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Macro and Markets, Cash Management

The mood music for 2020

December 2019

US-China trade tensions have dominated the past 12 months and the negative impact on capex and business spending as yet show little sign of lifting, reports Deutsche Bank economist Torsten Slok

Twelve months ago, 2018 was ending on a bad note for US equities. Capex spending and investment by US corporates had started to slow in response to US-China trade tensions and investors viewed the Federal Reserve as falling behind the curve in not adjusting its policy of small but steady rate increases.

As 2019 concludes, the trade war still casts a shadow over the economic outlook as the markets await more details on the mooted phase one deal between the US and China. However, more important than the piece of paper signifying an agreement between the two countries is how US corporates respond to it, says Torsten Slok, Chief Economist at Deutsche Bank Securities.

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In his latest Global Economic Update podcast, part of the Podzept series from Deutsche Bank Research, Slok offers an economic outlook for the year ahead, in conversation with Matthew Barnard, Deutsche Bank’s Associate Director of Company Research, North America. He notes that the main theme for 2019 has been a marked slowdown in capex spending by US corporates, one that has been evident since August 2018.

US companies that usually plan their spending on a relatively long-term horizon have noticeably shortened it. Capex spending and business fixed investment in new equipment and infrastructure, including software, electronics and computers, has been held back. Equally troubling is the impact on business sentiment: confidence levels among US chief executives has fallen back to the levels of 10 years ago and the immediate aftermath of the global financial crisis.

Contrast this with US equity markets, which moved higher once the Federal Reserve changed its stance and began signifying an easing bias. The change of course came early in the year and three 0.25% rate reductions followed in July, September and October; in response the Standard & Poor’s 500 index has hit record highs in 2019 and is more than 25% up on a year ago.

Fed’s changing stances

Whether this ebullience continues into 2020 is questionable. Slok suggests that several of the underlying behavioural responses to the trade war suggest a downside risk to the economic outlook. “While it would be good news were the trade war to go away as an issue, the risks centre not just on whether a deal is signed but whether business behaviour is likely to change. Are companies about to open the drawer and spend a lot more on capex projects?”
While it would be good news were the trade war to go away as an issue, the risks centre not just on whether a deal is signed but whether business behaviour is likely to change.

Torsten Slok

Add to this next November’s US presidential elections and there is also the possibility of a “pivot from trade war uncertainty to election uncertainty” and business spending weakness persisting, he adds, noting that business spending accounts for 15% of US GDP and is one of its most cyclical components. And currently there is little evidence that the downward trend is about to be reversed.

After reversing most of the interest rate hikes that it imposed during 2018, the Fed’s message has changed again now. It now appears to feel that an economic ‘soft landing’ has been achieved, and there is no need for any further reductions are needed in the near term. Slok says that the change of tone – from hawkish to dovish and most recently to neutral – has driven investors’ hunt for yield, which has returned to benefit equities.

“When the risk-free rate – which is basically the federal funds rate – goes down the that encourages investors to take more risk,” he comments. “So almost all of the riskier assets have done very well this year.”

Australia’s achievement

Barnard says that his projection for US GDP growth in 2020 is 1.9%. However what has become the longest period US economic expansion in history is unlikely to endure long enough to match Australia, whose economy has now been recession-proof for almost 30 years. Slok believes that the US expansion is not yet at its end – and the removal of trade war uncertainty could extend it further – but cautions that “we’re also wrestling with some of the features that are typical of the late stages of the growth cycle.”

Foremost among these warning signs is that profits as a share of GDP typically peak midway through a growth cycle and start to fall in its later stages. The peak for US corporates was reached back in 2015, and profits to GDP ratio is now in decline as wage deals are moving upwards. “Companies are having to pay more to their workers, so there’s less available for the bottom line,” Slok confirms. “And when profits as a share of GDP start going down that’s a sign you’re approaching the end of the cycle.”

Add to this evidence of a decline in credit quality, with delinquency rates starting to rise both for car loans and credit cards coupled with greater reluctance on the part of investors to lend to those consumers with poorer credit ratings. Slok reports a similar situation with corporate credit.

“Those companies with lower ratings are finding it harder to get finance for their business investments, with spreads beginning to widen at the bottom of the credit spectrum. In the corporate bond markets with the credit spread there’s a widening gap between the CCC-rated and everything else in high yield, which has been widening out by approximately 500 basis points.

“And if the Fed cuts rates by 0.25bps that really doesn’t help much.” So only if and when there is a turnaround in the lower quality risks and credit starts to flow again can it be confidently predicted that the cycle is set to continue for much longer.”

In addition to a decline in profits as a share of US GDP and more vulnerable-looking US consumers, an issue that has risen up the agenda since September is the decline in the repo market. While it’s on investors’ minds and has the Fed’s attention, Slok believes it is not as significant from a macroeconomic economic or as a factor in the economic outlook.

“That being said, we’re already seeing repo rates at the end of the year of around 4-4.5%, so there are some things simmering underneath this problem,” he concedes.“But it’s not special, rather a typical problem at year-end and not a specific one for 2019. So we’re not going to lose any sleep over it beyond carefully monitoring what’s going on.”

A second Trump term?

When you look at past election cycles, when the main parties are running fairly close – by which we mean no more than three percentage points between them – we usually see markets flatten out three to four months ahead of the polling date.

Matthew Barnard

The podcast concludes with an assessment of risk associated with November’s presidential election. As Barnard notes; “When you look at past election cycles, when the main parties are running fairly close – by which we mean no more than three percentage points between them – we usually see markets flatten out three to four months ahead of the polling date. They then rally once the result is known, regardless of who wins.”

The big question hangs over future US fiscal policy. What will happen to government spending and to taxation? “At this point, at the end of 2019, Trump has hinted strongly at tax cuts for the middle classes of 15 percentage points, which would result in a fiscal boost after the election if enacted,” reflects Slok

“The Democrats are opting for an increase to the US minimum wage, which would also be good for consumption, They’re also thinking about forgiving student debt, which is also relatively positive. As the stock of student loans outstanding is US$1.5trn, if that debt load is at least written down in a significant way it would certainly lift consumption.”

Slok notes that some Democratic candidates also talk of corporate tax hikes, which would be negative for corporate spending, but whatever the outcome in November there is a strong prospect of a post-election boost to government spending. “So what happens to corporate taxes – whether they go up again and if so by how much, along with what happens to capital gains taxes, labour protection and environmental protection – all make it difficult to quantify the exact implications.

“But also it’s not clear to us that there are any scenarios that would involve the stock market falling a lot, or conversely in which it would go up a lot.

“The final point – and a very important one this year – is that we’ve also been thinking in terms of what it means for monetary policy and whether the Fed in that kind of environment would be back raising rates again if there is a fiscal boost. Or whether they will maintain the present tone in which rates stay low for a very long time.”

Podzept, a podcast which addresses the current issues driving the world of economics and finance. Listen to top Deutsche Bank analysts and thinkers discuss their findings. Click here or subscribe to Podzept on iTunes or Spotify


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