As uncertainty revs up, global GDP is on track to rise 3% in 2019, the slowest pace in a decade.1 Global trade volumes fell in 2019 for the first time since the Great Recession, reflecting roller coaster U.S.-China trade negotiations, a lack of progress on Brexit, and political unrest in Hong Kong and some Latin American countries. Central bankers have responded with stimulus to keep the decade-long expansion going. While low interest rates and accommodative financial conditions will likely prolong the expansion, much will depend on geopolitical influences. We are monitoring these developments and have concluded that our Stagnation outlook for the U.S. economy over our forecast time horizon of twelve months still stands, with a recession likely in 2021.

China’s exports to economies involved in the regional supply chain have continued to grow as manufacturers increased shipments to the rest of Asia.  The December U.S. announcement of the Phase One trade deal has committed China to terms on increased intellectual property protection, limits on forced technology transfer, exchange rate transparency, further opening of the financial sector, and increased purchases of U.S. goods and services.2

European growth prospects have improved after several months of stagnating, with survey data improving across both the business and consumer space. In his last meeting as the ECB president, Mario Draghi held rates unchanged. In Germany, disruptive regulations, the global trade conflict, and weakness in global car sales have been blamed for the slump in German car production.3 Data continues to show that German carmakers continue to do well globally. The U.K. Conservative election victory suggests that the withdrawal agreement legislation will likely be passed, allowing for a stable Brexit transition to begin at the end of January.

Slowdowns in China, Germany, and South Korea as well as protests in Latin America, the Middle East, and Hong Kong may be helping U.S. economy to avoid a downturn by driving investment toward America’s relatively safe harbors. The FOMC left rates unchanged at the December meeting.4 The resilience of the U.S. consumer has helped offset challenges in the factory space, thanks to a solid job market that has bolstered confidence and spending. In early December, the Phase One trade deal between China and the U.S. and the revised NAFTA were announced.

Canada’s third quarter gross domestic product data delivered an expected slowdown, as a drop in exports and drawdown in business inventories masked a rebound in domestic demand.5 Strong economic growth earlier in the year has kept the Canadian dollar in its number one spot among major currencies in 2019, supported by some of the highest yields in the G-7 and by the BOC’s reluctance to ease policy like the Federal Reserve and European Central Bank.6

In November, the S&P 500 was up 3.6%, its biggest monthly gain since June, while the S&P SmallCap 600 and the S&P MidCap 400 gained 3.1% and 3.0%, respectively. Canadian equities posted gains in November, with the S&P/TSX Composite up 3.6%. The S&P Europe 350 gained 2.8%, keeping it on track for its best year since 2009. The S&P United Kingdom joined the positive trend, gaining 1.8%, despite uncertainty caused by the pending general election. Trade optimism also helped lift Asian equities in November. U.S. fixed income performance was mixed, with leveraged loans as the top performer while Treasuries lagged. With the People’s Bank of China cutting rates in November, Pan-Asian yields ticked down and bond prices rose.

In December, we maintained the November allocation between Equities and Fixed Income across all models. Allocation to equities remains at 17% in Tactical Conservative, 22% in Tactical Moderate Growth, 36% in Tactical Growth, and 44% in Tactical Aggressive Growth. Within the Fixed Income allocation, we maintained the weight of the 7-10 year maturity in order to protect the portfolio from a rebound in long rates, as treasury yields have been declining and the yield curve is close to inverted. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class.

We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame , President and CIO

 

International Monetary Fund. World Economic Outlook. October 2019.

ForeignPolicy.com. Why China Isn’t Celebrating the Phase One Trade Deal. December 18, 2019.

Trading Economics. Germany Car Production. November 2019.

Trading Economics. U.S. Fed Funds Rate. December 11, 2019.

Trading Economics. Canada GDP Growth. November 29, 2019.

Trading Economics. Canadian Dollar. November 30, 2019.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. November 30, 2019. Index performance is based on total returns and expressed in the local currency of the index.

 

Global growth continues to be weak, with the global economy impacted by the U.S.-China trade war on the one hand, and global monetary easing on the other. The trade standoff has taken a toll on business confidence, industrial production, and trade flows. It has weighed heavily on global manufacturing and hit export-oriented economies, including China, Taiwan and Korea. The trade war has had less impact on the more domestic-oriented econo­mies like the U.S. though, and as a result, there is a pronounced growth divergence among sectors and regions within the global economy. We are monitoring these developments and have concluded that our Stagnation outlook for the U.S. economy over our forecast time horizon of twelve months still stands, with a recession likely in 2021.

China’s growth slowed to 6.2% year-over-year in the second quarter from 6.4% in the first quarter, as the escalating U.S.-China trade tensions weakened business confidence and export growth.1 Emerging market economies that are less levered to the global export cycle, such as India and Brazil, have also succumbed to a slowdown in growth amidst weaker consumer spending and slow progress on reforms.

Beyond U.S.-China trade tensions, other global risks exist. Eurozone growth is slow, with Germany and Italy teetering on the edge of recession. The European Union granted the U.K. a three-month extension on Brexit, moving the deadline to January 31. The U.K. will also face a general election on December 12, adding a degree of uncertainty to future negotiations. The U.K. economy contracted in the second quarter of 2019, adding to the overall negative mood.2 Violent protests continue in Hong Kong despite a significant concession from the territory’s government in officially pulling the controversial extradition law. Growing tension in the Middle East, made worse by attacks on the Saudi oil fields, create another headwind.

Given the weak growth backdrop and elevated geopolitical risks, many global central banks have undertaken easing, aiming to stimulate growth and counter the negative effects of the trade war. At the same time, globalization appears to have increased the co-movement of government bond yields. The correlation of 10-year government bond yields in the major G7 economies increased steadily from the 1980s until 2007 and has remained high since then.3 This means that the diversification benefit from investing in foreign bond markets has fallen. With interest rates already at near or below zero in many countries, the power of monetary policy is diminished.

U.S. Real GDP grew 1.9% in the third quarter, a slowdown from 2.0% growth in the second quarter.4 A divide in the U.S. economy exists between business investment, flagging the trade war and weaker confidence and consumer spending/housing benefiting from a strong job market and the decline in longer-term interest rates. Nonfarm payrolls topped expectations with a 128,000 increase in October. Prior-month upward revisions lifted September to 180,000 and August to 219,000.5 The Bank of Canada left interest rates unchanged at 1.75% when they met on October 30. There have now been three consecutive Federal Reserve rate cuts with no matching move from the Bank of Canada, bringing U.S. overnight rates below those in Canada.6

U.S. equities posted gains in October with the S&P 500, S&P MidCap 400 and S&P SmallCap 600 gaining 2.2%, 1.1% and 2.0%. Canadian equities lost in October, with the S&P/TSX Composite down 0.9%. European equities ended the month in positive territory as the S&P Europe 350 gained 1.1% while the S&P United Kingdom declined 2.0%.

In November, we maintained the October allocation between Equities and Fixed Income across all models. Allocation to equities remains at 17% in Tactical Conservative, 22% in Tactical Moderate Growth, 36% in Tactical Growth, and 44% in Tactical Aggressive Growth.  Within the Fixed Income allocation, we shifted the remaining balance of our 20+ year maturity treasury exposure in each of our portfolio models to the 7-10 year maturity in order to protect the portfolio from a rebound in long rates as treasury yields have been declining and the yield curve is close to inverted. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class.

We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 Trading Economics, China GDP. October 18, 2019.

2 Trading Economics. United Kingdom GDP. September 30, 2019.

3 Capital Economics. Asset Allocation. October 24, 2019.

4 Trading Economics. U.S. GDP. October 30, 2019.

5 Trading Economics. U.S. Nonfarm Payrolls. November 1, 2019.

6 Trading Economics. U.S. Overnight Repo Rate. November 2019.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. October 31, 2019. Index performance is based on total returns and expressed in the local currency of the index.

 

 

Having already slowed from 4% to 3%, world GDP growth is set to take another leg down as growth in advanced economies slows to its weakest pace since 2012.1

Under the cloud of protectionism, global trade flows, which have been decelerating due to tariffs, are now outright contracting on a year-on-year basis. As a result, most of the weakness in the world economy this year has been in industry, while the services sector has held up quite well.2 We are monitoring these developments and have concluded that our Stagnation outlook for the U.S. economy over our forecast time horizon of twelve months still stands, with a recession likely in the last quarter of 2020 or early 2021.

