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by  Eric Lascelles Jul 8, 2019

1) Monthly webcast:

2) Markets rally:

  • The S&P 500 rallied to a new all-time high in early July. This was motivated by a mix of dovish central banks and a slight improvement in U.S.-China relations.
  • At the same time, the U.S. 10-year yield rallied to below the 2.00% threshold for the first time in nearly three years, despite a policy rate that is a full two percentage points higher than it was at the last such occasion.
  • Naturally, the resulting financial market returns have pleased investors of nearly all stripes, though one wonders how long the two variables can continue this unusual behavior of rallying at the same time.

3) Longest expansion:

  • As of July, the U.S. economic cycle has now delivered its longest sustained expansion in history, dating back 34 cycles to 1854.
  • As research from the U.S. Federal Reserve was quick to point out under Janet Yellen, the ebb and flow of the business cycle is determined by far more than just the clock on the wall (although the research does admit that the risk of recession gradually rises with time, alongside many other considerations).

4) Why this lengthy expansion makes sense:

  • Economic expansions are usually longer when they follow a particularly deep correction like the global financial crisis since. This makes sense since there is more ground to make up before overheating.
  • Similarly, expansions usually run for longer when the pace of expansion is unusually slow. This also makes sense, since slow growth means it takes longer to reach full capacity. Growth has indeed been unusually slow over the past decade.
  • Relative to the early decades of the 20th century, when recessions were frequent occurrences, the introduction of a variety of social safety nets like unemployment insurance have reduced the frequency with which an economic lull snowballs into a fully blown recession.
  • Improvements to financial market regulation over the past century has reduced the frequency of financial market crises that lead to recession, though clearly not eliminated them altogether.
  • The incremental professionalization of central banks (and in the U.S. case, the reintroduction of a central bank in 1913) have reduced the frequency of economic downturns.
  • The spread of Keynesian fiscal policies may also have helped to stabilize economies relative to the past, though this is fiercely debated.
  • Over the decades, the gradual increase in the importance of the service sector relative to the goods sector has also contributed to longer periods of economic stability, as the demand for services is generally smoother. The demand for health care, education and government services is minimally linked to the state of the economy; consider the steadiness of a monthly cell phone bill versus the decision to buy a new car. In comparison, the goods sector is occasionally battered by inventory overcorrections that contribute to downturns.
  • The advance of globalization over the past 50 years has helped to smooth out growth. Weak demand in one part of the world (or domestically) can be mitigated by steady demand from another part of the world.

5) Why this cycle is nevertheless vulnerable:

  • Despite a generally diminished risk of recession today relative to 100 or even 30 years ago, the risk is not nil. Our business cycle scorecard argues this is a late point in the cycle. A variety of yield curves make the same argument. The New York Fed’s own yield curve model argues for roughly a 30% chance of recession over the next year – at least triple the normal risk.
  • Furthermore, with interest rates already fairly low and government debt loads quite high, there is less scope to stimulate an economy back to life than in the past, though central banks are certainly doing their darnedest right now.
  • While an interconnected global economy can help to mute the effect of economic weakness in any one region, the problem today is that most parts of the world are simultaneously decelerating, nullifying this offset.

6) U.S.-China “truce”:

  • The market is probably right that the result of negotiations at the G20 was about as good as could be hoped.
    • U.S. President Trump’s threat of a sizeable new round of tariffs was not implemented.
    • U.S. restrictions on Huawei have been marginally reduced.
    • China has promised to buy more U.S. agricultural products.
  • However, to our eye, this falls well short of a truce.
    • Sizeable tariffs continue to yawn in both directions, impinging economic growth.
    • Aggressive corporate-level restrictions remain mostly in place.
    • China had already promised to buy more U.S. agricultural products many times before.
  • Whether a genuine ceasefire eventually occurs will be determined by whether the short-term need for more growth in China and the U.S. (given the former’s 6.0% to 6.5% growth target and the latter’s 2020 election race) outweighs U.S. desires for a more balanced global playing field. Our assumption is that the former consideration prevents tariffs from rising further, but the latter consideration keeps existing tariffs in place, exerting a moderate economic drag. Frictions of various sorts will likely persist between the two countries for many years to come, probably past the end of President Trump’s tenure in the Oval Office.

