- US economy is pumping but winds of uncertainty are rising
- Euro zone’s search for swell continues
- China continues to successfully navigate their deleveraging
- High economic policy uncertainty combined with rising interest rates and an economy performing above potential increase risks to equity investors - is this the session to sit out?
A recent surf trip got me thinking about the marco economic climate and how to profit from it. Timing will make or break your surf session. To maximize the experience one has to time the tide, the wind, the swell, the crowds, and ultimately, the wave. Get it right and you will be buzzing for days; get it wrong and you are better off watching from the beach with a coffee. Macro economic investing is like that too. Time the economic cycle right and you can ride the wave to epic returns; time it wrong and get caught inside of bad trade.
Blown out waves are waves which the wind renders un-surfable… or at least much less rewarding to surf due to shorter, choppier rides, and a lot of difficult paddling. If the wind is really strong, it is best to just have a coffee and watch the action from the beach. Have recent political events, including the movement towards trade wars by the US and the rise of populism in Europe, blown out investment opportunities? It is Vital Data Science Inc.’s view that recent events have increased the likelihood that equity markets are near a peak or are in the beginning stages of a correction.
In this post we update readers on the macro economic climate and provide the results of quantitative modelling using our Bayesian Network model which provide probabilistic scenario forecasts. Based on those forecasts we describe our provide an update on our asset allocations.
US - rising rates and policy uncertainty to ruin the session?
Chart 1: US GDP gaps - economy is performing above potential
Source: FRED, Vital Data Science Inc.
The US economy has been expanding for a very long period, 34 quarters to be exact, in what has become one of the longest and most profitable recoveries in generations. We have now entered the final stretch: the economy is performing above its potential (chart 1) and monetary policy is tightening. As I have pointed out in previous analysis’, the period where the economy performs above its potential can persist for a relatively long time, however I do not believe that we are in a situation where this will be the case.
While debt creation is under control (chart 2), debt levels remain near historical highs for consumers, business and government (chart 3) which decreases the capacity for further economic expansion and increases the sensitivity of each party to interest rates, which are increasing.
Chart 2: US Debt to GDP and Fed Funds rate - debt creation is under control
Source: FRED, Vital Data Science Inc.
Chart 3: Deleveraging has stalled and debt levels are near historical levels
Source: FRED, Vital Data Science Inc.
Besides relatively high debt levels, the US economy is in good health: consumer sentiment and spending are high, U6 unemployment rate is at levels not seen since the last recession, and inflation is picking up. Most economic indicators indicate no immediate signs of recession. However tightening monetary policy and political uncertainty are beginning to creep into investors minds. I believe that this is presenting in two ways: 1) increased discount rates which are trimming equity returns despite strong earnings growth and a growing world economy; and 2) the collapsing of the spread between short and long term treasuries. In short, political uncertainty is blowing out an otherwise good investing session.
China - executing on a delicate deleveraging plan and planning for future growth
The Chinese Communist Party continues to successfully execute the deleveraging. Debt continues to increase, however China analysts are beginning to forecast a decline of debt to GDP ratios starting later this year. Limiting of credit will negatively impact growth rates, however if the deleveraging is managed such that credit is limited to less productive businesses, the decrease in credit may be manageable. So far, so good.
But China is not a debt story: China is positioning itself for future success with the Made in China 2025 and Belt and Road initiatives. The goal of the initiative is to revamp China’s manufacturing sector to continue to win in the future by internalizing key component design and manufacturing (i.e. chips), and modernizing manufacturing (i.e. robots). The initiative focuses on 10 key sectors:
- Information technology (chips, 5G)
- High end numerical tools and robotics
- Aerospace equipment
- Ocean engineering equipment and high-tech ships
- Advanced railway equipment
- Energy saving and new energy vehicles
- Power equipment (clean coal, renewables)
- Agricultural equipment
- New materials
China will focus investment into these key sectors. While China has a long road ahead to dominance in sectors, China’s unique ability to coordinate laws, economic policy, social policy, and investment simultaneously, will allow the country to continue to make significant advances.
An interesting element of this Made in China 2025 initiative is that it is not just inward facing: China will seek to, acquire foreign talent through acquisitions in these key sectors to build its own capabilities. The previous strategy was to attract foreign investment in the form of joint ventures, acquire knowhow in the process, and deploy and innovate internally. The change in strategy is significant because instead of leveraging its massive consumer market, China will instead leverage its also massive savings and continue to spread globally. There is no doubt that China acquiring the national champions in other regions will cause tensions with other world powers, China is an experienced global investor and will apply the lessons of previous successes and failures to maximize success and reduce tension. Further, Chinese capital and a long outlook on investment will continue to be welcome in regions with limited access to other forms capital and which may not fit the traditional targets of short term minded western investors.