The outlook for some emerging markets has been improving, but as emerging economies have benefited from globalization, they are more likely to lose out from de-globalization. China’s economy has remained resilient in recent months, but GDP growth is set to be the weakest in decades. With the property construction boom near the end of its cycle, headwinds from higher food inflation, and cooling global demand, a slowdown will be unavoidable.

In Europe, the outlook for exports is poor because the euro-zone’s key trading partners are losing momentum. To offset the slowing growth in Europe’s economic heartlands and ongoing Brexit uncertainty, the European Central Bank has extended its deposit rate further into negative territory and announced another round of asset purchases.3 It is encouraging that the share of non-performing loans continues to drop in places like Spain and Italy, reflecting a more resilient banking sector.4

In the U.S., consumer spending increased at a nearly 4% annualized rate for the first nine months of 2019 with rate-sensitive durable goods purchases rising at a double-digit pace. U.S. customs receipts hit a record $7.2 billion in August, good news for the Treasury but bad news for domestic firms who are paying those tariffs.5 The average tariff rate on U.S goods imports has doubled over the last year and a half.

Canadian GDP was flat in July, ending a run of upside surprises that amounted to the best monthly growth streak in two years. Maintenance shutdowns in the oil and gas sector and a pullback in drilling activity weighed on growth in July.6

Despite slowing economic growth, ongoing trade tensions, and a presidential impeachment inquiry, U.S. equities recovered in September. Large-caps underperformed mid and small-caps, with the S&P 500 up 1.9%, while the S&P MidCap 400 and S&P SmallCap 600 gained 3.1% and 3.3%, respectively. For the first three quarters of 2019, the S&P 500 outperformed, gaining 20.6%, while the S&P MidCap 400 and S&P SmallCap 600 gained 17.9% and 13.5%, respectively. Canadian equities gained during the month, third quarter, and YTD, with the S&P/TSX Composite up 1.7%, 2.5%, and 19.1% for those respective periods. The S&P Europe 350 shrugged off the gloom to finish the month, quarter, and YTD with gains of 3.8%, 2.6%, and 20.0%, respectively. A declining pound helped support the S&P United Kingdom which gained 0.8% for the quarter and 3.0% in September. Fixed income markets posted negative results in September.

The U.S. dollar maintained its positive momentum through September even after the Federal Reserve cut rates for a second time this year. In contrast, the euro slumped to its weakest level since 2017 as economic data in the Eurozone continued to deteriorate while U.S. economic results surprised to the upside. The loonie remained strong against the U.S. dollar in spite of the dollar strength and declining crude prices.

In October, we maintained the September allocation between Equities and Fixed Income across all models. Allocation to equities remains at 17% in Tactical Conservative, 22% in Tactical Moderate Growth, 36% in Tactical Growth, and 44% in Tactical Aggressive Growth. Within the Fixed Income allocation, we shifted a part of our 20+ year treasury exposure in each of our portfolio models to the 7-10 year in order to protect the portfolio from a rebound in long rates, as treasury yields have been declining and the yield curve is now inverted. Gold continues to be present in all models as it performs well in high risk, low yield environments as a risk-free asset class.

We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 Capital Economics. Global Economic Outlook. Q4 2019.

2 Capital Economics. Global Economic Outlook. Q4 2019.

3 S&P Dow Jones Indices. Index Dashboard: Europe. September 30, 2019.

4 National Bank of Canada. Monthly Economic Monitor. Economics and Strategy. October 2019.

5 RBC Economics. Financial Markets Monthly. October 4, 2019.

6 RBC Economics. Financial Markets Monthly. October 4, 2019.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. September 30, 2019. Index performance is based on total returns and expressed in the local currency of the index.

 

 

Section 1: Q4 2019 Outlook

 

Globalization Has Changed the Global Economy. Are We Now in a Period of De-Globalization?

Our investment approach is focused on the expected behavior of asset classes in various economic environments. Our research shows that in addition to five broad economic environments – Growth, Stagnation, Inflation, Recession and Chaos – the global economy also experiences regime shifts, which are temporary, and regime changes, which are permanent. Globalization results in regime change, as does de-globalization. In this Fourth Quarter 2019 Outlook, we take a closer look at the current state of globalization. The recognition of this changing environment is critical in determining our investment positioning in 2020 and beyond.

Economic theory suggests that globalization benefits the world economy. The absence of trade barriers should allow each country to specialize in the production of goods and services in which they are relatively efficient, leading to global productivity gains.

History shows that waves of globalization are driven by both technology and policy, but protectionist shifts tend to end them. In some cases, like in the 1970s, a pushback by policymakers can cause globalization to stall. In more extreme environments like the experience of the 1930s, a sustained policy backlash can push globalization into reverse. So far, the current trade war looks more like a stall but the risk of a de-globalization outcome similar to the 1930s is rising.

 

SOURCE: DEMIG (2015), OUR WORLD IN DATA, CAPITAL ECONOMICS

 

It takes a large and sustained push by policymakers to cause a period of de-globalization. As we begin Q4, the global economy is facing two dangers. The first is that a global economy that is already injured by geopolitical conflicts, including trade wars, endures further negative shocks. The second is that we overestimate resiliency and the feedback loop of slower growth that is occurring in many major economies around the globe.

This is occurring as the U.S. House of Representatives initiates a preliminary inquiry as to whether to proceed with a formal impeachment investigation of President Trump, China potentially delays trade solutions until the 2020 Presidential election, and the deadline for a Brexit decision falls at the end of October. Each of these challenges to the global economy could potentially be prolonged.

Compounding these risks, interest rates worldwide remain low or negative. It is estimated that over 80% of sovereign debt is trading with negative real rates.i While the U.S. Federal Reserve Bank continues to manipulate the economy with artificially low-interest rates, this policy is likely to backfire as the Federal Reserve’s policies mask the true state of the economy. Without an accurate financial picture, businesses lack the knowledge required to make investments. The resulting inaction could bring about the recession the Fed claims it wants to avoid. In addition, the idea that sub-zero interest rates lower the cost of borrowing has not proven to bring about the anticipated economic stimulus that central banks initially anticipated. Instead of paying banks to hold their money, businesses and individuals will find other sources in which to put their money.

 

Time to Include Gold in our Portfolio Models. Gold is Negatively Correlated with Interest Rates.

Economic events can create structural shifts in the acceptance level of risk. The global financial crisis of 2008-2009 is one example of these structural changes, referred to in our modelling as Chaos. Looking back at events including Black Monday, the LTCM crisis, and the global financial crisis of 2008 – 2009, World Gold Council analysis shows that gold mitigated portfolio losses incurred by investors during almost all tail events under consideration. For example, investors in the U.S., Europe, and the UK, who held a 5% allocation to gold reduced losses by approximately 5% during eight tail risk events.ii

Our Portfolio Models are seeking exposures that offer low correlations among stocks and bonds to mitigate downside risk. In a year marked by noticeable geopolitical unrest, policy uncertainty and the risk of an impending recession, gold becomes a preferred investment to bonds and equities. And while one of the negatives of holding gold is that it does not generate income and has a cost to store it, the periods when bonds have a negative carry momentum become strong periods for gold.

During September, global monetary policy continued to influence gold price performance as many central banks around the world cut rates or expanded quantitative easing measures. The Federal Reserve cut rates by 25 basis points in July, and again in September.iii

Gold has important diversification properties that are evident during periods of systemic risk. Gold has little or no correlation with many other assets, including commodities, during times of stress. In addition, the correlation is dynamic, changing across economic cycles to the benefit of investors. Like other commodities, gold is positively correlated to stocks during periods of economic growth when equity markets tend to rise. Gold is negatively correlated with other assets during risk-off periods, protecting investors against tail risks and other events that can have a significant negative impact on capital or wealth – a protection not always present in other commodities. As a result, gold can enhance portfolio stability and improve risk-adjusted returns.

 

Many Central Banks are Adding to Gold Reserves

Analysis of several factors that are propelling the gold market include central bank gold demand. Physical gold is expected to play an important part as countries shore up their havens, both on the private and official levels. While gold no longer plays a direct role in the international monetary system, central banks and governments still hold extensive gold reserves to preserve national wealth and protect against economic instability. Today, gold is the third largest reserve asset globally, following U.S. dollar and Euro-denominated assets.iv Gold is increasingly used as collateral in financial transactions, much like other high-quality liquid assets such as government debt.

History shows us that central bankers were net sellers 30 years ago. These same banks have turned to buying gold since 2010, culminating more than 650 tons of bullion bought from the official sector in 2018 with the trend persisting through the first half of 2019.v This is more than at any time since the end of the gold standard.

