Economic and Market Outlook November 2018 Jim Allworth RBC Ds Investment Strategist October 2018
Our Long-Term Operating Framework Credit conditions remain extremely accommodative Every U.S. recession but two in the past 100 years has been preceded by the arrival of tight money Every U.S. recession has been associated with a bear market for stocks It could be a year, probably longer, before credit tightens enough to make a U.S. recession inevitable Give equities the benefit of the doubt until then but be prepared to lean against risk when it arrives.
Bull markets don t die of old age. they are murdered by U.S. recessions Sources: U.S. Federal Reserve
Pros All 6 indicators claims, u rate, yield curve, FF rate vs nominal growth rate, Leading Index, ISM new orders minus inventories say no recession in sight Inversion of the yield curve at least 4 hikes away S&P cycle peak has never occurred more than two months prior to inversion, sometimes long after Breadth (advance-decline line) all recently at new highs A/D line usually starts to diverge from the index four to six months before S&P peaks P/E multiple far from expensive
Cons Global PMIs have probably peaked Fed tone suggests hikes may come faster, market not buying it. Most Central Banks tightening in one form or another Earnings have further to go but earnings momentum and p/e s may have peaked Financials have been weaker Sentiment still too complacent
Watch the U.S. consumer 71% of GDP Unemployment rate near 50 year low, UI claims at all time lows, 7+ million jobs going begging Last month 61% of small/medium businesses tried to hire but 87% unable to find qualified applicants - only 3% say credit is a problem. $9+ trillion (50% of GDP) sitting in bank accounts owned by individuals earning nothing. More than twice that in money, bond, and stock funds, in ETFs, and in direct ownership of securities. Labour tightness gradually pushing wage inflation higher average hourly wages of job movers growing at 4%+ - but so far the Fed looks to be ahead of the curve.
QoQ % change -45 Senior loan officer survey on bank lending practices Loan officers reporting tightening standards -25 Easing -5 15 Tightening 35 55 75 Mortgage loans to individuals (inverted) Commercial & industrial loans (inverted) 95 1990 1995 2000 2005 2010 2015 2020 Source: Federal Reserve, Haver Analytics
QoQ % change -40 ECB Euro Area bank lending survey Banks reporting tightening credit standards -20 Easing 0 20 40 Tightening 60 80 Loans to individuals for house purchases (inverted) Loans to enterprises (inverted) 100 2003 2005 2007 2009 2011 2013 2015 2017 2019 Source: European Central Bank, Haver Analytics
Manufacturing PMI Global growth momentum peaked as trade worries mount 58 57 56 55 54 53 52 51 50 49 Global manufacturing growth retreated from peak Expansion 48 47 Contraction 2012 2013 2014 2015 2016 2017 2018 J.P.Morgan Global PMI Developed markets PMI Emerging markets PMI Note: PMI refers to Purchasing Managers Index for manufacturing sector, a measure for economic activity. Source: Haver Analytics, RBC GAM
Percentage points Trump economic effect: short-term boost, longer-term drag Effect of Trump policies on U.S. GDP 1.4 +1.2 1.2 1.0 0.8 0.6 +0.7 Negative economic effect on GDP growth later (protectionism, less immigration, fading fiscal stimulus) 0.4 0.2 0.0 +0.4 +0.2 +0.1-0.2 Positive effect on GDP -0.4-0.4-0.4 growth in short run -0.5-0.6 (confidence, deregulation, -0.8 tax cuts, spending bill) 2017 2018 2019 2020 2021 2022 Cumulative effect on GDP level Effect on annual GDP growth Source: RBC GAM assumptions and calculations
Likelihood U.S. economy most likely late cycle no big change this quarter U.S. business cycle probability Conceivably here Most likely here A smaller but material risk Start of cycle Early cycle Mid cycle Late cycle End of cycle Note: Calculated via scorecard technique by RBC GAM. Source: RBC GAM Recession 11
4.00 Yield differential between the U.S. 10-year Treasury Note and the 1-year Note 3.00 2.00 1.00 0.00-1.00-2.00 Indicates where yield curve inverts Shaded areas indicate recessions. -3.00-4.00
Time between inversion and the peak of the market Month of yield curve inversion inverts Month recession begins begins Interval between Month of yield curve inversion inverts Month S&P peaks Interval between Dec-56 Sep-57 9 Dec-56 Jul-57 7 Sep-59 May-60 8 Sep-59 Aug-60-1 Apr-68 Jan-70 21 Apr-68 Dec-68 8 Mar-73 Dec-73 9 Mar-73 Jan-73-2 Sep-78 Jan-80 16 Sep-78 Sep-78 0 Sep-80 Jul-81 10 Sep-80 Dec-80 3 Feb-89 Jul-90 17 Feb-89 Jul-90 17 Apr-00 Mar-01 11 Apr-00 Mar-00-1 Jan-06 Dec-07 23 Jan-06 Oct-07 21 average 14 months average 5.8 months median 11 months median 3 months GPAC 13 October 2016 RBC Capital Markets, LLC / Portfolio Advisory Group - U.S. Equities
The Leading Indicator suggests there is no recession in sight. 10.0 8.0 6.0 U.S. real GDP growth (left scale) 20 15 4.0 10 2.0 5 0.0 0-2.0-5 -4.0-6.0 U.S. leading indicator YoY % change (right scale) Sources: Conference Board; Dept. of Commerce:RBC Wealth 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016-10 -15
Monetary stimulus has passed its peak Peak monetary stimulus Improving growth/inflation Disappearing economic slack Fed rate hikes, staged balance sheet decline BoE QE ending this year? ECB QE monthly purchases cut by two-thirds, ending this year? Rising yields? Source: RBC GAM
