of the trade war, we believe services sector U.S. payroll growth will hold up. We are also encouraged to see historically high U.S. savings rates, which should smooth downside deviations of income. Most importantly, global central banks seem committed, albeit publicly hesitant, to providing a backstop with the vast majority currently in easing mode. In addition, many global central banks are employing stimulative actions; China has recently cut its reserve requirement and continues to pursue targeted stimulus measures. These steps have intensified China’s credit impulse, which tends to lead global economic activity and provides us with hope that monetary policy can still be effective, even if it has become less efficient. Outside the United States, there seems to be more scope for fiscal support, and in Europe, there is a serious need. Nevertheless, we think more internal pressure or pain will be required to convince Germany to depart from its deep-rooted conservative predisposition. Spending for the benefit of Italy and other struggling European countries should ultimately help them, but it is a difficult political sell.

Our portfolios remain modestly overweight stocks, which we view as relatively attractive versus fixed income given our outlook for low, slow, but still positive economic growth. Yet, we recognize the risks facing our positioning and the high probability that the gravitational pull from extraordinarily low foreign developed-market bond yields will drag on U.S. yields (Figure 3). Thus, we lengthened duration to neutral in fixed income portfolios following the sharp rise in yields at the beginning of September. We balanced this trade with a lessening of a long held underweight to U.S. small-cap stocks at the tail-end of the vicious defensive versus cyclical stock unwinding. Despite the violent reversal, the valuation gap between large and small caps is near historical extremes; we believe this gives small caps an opportunity to close the distance.

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