The Belt and Road initiative is further pushing China out into the global stage. Through this initiative, China makes investments in infrastructure to help link it to, as well as develop, new markets. So while other nations look inward, China is expanding its global reach. China is doing this by funding, through debt, infrastructure project in markets near the power to help facilitate business. This initiative not only increases trade and business through better infrastructure, it gives the Chinese leverage and influence in other regions through investment dollars.
Thus far, the Chinese have been able to walk the tight rope of deleveraging their economy, increasing domestic demand, and investing for the future. While the future will surely have its share of challenges, the Chinese have proven to be excellent managing their economy.
Europe: searching for swell
As Europe deleverages (chart 4) the economic zone was able to lock in solid GDP growth of almost 3% in the final two quarters of 2017. First quarter 2018 growth pulled back slightly to a still respectable 2.4% as the increasing value of the Euro cooled growth. More recently, turmoil in Italian politics caused investors concern of a possible Italian exist from the Euro. While the Italian situation did not turn into a crisis or Euro exit, political risks in the economic zone remaind, and it is having trouble generating steady and strong economic growth. Every time shoots of growth appear, political uncertainty - whether Brexit, Russia/US relations, or populist surges in the PIGS or Eastern countries - blow out the potential waves economic strength.
Chart 6: Euro Area continues to deleverage
Source: FRED, Vital Data Science Inc.
Bayesian network model results and investment strategy
In order to better understand the combined impact of the Fed Funds rate, GDP growth, and political uncertainty on equity prices, Vital Data Science Inc. developed a Bayesian Network model with with GDP gaps, monetary policy, treasury spreads, and economic policy uncertainty as factors, and SP500 performance as the response. The model, which is depicted in Chart 6, shows parent nodes and their possible values in blue, and child nodes with possible values in red. Economic data was categorized from numerical economic data using a proprietary algorithm specifically designed for Bayesian Networks. The model was trained on data going back to 1950. Economic policy uncertainty values were sourced from policyunertainty.com, the remainder of the data from the Federal Reserve database.
The model output is a series of probability distributions under the different combinations of factor categories. The relevant combination for today is:
GDP gap: inflationary
GDP gap trend: uncertain or up
Monetary policy: tightening
10 year to 2 year Treasury spread: positive
Economic policy uncertainty: high
Chart 6: Bayesian network model
Source: Vital Data Science Inc.
Today’s factor categories are generally associated with a near peak of the short term economic cycle. This is when interest rates increase to stem inflation, ultimately causing the economy to contract. We are not at the contraction, but given how the economy is perform and tightening monetary policy, we are relatively close - another 34 quarters of growth highly unlikely! According to our model, a near peak of the short term economic cycle when combined with tightening monetary and high political uncertainty is associated, 50% of the time, with a bear market. Put in a different way, Vital Data Science Inc.’s model forecasts a 50% chance that the market does not regain the highs reached at the beginning of 2018 before entering the next recession - equity markets may have already entered the early stages of a bear market. It is important to note that the model also forecasts a 50% chance that the bull market will continue. To provide perspective of the result, during the early stages of the short term economic cycle, depending on monetary policy and economic policy uncertainty, our model predicts a 70% to 80% chance of being in a bull market. The shift down to a 50% chance of the bull market continuing is significant.
Under similar circumstance, except when political uncertainty is assumed to be low, the model predicts a 20% chance of being near the end of the bull market (i.e. the previous peak may be topped, but we are within 9 months of entering a bear market) and a 25% chance that the have already entered a bear market. In this scenario, there is a 55% chance that the bull market continues. Historically, periods where the economy performs above its potential for a long period coincide with low levels of political uncertainty, which gives investors more time to ride the wave of high equity returns for longer. Currently, the opportunities are being blown out by political uncertainty.
Given that generally there is a high probability of being in a bull market (usually ~80%), probabilities near 50% indicate that we have entered a risky period for equity markets. While Vital Data Science is not short equities, we have reduced equity positions in favour of holding a high proportion of gold and cash. To tie back to the surfing analogy: Vital Data Science has decided to sit this session out and enjoy a coffee from the beach.