U.S. rate hikes continue to plod along 6 U.S. Fed tightening, but remains accommodative 5 4 3 2 1 First tightening cycle since June 2004 0 2003 2006 2009 2012 2015 2018 Note: Shaded area represents recession. Source: Federal Reserve Board, Haver Analytics, RBC GAM 16
Inflation could surprise to the upside forcing the Fed s hand 3.5 3 2.5 NY Fed Underlying Inflation Gauge (adv 18 mos). 2 1.5 1 Core CPI 0.5 0-0.5-1 95 97 99 01 03 05 07 09 11 13 15 17 19 Sources: New York Federal Reserve; U.S. Bureau of Labor Statistics 17
1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 2015 2019 How high do rates have to go? 15 10 5 0-5 Percentage Point Gap between Federal Funds Rate and Nominal GDP Growth Rate (YoY) 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1-10 0 18 Source: U.S. Federal Reserve
Unemployment claims bottom long before a recession begi 700,000 610,000 520,000 430,000 340,000 250,000 160,000 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 Recession periods Unemployment claims Unemployment claims smoothed trend Source: U.S. Bureau of Labor
12.0 U.S. Unemployment Rate 1 10.0 8.0 6.0 4.0 2.0 0.0 48 52 56 60 64 68 72 76 80 84 88 92 96 00 04 08 12 16 Recession Periods Unemployment Rate Unemployment Rate Smoothed 0 Source: U.S. Dept. of Labor; National Bureau of Economic Research
Difference between ISM New Orders Index and ISM Inventories Index 3 month moving average source: Institute for Supply Management 35 30 25 20 15 10 5 0-5 -10-15 -20 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 Recession Periods Moving Average
19.0 18.6 18.2 17.8 17.4 17.0 16.6 16.2 15.8 15.4 15.0 14.6 14.2 millions Employment Sources: U.S. Labor Department; Statscan Canada (Left scale) United States 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 millions 166 163 160 157 154 151 148 145 142 139 136 133 130 127
GDP growth (YoY % change) Canada and U.S. have strikingly similar growth trends Canadian and U.S. growth moved in sync 6 5 4 3 2 1 0-1 -2-3 -4-5 1994 1998 2002 2006 2010 2014 2018 Canada U.S. Source: BEA, Statistics Canada, Haver Analytics, RBC GAM
Size of tariff A second dimension to tariff math: duration Heat map of cumulative tariff pain Months Quarters Years Permanent Entire focus is on size of tariff Slightly negative Negative Trade war Duration but how long tariffs last is just as relevant Legal according to WTO law? Legal according to U.S. law? Trump to tolerate economic pain? Congress to halt tariffs? Future President s stance? Source: RBC GAM 24
U.S. trade scenarios for 2018 2019 Scenario Worst case Negative Slightly negative Neutral Best case Likelihood 20% 35% 25% 10% 10% Detail Economic effect Trade war US: -0.7 to -4.0% CN: -0.8 to -1.8% CA: -1.1 to -4.8% Substantial increase in tariffs US: -0.4 to -0.8% CN: -0.4 to -0.8% CA: -0.4 to -0.8% Several smallish tariffs US: -0.3% CN: -0.2% CA: -0.4% Reverse Trump tariffs US: 0.0% CN: 0.0% CA: 0.0% Foreign barriers fall to pressure US: positive CN:? CA:? Other thoughts: Most trade models say protectionism damage is fairly small (see above). U.S. giving tariff exemptions to importers of certain sub-products. Governments compensating adversely affected exporters. Trade uncertainty likely exerting economic drag in meantime. Damage to corporations may be several times larger than hit to GDP. Ossa (2015) argues standard models understate gains from trade by factor of 2-3. Integrated U.S.-China and North American supply chains increase damage for multi-nationals. Source: RBC GAM
Canadian conventional 5-year mortgage lending rate (ppt, 5-year change) Higher rates to be a drag on Canadian housing market 0.8 Mortgage rates now higher for renewers 0.4 0.0-0.4 Mortgages renew at higher rate Mortgages renew at lower rate -0.8-1.2-1.6-2.0-2.4-2.8 2006 2008 2010 2012 2014 2016 2018 Source: CMHC, Haver Analytics, RBC GAM
Canadian housing sending conflicting signals Housing starts (# of units) Existing sales (# of units) Home prices (% growth) Canada Toronto Vancouver Level Momentum Level Momentum Level Momentum Strong Neutral Strong Neutral Strong Negative Weak Positive Weak Positive Weak Negative Weak Negative Weak Neutral Weak Negative Note: Housing starts refer to number of units started, existing sales represent number of existing units sold, home prices measured as MLS Home Price Index growth rate. Momentum evaluated as 6-month rate of change of the variable used in the level series (home price momentum also considered 1-month and 3-month price acceleration/deceleration). Source: Haver Analytics, RBC GAM
OECD crude oil surplus stocks (million barrels) Global oil markets tighten 400 350 300 250 200 150 100 50 0-50 -100 Global oil inventory already in small deficit -150 2006 2008 2010 2012 2014 2016 2018 Note: OECD commercial crude oil inventory less 5-year average of commercial stocks. Source: EIA, RBC GAM
Summary Thoughts Bull market intact and likely to be so until before a recession arrives probably not before late 2019, perhaps beyond. Give equities the benefit of the doubt. Market usually peaks around the time the yield curve inverts occasionally well after. Market peak usually preceded by breadth break down by 3 to 6 months. No such breadth breakdown in evidence. Watch Fed, unemployment, credit availability. Market in 2018 has been oscillating between an attractive 16X earnings and a riskier 20X earnings. Focus on rebalancing, culling/replacing stocks that no longer earn high conviction. Pay attention to risk in fixed income markets.
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