7) Economic growth trend is downward:

  • Purchasing manager indices continued to weaken in June, spanning both manufacturing and non-manufacturing measures.
  • The U.S. ISM (Institute for Supply Management) Manufacturing Index fell from 52.1 to 51.7.
  • The ISM Non-Manufacturing Index declined from 56.9 to 55.0.
  • China’s composite Caixin PMI (Purchasing Managers Index) fell from 51.5 to 50.6.
  • The U.K. composite PMI fell from 50.9 to 49.7: a sub-50 reading theoretically consistent with decline (though only in the relevant sectors – it usually takes a reading of around 43 or lower to signal recession in the broader economy).
  • Citi Economic Surprise Indexes are now nearly universally negative across the major countries.
  • It would thus be disingenuous to suggest that there are still significant green shoots of growth, as was the case early in the spring.

8) But not all aspects of the global economy are negative:

  • However, the macro story is not quite universally negative. There remain a mix of indicators, with some still pointing to stability, at least.
  • The latest Eurozone composite PMI managed to go roughly sideways (in fact, up a tenth of a point).
  • The most recent U.S. Beige Book argued for slightly more as opposed to slightly less growth.
  • While hardly accelerating, service-oriented sectors are holding up better than the manufacturing sector – something that is receiving less attention than perhaps it should.
  • Consumer spending metrics remain fairly cheery in the U.S., which makes sense given the durability of American households that have paid down their debt since the global financial crisis and currently sport an impressive 7% savings rate. This is also what saved the economy in 2016 when manufacturing metrics such as core capital goods orders fell even more aggressively than this time.
  • The latest U.S. job number managed a happy 224K gain. This has substantially diminished concern after the weak 75K performance from the month before.
  • Even though the broader hiring trend is slightly off earlier highs, U.S. productivity growth has revived to the extent that reasonable economic growth is still entirely achievable.

9) Fed updates ahead:

  • The Fed has clearly signaled that rate cuts are in play. Indeed these are more likely than not over the remainder of 2019.
  • However, and somewhat stubbornly, we continue to highlight the risk that the Fed doesn’t deliver quite as much stimulus as the market is currently budgeting for. Why?
    • Inflation isn’t actually all that low. The U.S. core Consumer Price Index (CPI) is expected to land precisely at the Fed’s target of 2.0% when published later this week.
    • Protectionism did not ratchet higher after the G20 meetings.
    • The central bank’s growth outlook remains adequate.
    • The latest payrolls report alleviated concern about the labour market.
    • The median forecast among Fed participants is (if only just barely) for an unchanged policy rate this year.
  • What does this imply? It could simply point to a 25bps rate cut rather than the 50bps cut some are speculating about for later this month. But it is also far from impossible that the Fed opts not to cut quite yet.
  • We will learn more this week. Fed Chair Powell will testify twice to Congress and the Fed Minutes will reveal more about the thought process that went into the dovish signal from the most recent Federal Open Market Committee (FOMC) meeting.

10) The case for (a bit) more inflation:

  • U.S. inflation for June will be published later this week. As a general rule, we favour slightly above-consensus readings over below-consensus ones. The logic behind this includes the following facts:
    • Protectionism is inflationary.
    • Economic slack has utterly vanished from the system.
    • The Phillips Curve is not entirely flat and may even be convex (which would imply an acceleration of inflation at the very end of the cycle).
    • The Fed itself has acknowledged that some recent inflation weakness is due to one-off and thus temporary factors.
  • To be sure, outright high inflation is unlikely given the structural depressants of an aging population and technological deflation. But the point is that inflation isn’t obviously destined to continue declining as per low inflation expectations.

11) In the meantime, enjoy the low inflation:

  • In the meantime, low and even normal inflation is a welcome thing:
    • It allows central banks to remain more accommodating than otherwise.
    • It reduces the risk of economies overheating and thereby prematurely bringing the cycle to a close.
    • It reduces the effective tax rate on real investment returns.
    • It helps to maintain the happy negative correlation between equity prices and bond prices that is so fundamental to modern portfolio management.

12) Why, then, do central banks worry about low inflation?

  • The problems with excessively low inflation are fairly subtle.
  • If inflation is allowed to drift too low, it can turn into deflation. And when prices are falling, it always makes sense to defer a purchase until tomorrow, creating serious economic issues.
  • Structurally low inflation takes the nominal interest rate closer to 0%. This reduces the amount of room for a central bank to deliver stimulus in the event of an economic downturn.
  • In other words, central banks have to be the sober adult in the room, seeking to ensure that inflation remains low for reasons of economic efficiency, but not too low.

