The Daily Update - Watching Closely as Stimulus Fades and Tariffs Fetter

Global growth continues to stall, the US yield curve has been inverted for three months, BBB credits now make up over half the investment-grade universe (and equate to 4x the amount outstanding in 2008), numerous PMIs and employment figures have been recent disappointments, trade disputes are unveiling their long-term incompatibilities, and each new day marks the longest economic expansion on US records. These are all good reasons for market caution and yet the S&P 500 remains just 2% from its all-time highs. So is this apparent contradiction fueled by conviction or necessity?

First, whilst low rates in general continue, corporates’ ability to service their debts remains robust. Historically, non-financial corporate net interest payments as a percentage of net operating surplus have ballooned around 8% yoy heading into all of the seven US recessions since the 1970s; presently (and for the most part of this decade) they have stayed low and continue to fall. Second, in the low rates and post-QE world, the explosion of the monetary base without real growth in business lending has fuelled asset prices and incentivised debt buybacks. This has helped drive the TINA (There Is No Alternative) flows into equities that are arguably expensive but yet offer relatively attractive dividend yields in a low-rates world.

Although this central bank intervention was necessary to begin with, each successive round of QE and prolonging low-rates has lost more of that initial potency. Moreover, the correlations and December’s knee-jerk reaction to the Fed, allude to a market addiction to the flow and not just the stock. So although these are protracted factors that should take time to unwind – in the form of a drag on growth for at least a decade – they have also increased market instability as convictions fall ever further behind flows.

None of these signals are clear-cut signs of an impending global recession but they do both weaken longer-term prospects and will magnify the market reaction once consensus is finally that a recession is on the cards. The coming months look set to be particularly informative as we approach two Fed meetings – where markets are now implying a 78% chance of a cut (from a 90% chance of hike 6-months ago) – and as we see more clearly the compound effects of not just rising tariffs but the falling away of Trump’s expansionary budget that reflated the economy during his first two years in office. Arguably, the strong dollar and early rate cuts were supported by such transitory policy effects; whereas now growth in real imports – which reached 10% yoy at the peak ending 2017 – has steadily fallen to flat and looks set to turn negative imminently.

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