We expect that central banks will continue to power gold’s move higher and beyond the current supply and demand dynamics. The October 2019 report from the World Gold Council notes that investors have begun to turn to gold to escape an environment of negative interest rates as treasury yields come under continuing pressure. The U.S. 30-year Treasury acts as a signal here. Should the 30-year U.S. bond fall into negative territory, as has already happened in Germany and France, we expect gold to hit new cycle highs.

 

With rates likely to stay low and geopolitical unrest unlikely to abate, the demand for gold exposure is expected continue.

 

SOURCE: BLOOMBERG, WORLD GOLD COUNCIL

 

SOURCE: BLOOMBERG, WORLD GOLD COUNCIL

 

 

Section 2: 4 Themes

 

Theme 1: Global Trade and GDP are Deteriorating

The multilateral trading system remains the most important global forum for settling differences and providing solutions for the challenges of the 21st century global economy. Trade conflicts heighten uncertainty, leading some businesses to delay the productivity-enhancing investments that are essential to raising living standards. Trade conflicts can also heighten political tensions and occasionally physically aggressive behaviors between countries.

 

The World Trade Organization Lowers Trade Forecast as Tensions Unsettle Global Economy

Escalating trade tensions and a slowing global economy have led WTO economists to sharply downgrade their forecasts for trade growth in 2019 and 2020. World merchandise trade volumes are now expected to rise by only 1.2% in 2019, substantially slower than the 2.6% growth forecast in April.vi The updated trade forecast is based on consensus estimates of world GDP growth of 2.3% at market exchange rates for both 2019 and 2020, down from 2.6% previously.vii Slowing economic growth is partly due to rising trade tensions but also reflects country-specific cyclical and structural factors, including the shifting monetary policy stance in developed economies and Brexit-related uncertainty in the European Union.

The projected increase in 2020 is now 2.7%, down from 3.0% previously.viii The economists caution that downside risks remain high and that the 2020 projection depends on a return to more normal trade relations. Risks to the forecast are heavily weighted to the downside and dominated by trade policy. Further rounds of tariffs and retaliation could produce a destructive cycle of recrimination.

Shifting monetary and fiscal policies could destabilize volatile financial markets. Continued slowing of the global economy could produce an even bigger downturn in trade. In addition, a disorderly Brexit could have a significant regional impact, mostly confined to Europe.

 

US Economy Starting to Feel the Pain

More recently, increased foreign competition has been blamed for U.S. manufacturing job losses over the past twenty years. In practice, while the integration of several billion workers into the global economy has contributed to both a loss of manufacturing jobs and a more general squeeze on labour’s share of income in the developed world, most academics agree that other factors, including technological change, have played a bigger role.

The U.S. economy posted strong gains in the first half of 2019, although some measures were negative. Consumer spending surged in the second quarter, supported by the strong labour market. The decline in interest rates over the summer tees up for U.S. consumers to be the key driver of activity in the second half of the year. Companies continue to hire, and the unemployment rate recently hit a 50-year low.ix Labour market tightness is finally translating into a pickup in wages. Business sentiment has deteriorated amid unrelenting uncertainty about trade. Business investment fell in the second quarter for the first time in three years and exports sagged with the weakness concentrated in the manufacturing sector. While fundamentals are still positive for the consumer, the government’s protectionist policies pose risks to the outlook. The persistence of healthy labour-market conditions, as well as efforts by several central banks to shore up an expansion that’s already passed the 10-year mark, will provide support to the global economy. Another tranche of tariffs on Chinese imports coming into effect in mid-December will hit U.S. consumers.

Open borders tend to boost productivity at a global and national level (particularly for developing countries). However, globalization has distributive consequences within economies. Workers and capital owners in competitive export-orientated industries tend to gain, while consumers’ purchasing power rises from access to cheaper imports. But relatively inefficient domestic industries can lose out to more productive foreign competition.

Our current outlook does not see any material improvement over the next twelve months.

 

Theme 2: Brexit and the EU: Deal or No-Deal?

The prolonged and twisted saga of Brexit has been a weight overhanging global markets since 2016. UK growth was synchronized with its main trading partners in 2015 but slowed following the 2016 Brexit vote from a range of 2.0- 2.5% to around 1.5-2.0% in 2017.x This occurred despite a clear strengthening in global activity. Throughout the latest phase the labor market has held strong and helped consumers to keep the economy from stagnating. The realistic prospect of no-deal since the change in prime minister has combined with a regional growth slowdown to produce a collapse in business confidence and signs in some of the leading surveys that the labor market is about to weaken. The domestic drag began to stabilize in 2018 after the initial purchasing power shock from the weaker currency peaked. Later in 2018, growth among the UK’s main trading partners slowed and growing complications in the Brexit negotiations prompted a phase of outright decline in UK business spending. Since the referendum UK business investment has weakened by almost 10% compared to capex in other developed markets. Given that UK investment was growing faster than elsewhere prior to the vote.

In a major blow to Prime Minister Boris Johnson, Britain’s highest court ruled in early October that his decision to suspend parliament for five weeks in the crucial countdown to the country’s Brexit deadline was illegal. And unresolved is a legal and operational solution including the Irish border backstop. Currently, there are no border posts or physical barriers between Northern Ireland and the Republic of Ireland. The backstop is designed to ensure that this continues after the UK leaves the EU. The backstop would only be needed if a permanent solution to avoid border checks could not be found. If it was needed, the backstop would keep the UK in a close trading relationship with the EU to avoid checks altogether.

If the sides fail to reach a deal, Mr. Johnson could be forced to seek a third Brexit extension. That’s because MPs have passed a law – known as the Benn Act – that requires Mr. Johnson to ask for a Brexit delay by October 19. This will push the deadline back from October 31 to January 31, 2020. MPs say the law is necessary in order to prevent a no-deal Brexit.

These events unfolding in the UK have the potential to impact European markets and beyond. Regardless of the outcome of Brexit, there is no doubt that the trading relationship between the EU and Great Briton has changed While many Dutch politicians say they dread the economic repercussions of the looming Oct. 31 Brexit deadline, the Netherlands is working to minimize the damage, in part by attracting some of the organizations and businesses that have already fled the United Kingdom.xi

 

SOURCE: NETHERLANDS FOREIGN INVESTMENT AGENCY

 

Theme 3: Low and Negative Interest Rates: A Dilemma for Central Banks and the Aging Population

Many central banks reduced policy interest rates to zero during the global financial crisis to boost growth. Ten years later, interest rates remain low in most countries. Core inflation has been low and stable for 15 years and shows no signs of acceleration anytime soon.

The U.S. Federal Reserve cut rates on July 31 for the first time since the Great Recession, and the ECB committed to a range of policy steps to fuel growth and get inflation to levels closer to its stated target. The minutes to the September FOMC meeting show that the Committee held a range of views with respect to both the appropriateness of the September rate cut and to what the Committee should communicate about the future direction of rates. The majority who wanted a cut last month cited trade policy uncertainty, slowing global growth, low inflation, and risk management as motivating considerations. Several participants favored leaving policy rates unchanged and argued policy should respond more to the data than to risks. Some argued that cutting too much now would leave monetary policy with less scope to boost aggregate demand if such shocks materialized.

The two major central banks were among a dozen that eased policy rates to combat the negative spinoff from rising trade tensions and political turmoil. The Bank of Canada was an outlier, staying on the sidelines as Canada emerged from a six-month slump in economic activity. And there is still no firm line of sight on how the UK will leave the European Union. Given these tensions, it will once again fall to extraordinarily stimulative monetary policy to sustain global growth, as few governments have committed to providing fiscal support.

 

Savings Gluts Provide Fuel for Low Rates

From the demand side, as populations age, they have a propensity to save. Prior to 2005, the global saving rate was never above 24.5%. Since then it has only been lower during the panic of 2009. The rate equaled its record high of 26.7% in 2018. This works out to roughly $21 trillion saved every year.xii Since many seek to match the investments in their savings to their life expectancies, they tend buy bonds.

The savings glut is leading to massive bond buying that is resulting in yields dropping below the inflation rate nearly everywhere in the developed world. Only two countries in the developed world have real 10-year yields above zero: Portugal and Italy.xiii Everywhere else, older people are buying bonds and driving yields below the inflation rate. Demographics tells us the developed world is not running out of old people anytime soon. The savings glut will continue.

While the global economy has been recovering, future downturns are inevitable. Severe recessions have historically required 3–6 percentage points cut in policy rates. If another crisis happens, few countries would have that kind of room for monetary policy to respond.