13) Bank of Canada preview:

  • The Bank of Canada has a tricky path ahead, with more information to come from its decision later this week.
  • On the one hand, nearly every other major developed-world central bank has pivoted toward rate cuts. To be caught out of step could prove problematic, as demonstrated by a Canadian dollar that has appreciated notably in recent weeks. Worldwide considerations such as softening global demand and rising protectionism are no less relevant to Canada than to other nations.
  • However, Canadian inflation is not low – if anything, it is running slightly higher than target. Furthermore, Canada has recently managed a string of positive data, from almost absurdly strong trade numbers to a +0.3% monthly GDP print, with improved CFIB (Canadian Federation of Independent Business) and Business Outlook Survey readings as well. Canada’s housing metrics have similarly turned higher after a lengthy swoon.
  • While one could point to the latest job report for evidence of weakness, the -2K reading in June doesn’t do justice to the broader context of rising full-time employment and rising payroll employment, nor to the longer-term trend which remains quite positive.
  • We stop short of an ode to the strength of the Canadian economy as a variety of challenges remain and some of the strength (in particular, trade) may prove short lived. But, for the moment, it is hard to argue that Canada needs rate cuts.
  • As a result, the market is probably right in assigning virtually no chance of a rate cut this week and only a slim chance in September. After that, the probability begins to rise, but never past a one-in-four chance by year end. To our eye, the risk of cuts is probably a little higher than the market imagines given Canada’s interconnectedness to the U.S. in particular. But it is still not very likely in the near term.

14) New ECB head?

  • Rumour has it that Christine Lagarde is now the front-runner for the European Central Bank job. The position becomes available this fall when current president Draghi’s term comes to an end. This would solve two problems at once:
    • circumventing the alternative of appointing a potentially ill-timed monetary policy hawk out of Germany
    • simultaneously installing a well-respected individual.

15) New IMF head?

  • In a somewhat incestuous development that speaks to the small world in which elite policymakers operate, while Christine Lagarde could become the next head of the ECB, current Bank of England (and ex Bank of Canada head) Mark Carney is now rumoured to be a leading candidate to replace her at the IMF. As with Lagarde, he represents a strong and logical choice given his background. Intriguingly, while Lagarde’s theoretical appointment would represent a politician breaking the tradition of trained economists heading the ECB, Carney would be an economist breaking the tradition (at least in the 21st century) of politicians heading the IMF.

16) Iran tensions:

  • We detailed U.S.-Iranian tensions in a recent #Macromemo, arguing that the risk of military conflict is unusually high, if not our base-case scenario.
  • Recent developments have been intense, with U.K. operatives detaining an Iranian tanker allegedly attempting to violate sanctions by transporting crude to Syria via the Mediterranean.
  • At the same time, Iran has now exceeded the uranium enrichment limits it initially agreed to with western nations. However, the country is apparently still more than a year away from having sufficient quantities to secure a nuclear weapon.

17) OPEC decision:

  • OPEC has opted to extend its oil production cut for another nine months, as expected. This helps to sustain the price of oil, though much on that front will depend on Iranian developments and the trajectory of global economic growth (=oil demand).

18) U.S.-North Korea:

  • The U.S. and North Korea are talking again, with a surprise visit by President Trump to North Korean soil during the recent G20 meetings in Japan.
  • Suggesting a break from the previous strategy, U.S. demands are apparently less directly focused than in the past on the denuclearization of North Korea.
  • We find it hard to believe that North Korea will ever voluntarily opt to abandon its nuclear weapons given the security they afford.
  • Simultaneously, we do not view North Korea as a serious risk to the world order or global growth as it has zero incentive to ever use its weapons in an act of aggression.

19) Hong Kong protests:

  • Recent Hong Kong protests represent the continuation of the Umbrella Movement begun in 2014 to protest the growing clout of mainland China over the city. Protests in recent weeks are said to have numbered as many as two million people out of a population of just seven million.
  • Recent efforts were largely successful. Hong Kong’s legislature ultimately opted not to approve an extradition agreement with China that would have allowed China to demand the transfer from Hong Kong of people accused of wrong-doing.
  • Protestors then went further, temporarily occupying and damaging Hong Kong’s legislative chambers. They later retreated as the police presence grew. However, little was seemingly achieved with this last move, as Chief Executive Carrie Lam remained in place and the protest movement lost a degree of public sympathy.
  • Interpreted more broadly, the Hong Kong protests are emblematic of a Western push back against China’s creeping power. As we have argued in the past, the West and China are likely to continue experiencing a variety of frictions for the foreseeable future as China begins to flex its geopolitical and military might, and as the world pushes back against China’s built-in economic advantages.

20) Japan—South Korea tensions:

  • Providing further proof that the world’s protectionist and geopolitical tensions are not merely the result of White House policy, tensions between Japan and South Korea have also lately increased. These tensions are rooted in a disagreement over World War II reparation payments. Japan has now limited the export of certain semiconductors to South Korea.

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