Questioning the soft landing scenario

Here at Dorval Asset Management, we believe that the cycle has been in the maturity stage since autumn 2017, judging by the economic and market environment, which is characterised by ongoing world growth set against a gradually increasing likelihood of a cyclical downturn or even a recession in some countries. As the cycle reaches a peak and makes visibility more hazy, we have cut back our equity exposure rate in our flexible funds over the past almost two years, and now maintain this cautious approach, although some windows of opportunity may open. 

 

Risk of end to expansion cycle in the US

In the absence of a financial crisis and with current inflation strikingly sluggish, a soft landing for the world economy in 2019 seems to be a feasible scenario. However, this prospect is still subject to a vast ‘stress test’ in the shape of waning US fiscal stimulus, the crisis that has taken hold in the key automotive and semi-conductors sectors due to these industries’ transition, and – last but most definitely not least – a near recession in world trade, which has been thrown out of kilter largely by the US administration’s policy. Looking to this side of the pond, falling German exports and the country’s automotive sector crisis have already severely hampered its GDP growth. In the US, some research indicates that Trump’s tariff hikes have already cancelled out a large chunk of US households’ gains from the tax cuts waved through in 2017. Lastly, the yield curve has inverted slightly, which could be the harbinger of an impending recession. So, there is now a real question as to whether the longest US growth cycle in history is about to come to an end.

 

Powerful factors act as counterweight to recessionary forces

This turnaround in the cycle is possible, especially if Donald Trump decides to further lengthen the list of goods hit by border duties, but it is definitely not set in stone, as:

- Trump can always do what he did with Mexico and decide to hit the pause button on his threat of extending tariffs to the approximately $300bn in Chinese goods that are thus far unaffected by border duties: these include a lot of consumer goods. The president will need a strong economy to prop up his re-election campaign, which is set to be tough as his approval ratings fall short. His border tax policy has met with little enthusiasm in the US, with households beginning to see it as a risk factor, while in the business world more and more companies are criticising this approach.

The near-recession for both industry and trade in developed countries has not spread to the rest of the economy – or at least not yet – and purchasing power gains - are shoring up consumer spending on the back of higher wages and oil prices sitting 15% below the 2018 average. We are also seeing some moderate fiscal easing in Europe, especially in France. Meanwhile, the most domestic sectors of the economy, such as construction and real estate-related services, are still buoyed by very positive financial conditions, such as the ECB’s mighty TLTRO program in Europe. The combination of these factors, plus a sharp drop in long-term rates and a shift in monetary policy direction act to provide a powerful counterbalance to recessionary forces. Even Italy – always a source of concern for observers – is still seeing a continuation in domestic reflation, as shown by the very positive climate in the building sector. Looser and better-tailored economic policy management is thus making developed economies more resilient.

- Lastly looking to China and other emerging markets, policy efforts to stabilise growth are well under way. The Chinese authorities are aiming to keep growth at 6% at least this year via gradual support from monetary and fiscal policy, and they look set to meet this goal. Meanwhile, the turnaround in the US short-term rate cycle means that some countries such as India, Russia and Indonesia can cut back their interest rates again, after having to hike them in 2018.

 

Stabilised equity markets, and opportunities if world growth holds up

The advanced maturity of the economic cycle has led to a significant deterioration in the risk/return ratio on the equity markets since the end of 2017. The main stock-market indices currently stand at the same mark as 18 months ago, but there has been a number of – sometimes dramatic – corrections. These market moves have sent a lot of investors spiralling into a state of pessimism that could turn out to be excessive or premature if the world economy actually holds up in the end. Today’s situation is very different to the start of 2018, which featured a dangerous degree of euphoria. Support from the central banks, higher equity risk premiums and plummeting long-term rates have ended up stabilising the market. Opportunities have also emerged, especially on some European small- and mid-caps. Dorval AM will continue to seek out these openings in the digitalisation of the economy and energy transition themes, as well as in consumer spending driven by purchasing power gains. In our more defensive international funds, Dorval AM pursues geographical and sector diversification, with a focus at this stage on baskets of companies with steady growth, while we also play European monetary reflationary stimulus with Southern European bonds, especially in Italy

 

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