It wasn’t long ago that the ink was drying on our 2020 outlook. In it, we touted the conclusion of the third major policy-driven growth scare (along with 2012’s European debt crisis and 2015’s Federal Reserve [Fed] rate hike) of the elongated business and credit cycle. Stable growth and supportive policy were to be the theme of 2020. The Fed had already overturned the 2018 rate hikes and had successfully eased financial conditions, while the Trump administration had inked a Phase 1 trade deal with China. China, for its part, was working to stimulate its economy. The January reading of the Institute of Supply Management Manufacturing Purchasing Managers Index, as good of a leading indicator of economic activity as any other, would have traditionally been viewed by us as a resounding affirmation that the growth scare had passed. “Risk on!” we would have rejoiced.
The ISM Manufacturing PMI bounced back into expansion territory in January
Sources: Institute for Supply Management, Bloomberg
The coronavirus detoured the economic growth path
Alas, “the normal times” were not to be. The rise of the coronavirus and the ensuing quarantines and ongoing lost production will ultimately represent a severe growth drawdown at an inopportune time for the global economy. No sooner was the third major growth scare of this cycle abating than the fourth significant scare was now upon us. In my view, that blue line in the chart above will no doubt be back below 50 in no time.
I am not going to attempt to quantify the expected loss in economic activity. (Other than to note that my colleague Paul Jackson, Head of Global Asset Allocation Research, is hopeful for a short, sharp downward shock to the Chinese economy during the first quarter, with recovery during the second quarter and second half – a path that is dependent on how long daily cases and deaths continue to rise.)
Instead, I will address the growth scare from the perspective of a market strategist, using frameworks to A) assess whether the business cycle is ending and B) determine potential market leadership based on the direction of economic activity and the policy response.
What does the ‘end-of-cycle dashboard’ show us?
It would be rare, if not unprecedented, for an infectious disease outbreak to lead to a global economic recession. Then again, global growth was already in a precarious state, the result of the uncertainty stemming from the US-China trade war. Rather than simply speculate on the prospect of a technical recession, I instead deploy an end-of-cycle dashboard comprised of telltale market indicators. Among them:
- The shape of the US Treasury yield curve: As I pen this commentary, the spread between the 10-year US Treasury rate and the 2-year US Treasury rate is 11 basis points.1 Call it modestly steep or stubbornly flat but importantly, it is not inverted. Each of the past half century’s recessions have been proceeded by a prolonged inversion of the yield curve.2 Yes, the federal funds rate is above that of the 10-year US Treasury rate, as of this writing, but the relatively benign inflation environment provides cover for the Federal Reserve to cut rates, if necessary.
- The strength of the US dollar: The US dollar has been strengthening once again and may break out against a trade-weighted basket of currencies. Watch the dollar closely, as capital flight to US-dollar assets would weigh on international activity and provide a headwind to the earnings of US multinational corporations. If the dollar gets too strong and deflationary impulses emerge, the Federal Reserve would once again be forced to act to stabilize the currency.
- The spread of US corporate bonds to Treasuries: Corporate bond spreads have thus far been behaving, remaining very tight from a historical perspective. In fact, high yield bond spreads tightened in the first half of February.
Pulling it all together, financial conditions thus far remain exceedingly easy compared to the starts of each of the past three recessions, as illustrated in the chart below. The picture does not seem to be suggesting that a recession is in the offing.
The Goldman Sachs Financial Conditions Index does not suggest that a recession is imminent
Sources: Goldman Sachs, Bloomberg, L.P.
Where do we expect to see market leadership?
To determine market leadership, we ask ourselves three primary questions:
- What direction is the global economy trending?
- How will policymakers react to existing conditions?
- What will the impact of economic growth and policy be on capital flows?
To answer Question 1: There is no doubt that global economic activity is decelerating, with many of the usual trappings – lower rates, stronger dollar, weaker industrial commodity prices, bonds and bond proxies performing well even as the broader market has thus far held up well (don’t be surprised however if economic volatility leads to some near-term market volatility). However, in my view, the time to get defensive may have passed or prove short-lived. The optimist in me is hopeful that the virus can be contained, the Chinese labor force will gradually get back to work, and pent-up demand will support growth in the latter half of the year.
Regarding Question 2: I would also expect US and Chinese policymakers to act quickly, if necessary, to support growth and reflate the global economy.
As for Question 3: I believe that stabilizing growth and supportive policy would help support stocks over bonds, growth assets over value-oriented assets, and credit over Treasuries. This was my view at the start of the year and has been for most of this cycle.