Perspective - Managers' views
Friendly monetary policy from Fed can ease pressure on growth
It was quite clear that investor concerns are now focused on growth and political risk, with the threat from trade tensions fading.
It was quite clear that investor concerns are now focused on growth and political risk, with the threat from trade tensions fading. Given the slowdown in activity, particularly in Europe and Asia, and the recent inversion of the US yield curve this is not surprising. The latter has been a good predictor of recessions in the past and investors are very aware that equity returns in 2018 were almost entirely driven by corporate earnings per share growth (EPS) as the market de-rated.
This may change going forward as a more friendly monetary policy from the US Federal Reserve (Fed) has helped markets re-rate and bounce back recently. Following the FOMC meeting in March we have taken out the one remaining rate hike in our forecast and now expect the next move in fed funds to be down in 2020. This will support liquidity and bond markets including credit. Equity markets can also benefit, but eventually will re-focus on growth if gains are to be sustained.
Searching for green shoots
Although near-term indicators are still weak we continue to forecast a pick-up in activity in Q2. Encouragingly, there are one or two green shoots of recovery coming through. For example, commodity prices have firmed (industrial metals rose 3.8% over the past month), the global purchasing managers' index (PMI) rose in February whilst in the US the composite ISM strengthened and the housing market has firmed (NAHB and home sales).
China is adjusting its inventory down which ties in with the rapid cut back in imports from the US. Elsewhere though the picture is more mixed with both Korea and Taiwan showing a build-up of inventory as the semiconductor market has slowed. Inventory adjustments can lead to drops in output, but should be short lived as long as final demand holds up. The evidence on the consumer side where real wages are firming suggests this is still the case.
Pressure on profits
Whilst this gives us some comfort that activity will turn and salve investor concerns, looking further ahead there is still cause for concern as we see growth slowing in the US as stimulus fades in 2020. Our GDP forecast of 1.6% compares with consensus of 2%. In particular we are concerned about profits which ultimately matter more than GDP growth for equity investors.
One of the key changes in our recent forecast update was a lower inflation profile which has fed into an easier monetary stance from the central banks. Whilst currently seen as positive for markets helping to support the level of valuations, lower inflation also implies more pressure on profit margins. Companies are facing rising wage costs and if they are unable to pass these on in prices then margins have to take the strain.
Our forecasting model suggests that caution on US earnings in the following quarters would be appropriate, as it signals an economic profits recession in 2020. An official US recession in 2020 is not the central forecast, but we expect profits to peak in Q3 2019 as the US economy slows thereafter. US economic profits (excluding financials) are expected to rise by 6% in 2019, but as the US economic slowdown continues in 2020 and growth falls below trend, they are expected to decline by almost 4% next year.
In the near term we believe that growth worries are overdone, but looking further out we share our client concerns on growth. The analysis of profit margins suggests we will see a squeeze on corporate earnings in 2020. Corporate cash flows will come under pressure and this will provoke a reaction from the sector. Typically companies would cut jobs and capital spending which will weaken GDP directly through business capex and indirectly through weaker household incomes, confidence and consumer spending.
This in turn could bring the cycle to an end and lead to a recession. It would be consistent with the yield curve, which has a good track record in this respect.
For the current cycle to continue we would need to see action to prevent the margin squeeze. One possibility is that the corporate sector keeps labour costs under control either through limiting wage gains, or by boosting productivity growth. Alternatively, we would need stronger demand to support output thus boosting capacity use and productivity. This might come externally through stronger demand from China, but the more likely source would be from the Fed easing monetary policy by cutting interest rates.
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