 

Theme 4: ETFs have a Positive Role in Market Volatility and Liquidity

Passive investing has historically attracted criticism, typically focused on illiquidity. The liquidity of ETFs varies due to characteristics determined by their underlying markets and indexes. The underlying markets for equity ETFs and credit ETFs are fundamentally different. In addition, apart from the underlying securities in an ETF, there are multiple layers of liquidity in the primary and secondary ETF markets, and the liquidity should never be less than that of the ETF’s underlying holdings. This is a superior feature compared to mutual funds.

ETF market makers and authorized participants looking for arbitrage opportunities trade dynamically to balance the supply and demand for ETF shares and their underlying assets. One of the key features of ETFs is that the supply of shares is flexible. Shares can be created or redeemed to offset the changes in demand. This structure has two important functions: it creates liquidity for the ETF shares by meeting the supply-and-demand needs of investors who trade on an exchange; and it helps keep an ETF’s price per share close to the ETF’s net asset value (NAV).

Index vehicles may be price takers at a microeconomic level but help to set prices at a macroeconomic level. The arbitrage mechanism allows for authorized participants to factor into the price the impact of macro and geopolitical events that may not yet be reflected in the underlying securities when these events occur while the primary markets are closed due to time zones and holidays. Historical evidence is consistent with the idea that higher correlations today are not the result of passive indexing, but rather reflect the macro environment and common factor risks.xiv

Recently there have been liquidity events that have tested the mechanisms behind ETFs. A number of credible studies have concluded that the arbitrage mechanism associated with the create and redeem feature of ETFs in fact helps, rather than hinders market liquidity in these extreme events.xv xvi

 

 

Section 3. Investment Outlook

 

Slowing Global Growth and Inverted Yield Curves Leads Us to a Stagnation Forecast for the Next Twelve Months

SOURCE: FRAME GLOBAL ASSET MANAGEMENT

 

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

 

Section 4. September 2019 Portfolio Models

We have maintained our Stagnation outlook for the U.S. economy as growth is capped over our forecast time horizon of twelve months. While geopolitical developments have always played a role in economies and markets, their scale and impact has been steadily rising since the 2008 financial crisis. Against a hostile trade backdrop, the global economy is losing momentum. Forecasts for world GDP growth this year have fallen to 3.2% from the 3.9% economists expected a year ago. Inverted yield curves and slumping manufacturing activity that are traditional recession predictors are contributing to a cautious business mood. Few governments have committed to providing fiscal support, leaving extraordinary stimulative monetary policy as the tool of choice to combat the recession threat. Our concern is that central banks in several countries are operating at the limits of what monetary policy can do. This has negative feedback implications for fiscal policy and financial markets.

We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

October 14, 2019

 

iWorld Gold Council. Global Gold-backed ETF Flows. October 8, 2019.
iiWorld Gold Council. Gold and Tail-risk Hedging. January 2013.
iiiTrading Economics. U.S. Fed Funds Rate. September 19, 2019.
ivWorld Gold Council. Gold Versus Commodities. October 2019.
vWorld Gold Council. Gold Versus Commodities. October 2019.
viWorld Trade Organization. Press Release. October 1, 2019.
viiWorld Trade Organization. Press Release. October 1, 2019.
viiiWorld Trade Organization. Press Release. October 1, 2019.
ixTrading Economics. U.S. Unemployment Rate. October 4, 2019.
xJ.P. Morgan. Global Data Watch. October 11, 2019.
xiNetherlands Foreign Investment Agency (NFIA). More Brexit-impacted companies choose the Netherlands due to ongoing uncertainty. August 26, 2019.
xiiNational Accounts of OECD Data. Household Savings. 2019.
xiiiTrading Economics. Ten Year Yields. October 15, 2019.
xivMadhavan, A. and Morillo, D. “The Impact of Exchange Traded Funds: Volumes and Correlations.” The Journal of Portfolio Management. Summer 2018, 44 (7) 96-107.
xvMSCI. “Have High-Yield ETFs Created Liquidity Risk?” Reka Janosik. March 27, 2019.
xviAquilina, M., Croxson, K., Valentini, G. “Fixed income ETFs: primary market participation and resilience of liquidity during periods of stress.” Financial Conduct Authority. Research Note. August 2019.

 

 

 

While geopolitical developments have always played a role in economies and markets, their scale and impact has been steadily rising since the 2008 financial crisis. Against a hostile trade backdrop, the global economy is losing momentum. Forecasts for world GDP growth this year have fallen to 3.2% from the 3.9% economists expected a year ago.1 Uncertainty about Brexit and U.S.-China trade relations have combined with stresses in some emerging economies to weigh on the outlook. In August, the U.S. escalated its trade war with China by threatening to impose 15% tariffs on roughly US$300 billion of goods exported by China to the U.S., which until now had been exempted from trade barriers.  September saw an unprecedented liquidity squeeze in USD money markets, the ECB resumption of unconventional easing, a second consecutive Fed cut and other central bank decisions, and an attack on Saudi oil infrastructure. The drone attack on the Abqaiq oil process facility in Saudi Arabia resulted in a loss of approximately 5.7 million barrels (5% of global oil supply).2

Inverted yield curves and slumping manufacturing activity that are traditional recession predictors are contributing to a cautious business mood. Few governments have committed to providing fiscal support, leaving extraordinary stimulative monetary policy as the tool of choice to combat the recession threat.  Our concern is that central banks in several countries are operating at the limits of what monetary policy can do. This has negative feedback implications for fiscal policy and financial markets.

In the Euro area, GDP growth is expected to remain subdued in Q3. The persistence of healthy labour market conditions as well as efforts by several central banks to shore up an expansion will provide support to the global economy. Germany remains in an industrial sector slowdown that saw GDP decline in two of the last four quarters (year-over-year growth of 0.4% is the weakest since the euro crisis).3 Other more domestically oriented economies like France and Spain have expanded more steadily. UK GDP surprised to the upside in July, rising 0.3% month-over-month.4 It looks like the UK will avoid a technical recession (two consecutive quarters of negative growth) in Q3 but uncertainty around another Brexit deadline will make it hard to predict the economy’s underlying direction.

In the U.S., the stronger-than-expected 0.6% month-over-month rebound in industrial production in August suggests that the drag on U.S. producers from weaker global demand may be starting to fade.5 The U.S. consumer is holding up very well, as shown by August retail sales were up 0.4% month-over-month and 4.1% year-over-year.6 The Fed voted to cut its key policy interest rate by an additional 25 basis points to 2.00% on September 18th. The measure of core inflation remains low at 1.6% year-over-year. The Fed cut the interest rate on excess reserves (IOER) rate by 30 basis points to 1.8%. The offer rate on the reverse repo facility was cut by 30 basis points to 1.7%, in order to make it less attractive so it doesn’t soak up as much liquidity.7

After a slow start to the year, Canada’s economy bounced back as real GDP growth accelerated to 3.7% annualized in the second quarter. Trade contributed to growth as exports surged at the fastest pace in five years. Nominal GDP grew 8.3% annualized, on top of the prior quarter’s 5.7% increase.8 The USMCA has yet to be ratified. Canada’s direct exposure to China is relatively limited, as China accounts for about 5% of Canadian exports.9

U.S. equities declined in August, reflecting implications of an inverted yield curve and a possible trade war with China. Large caps declined, with the S&P 500 down 1.6%, while the S&P Midcap 400 and S&P SmallCap 600 were down 4.2% and 4.5%, respectively. Interest rates in the U.S. declined across the board, leading to strong fixed income performance. Canadian equities gained in August, with the S&P/TSX Composite up 0.4%. The S&P Europe 350 declined 1.4%. U.K.’s fears of a “no deal” outcome helped send the S&P United Kingdom down to a 4.2% loss in August while sovereign bond prices rose across the continent. Asian equities slipped lower in August, as protests in Hong Kong combined with U.S.-China trade war worries weigh on regional markets. The S&P China 500 lost 0.6% in August. Asian fixed income indices ticked up across the board.

We maintained the August asset allocation across all models in September. Allocation to equities remains at 17% in Tactical Conservative, 22% in Tactical Moderate Growth, 36% in Tactical Growth, and 44% in Tactical Aggressive Growth.  With Treasury yields declining, Gold is present in all models as it performs well in high risk, low yield environments as a risk-free asset class. Geopolitics now a primary driver of markets. We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 International Monetary Fund. World Economic Outlook. July 2019.

