It has been 3 months since our “2019: Second Quarter Wrap”. Now that the 3rd Quarter is over, let’s see where we are:
Starting with the U.S.: The yield curve may not be the best predictor of a recession…
The Fed’s trillion-dollar balance sheet has put downward pressure on the long end of the yield curve (research estimates the 10-year treasury yield by as much as 0.7% percentage point in 2019). Further, $16 trillion in sovereign bonds with a negative yield are weighing down longer-term yields. This rapidly increasing U.S. debt is being funded by issuing a high volume of short-term Treasury bills, putting significant upward pressure on the short-end of the yield curve. This combination of downward pressure on long-term rates and upward pressure on short-term rates is distorting the yield curve. Low-yield U.S. Bonds are a preferred option to negative yield European bonds – an indicator of the (relative) strength of the economy. A recession will come, but perhaps not so quickly.
The drone attack on Saudi Arabia’s crude oil facilities resulted in an interesting development. To stabilise energy prices, the U.S. released crude oil from its Strategic Petroleum Reserve – this makes the U.S. a material exporter of crude oil and more importantly, reduces the trade deficit.
U.S. inflation remained below the Feds 2% target. In the September FOMC meeting 7/10 members voted to reduce rates by 0.25% (the other 3 dissented) – federal fund rates now are between 1.75% and 2%. Powell also made it abundantly clear that the Fed would “conduct policy without regard to political considerations”. Other macro indicators continued to be favourable with increase in retail sales in July coupled with increase in productivity / output per hour worked. Retail spending is projected to increase from 2018 levels of 68% of GDP and housing starts are growing at the fastest pace in 12 years with August surging by 11.5% to 1.36million. The data point of concern is the decline in business investment (18% of 2018 GDP) in the 2nd quarter by 0.6% (Industrial production was still up 0.6% in August).
Moving on to Europe: A recession for the UK?
In the last update we highlighted the collapsing of European interest rates – a cause for worry even for the larger German, Swiss and French economies. The ECB in its September meeting left its main refinancing rate unchanged but reduced deposit rates by 10bps to -0.5%. The ECB also lowered its 2019 GDP forecast to 1.1% (vs. 1.2% previously) and inflation to 1.2% (vs 1.3% previously). In an attempt to boost growth, the ECB approved monthly bond purchases of Euro 20bn (starting November 2019). Negative interest rates are now creating a new problem for Europe – inflation of real estate prices. The Financial Times recently reported that cities like Paris and Frankfurt have moved to the “bubble risk zone”.
Brexit has now completely taken over the UK – not only is the economy suffering, but the political mishandling has become a joke. The consensus for the no deal hard exit remains and while previously the fear was a weak pound, the additional risk now is a recession in the UK.
China: Ever increasing problems
The Chinese economy continued its slowdown. August data showed manufacturing PMI remained negative for the fourth consecutive month with industrial output rising 4.4% – the lowest for a single month since 2002. August also saw a contraction in exports and imports – signs of reduced orders from overseas, reduced purchasing capacity and job creation. Citigroup has lowered its growth forecast to 6.2% (from 6.3%) for 2019 and 5.8% (from 6%) in 2020.
Chinese President XI has a goal to dominate five industries by 2025 – global high-tech manufacturing is a key component, but President Trump continues to play hardball resulting in the escalating trade and intellectual property fight. While a trade deal is good for the global economy, till the U.S. elections it is fair to assume both sides will continue this back and forth – the Chinese waiting for the election results and Trump playing the balancing act between a strong economy and negative impact of trade wars. The recent unrest in Hong Kong has resulted in a new problem for China – the restrain shown by the Chinese state is representative of its economic vulnerability (read impact of trade wars) and also its desire to showcase its new found political restraint / accommodative policy.
Closer home in India: The Government has realised the problem in hand
Repo rates in 2019 have reduced from 6.5% to 5.15% in 2019 i.e. by 135 basis points. Whilst the RBI has maintained the “accommodative” stance, the challenge is that the monetary transmission that RBI wanted has not happened – the December weighted average lending rate on fresh loans was 9.79% compared to 9.77% in July. The benefits that RBI is giving to public sector (PSU) banks are being absorbed to take care of existing balance sheet problems and new lending is not happening. The integration of 10 PSU banks into 4 (post merger there will now be a total of 12 PSU Banks) while beneficial in the long term may further distract form near term lending. The private sector banks have historically always lent at a higher rate than the public sector. Further, the market does not believe that Government would stick to its announced borrowing programme and therefore the GSEC is not yielding down. So in effect we are at a liquidity and transmission rate log-jam.
The government escalated efforts to repair economic growth with a c. $20bn tax cut, making the tax rate for companies comparable to some of the lowest in Asia. Domestic companies effective tax rate is reduced to c. 25% and for new companies at c. 17 %. While this will result in a widening of the fiscal gap (notwithstanding the RBI windfall of c. $24bn) this is positive. The government will now return to its focus of PSU divestment – which not only increases efficiency, but also helps limit fiscal slippage.
With the liquidity log-jam and the expectation of fiscal slippage, we are witnessing a scenario of volatility in both equity and debt valuations. It may be prudent to keep some dry powder in hand.