Uncertainty casts its shadow over the U.S., Europe, and China

This week, we are going to take a deeper dive into the issues currently facing the U.S., Europe, and China. Guiding us through this “regional roundup” are three of Invesco’s Global Market Strategists who are on the ground in New York, London and Hong Kong. While the details differ in each region, the biggest commonality they report is the heavy shadow of uncertainty that continues to linger over markets.

Brian Levitt: Can the U.S. avoid a cycle-ending policy mistake?

For our entire lives we’ve been told that it is always darkest before the dawn. Alas, it’s not actually true. The brightness of the night sky varies depending on the moon’s appearance relative to the sunrise. Sometimes it’s darkest in the middle of the night. Nonetheless, it’s a comforting sentiment that is often relevant in life and tends to be applicable for financial markets.

The overarching tone in the economy and the financial markets this summer has been, well, dark. The uncertainty surrounding U.S. trade policy with China has eroded U.S. business sentiment meaningfully,¹ thereby grinding business investment down.² The U.S. Treasury yield curve – in my view as good of an economic and financial market indicator as any other – inverted, albeit briefly.³ Just last week we learned that the Institute for Supply Management’s Manufacturing Purchasing Managers Index for the U.S. had fallen below 50, the demarcation level between expansion and contraction.⁴ Services held up better, but manufacturing has tended to do a better job of capturing the inflection points in the economy.⁵ Even the headline jobs number showed a hint of weakness, even as wages trended higher.⁶

Yet, the broad U.S. market, as represented by the S&P 500 Index, is only 1.16% from its all-time high.⁷ The late-July to mid-August peak-to-trough decline of 6% in the broad market was only roughly half of the median price decline markets have experienced every year since 1980 – and not as bad as the correction in late 2018 or the market downturn in May 2019.⁸ The spread between the 2-year and 10-year U.S. Treasury rates turned positive once again.⁹ The Chicago Board Options Exchange Volatility Index (VIX) has retreated. Credit spreads have largely behaved.¹⁰ What gives?

In my view, the market has endured rolling policy errors over the past year. In late 2018, it was Federal Reserve (Fed) rate hikes. In May 2019, it was the prospect of ever-escalating tariffs on Mexican goods. Currently, it’s about trade policy with China. In the first two instances, policymakers backed away from the policy mistake: The Fed is now easing and the Trump administration called off the plans to impose tariffs on Mexico. Now we get word that the administration plans to meet with China in a month’s time.

Is it possible that we are heading into an environment of improving policy (note that I didn’t say good, but improving) that will stabilize business sentiment and reinvigorate economic activity? Figure 1 shows us that the U.S. stock market has tended to perform very well in the 12 months following a peak in the U.S. Economic Policy Uncertainty (EPU) Index, which stood at its most extreme level at the end of August. The lone negative 12-month period post a spike in the U.S. EPU Index came in the aftermath of the 9/11 terror attacks on the U.S.

Figure 1: Markets have performed well following spikes in economic uncertainty

U.S. Economic Policy Uncertainty (EPU) Index

S&P 500 total return: 12 months following spikes in U.S. EPU Index

Sources: Baker, Bloom & Davis and Standard & Poor’s, as of Aug. 31, 2019

I suspect that it is dawning (pun intended) on policymakers that in a growth-starved world, the cardinal rule is to do no harm. I believe that markets would reward them for their lack of efforts. Of course, where you stand depends on where you sit, and the U.S. has been the brightest star (see what I did there?) throughout this cycle. I’m looking forward to hearing from Arnab in the U.K. and David in Hong Kong.

Arnab Das: Can politicians find a clear path forward for the U.K. and Europe?

Moving across the pond to Europe, there’s been an awful lot of noise and some signal recently in politics that I believe boils down to kicking the can, balanced by continued uncertainty over the longer term. In my view, the net effect – in line with U.S. developments – is improvement at the margin, which should help support economic growth and both regional and global risk assets at some expense to “safe-haven” government bonds. That said, I believe the continued uncertainty, combined with the somewhat reduced dovishness of major central banks – especially the European Central Bank (ECB) and the Fed, is likely to limit the extent of these retracements and keep market volatility high.

