Uncertainty, but no sign of recession

Economic fundamentals in major markets around the world are good, so there are no signs of recession. American consumers are spending, basking in low unemployment and rising wages. And with inflation also low, central banks have no reason to raise interest rates.

The picture elsewhere also is pretty good. China has reflated its economy, which helps other emerging economies. Europe’s and Japan’s economies are growing, albeit at their normal slow pace. Canada’s economy has slowed but still is chugging along.

Fundamentals are not the only determinant of the way economies perform. Geopolitics can be equally and sometimes more important because they affect consumer, business and investor confidence.

And the geopolitics pot is boiling with the U.S./China trade war, U.S./Iran tensions, North Korea remaining a wild card and the threat of a U.S./Europe trade war in six months.

Stock markets weren’t happy in May as the U.S./China tariff battle escalated. Both the S&P 500 composite index and the Dow Jones industrial average dropped by 5% after the U.S. increased tariffs on Chinese goods on May 10 and those U.S. stock indices still were down by about 4% as of May 24.

Those market losses are much less alarming than the nearly 20% drop the markets suffered in December 2018. Markets will be reassured if the trade war is resolved in the next few months and nothing else goes wrong. But the markets clearly are nervous.

However, a quick resolution is far from certain. Charles Burbeck, a global equities investor in London, says it may take six months. Both sides in the dispute have hardened their positions; both economies are growing more than was anticipated a few months ago, so, with no risk of imminent damage to their economies, neither side has an incentive to move quickly.

Jurrien Timmer, director of global macro with FMR LLC (a.k.a. Fidelity Investments) in Boston, says the delay in resolving the trade war “suggests that price/earnings (P/E) multiples will come down some more.” He notes that the average P/E ratio in the U.K. has dropped to around 12 from 16 during the three years that Brexit has been dragging on. He doesn’t anticipate that much of a drop due to the trade war, but says “investors want to be compensated for increased uncertainty.”

Nevertheless, most analysts aren’t suggesting major changes to asset allocation in investment portfolios. “Investors usually need a 50% or more chance of recession within the next year before rebalancing or going more defensive,” says Sébastien Lavoie, chief economist with Laurentian Bank Securities Inc. (LBS) in Montreal. He puts the current chance at 30%.

However, your clients may want to consider some tweaks. For example, a report from National Bank Financial Inc. (NBF) suggests taking some profits from equities and leaving the proceeds in cash to use when market slides provide opportunities.

The NBF report also states that reducing exposure to emerg- ing markets could be considered. If the trade war continues, China’s growth will be dampened and the U.S. dollar (US$) will rise. Emerging economies depend on China to buy their exports, and these countries also have significant debt in U.S. dollars. When the US$ rises, the cost of servicing that debt increases in tandem.

Dominique Lapointe, Lavoie’s colleague at LBS and an economist who works on tactical asset- allocation recommendations, suggests adding equities from defensive sectors – specifically, telecommunications, consumer staples and utilities – while still investing in growth stocks, such as information technology (IT) and industrials. The amount of defensive investments depends on how worried your clients are. If they are “really worried,” Lapointe says, some U.S. REITs could be a good idea.

Lapointe isn’t suggesting financials right now because the yield curve is flat, giving banks little differential between the short-term rates they charge for loans and the long-term rates their assets are invested in. He does say, however, that Canadian banks are “really solid.” They are well-capitalized, with excellent rules for risk management. “Even if there’s a recession,” he says, “these banks should be fine.”

Burbeck likes both IT and U.S. banks, particularly in combination, which, he says, provides balance between growth and value. He notes the possibility of IT regulation, but says it probably would be welcomed by companies because it would raise the barriers to entry and make retaining market share easier. Interestingly, Burbeck isn’t worried about fintechs making banks vulnerable for the same reason: “The real strength of banks is mortgage loans, and that requires large amounts of capital and is heavily regulated.” He also could see banks buying fintechs to enter that consumer channel.

Another consideration is currency movements. Lavoie is forecasting the Canadian dollar (C$) to be around US80¢ by the second quarter of 2020, up by about 7% from the recent value of US75¢. That would cut into or even eliminate returns on U.S. investments unless your clients hedge their currency exposure.

