I spent the last two weeks crisscrossing Asia on business, visiting with institutional clients. Three main themes emerged. First, the Chinese economy has indeed slowed. Second, Asian investors are feeling optimistic about the short-term outlook for risk assets. Third, I gained a significant amount of weight after consuming hotel buffet breakfasts for 10 consecutive days. Alas, the upcoming holiday season may delay my return to fighting form…

Monthly webcast:

• In late November, we published a monthly economic webcast entitled “Happy Markets / Mixed Macro Signals”.

2019 review / 2020 preview:

• No year-ending note would be complete without a moment of reflection about the year that was and the year that will be.
• Reflecting on 2019:
  • In many ways, 2019 was much akin to 2018. Global economic growth continued to decelerate and substantial downside macro risks continued to dominate the discussion.
  • However, the market performance couldn’t have been more different between the two years, with 2019 risk assets substantially outperforming.
  • Three key differences helped to differentiate 2019 from the prior year.
  • First, central banks pivoted from rate hikes to rate cuts, delivering significant stimulus. This boosted market confidence considerably.
  • Second, global growth began to tentatively bottom in the fall of 2019, providing hope for investors.
  • Third, downside risks began to shrink over the final third of 2019. This included a reduced risk of recession, a fading risk of a No Deal Brexit and a tentative trade deal between the U.S. and China. Markets were thus able to climb a wall of worry.
  • As these developments unfolded in real time, we increased our own equity allocation over the past quarter.
• Looking forward to 2020:
  • Global growth should continue to bottom. This is not a certain proposition, but likely. The lagged effect of prior monetary stimulus promises to be the primary support, while the lagged effect of prior protectionism should exert the opposite influence, preventing growth from accelerating significantly. A rebound is already evident in China and the Eurozone, whereas the evidence is more mixed in the U.S. and still quite sour in Japan and the U.K.
  • The latest evidence of stabilizing growth is that the consensus outlook for GDP growth in major markets for 2020 actually increased in November for the first time in many months.
  • Downside risks should be somewhat less existential than in 2018 and 2019, though let the record show the business cycle still looks quite old. As well, a permanent Brexit deal remains to be negotiated, U.S.-China frictions are unlikely to vanish altogether, and the pivotal U.S. 2020 election grows ever nearer.
  • In theory, a further stabilization of growth and an environment of relatively contained risks should prove a positive for risk assets in 2020. But let us not forget that markets relish nothing more than rising in response to the elimination of problems and risks. To the extent there appear to be fewer such issues to begin with, there might be less scope for outsized gains than in 2019.

U.S.-China trade deal:

