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On Trump, Zuma and US economic insanity

31 August 2023 Gareth Stokes

If you keep a close eye on the political news out of the United States (US), then you have to wonder how that country ever made it to the top of the global ‘pile’ measured by gross domestic product (GDP). Per Wikipedia.org, the US has a nominal GDP of around USD26.85 trillion midway through 2023, while its currency, the US dollar, remains the currency of choice for global trade and investment, accounting for some 60% of global currency reserves around the same date.

The Trump, Zuma phenomenon

So, why has this writer kicked off today’s newsletter with such a doubting opening? Well, consider this, dear reader. While the Democrats are screaming for a certain Donald Trump to be incarcerated, the Republicans have pushed 99% down the path of choosing him as their preferred candidate to contest the next US Presidential Elections. Mind you, South Africa is quite accustomed to this level of political skulduggery, having just seen our ex-President serve another hour or so of a 15-month jail sentence that once saw him spend two months in a prison hospital room. PS, this would be our beloved (sic) JZ, who rather ironically carried plenty of jailable baggage, when he was sworn in as President back in May 2009. 

Ok, enough bluster, let us get this article back on track. Today’s ‘these Americans be crazy’ opening paragraph crystalised while the writer attended a series of presentations by Momentum Investments, which delved into the outlook for global inflation and interest rates in addition to speculating on the likelihood, extent and timing of a US economic recession. The economic insanity on naked display centred on the US fiscal and monetary policy response to the last two significant economic crises, the 2008-9 Global Financial Crisis (GFC) and the 2020-21 COVID Pandemic. Government and the US Federal Reserve responded to these threats by printing money, dishing that money out to businesses and individuals, and dropping interest rates to the bare minimum, if not lower. 

USD18 trillion in negative yielding bonds?

Interest rates hovered at or near zero for over a decade, with a staggering USD18 trillion in developed market bonds offering negative yield at a point during that period. It was against this backdrop that Herman van Papendorp, Head of Investment Research and Asset Allocation at Momentum Investments, took to the virtual stage to share how US interest rates and recession might impact portfolio positioning. He got straight to the point. “As far as the main global themes driving the outlook for financial markets, we think the likelihood for US recession and the US rates cycle are paramount for portfolio positioning in the next year or so,” he said. 

More importantly, he noted that the outcome of the recession theme will determine whether or not there is substantial downside risk for global equities. So, is a US economic recession inevitable? “Although the debate about the probability for US recession has been ongoing since the latter part of last year, the jury is still out on whether we will see it in the coming quarters, or whether recession can be avoided altogether,” Van Papendorp said, before conceding that on the balance of evidence there was a better-than-even chance of a recession in the US economy late in 2023, or in the first quarter of 2024. There are four main indicators to support his view. 

Four indicators that point to US recession

First, the so-called monetary policy transmission lag, referring to the length of time it typically takes before interest rate hikes pass through into the wider economy. “Since the US central bank started its hiking cycle in March 20222, policy rates have increased more over the last 12-months than at any time since 1981,” Van Papendorp said. In his estimate, the full effect of these cuts will only become visible 12 to 18 months after the rate cutting started. “The risk is that the mounting cumulative impact of the sequential rate increases late in the cycle, in retrospect, could turn out to have been the proverbial straw that broke the US economy’s back,” he said. 

Second, the US leading economic indicator has turned negative. This indicator includes 10 variables across the manufacturing sector; labour market; housing sector; credit, equity and rate markets; and consumer sentiment. The charts support that across 60-years of history, recession follows periods during which the leading economic indicator’s momentum turns negative. This turns out to be “one of the [strongest] arguments that the bears on the US economic cycle are putting forward that a US recession is coming”. 

Third, is the significant tightening in lending standards undertaken by US banks since late last year. Van Papendorp shared a graph to illustrate how banks’ loose lending criteria in the immediate aftermath of the pandemic had given way for tougher measures. The reason is that US banks have become increasingly concerned about the financial strain on businesses and consumers due to high inflation and repeated interest rate hikes, possibly exacerbated by the collapse of Silicon Valley Bank earlier in the year. “By limiting the availability of finance for the US corporate and household sectors, this increases the risk for a sharp slowdown in US economic activity, or even recession, in the quarters ahead,” he explained. 

The fourth and final indicator that supports the US recession argument exhibits in the yield curve inversion of the 10 Year-3 Month Treasury Yield Spread. This indicator is recognised as “an infallible recession indicator that has, historically, never giving a false signal”. Van Papendorp explained that whenever this part of the yield curve inverted in the past, there has always been a recession following somewhere between five- and 16-months after the yield curve went into inverted territory. The yield curve inversion occurred in October 2022, suggesting a recession at any time between March this year and February 2024. 

Is it time to position defensively?

If you proceed on the basis that US recession is inevitable, you will need to start thinking about how to position your clients’ investment portfolios. A good starting point is to understand what US recession might mean for different asset classes. “Although US recession may still be avoided, there are enough indicators pointing to a reasonable likelihood that a recession could transpire, which would imply a risk for meaningful global equity market downside, particularly as the US equity market does not seem to attach a high probability to a recessionary outcome,” Van Papendorp said. “It is prudent to position portfolios somewhat defensively by favouring exposure to US bonds, gold and alternative assets as hedges against the potential for sharp equity drawdowns”. He added that US bonds anyway appeared attractive versus global equities from both a rate cycle perspective and on a relative valuation basis.  

“In the past, whenever inflation was high … and at the time of a peak in the US rate cycle, the subsequent US equity performance was pretty subdued,” he said. “Furthermore, US bonds historically strongly outperform developed market equities in the year following the peak in the US policy rates [and especially] during cycles when the yield curve was inverted, as is now the case”. The highest US interest rates in four decades have also made the yield on US cash and bonds attractive as income-providing alternatives to equities. 

The expert’s closing remark

To conclude or reiterate: “It is currently prudent to position portfolios somewhat defensively [in recognition of] the still significant risk for a US recession … the historical superior performance from US bonds over global equities at the peak in the US rate cycle together with the better relative valuations of US bonds versus equities adds to our favourable disposition to US bonds in our portfolio positioning. 

Writer’s thoughts:

The level of technical knowledge on display at asset manager presentations always amazes me. The question is to what extent financial and investment advisers get to apply these asset class, economic indicator and portfolio construction insights in practise, versus just leaving the tough decision making to fund managers? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za

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