So how to make heads or tails of all the Brexit news and noise? The good news: Westminster finally found the numbers and the gumption to seize the U.K. Parliamentary agenda from the government and pass legislation to require the recently installed Tory Prime Minister Boris Johnson (or “BoJo” – a nickname I’ll use just as he does with Brits and world leaders alike) to seek approval from Brussels for a three-month extension to the current Oct. 31 Brexit date, if no deal is approved by Oct. 19. So, the threat of a no-deal Brexit is being pushed out into January 2020. The bad news: Procrastination paves the way to protracted political uncertainty including the potential for a fourth Brexit extension, a second early general election, and probably even more troubling political fireworks – and perhaps a no-deal Brexit after all that, anyway.

The political runes now point toward an early election, perhaps in November, centered on Brexit yet encompassing other, even greater uncertainty. The main opposition Labour Party is lining up a platform of big-time policy disruption – including higher taxes, salary and bonus caps, and renationalization plans – that many see as tantamount to expropriation. Many Members of Parliament and voters would stand shoulder-to-shoulder with Labour on preventing a no-deal Brexit, yet would oppose such an agenda. They and others may well prefer BoJo’s version of Brexit Britain (which seems to emphasize growth and investment through deregulation as well as fiscal loosening financed with bond issuance) to Labour’s platform (renationalization, re-regulation, and fiscal loosening financed by taxes on capital and equity, as well as bonds, which seems to emphasize redistribution at the expense of growth and investment).

The alternative of remaining in the EU might by itself be market and macro supportive, but if it comes with a Labour government that increases the chances of a radically redistributive economic policy agenda at the expense of growth, it would render continued U.K. alignment with the EU and U.S. economic models difficult to sustain. I expect the political debate to move from radicalism to gradualism and toward a U.S. or EU version of capitalism rather than full-blown socialism. But in the short term, and in short, the only certainty in the U.K. seems to be continued uncertainty.

Across the channel in the eurozone (EZ), the political debate seems like it’s becoming much less fluid and disruptive, but the economy is still weak, and both monetary and budgetary policy debates are also becoming somewhat less dovish than hoped even very recently – not unlike the Fed. The good news is that, at least for the time being, the spillover of Italian internal political tensions into confrontations with the EU about budget rules has calmed down as a new, less-disruptive coalition is being formed between the Five Star Movement and the Democratic Party (PD) in Italy.

That said, it remains to be seen how stable this new arrangement is. On the face of it, this arrangement may seem more sustainable, since both partners are from the left, rather than the prior left-right odd-couple coalition. But hard right-wing League leader Matteo Salvini and his party are more popular than either the Five Star Movement or the PD; furthermore, Salvini may well prefer to be an outsider in opposition in order to snipe at the coalition. Plus, this new coalition will be Italy’s 67^th government in the 75 years since World War II. Rapid political turnover has long stood in the way of major structural reforms that require taking the long view, given that the political costs of reform are usually front-loaded and the economic payoffs longer term.

Moving onto the EZ economy and the ECB, among mixed data, the trend seems to be going from weakness to weakness in the key sectors of industry – like autos, machinery, and investment – and in the all-important German economy. It’s not all bad news as France continues to do somewhat better than it had during the yellow-vest protests against diesel fuel taxes, which slowed the economy significantly. But Germany’s export machine for cars, machine tools, and capital goods continues to suffer from the Brexit noise as well as the U.S.-China trade war, which is hurting global trade as well as corporate capex.

Yet the discussion around stimulus, which had been gathering momentum on both monetary and fiscal policy in recent weeks, seems to have hardened as policymakers and politicians from EZ Core Creditor countries, like Germany, push back against hopes that there would be pro-active fiscal and monetary easing, in contrast to the U.S. in 2018-19. I believe market expectations and hopes had run too far ahead of reality on both the ECB and budget policy.