• A long-awaited “Phase One” U.S.-China deal was announced on December 13, just before the December 15 deadline that would have further increased tariffs between the two countries. The U.S. has indicated it hopes to sign the deal in early January.
• The announcement is certainly very good news, though it is not the final word on the subject.
• The main details of the tentative agreement are as follows:
  • The U.S. will not implement its threatened 15% tariff on another $160B of Chinese consumer goods, and China will call off its own planned retaliatory tariff. This is an important development, as the proposed U.S. tariffs were set to impact highly visible products such as the iPhone. Also, the consumer-oriented nature of the products (and the low margin on most consumer goods) meant that the tariff would have visibly impacted American pocketbooks.
  • The U.S. tariff rate applied to $120B of Chinese consumer goods back on September 1 will be cut in half from 15% to 7.5%.
  • China has pledged to buy more U.S. products, totaling approximately $100B more per year for each of the next two years, with $16B-$20B more in agricultural purchases. This last promise may be hard to meet, as it would require China to roughly triple its annual U.S. agricultural imports relative to 2018, and to go roughly 50% beyond 2017 levels.
  • China has committed to changing its intellectual property (IP) rules, enforcing existing IP laws more vigorously, and possibly also reducing the extent to which U.S. firms are forced to share their technologies with Chinese companies. The details on this are still sketchy, and it is possible elements will be delayed until a Phase Two deal.
  • China has also promised to further open its financial services sector to foreign firms, though the country is already well underway in this regard with expanding opportunities for foreign investment into Chinese markets and even more direct participation in the country’s financial system.
  • Finally, China has promised not to manipulate its currency, though we note that it has lately been in the business of defending rather than repressing its currency, and the country is already fairly transparent about its actions.
• Virtually all of this had already been rumoured or tentatively committed to by China during prior rounds of negotiations or earlier in this negotiating process.
• We always figured the two countries would manage to avoid increasing tariffs further on December 15, though our base-case forecast had not assumed an outright reduction in tariffs. As such, this constitutes a modest upside surprise.
• However, let us not exaggerate the benefits of the trade deal:
  • Most tariffs remain in effect, such that the U.S. effective tariff rate on imported goods has merely declined from 4.6% to 4.2% – still much higher than the 1.7% rate that prevailed in 2017. As such, the cut merely reduces the tariff rate 14% of the way back to pre-trade war levels. For context, had the December 15 tariffs been applied as originally planned, that would have increased the tariff rate from 4.6% to 5.6%.
  • This trade deal is not yet truly complete. Language is still being finalized and formal approval is required. Recall that a deal had seemed near completion in the spring before unraveling. While a failure of that magnitude is unlikely, further work is likely needed given that the countries were forced into a hasty agreement by their mutual desire to avoid raising tariffs on December 15. As such, the risk of disagreement or dilution is real.
  • A Phase Two agreement will likely prove elusive. Phase One encompasses the easier elements of a deal, and China is unlikely to succumb to U.S. pressure to significantly reduce its support of state-owned enterprises. More generally, we expect the U.S. and China to remain locked in a low-grade struggle on multiple levels for the foreseeable future.
  • Finally, tariffs may still prove more damaging to 2020 growth than they were to 2019. Even though the tariff rate is set to be lower in early 2020 than it was in late 2019, keep in mind that the first half of 2019 had relatively mild tariffs. Furthermore, tariffs inflict economic damage with a lag, such that the peak tariff era of H2 2019 is of central relevance for H1 2020 growth.

U.K. election/Brexit:

• Downside Brexit risks continue to shrink, to the delight of financial markets.
• The December 12 U.K. election yielded an even larger Conservative majority for Prime Minister Boris Johnson than was projected by pollsters.
• Fascinatingly, the election has seemingly uprooted long-standing party affiliations as working-class voters abandoned their traditional Labour Party preference in favour of the pro-Brexit Conservatives. Whether this represents a structural re-alignment of support akin to what has happened in the U.S. over the past few decades (or instead a tactical shift) is not yet clear.
• In line with our expectations, markets have viewed this as a very positive result. This is not so much because a Conservative win delivers the perfect form of Brexit – the now-likely Johnson deal is arguably more damaging than a variety of milder alternatives – but because there are two key positives:
  1. The election offers a clear path forward. A majority government should provide a degree of coherence that had proven unachievable for the prior minority government. The Conservative Party itself has been purged of dissenters – most should now line up in support of the Prime Minister’s plan. As such, the Johnson interim deal will almost certainly be pursued by the U.K. and will very likely be formally agreed upon by the European Union (EU) before the January 31 deadline. The chronic uncertainty of the past three and a half years had proved crippling for British businesses, whereas there is now a much clearer, if imperfect, path forward. Crucially, the risk of a No-Deal Brexit has shrunk considerably. While a minority Labour government might have pursued a softer form of Brexit, the uncertainty would have ratcheted upwards again.
  2. Financial markets were anxious about the Labour Party’s anti-business platform. The Conservative win is considered a dodged bullet in this regard.
• Of course, the Brexit deal in question is merely an interim arrangement. The U.K. will then have to pivot toward negotiations with the EU and other nations regarding what the country’s permanent relationship will be with its neighbours. The Conservatives would like to wrap this up by the end of 2020, but that seems optimistic given the complexity involved. In all likelihood, an extension will be necessary. As such, Brexit uncertainty hasn’t so much vanished as morphed into a new, slightly less urgent (but equally consequential) phase.