However, not everyone expects the C$ to rise in value. Beata Caranci, senior vice president and chief economist at Toronto-Dominion Bank in Toronto, is forecasting the loonie will remain near current levels.

The bottom line is that you and your clients need to keep an eagle eye on economic fundamentals, geopolitical developments and currency movements.


“Recessions usually come when rising inflation forces central banks to raise interest rates. But inflation has remained persistently low,” says Timmer. “I can’t come up with a case for an imminent downturn in the U.S.”

Neither can most other economists and analysts, but there are some sleepers. For example, Lavoie is concerned about the amount and quality of U.S. corporate debt. In March, 55% of U.S. investment-grade debt was rated BBB vs 43% a year ago. This credit bubble could burst if interest rates rise, which he anticipates will happen in 2020.

Burbeck agrees. He’s particularly concerned about private- equity debt, which is less scrutinized because it’s private. He notes that the sector is growing as more and more public companies go private.

Caranci also flags corporate debt as being vulnerable, but she doesn’t anticipate rates will rise over the next year and a half.

Timmer isn’t as concerned, saying the rising debt just reflects companies taking advantage of low interest rates to push out their bond issues’ maturities. He also doesn’t anticipate rates will rise.

Analysts also are divided on inflation. Assuming the U.S./China trade war is resolved within the next few months, Timmer and Caranci don’t foresee signs of inflationary pressure emerging. However, Lavoie, Burbeck and Francois Bourdon (the last is chief investment officer at Fiera Capital Corp. in Montreal) think inflation will rise even without the tariffs continuing.

Bourdon sees several factors that have delayed increases in inflation now that the U.S. economy is operating at full capacity. These include improved productivity, companies’ ability to source from alternative suppliers, the disruptive impact of companies such as Uber Technologies Inc. and Amazon.com Inc. (which have forced competitors to keep prices low) and the ability of consumers to find bargains through online shopping. But the deflationary impact of those factors won’t last and he says we’ll see prices rise soon, adding that he wouldn’t be surprised if the Federal Reserve Board raises interest rates before yearend.

Burbeck also believes inflation is lagging. He agrees that online shopping has kept down the price of goods but not services – and wages are a major component of services’ prices. He also notes that China has been a huge deflationary force, which is one reason the U.S. is trying to end the trade war.

Geopolitical issues

The U.S. economy can swallow the tariffs President Donald Trump imposed on China on May 10 without risking recession. But if the additional tariffs threatened by Trump are imposed and remain in place for an extended period, the odds of an economic downturn will rise.

Caranci analyzed the impacts of escalation of the trade war, looking at both direct impacts and the more worrisome indirect impacts coming from changes in consumer, business and investor confidence. If the U.S. imposes tariffs of 25% on all Chinese goods, U.S. economic growth could drop by almost one percentage point (ppt) and inflation rise by 0.7 ppt. Most economists anticipate that the U.S.’s economy will grow by only about 2% this year, so if other negative factors come into play, there could well be a recession.

China is in better shape. Its economy is much stronger, growing by more than 6%, so knocking 0.5 ppt off that – Caranci’s estimate of maximum impact – wouldn’t be a major problem. In addition, the Communist government has the ability to stimulate the economy quickly, as has been done in the past year.

Trump also has threatened to levy 25% tariffs on imports of cars from Europe and Japan, although he has delayed a decision on that for six months. Lavoie and Burbeck are more concerned about this threat than they are about the U.S./China trade war. “The U.S. is more dependent on Europe than [it is on] China for what it imports and what it exports,” Lavoie says.

Burbeck says that the tariffs would hurt Germany, Europe’s major growth engine, in particular. Germany’s large auto industry is struggling with decreased demand for diesel automobiles and lags other countries in developing electric cars.

In addition, there are tensions between the U.S. and Iran, and the U.S.’s relationship with North Korea is deteriorating. The US$ could take off amid concerns about nuclear arms in both Iran and North Korea, while oil prices could soar if a flareup surrounding Iran happens.