2 S&P Dow Jones Daily Dashboard. September 16, 2019.

3 Trading Economics. Germany GDP Growth. August 27, 2019.

4 Office for National Statistics. UK GDP Growth for July 2019. September 9, 2019.

5 Trading Economics, U.S. Industrial Production MoM. September 17, 2019.

6 Trading Economics, U.S. Retail Sales in August. September 13, 2019.

7 Federal Reserve, IOER. September 19, 2019.

8 Trading Economics, Canada GDP. August 30, 2019.

9 Trading Economics, Canada Exports. August 30, 2019.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. August 30, 2019. Index performance is based on total returns and expressed in the local currency of the index.

 

 

The pace of global growth continues to slow this year as policy uncertainty takes its toll on the world’s economy. The 1% decline in global growth over the past year in conjunction with the trade war and a number of geopolitical conflicts raises the risk of recession as the rules-based approach to governing international trade is breaking down.1 We are monitoring these developments and have concluded that our Stagnation outlook for the U.S. economy over our forecast time horizon of twelve months still stands, with a recession likely in the last quarter of 2020.

In a year in which politics is generating a large negative sentiment shock, macroeconomic policy has thus far cushioned the blow. The Fed’s early-year pivot away from normalization signals a more growth-supportive policy. China’s moves on multiple fronts are validating its commitment to do “whatever it takes” to prevent growth from slipping below 6%.2 Reinforcing the two largest economies’ efforts, 17 of the 30 central banks have lowered policy rates in the last three months.3

Developing market unemployment rates stand at a 40-year low although the major growth disappointments this year have come from Western Europe. Germany’s GDP shrank 0.3% quarter over quarter in the second quarter. Excluding Germany’s contraction, Euro area GDP rose 1.2% quarter over quarter. At the country level, growth in Italy was also weak at 0.1% quarter over quarter, and other countries were sluggish including France at 1%. These were offset by some firmer performances including Portugal at 2%, Spain at 1.9%, and the Netherlands at 2.1%.4 Boris Johnson began his term as U.K. Prime Minister with demands for a renegotiation of the E.U. withdrawal agreement, issuing a threat to leave without one otherwise. The pound sterling declined to near its lowest in two years.

While the outlook for global economic growth may be more qualified, recent U.S. data has exceeded expectations. Consumers continue to power the U.S. economy. Tariffs have done little to reduce the U.S. trade deficit with China and the country’s overall deficit continues to widen, particularly with Mexico, the EU, and some of China’s neighbours. Exports have slowed over the last year while imports have continued to increase. U.S. industry is participating in the global slowdown as factory output fell again in July after declining in the first half of 2019.5 Despite the slowing, job gains are still solid. U.S. business investment declined in Q2 for the first time since 2016.6

The FOMC statement on July 31st explained that Fed motivation to cut was driven by negative global factors. The cut of 0.25 percentage points was America’s first in over a decade. Despite President Trump’s complaints that the strong dollar is holding back the economy, the dollar isn’t that far above its long-run average. The 3% appreciation over the past 12 months is minor in comparison to the 16% surge in late 2014 and early 2015.7 The strengthening against the Chinese renminbi has actually been a positive by limiting the upward pressure on prices from tariffs on Chinese goods.

The odds of the Bank of Canada following the U.S. Fed and other global peers with lower interest rates have increased as the U.S.-led trade war with China has intensified – with risks if anything tilted to an earlier move than the 25 basis point cut that was expected in early 2020.

After a record June, accompanied by continued earnings beats and a month-end interest rate cut from the Federal Reserve, U.S. equities continued to post gains in July. The S&P 500 was up 1.4% while the S&P MidCap 400 was up 1.2% and the S&P SmallCap 600 was up 1.1%.  Canadian equities gained during July, with the S&P/TSX Composite up 0.3%. The S&P Europe 350 gained 0.3% on the month. Asian equities were mixed in July on the back of increased regional and global trade concerns. In fixed income, Treasuries declined.

The risk that rates could move into negative territory would have dramatic consequences for the bond, equity, and currency markets in the United States. In response to this threat, we added gold across all models in August. Allocation to equities is now at 17% in Tactical Conservative, 22% in Tactical Moderate Growth, 36% in Tactical Growth, and 44% in Tactical Aggressive Growth. Equity exposure was maintained in the S&P 500 in all models. The S&P MidCap 400 was eliminated in the Conservative and Moderate Growth models and reduced in the Growth and Aggressive Growth models. Exposure to U.S. Municipal Bonds was reduced in the Conservative and Moderate Growth models.

We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 J.P.Morgan. Global Data Watch. August 16, 2019.

2 Trading Economics, China GDP Annual Growth Rate. July 15, 2019.

3 J.P.Morgan. Global Data Watch. August 16, 2019.

4 Trading Economics, Euro Area GDP. August 14, 2019.

5Trading Economics, U.S. Factory Orders. August 2, 2019.

6 Trading Economics, U.S. Economic Indicators. July 19th, 2019.

7Trading Economics, U.S. Currency Exchange Rates. August 21st, 2019.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. July 31, 2019. Index performance is based on total returns and expressed in the local currency of the index.

 

 

 

The pace of global growth is slowing this year as policy uncertainty takes its toll on the world’s economy. Data points to the global economy expanding by 3.3% this year, slower than 2018’s 3.6% pace, with trade volumes declining and business sentiment deteriorating. Central bank actions and intentions have boosted both equity and bond markets so far this year, a sign that investors think monetary policy support will be sufficient to offset trade headwinds. This action by central banks supports our Stagnation outlook for the U.S. economy as growth is capped over our forecast time horizon of twelve months.

The prospect of a prolonged U.S.-China trade war, the lack of clarity around Brexit, and political and economic upheaval in countries like Venezuela have contributed to the downside risks of our outlook. European economies have notable international financial and economic linkages, and a sharp economic downturn in Europe would affect banks, markets, and the global economy.

The U.S. economy continued to grow at a solid clip in the first quarter of 2019 on the back of net exports and inventory building. U.S. inflation is closer to the Fed’s objective but has been below 2% for much of the last decade. With inflation pressures remaining “muted,” a rate cut would be less about the state of recent economic data and more about providing insurance against trade tensions and slowing global growth. Prospects for some American companies have dimmed. Analysts expect earnings of the biggest companies, which have just begun reporting second quarter results, to have declined. This would mark two consecutive quarters of falling profits. 2

The Bank of Canada looks set to diverge from the Fed, holding rates steady. Firmer current core inflation (close to 2% for the last year) and an already more accommodative stance give the BoC some room to move later. 3

After a setback in May, a dovish Federal Reserve and optimism surrounding a potential trade deal during the G20 talks contributed to a rebound in U.S. equities in June. The S&P 500 was up 7.0% while the S&P MidCap 400 was up 7.6% and the S&P SmallCap 600 was up 7.5%. For the second quarter, large-caps outperformed smaller-caps with the S&P 500 up 4.3%, the S&P MidCap 400 up 3.0% and the S&P SmallCap 600 up 1.9%. The S&P/TSX Composite was up 2.5% in June and up 2.6% in the second quarter. The S&P Euro (350 Eurozone), S&P Europe 350, and S&P United Kingdom indexes were up 4.5%, 3.3%, and 3.2% for the quarter, respectively. The S&P China 500 was up 6.6% in June but remained in negative territory for the quarter, down 0.62%. U.S. fixed income performance was positive across the board, with corporates outperforming Treasuries, while commodities declined during the quarter, driven by weakness in energy, industrial metals, and livestock.

In July, we maintained the existing allocation between equities and bonds across all models. This asset allocation continues to reflect our expectation that the U.S. economy is under pressure but is more stable than other global equity markets.  Allocation to equities remains at 30% in Tactical Conservative, 40% in Tactical Moderate Growth, 50% in Tactical Growth, and 60% in Tactical Aggressive Growth. Within equities, exposure is distributed between the S&P 500 and S&P MidCap 400. We are of the view that smaller companies will feel the impact of the uncertainty that exists in the current climate while longer treasuries will continue to benefit from the downward pressure on interest rates and the relative attractiveness of interest rates in the U.S. versus the rest of the world.

Economic and market risks are elevated as a result of the U.S. administration’s use of tariffs at a time when global growth is slowing. From our perspective, financial market volatility in Europe could spill over to global markets, including the United States, leading to a pullback of investors and financial institutions from riskier assets, which could amplify declines in equity prices and increases in credit spreads. In addition, spillover effects from banks in Europe could be transmitted to the U.S. financial system directly through credit exposures as well as indirectly through the common participation of globally active banks in a broad range of activities and markets. The consequent U.S. dollar appreciation and weaker global demand in such a scenario would depress the U.S. economy through trade channels, which could reduce earnings of some U.S. businesses, particularly exporters. Such effects could harm the creditworthiness of affected U.S. businesses, particularly those that already have high levels of debt. We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame , President and CIO

 

1 International Monetary Fund, World Economic Outlook. April 2019.

2 The Economist. Profits are down in America Inc. July 20, 2019.

3 RBC Economics. Current Trends Update – Canada. July 19, 2019.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. June 28, 2019. Index performance is based on total returns and expressed in the local currency of the index.

