November 15, 2019 | 13:12
Yields low, stocks strong; nothing can go wrong?
From This day in History for November 15:
1999 - Representatives from China and the United States signed a major trade agreement that involved China’s membership in the World Trade Organization (WTO).
2019 - "The mood music is pretty good" around the U.S./China trade talks, sayeth Larry Kudlow.
Well-mannered folks are taught early on that in order to avoid awkward arguments to never discuss politics, religion or Don Cherry in polite company. Sometimes money is substituted as the third item on that list, as it, too, can cause all sorts of tense disagreements. A massive example this year may be playing out in financial markets before our eyes, as stocks and bonds seem to be sparring over the economic outlook. While equity markets continue to scale new heights, bond yields are staying extremely low as global growth wallows, and trade disputes remain unresolved. To wit, Canada’s TSX is working on an 11-day winning streak and has scaled the 17,000 mark, even as the yield curve is inverted amid paltry GDP growth of 1.5% this year, prompting many to look for BoC rate cuts in 2020. What gives?
Part of the explanation behind this year’s powerhouse gains in global equity markets is the weirdly weak starting point to 2019. Recall that the MSCI World index fell over 10% last year, including the near-20% Q4 drawdown in the S&P 500, as markets braced for a recession that didn’t happen. So, even as global growth has dipped to its weakest pace since 2009 this year at 2.9%, and the trade war flared more than conventional wisdom expected, growth was still better than what was priced in at the dawn of the year. And, the Fed’s pivot and three-step rate cuts turned sentiment around on a dime. Together, these two factors have helped drive the MSCI to a 19% gain so far this year, the second best annual rise this decade, and moving closer to 2013’s massive 23.9% advance.
At the same time, the dovish turn by the Fed, the ECB, and a gamut of other central banks helped slice bond yields widely. A pullback in oil prices also chipped in—WTI at $57 is down 12% from last year’s average level—by trimming headline inflation broadly at this advanced stage of the business cycle. And, of course, core inflation remains the dog that didn’t bark. This week saw yet another mild core CPI reading in the Euro Area (1.1% y/y), the U.K. (1.7%), and the U.S. (2.3%). True, the last one seems a tad out of place in that list at 2.3%, but such a pace for CPI implies that the Fed’s preferred core PCE deflator measure will likely remain below 2% in October.
The trade war has flung itself into the middle of this relatively neat picture of slower growth and tame inflation pressure. The noise/signal ratio is extraordinarily high on this front; but, at the margin, the net impact has been to chill growth further and nudge interest rates lower, creating almost a saw-off for equities. Markets are still rising to the bait of any hints of good news on a potential deal, which helped drive prices to new records this week. Investors managed to look past a series of reports that talks were hitting snags on China’s farm goods purchases and possible U.S. tariff rollbacks—i.e., pretty much the crux of the Phase One deal. And recall that the initial plan had been to sign said deal in mid-November at the (now cancelled) APEC meetings. We are told that the “mood music is pretty good” around negotiations, but just note that, if the mood sours, the default position is higher U.S. tariffs as of December 15.
Meanwhile, there were plenty of signals that both the U.S. and Chinese economies are feeling the weight of the trade war. In China, it’s relatively obvious, with industrial production fading to its slowest pace in 17 years at 4.7% y/y last month and retail sales cooling to 7.2%—both more than half a point south of consensus. In the U.S. data, the chill may be a little less clear-cut, but manufacturing output is down 1.3% y/y with many areas aside from GM-hit autos reporting drops. Jobless claims are at a four-month high, retail sales have been sluggish (3.1% y/y), and business sentiment is much more cautious. On balance, U.S. GDP growth is on track to cool further in Q4 and early next year to little more than 1.5%, even with a trade truce.
The focus will remain trained on trade in the coming week, as the economic calendar is cluttered with largely secondary items. The FOMC Minutes won’t hold much drama, as recent Fedspeak has been quite transparent in pointing to no further cuts for now. A slew of housing reports are expected to show the sector adding small support for growth. It’s a bit more filling in Canada, with CPI and retail sales on deck, and Governor Poloz speaks in Toronto on Thursday.
And, on another trade front, we may finally get some movement on the USMCA, after more than a year in limbo. House Speaker Pelosi offered her most direct and upbeat comments on the deal’s prospects this week, suggesting that the House may vote on it imminently. While North American trade has completely fallen off the market’s radar, suffice it to say that the issue has not faded for business decisions on the ground—and it would be very good news indeed if the issue could be safely put to bed at long last.
It’s interesting what can generate headlines these days. Canada’s PBO reported this week that, even before any new spending measures arising from the election, the federal budget deficit is tracking above Budget expectations. Specifically, next year’s shortfall could be $23 billion, while the Budget looked for a deficit just under $20 billion for FY20/21. That would translate into just under 1% of GDP, versus an expectation of… well, just under 1% of GDP.
Somehow, it is not at all shocking that a newly elected government is about to inform us that finances are worse than expected—although we will point out that nominal GDP is actually right on track with Budget projections. And, spending proposals outlined during the campaign, and minority government realities, are expected to boost the deficit closer to $30 billion in the coming year.
Let’s put things in context. This week, the U.S. reported a budget deficit of $134.5 billion (or 0.6% of GDP) in the month of October. That lifted the 12-month cumulative gap to above $1 trillion, or 4.7% of GDP, up $202 billion in the past year. The increase over the past year alone clocks in at 0.9% of GDP. Yet, overall U.S. GDP growth has been just 2.0% y/y. So, if not for the heftier deficit, one could readily make the case that growth may have been closer to 1% otherwise. And that much more subdued figure may help reveal the true dampening impact of the ongoing trade war.