Impeachment imminent:

• The U.S. House of Representatives appears to be on the cusp of impeaching President Trump, with the deciding vote likely on Wednesday December 18.
• The House Judiciary Committee has approved two Articles of Impeachment. The first Article accuses the President of abuse of office relating to pressure put on Ukraine to investigate U.S. political rivals. The second Article accuses the President of obstruction of justice relating to the blocking of witnesses and disobeying subpoenas.
• The matter now goes to a full vote in the House of Representatives and seems almost certain to result in an impeachment given the easily-achieved requirement of a simple majority of voters from the Democrat-majority House.
• However, an impeachment does not mean a removal from office. President Clinton was impeached, but not removed from office. Conviction can only occur if the subsequent Senate trial opts to convict.
• The special trial in the Senate will be presided over by the Chief Justice of the Supreme Court, prosecuted by a select group of House lawmakers, with Senate members acting as jurors. Historically, the Senate has commenced hearing the case within a few weeks of the impeachment, with the two historical episodes taking 36 days (Bill Clinton) and 81 days (Andrew Johnson) to resolve. This one may be at the shorter end of the spectrum given the reluctance of the President to allow witnesses to testify.
• It seems quite unlikely that the Senate will opt to convict and thus remove the President from office, for a variety of reasons:
  • History shows that no American President has ever been convicted.
  • The Senate is Republican-dominated, and support for the President among the Republican base remains strong.
  • Unlike the simple majority required by the House, the Senate vote requires a super-majority of 67 out of 100 Senators. That would necessitate 20 Republican Senators joining ranks with the Democrats and Independents – an extremely unlikely development.
• As such, the impeachment efforts will represent a rebuke of the President, but not actually change who walks the corridors of power. Amazingly, despite the acrimony around this matter, Democrats and Republicans are actually managing to make progress on other fronts, including toward a spending bill that would avoid another government shutdown, and toward a USMCA trade agreement.
• We are doubtful that the impeachment effort will prove a winner at the polls for Democrats. It certainly wasn’t a vote-getter for the Republicans in 1998. Instead, the party appears to be pursuing the matter with the view that history will judge them poorly if they do not at least make an effort to hold the President to account.

Smaller items:

• The U.S. Federal Reserve delivered a neutral policy decision, maintaining its view that three rate cuts should suffice. It may well prove correct, though we highlight the fact that it is historically rare for the Fed to restrain itself to a mere three cuts – far more frequently, several hundred basis points of easing ultimately prove necessary. Furthermore, even if no rate change in 2020 were the correct base-case forecast, it is important to factor in the bear-case forecast of a recession, which would presumably require a further six cuts. When combined into a weighted outlook, the conclusion is that some rate cuts should still be priced.
• The big U.S. job gain of 266K in November is an important development, as it goes against the grain of tentative deterioration elsewhere in the sector. We remain somewhat nervous about diminished job openings, higher jobless claims and reduced hiring intentions, but for the moment actual job creation remains seemingly unaffected. And as the market’s nerves ease and growth stabilizes, the risk of a serious deterioration in job creation is fading.
• The Bank of Canada rendered a fairly neutral decision, indicating that it remains content on hold for the moment. We still believe there is a chance of rate cuts, as argued by recent poor job numbers.
• Whereas the global economy demonstrates tentative stabilization, Japan remains in a weak economic position, with soft PMIs, a deteriorating Tankan Survey, industrial production that fell 4.5% in October and a sharp 14.4% decline in October retail sales. Of course, this last element is the result of a sales tax hike that occurred at the start of that month, and comes on the heels of a 7.2% increase in retail sales beforehand as shoppers made their big-ticket purchases early. Nevertheless, it is likely to continue to wear on the economy for several months, and prior episodes of sales tax hikes proved surprisingly damaging to the country’s short-term economic prospects. Fortunately, Japan has announced several hundred billion U.S. dollars of new fiscal stimulus. This will trickle forth over the span of multiple years and so doesn’t radically change the story. We forecast just 0.25% Japanese GDP growth in 2020.
• Finally, the USMCA deal between the U.S., Mexico and Canada appears to be proceeding. It is going to a vote in U.S. Congress. After a moment of miscommunication and hesitation, Mexico appears to accept the new labour and environmental demands placed upon it. Canada also seems willing to proceed. More than a year after the deal was tentatively struck, it may actually be implemented in the relatively near term.