 

 

Section 1: Q3 2019 Outlook

 

The Danger of Politicizing the Central Bank

As we enter the third quarter of 2019, we review recent global monetary policy and question how it has changed the traditional ways that we use it to detect risk in markets and the global economy.

The global economy is expected to continue to slow in the coming quarters resulting in lower inflation and downward pressure on interest rates. Central banks in developed and emerging markets are now generally cutting rates and quantitative easing (QE) is making a comeback. Weak economic data versus central bank activism remains the key theme.

Recently global markets have been encouraged by a truce in the trade war between the U.S. and China as President Trump and Chinese President Xi Jinping agreed to return to talks late in June. While the truce is encouraging following decades of growing trade flows and cooperation, the process of global trade integration faces risk of stalling or going in reverse. And while the U.S. has proven successful in securing a trade deal with Canada and Mexico (that has not yet been signed off on) and extracting some concessions from China, uncertainty remains due to the growing, rather than shrinking trade deficit in the U.S.

Trade contributed 0.94 percentage points to the U.S. economy’s 3.1% annualized growth pace in the first quarter. i Building on that trend, the U.S. trade deficit jumped to a five-month high in May, widening to USD 55.5 billion from a revised USD 51.2 billion in April. Imports surged 3.3% and exports rose 2%. The politically sensitive goods trade deficit with China increased 12.2% to USD 30.2 billion despite the recent increase in import tariffs on Chinese goods. Imports increased, likely as businesses restocked ahead of an increase in tariffs on Chinese merchandise. Data for April was also revised higher to show the trade gap widening to $51.2 billion instead of the previously reported $50.8 billion. ii

Many economists highlight that the most important role of the U.S. economy, as the largest economy in the world and the globally recognized main reserve currency, is in providing liquidity to the global economy and driving demand around the world. Contrary to current Trump trade policy, this implies that the U.S. trade deficit is central to global economic stability. The dollar’s role as the global reserve currency and primary tool for global transactions means that many other countries rely on holding dollar reserves, creating massive demand for U.S. financial assets. This means that the U.S. pays little for its foreign borrowing, allowing it to finance its high consumption at low cost, which boosts global demand.

The IMF Working Paper on Tariffs from May 2019 found that U.S. GDP would decline in scenarios that include retaliation on Chinese trade tariffs imposed by the U.S., but also that U.S. output would decline in the case where China only limits exports of selected goods to the United States. iii This is because those foreign goods (electronics and other manufacturing goods) are particularly difficult to substitute with domestic production, and thus tend to be replaced by additional imports from other countries.

The risk that the Trump trade standoff will unwittingly destabilize the entire global economy and thus have dire consequences for the U.S. economy itself is the greatest current risk to equity markets and the broader global economy.

 

 

Global Fundamentals and the Limits on Central Bank Action

After the June FOMC meeting Chair Powell signaled a strong easing bias but indicated a desire to learn more about upcoming policy and data developments. Since then the two main events – the G20 summit and June payrolls – have been positive. U.S. data show that growth has been solid for the first half of the year, supported by a strong labor market and strong financial markets. Inflation remains subdued, and inflation expectations have fallen such that they are no longer consistent with the Fed’s 2.0% target.

But the global picture has deteriorated, and business sentiment has fallen, suggesting that the outlook for the U.S. has also deteriorated. The ECB is expected to ease policy again as the euro area is heavily exposed to a further slowdown in global growth because it has much less policy flexibility. The shift in global policy bias toward easing has also affected the debate around likely Bank of Japan action too, prompted in part when Japanese government bond yields fell further into negative territory.

The gap that has opened between the U.S. manufacturing and non-manufacturing sectors makes clear that trade policy uncertainty is the primary driver of the slowdown. The case for an “insurance” ease remains strong as global growth momentum is slipping and the latest declines in U.S. and global business confidence have yet to be felt.

While it is understood that the unique position of the U.S. in the global economy warrants a central bank that considers the global economy, recent comments by President Trump suggest that his political motives for seeing a continuation of strong equity markets are an attempt to influence the central bank and Chair Powell. Trump’s call for rate cuts while reminding everyone that the American economy is the best it has ever been leads us to this conclusion and has distorted the ability of market participants to detect actual underlying risk.

Central banks in most modern economies are designed to be insulated from the short-term whims of politicians. The goal is to give central bankers the freedom to snuff out inflation, even if that hurts political leaders at election time. Since the global meltdown of 2008, central banks, in the name of protecting the economy, have reacted to sharp market falls by easing policy. Investors have been placated into seeing the stock market as a roller-coaster ride backed by engineers. This creates a false sense of confidence in those markets that can lead to larger negative shocks.

How long can bad news, by going to lower interest rates, be good news for equity prices? Signs that central banks have abandoned monetary policy normalization and are ready to provide additional policy stimulus have encouraged markets as we enter the third quarter of 2019.

Fed rate cuts may happen with the intent to reassure economic actors that the ongoing expansion will continue. But slowing economies and soft inflation imply lower revenue growth, excess capacity, and competitive pricing pressures. The risk is that monetary policy may delay the correction but not prevent it. Given the deterioration in the global economy and policy uncertainty at home, when the correction does come, it will be all the more unanticipated.

Market skepticism, asset purchase limitations, and the potential adverse effects of greater negative yields on banks are all issues we see challenging risk assets. We continue to hope that the U.S. will develop policies that jointly address the U.S.’s need for strong demand and full employment and the rest of the world’s need for dollars by channeling foreign capital into productive, job-creating domestic investment.

 

 

Section 2: 4 Themes

 

Theme 1: Slowing Global Growth

The pace of global growth is slowing this year as policy uncertainty takes its toll on the world’s economy. Data points to the global economy expanding by 3.3% this year, slower than 2018’s 3.6% pace, with trade volumes declining and business sentiment deteriorating. v

Economic and market risks are elevated as a result of the U.S. administration’s use of tariffs at a time when global growth is slowing. The prospect of a prolonged U.S.-China trade war, the lack of clarity around Brexit, and political and economic upheaval in countries like Venezuela have combined to generate downside risks to the outlook.

The stakes are high for this year’s European Parliamentary elections where the populists are likely to continue gaining ground, while lingering tensions and a lack of progress in Brexit negotiations raise the odds of a “hard Brexit” scenario. Another near-term risk, which was cited in the November FSR (Federal Reserve Financial Stability Report, May 2019) is elevated tensions between the European Commission and Italy over Italy’s budget plan, which had raised the country’s borrowing costs and prompted worries about its long-term fiscal sustainability. vi These concerns have been deferred for now, as Italy and the European Commission agreed on a budget plan for 2019, but Italy still faces longer-run fiscal challenges.

European economies have notable international financial and economic linkages, and a sharp economic downturn in Europe would affect banks, markets, and the global economy. Financial market volatility in Europe could spill over to global markets, including the United States, leading to a pullback of investors and financial institutions from riskier assets, which could amplify declines in equity prices and increases in credit spreads. In addition, spillover effects from banks in Europe could be transmitted to the U.S. financial system directly through credit exposures as well as indirectly through the common participation of globally active banks in a broad range of activities and markets. The consequent U.S. dollar appreciation and weaker global demand in such a scenario would depress the U.S. economy through trade channels, which could reduce earnings of some U.S. businesses, particularly exporters. Such effects could harm the creditworthiness of affected U.S. businesses, particularly those that already have high levels of debt.

Amid the uncertainty, global central banks have moved to the sidelines. Even with the economic expansion in its tenth year, contained inflation pressures have removed any urgency for central banks to act.

 

Theme 2: China’s Non-Financial Sector is Dangerously Over Leveraged

In China, the pace of economic growth has been slowing over the past several years, and a long period of rapid credit expansion has left the non-financial sector highly indebted and lenders more exposed in the event of a further slowdown.

