Road to 2020: part 1

2019 has been another great year for global equity investors as the S&P 500 has yet again returned 23% YTD (as of Nov 15th 2019). Over the past 6-8 weeks, the intensity of the two big geopolitical risks (Brexit and the Trade Wars) have subsided to a certain extent, while dovish central banks, and a better than expected Q3 earnings season have all helped lift equity markets to record highs.

However, we cannot ignore the elephant in the room; the fact that since peaking at 3.8% in 2017, economic growth outside of the U.S. has been decelerating, reaching 2.1% in the third quarter of 2019. Manufacturing has led the way down, especially in big export powerhouses in Europe and Asia. However, although growth has slowed down significantly, major recession indicators are still far from giving a red signal. These are unique times and it is getting harder to predict an outperformance of equity markets again next year. This has led investors to ask a few key questions as we move into 2020:

1. Will the US economy stumble in the next six to 12 months?

2. Is the Eurozone economy heading into a recession?

3. Will China experience a sharp economic slowdown next year?

4. Will import tariffs undermine global growth?

5. Will tensions in the middle East disrupt oil supply and what does it mean for markets?

We plan to run a short five part series of publications to cover these questions in more detail as we discuss our investment strategy for 2020.

1. Will the US economy stumble in the next six to 12 months?

What does the data say

Recent data in the US has been mixed. Alarm bells went off mid-year as manufacturing and agriculture got hit hard by the trade disputes as the ISM manufacturing PMI fell below 50 in August, while Q2 was majorly influenced by Fed's policy stance. However, consumer spending has been helping balance things out and keeping the GDP growth healthy near the 2% mark. Other signs are suggesting that that job market is slowing down, but the 50-year low unemployment rate is holding up pretty well for now. Furthermore, the Fed has cut rates by 25 basis points each in July and September, noting downside risks from the trade disputes and slower economic growth outside the US.

Our view

Base case (45% probability): Stall speed

In our base case, we see the US economy continuing to expand at stall speed near the 1.8-2% market with the continued support from the US consumer. We expect trade tariffs to do moderate damage to growth in this scenario (especially in the first half of the year); we also expect moderating corporate earnings growth, low interest rate expectations, and equity markets showing subdued returns in the first half of 2020 (somewhere between -5% to 0%). We would still favor the US market over the Eurozone, considering the the Fed still has more room the play the interest rate game compared to the ECB which is already running negative rates.

Downside scenario (35% probability): Stumbling US economy

In this scenario, we expect US business investment to continue shrinking going into 2020. Long term yields will continue to stay below 3-month treasury yields and recession risk will be elevated with a break down in US-China trade talks. If President Trump decides to implement his broad-based tariffs, any chances of recovery in economic will shrink quickly. Keeping history in mind, market downturns normally start 6-months ahead of economic slowdown, and we believe in this scenario equity markets could potentially fall by 15% to 20%, on the back of earnings erosion and pressured profit margins within the business sector.

Upside scenario (20% probability): Recovery and the final run

The US-China trade negotiations are the biggest influencer in our upside scenario, as any sane conclusion to trade talks will put the economic story back on track in the interim. We can expect stronger profit margins in this scenario as the current low interest rate scenario combined with a healthy-ish economy will only incentivise businesses to invest more. We believe the Fed could take back some of the planned rate cuts in this scenario and the current cycle will fully extend by another year. We can expect global equities to regain advantage and add another 10-15% gain by the end of 2020. If trade talk conclude with with the US exporting more to China, the US dollar would also likely appreciate further against the euro and other major currencies.

Conclusion

Overall, global equity markets tend to stay in a positive state when global economy is growing moderately. However, these are unique times as moderate growth is being mixed with geopolitical risks, low interest rate expectations, and a late stage of the economic cycle which increases the risk of market corrections.

S. Khan

Head of Investment Research