Recession 2020: To be or not to be?

LWM QUARTERLY REPORT Q3 2019

If you have been reading the financial press recently, this is a topic that appears more frequently (and perhaps with more coherence) than Trump’s tweets. And, with economic growth slowing in most major economies around the world, it is a valid question. The problem is that most recessions are only declared once they have already passed. So, if your focus is on affirming a recession, it is somewhat like driving down the road, using only your rearview mirror.

Globally, manufacturing might be declared to be in a recession, plagued by issues related to the trade wars begun by the U.S. But manufacturing is not the whole economy. Looking at the world’s two largest economies, surveys in both the U.S. and China show consumer confidence at near record high levels and unemployment at relatively low levels. So, there is good news and bad news.

Global Manufacturing PMI (purchasing managers index) Note: Data points above 50 (yellow line) indicate expansion and data points below 50 point to a contraction.

The International Monetary Fund (IMF) predicts global GDP growth to slow to 3.2% in 2019, before recovering slightly in 2020. This is important as the rule of thumb suggests that global growth under 3.0% reflects a global recession (as opposed to 0% for an individual country). So, if the IMF is correct in its estimates, this will be a close call but not a recession. For reference, the forecasts for 2019 growth in Canada and the United States are 1.5% and 2.6% respectively, so slow growth.

What is perhaps more relevant to investors is what is happening with corporate earnings. Right now, that picture does not look particularly bright. According to data from FactSet, third quarter earnings from S&P500 companies is expected to decline by 3.7%, following two quarters of growth that hovered near zero. However, we are pleased to see expectations for the end of the year starting to moderate, as only a few weeks ago consensus suggested that earnings growth would stage a stunning rebound to 7%+ in the fourth quarter – an estimate we felt could only be supported by excessive use of now legalized marijuana.

Still, the fourth quarter is expected to be better, so what is anticipated to suddenly change? The main culprit for the weakness in earnings growth this year has been declining margins as revenue has continued to show some incremental gains. There seems to be two sources for expenses moving higher – labour costs, as wage inflation moves over 3%, and trade related costs, which are more difficult to pinpoint.

It seems unlikely the costs associated with the U.S. trade war with China (and other disputes) are likely to diminish any time soon. China seems to be settling in for a long period of negotiation. At the end of the last quarter we outlined the strong position in which China finds itself as discussions with the U.S. inch towards recommencing. However, a weakness has appeared in that position – food inflation. As the swine flu has ravaged domestic pork supplies, food inflation has reached the mid-teens. This may explain why American pork and soybeans were exempted from the latest round of tariffs applied by China, which coincided with news stories of large purchases of these commodities.

If trade issues linger like great aunt Millie by the dessert table, where is the improvement in margins likely to come from? Just as we are skeptical that great aunt Millie will lose 20 pounds by Christmas, we are also skeptical that earnings are going to make a sudden recovery in 2019.

But 2020 may be a different story. Central banks around the world have begun to stimulate their economies. The most important central bank, the U.S. Federal Reserve, has already cut interest rates twice. The global economy should be starting to benefit from this stimulus in the early part of 2020 and that may allow for the forecasted recovery in earnings to take hold. History suggests that once global central banks begin to stimulate, manufacturing begins to recover. If that were combined with a de-escalation of rhetoric on trade, even better. And, let’s not forget, that 2020 is an election year in the U.S. and no sitting President wants to go into an election during a recession (or even a near recession). Fiscal stimulus may not be out of the question.

Courtesy J.P. Morgan Chase & Co., Copyright 2019.

We and most others have geared our discussion around the traditional levers for financial markets and that is what is happening in the economy. But we shouldn’t forget that the last two recessions began with problems in the financial markets and trickled into the real economy – not the other way around.

On that note, a couple of ripples have disturbed the placidity of financial markets in recent weeks. Short-term lending between banks is an integral part of the financial system, ensuring liquidity is always available. But suddenly on September 16th, inter-bank lending seized. Normally interest rates on these short-term loans stay tied closely to the federal funds rate as set by the U.S. Federal Reserve, but on that day rates suddenly spiked, with reports of interest rates on these short-term loans as high as 8% at points during the day. There have been lots of theories floated as to why this happened, but no one seems to be completely certain of the cause. The inter-bank market has since calmed, although the incident left many feeling a bit jittery.

The second ripple has come from the market for Initial Public Offerings (IPO’s). We have long held the belief that, if there is a point of excess in current financial markets, it has been in the world of private debt and equity financings. The massive amounts of money that became available to funds investing in private companies following the financial crisis has created a surge in young companies that are disrupting normal business practices. Although most focus on the technological evolution, the greatest disruption may be the ability of these companies to get billions of dollars of money from investors without ever making a profit, and in many cases having no clear path to profitability.

Despite the success of these firms in private markets, public market investors are demonstrating greater skepticism. The latest issue has come from the dramatic flame-out of the planned IPO of private equity darling WeWork. The company raised money from private investors in several tranches over the years, with the last private investment being made on the basis of the firm being worth $47 billion. As the company prepared its IPO several irregularities appeared, and it seemed likely that the company would sell for less than $20 billion. The company cancelled its plans to go public, the CEO was ousted, and some pundits have even gone as far as to speculate on the company’s bankruptcy as the company may not be able to secure funds to cover its mammoth quarterly losses.

With such a dramatic, high-profile failure in place, following a string of mediocre performances by other recent IPO’s, a chill could descend over private markets as the potential for a profitable exit from these investments diminish. Once again, a source of liquidity could dry up, as these young companies that guzzle cash like beer at a frat party suddenly find the taps turned off.

Do these issues suggest a crisis is imminent? Emphatically no. But as it has been many years since we have experienced any disruptions to financial markets themselves, these events are worth noting and following.

To wrap up, we will address what we expect will be a common question in the months to come. If the U.S. congress impeaches Donald Trump will equity markets collapse? Although there are only two data points to reference in this discussion, the history suggests that equity markets continue to do exactly what they were doing before the impeachment process began. If that is the case, markets will continue to move sideways.

Year-to-date, 2019 has been a great year for investors, bouncing back from the sell-off that ended 2018. To continue this rally, we likely need several pieces to come together. Central bank stimulus needs to perk up economic growth and no further tariffs can be applied, allowing for a recovery in corporate earnings growth and financial markets to avoid any significant contraction in liquidity.