Developments that significantly strain the repayment capacity of Chinese borrowers and financial intermediaries, including a further slowdown in growth or a collapse in Chinese real estate prices, could trigger a collapse in this market. If problems arise in China, spill¬overs could trigger a domino effect with a broader pullback from risk-taking, declines in world trade and commodity prices, and U.S. dollar appreciation resulting. Such an event would tighten conditions in U.S. financial markets and affect the creditworthiness of U.S. firms, particularly exporters and commodity producers facing weaker demand and lower prices. vii

In the recently released book “Crash” by Adam Tooze, China’s credit boom is compared with other credit bubbles that ended badly. viii Tooze highlights that the U.K. banking sector has by far the heaviest exposure to Hong Kong and China in general — much more than the United States, Japan, or Europe. Although the Chinese have not slowed their credit bubble, they have shown an ability to restructure their banking sector in the past – in 1998 to 2005, for example – and more recently to shrink their shadow banking segment. The outlook for the global economy rides on how China manages its current credit situation. Trade-related uncertainty has made Chinese capex expansion less likely. On the monetary side, the ability to cut the reserve requirement ratio (RRR), or the benchmark interest rate and on the fiscal side, the government can issue more special local government bonds are both available. If the Chinese economy does stabilize this year, China’s currency could become a global currency stabilizer.

 

 

Theme 3: The U.S. Economy Balancing Act Between Slowing Manufacturing Growth and Strong Markets

The U.S. economy continued to grow at a solid clip in the first quarter of 2019 on the back of net exports and inventory building. ix Growth is likely to be somewhat weaker in Q2. Despite an uneven quarterly pattern, the key driver of the U.S. economy remains the consumer. Strong demand for labour pushed the unemployment rate to a 50-year low in early 2019 and wage growth accelerated. Non-farm employment increased by 224,000 jobs in June, handily beating expectations. The resilience of business hiring is in strong contrast to the recent business surveys’ generally downbeat message. In June, the unemployment rate edged up from 3.62% to 3.67%, and average hourly earnings increased only 0.2%. x

With more people working and wages rising faster than inflation, we expect consumer spending to increase this year. Business investment is also forecast to contribute to the economy as companies take advantage of last year’s cut in the corporate income tax rate and other supportive policies.

On trade policy, the U.S. is the instigator and the perpetuator. The recent removal of tariffs on steel and aluminum imports and the Trump Administration’s desire to ratify the new trade agreement with Canada and Mexico had dampened some of the pressures within North America. Unfortunately, the positive sentiment was crushed in late May when the U.S. threatened to levy tariffs on Mexican imports in order to force its southern neighbor to stem the flow of migrants. Tensions between the U.S. and China, meanwhile, have become increasingly heated after the U.S. bumped up tariff rates and made threats to expand the list of products affected.

The Fed can claim mission accomplished on getting the economy to full employment with most inflation measures at or slightly below the 2% target. Maintaining these conditions is the challenge now facing U.S. policymakers. The FOMC appears content to hold the fed funds rate at a slightly below neutral level as a nod to the risks to the economic outlook coming from an unpredictable presidency.

 

Theme 4: Canada Is Not an Island

Were Canada an island insulated from global developments, there would be little reason for concern about the economy. Growth is solid, the labor market is strong, and there is no sign of imbalances. But Canada is not an island, and global economic developments matter for its economy. With the global outlook having darkened in recent months, it is fair to say that downside risks prevail in Canada at this point, even if the domestic economy looks fine.

Falling oil prices and a deepening in the housing-market correction saw Canada’s economy grow at just a 0.3% annualized rate in the last quarter of 2018 and contributed to the economy growing at a similar pace in the first quarter of this year. xi A recovery in oil production, easing of pressure in the housing market and the end of an unseasonably cold winter saw the economy post a solid increase in March, paving the way for stronger gains ahead.

Canada’s own tensions with the U.S. have eased with the removal of U.S. steel and aluminum tariffs along with Canadian retaliatory measures. But the ongoing close integration of cross-border production chains means that anything that hurts the U.S. industrial sector will have spillovers to Canada. Concerns about a slowing in global growth could also spill over to Canada’s resource-producing regions via lower commodity prices.

Canadian business confidence has weakened with the manufacturing sentiment index slipping into negative territory in April for the first time in more than three years. xii Global policy uncertainty, frictions with the U.S., and the Chinese government’s banning of Canadian canola all played into the decline.

Although the recent removal of tariffs on steel and aluminum by both the Canadian and U.S. governments and renewed efforts to ratify the updated NAFTA set up to restore confidence, the impact will be limited by the persistence of tensions between the U.S., China, Europe, and Mexico, Canada’s top trading partners. We view the Bank of Canada as more likely to cut rates later this year than not, but we expect those cuts to arrive after the Fed cuts. The difference in timing and magnitude may give the Canadian dollar a slight upward bias relative to its southern neighbor but likely not a large enough one to pose economic danger.

Should significant problems arise in China, spill¬over effects could include a broader pullback from risk-taking, declines in world trade and commodity prices, and U.S. dollar appreciation. The effects on global markets could be exacerbated if they deepen the stresses in already vulnerable EMEs. These dynamics could tighten conditions in U.S. financial markets and affect the creditworthiness of U.S. firms, particularly exporters and commodity producers facing weaker demand and lower prices.

 

 

Section 3. Investment Outlook

 

Slowing Global Growth While the U.S. Fed Pulls Back on Tightening Leads Us to a Stagnation Forecast for the Next Twelve Months

SOURCE: FRAME GLOBAL ASSET MANAGEMENT

 

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

 

Section 4. June 2019 Portfolio Models

Our outlook is focused on tension between politics, policy, and the positioning of the corporate sector. The world economy remains vulnerable to the U.S-China power play. If tariffs persist or are ramped up further, already-weak world trade volumes will struggle to gain traction. In addition, rising political conflict (Brexit and Italy) and uncertainty have weighed on business sentiment over the past year and global capex is stalling. The dovish stance by central banks supports our Stagnation outlook for the U.S. economy as growth is capped over our forecast time horizon of twelve months.

China is committed to maintaining 6% growth and will respond to any slowing with further easing. xiii The U.S. and China have each raised tariffs and appear to be broadening the conflict to their respective tech sectors. The results of the European Parliament elections showed a significant step up in support for populist parties, who now control 28% of total seats in Parliament, up from 22% before. Turnout in the elections was low at 37%, some 30%-35% lower than may be expected in a general election or second referendum. xiv The Brexit Party’s win (mostly at the expense of the Conservatives) sent the message that many voters are willing to support a no-deal.

We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

July 14, 2019

 

iTrading Economics, U.S. Balance of Trade. July 3, 2019.
iiTrading Economics, U.S. Balance of Trade. July 3, 2019.
iiiCaceres, C., and Cerdeiro, D. A., 2019. IMF Working Paper. Strategy, Policy, and Review Department and Western Hemisphere Department. Trade Wars and Trade Deals: Estimated Effects using a Multi-Sector Model.

ivAhir, H., Bloom, N., Furceri, D. Caution: Trade uncertainty is rising and can harm the global economy. 4 July 2019. The source for the data on key dates in the U.S.-China trade negotiations comes from Bown and Kolb (2019). Item #6 comes from the BBC (2019). Note 1: The font in blue indicates the tariff measure taken, and the font in black indicates the narrative of the World Trade Uncertainty index. The WTU index is computed by counting the frequency of uncertain (or the variant) that are near the following words: protectionism, North American Free Trade Agreement (NAFTA), tariff, trade, United Nations Conference on Trade and Development (UNCTAD) and World Trade Organization (WTO) in EIU country reports. The WUI is then normalized by total number of words and rescaled by multiplying by 100,000. A higher number means higher trade uncertainty and vice versa. Note 2: The WUI is computed by counting the frequency of uncertain (or the variant) in Economist Intelligence Unit country reports. The WUI is then normalized by total number of words and rescaled by multiplying by 1,000. The WUI is then normalized by total number of words, rescaled by multiplying by 1,000, and using the average of 1996Q1 to 2010Q4 such that 1996Q1-2010Q4 = 100. A higher number means higher uncertainty and vice versa. While the latest spike is the result of uncertainty over Brexit and US trade policy, trade uncertainty explains more than 70% of the increase in uncertainty since the first quarter of 2018.

vIMF. World Economic Outlook. Growth Slowdown, Precarious Recovery. April 2019.
viFederal Reserve Financial Stability Report. Near-Term Risks to the Financial System. May 2019.
viiFederal Reserve Financial Stability Report. Near-Term Risks to the Financial System. May 2019.
viiiTooze, A., “Health of the Global Banking Sector: Differences by Region.” Columbia University.
ixTrading Economics, U.S. GDP. June 27, 2019.
xBureau of Labor Statistics. Economic News Release. Employment Situation Summary. July 5, 2019.
xiTrading Economics, Canada GDP. July 11, 2019.
xiiTrading Economics, Canada GDP. July 11, 2019.
xiiiSouth China Morning Post. China lowers 2019 GDP growth target to 6-6.5 per cent range. March 5, 2019.
xivJ.P. Morgan Economic Research. Global Data Watch. May 31, 2019.