Given the ECB’s limited room for maneuver with rates already below zero and self-imposed limits on buying government bonds not too far away, further economic weakness to the point of actual recession may be needed before the ECB can resume quantitative easing (QE) as well as any significant fiscal easing. Plus, the latent concern of the creditor countries that QE might provide disguised money-printing and financing of debtor economies’ budget deficits probably poses a political constraint to QE – at least pending a more severe slowdown if not a full-blown recession.

Thus, expectations seem to be coalescing around rate cuts into even deeper territory, which in my view would not be good for banks as their capital is already weak and margins very thin. All in all, the bigger picture is still that EZ banks’ historically important role as credit creation engines remains highly challenged. Banks account for about three to four times as much credit funding within the EZ than in the U.S., where borrowers are much more reliant on the credit markets than banks. If EZ domestic credit remains weak at a time when net exports are also weak, it is only reasonable to expect growth to be weak as well, with stagnation or recession risks remaining reasonably high.

David Chao: Can new policy measures in China counteract the effects of uncertainty?

The “uncertainty” theme that Brian and Arnab touched on also applies to the Chinese market – but there is a difference as to how uncertainty affects market participants in each region.

Unlike in the U.S., where market participants are faced with high levels of economic policy uncertainty, in China there is very little policy uncertainty because Beijing singularly controls fiscal, monetary, and industrial policies, and regularly spells out future policy prescription in its five-year plan. Instead, Chinese market participants have been faced with political uncertainty since the beginning of the year. Continued protests in Hong Kong, unabated U.S.-China trade tensions, and a decelerating economy have caused market volatility. September is an especially important month as the Central Government gears up to celebrate its 70^th anniversary on Oct. 1, and Beijing has recently come out more forcefully to tackle some of these challenges.

Last week, China’s State Council – the chief administrative body of the central government – sent a very strong monetary loosening and fiscal stimulus signal to the market. Most of the measures listed aim to support growth via fixed asset investment. Three important measures to be aware of:

1. An unspecified increase in this year’s municipal bond quota for infrastructure investments.
2. A near-term cut in the risk reserve requirement (the amount of cash that banks must hold in reserve) to inject liquidity.
3. Near-term interest rate cuts to the medium-term lending facility to financial institutions, and possible cuts to the loan prime rate to spur lending to state-owned enterprises.

Although I don’t expect the stimulus package to be as strong as the one instituted in the latter part of 2018 and into the first quarter of this year, this package is still significant and the strongest economic policy signal that has been issued so far this year.

I believe these policy measures should provide enough buffering against any dramatic economic slowdown brought on by recent events. Political uncertainty is countered by economic policy certainty, and I continue to expect gross domestic product (GDP) growth for 2019 to be within the government’s 6.0%–6.5% target. Chinese equities – both onshore A shares and offshore H shares – have been at discounted valuations. As Beijing starts to loosen its monetary policy and stimulate the economy ahead of Oct. 1, I believe Chinese risk assets should benefit.

Conclusion

Taking a step back and surveying the world as a whole, we see the need to take the good news of short-term improvements in stride with the longer-term challenges and underlying uncertainties. The thorny issues of the U.S.-China trade war, of Brexit, of restoring vim and vigor in Europe’s growth cycle, and of EU and EZ integration will persist. China is moving to shore up its economy, but seems unlikely to provide the worldwide lift that it did in 2009-2010 or in 2015-2016.

We also expect uncertainty to persist, offset by the efforts of policymakers and politicians to prevent downside risks from materializing. We therefore expect a narrower range of potential outcomes in the economy – neither a strong rebound nor a surge in recession risk – but more trundling along at an acceptable pace with risks shifting up and down with the passage of time and persistence of uncertainty.

The portfolio proposition we take from this worldview is to maintain diversification across asset classes and preserve room to maneuver as more clarity emerges. This approach stands in sharp contrast to heavily shifting into bonds (as many investors seemed to do very recently, and which we believe would be more appropriate in a recessionary scenario such as 2010-2012 or 2015-2016) or heavily shifting into riskier assets (as might make more sense for the type of synchronized global rebound scenario we saw in 2017)