Macroeconomic Update - Cyclical Bear Market Risk Growing.
We resume macro updates on a cautious tone, with Longview Economics providing several updates over the last few months, which signal an increased risk of recession in the US, and inline with this view, a shift in tactical asset allocation, to move underweight risk assets. They acknowledge, timing as always, is difficult to get right, and that the circumstances that prevail at present, may result in a short lived recession in the US, i.e. similar to 2001 and unlike 2008/‘09, given the differences between now and the pre-GFC environment.
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First the US
There are clear reasons why the FED believes the US is robust enough to raise rates. Service sector expanding, reasonable job creation, positive housing data. However there are a number of factors, which if the FED continues to tighten, could roll the economy over into recession: -
- Corporate cash flows are stretched – ie companies are reliant on external funding, which is typical before recessions. This leaves them vulnerable to either macro shock or tighter monetary policy.
- US manufacturing, capex & trade cycles are deteriorating – manufacturing is only 12% of GDP however it is a key cyclical signal. ISM, manufacturing sales, durable goods, Philly Fed and private fixed investment growth are either at recessionary levels, or in decline.
- All three key Leading Economic Indicators for the US economy have rolled over - the OECD (rolled over), ECRI (declining at fasted pace since Euro-zone crisis – 5% y-o-y)and Conference Board (flattened and then sharp decline).
- Business inventories have risen rapidly relative to sales – unless sales pick up it is likely that businesses continue to draw down on inventories. That is typical behavior at the end of the economic cycle – i.e. as companies slow their business activity and retrench/draw down inventory. Coupled with the shedding of jobs and capital expenditure, that is the heart of the recession dynamic.
- Credit Conditions are tightening - All of the last seven US recessions were foreshadowed by a tightening of credit conditions. Of note, the most recent Senior Loan Officer Survey showed a sharp tightening of credit conditions for large and medium sized companies (with a reading of +7.4) for Q4 2015. In the last economic cycle, this index spiked to a similar level (of +7.5) in Q3 2007 – i.e. just ahead of the recession that began in December 2007.
- High Yield Corporate Bond Spreads - (see chart further down) - The trend in US high yield corporate bond spreads (i.e. a measure of the corporate sector’s risk premium), is a key indicator. This has recently reasserted itself with the end of QE in the US, along with the rise in volatility (VIX).
The last US reporting season was also telling (chart below). What did it show?
- Top line revenue is contracting – perhaps circa - 3% (when healthcare is removed)
- There were more downgrades to upgrades
- CY 15 EPS growth looks like it is heading toward -2-3% vs analysts original expectations of ~+10%.
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Longview Bear Market Forecasting Model vs S&P500
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A Poor US Reporting Season followed by a strong rally (S&P500)
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US High Yield Corporate bond spreads (inverted) vs S&P500
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What about the Rest of the World?
The global earnings growth outlook is poor. Indeed, according to Longview, there has been no cumulative growth in the earnings outlook since 2011. Take the two economies that matter most at the moment, the US and China. From Longview surveys:-
China Earnings - analysis of 1,373 non-financial listed Chinese companies, for
example, shows that earnings are currently contracting at 39% Y-o-Y while revenues are -10% Y-o-Y.
US earnings - forecasts are currently (just) contracting year on year with q3’15 reported revenue and EPS growth of negative 4 – 5% (Y-o-Y).
In recent years (this economic cycle), global equities have only sustained rallies during periods of US QE.
Further the global economy is over-indebted (in particular China, and key emerging market economies), at a time when the FED has begun to remove cheap money. |
What can go right ?
An acceleration in Global GDP would lead to a further PE expansion.
- The US Consumer can lead global consumption, as they did in the late 1990's, particularly with the added stimulus from the oil price fall. However, the US consumer is still de-leveraging not re-leveraging as in the 90's.
- China can re-accelerate, which in turn supports many other emerging market economies. Whilst signs of stabilisation, China needs to work through the largest credit boom in recent decades.
(both of these are discussed in detail in a detailed Longview note)
- Other Central Banks - more QE from the ECB (markets dissapointed with last statement) and Japan (whatever it takes!)
- Europe - whilst showing signs of improvement, has traditionally been a "growth taker", or in other words services leaders of growth like the US and China.
The following chart best shows how the market PE has expanded, whilst growth has stalled. |
Global consensus 12m FWD EPS vs Global S&P1200 PER
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Conclusion
Whilst cash returns are very poor at present, Longview have suggested moving overweight cash vs risk (equities) on a 1 to 4 month view. In their recent notes they discuss a ~20% pullback. The FED response is also discussed, and is the key to watch, as it has been since the GFC. The importance of protecting the "wealth effect" (higher value in equities), for the US cannot be underestimated. So a playbook, as such, is we see a reversal of tightening, in the near future from the FED, should markets deteriorate.
Whilst we have incorporated these views into our model portfolios, we would warn readers not to take these comments as advice. This commentary does not take into account personal circumstances, and should not be acted upon without professional advice. Please read disclaimer in full.
Best regards
Tom. |
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