 

 

 

 

 

 

 

 

 

 

Our outlook is focused on tension between politics, policy and the positioning of the corporate sector. The world economy remains vulnerable to the U.S – China power play. If tariffs persist or are ramped up further, already weak world trade volumes will struggle to gain traction. In addition, rising political conflict (Brexit and Italy) and uncertainty have weighed on business sentiment over the past year and global capex is stalling. The dovish stance by central banks supports our Stagnation outlook for the U.S. economy as growth is capped over our forecast time horizon of twelve months.

China is committed to maintaining 6% growth and will respond to any slowing with further easing.1 The U.S. and China have each raised tariffs and appear to be broadening the conflict to their respective tech sectors.  The results of the European Parliament elections showed a significant step up in support for populist parties, who now control 28% of total seats in Parliament, up from 22% before. Turnout in the elections was low at 37%, some 30%-35% lower than may be expected in a general election or second referendum.2 The Brexit Party’s win (mostly at the expense of the Conservatives) sent the message that many voters are willing to support a no-deal.

In the U.S., the FOMC is ready to respond to slowing GDP and job growth.  Consensus expects two rate cuts later this year. Job growth has slowed through May, with the latest jobs report showing only 150,000 jobs added on average over the three months through May, down from a three-month moving average for job growth of 245,000 as recently as January.3 Trade policy could dampen growth further as most of the data reports that have been released to date cover a period before the recent escalations regarding tariffs toward China. The U.S. administration is using trade barriers as a tool of broader foreign policy and is signaling it will no longer defend the rules based global trading order it helped create over the past quarter century. The US dollar, still one of the world’s strongest currencies, has been trading at close to the highest levels in two years.

In Canada, there are signs that the recent economic slowing is giving way to a recovery as oil production curtailments are less frequent and housing markets have come off their bottom. The current 1.75% Bank of Canada policy rate is consistent with an economy operating at or near capacity. Economic growth is expected to settle around its trend pace of 1.7%. Population aging, private indebtedness, and modest productivity gains mean a slower pace relative to history.

In May, the trade war levied its toll, sending equity markets into reverse.  In contrast to the strong performance during the first four months of 2019, U.S. equities suffered. The S&P 500 lost 6.4%, while the S&P MidCap 400 lost 8.0% and the S&P SmallCap 600 lost 8.7%. Canadian equities posted losses in May, with the S&P/TSX Composite down 3.1%. The S&P Europe 350 dropped 4.7%, giving up all of April’s gains and moving into the negative territory for the second quarter. The S&P United Kingdom was down 2.9%. Asian equities dropped sharply in May. The S&P Pan Asia BMI declined 5.4%, with all 11 sectors finishing in the red. Fixed income performance was mostly positive, with Treasuries outperforming corporates. The 10-year U.S. Treasury Bond yield closed the month at 2.1%, down from the previous month’s yield of 2.5% (2.69% for year-end 2018, 2.40% for 2017, and 2.45% for 2016).

In June, we maintained the existing allocation between equities and bonds across all models. Allocation to equities remains at 30% in Tactical Conservative, 40% in Tactical Moderate Growth, 50% in Tactical Growth, and 60% in Tactical Aggressive Growth. Within equities, we eliminated exposure to the S&P SmallCap asset class and distributed the exposure equally between the S&P 500 and the S&P MidCap. We are of the view that smaller companies will feel the impact of the uncertainty that exists in the current climate while longer treasuries will continue to benefit from the downward pressure on interest rates and the relative attractiveness of interest rates in the U.S. versus the rest of the world.

Our outlook for 2019-20 has focused on tension between politics, policy, and the positioning of the corporate sector. Rising political conflict and uncertainty have weighed on business sentiment for a year and global capex is stalling. We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 South China Morning Post. China lowers 2019 GDP growth target to 6-6.5 per cent range. March 5, 2019.

2 J.P.Morgan Economic Research. Global Data Watch. May 31, 2019.

3 Trading Economics, U.S. Non-Farm Payrolls. June 7th, 2019.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. May 31, 2019. Index performance is based on total returns and expressed in the local currency of the index.

 

 

The global economy entered 2019 facing headwinds that included the ongoing uncertainty around the U.S. war on trade, a series of idiosyncratic events in the Euro area and the U.S. government shutdown. In April, the IMF lowered its growth forecast for 2019 to 3.3% from the previous level of 3.5% in its latest World Economic Outlook. This is the third time in six months that the fund has revised its outlook downward and is now projecting a decline in growth this year for 70% of the global economy.1 We continue to position our portfolio models to reflect the view that the U.S. will experience GDP growth over the next twelve months that is below 2.5%, resulting in Stagnation.

The U.S.-China trade tensions re-escalated in May with trade negotiations breaking down and tariffs raised by both sides.  The new baseline of the U.S.’s 25% tariff on US$200 billion in imports from China and China’s 5%-25% tariff on US$60 billion of U.S. goods reverses 45 years of pro-trade U.S. leadership.2 Recent experience also indicates that the tariffs will have a broader impact on other trading partners. While first quarter Chinese GDP growth came in better-than-expected at 6.4%, supported by a jump in industrial production and retail sales, it is likely to come under pressure in the remainder of 2019.3

The European economy has entered its fifth year of recovery, which is now reaching all EU member states. European parliamentary elections in May look set to increase the representation of populist parties, but Eurozone reform is unlikely before the next major downturn. In Germany, the economy grew, expanding by 0.4% in the first quarter.4 The trade war between the U.S. and China, two of Germany’s three largest export markets, is creating greater uncertainty. Brexit continues to dominate the political and policy environment in the United Kingdom.

In the United States, real GDP grew by 3.2% annualized in Q1 2019 after downshifting to 2.2% in Q4 2018.5 Business spending on equipment came to a halt after surging the prior quarter, partly due to trade policy uncertainty and a fading lift from tax cuts. Exports rose, which, coupled with a large drop in imports (largely payback from earlier moves to get ahead of tariffs), provided a full 1% trade related lift to GDP. On May 1st, the Fed held the rate target and guidance steady at 2.25-2.50%.6 The policy statement noted household spending and business investment slowing in Q1, an easing in global financial conditions, and improving data in China and Europe. Canada saw a robust April Labor Force Survey and good news on consumption and manufacturing have followed with auto sales having rebounded in the first three months of the year.

In April, large cap stocks in the U.S., Europe, Japan, and across Emerging Market indices displayed moderately high dispersion and near-record low volatility and correlations. U.S. equities were positive in April. The S&P 500, S&P MidCap 400, and S&P SmallCap 600 gained 4.1%, 4.0%, and 3.9%, respectively. Canadian equities posted gains, with the S&P/TSX Composite up 3.2%. The S&P Europe 350 gained 3.8% on the month with first-quarter earnings coming in better-than-feared for Europe’s blue-chips, and with further promises of stimulus from the European Central Bank. Another Brexit delay was welcomed by the U.K.’s equity markets as the S&P United Kingdom gained 2.1% in April. Chinese equities continued their recent winning streak as the S&P China 500 gained 1.9% in April to make it a 23.3% gain for the year to the end of April. Oil was stronger, aided by U.S. plans to tighten sanctions on Iran and political turmoil in Venezuela.

In May, we maintained the existing allocation between equities and bonds across all models. Allocation to equities remains at 30% in Tactical Conservative, 40% in Tactical Moderate Growth, 50% in Tactical Growth, and 60% in Tactical Aggressive Growth.  Within fixed income, we added exposure to long-term treasury bonds while we reduced positions in municipal bonds and 7-10-year treasury bonds. This asset allocation continues to reflect our expectation that the U.S. economy is under pressure but is more stable than other global equity markets. Longer treasuries will continue to benefit from the downward pressure on interest rates and the relative attractiveness of interest rates in the U.S. versus the rest of the world.

We will continue to monitor the data for growth, inflation, and recession signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1International Monetary Fund. World Economic Outlook. April 2019.

2J.P. Morgan. Global Data Watch. May 17, 2019.

3Trading Economics. China GDP Annual Growth Rate. April 17, 2019.

4Trading Economics. Germany GDP Annual Growth Rate. May 15, 2019.

5Trading Economics. United States GDP Growth Rate. April 26, 2019.

6Trading Economics. Fed Funds Rate Growth Rate. May 1, 2019.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. April 30, 2019. Index performance is based on total returns and expressed in the local currency of the index.