MASTERCLASS: ETFs - December 2019
November 22, 2019
Hoda Emam: Welcome to Asset TV. This is your Mid-Year Outlook Masterclass. The first half of 2019 saw a recovery in the markets. The US equity market posted a turnaround from the performance in Q4 2018. As we head into the second half of the year, the outlook for the US and global economy are being considered. I'm joined by Noah Wise, Senior Portfolio Manager at Wells Fargo Asset Management, and Christian Thwaites, Chief Strategist at Brouwer & Janachowski Advisors. So, let's go ahead and jump right in.
Hoda Emam: Noah, as we mark a monumental year for the US equity market, let's take a look at the fundamental drivers. What is your assessment of the US economy and the broader market performance?
Noah Wise: We believe that the US economy is actually pretty stable and sound footing. A key metric that we look at is real final sales to domestic purchasers. What this essentially does is it takes a look at real GDP growth, and it strips out inventories and the net trade effect. It's because those tend to be very volatile and create more noise than a signal for where the economy is going. When we look at that figure, the US economy has been growing on a year over year basis, at about 2.7%. You look at the post crisis period, we range from around 1% to 3% on that figure. We're a little bit higher than the trend, post crisis. We look at the US economy as being in relatively good shape. Albeit slowing down a little bit as we move forward from here.
Hoda Emam: Christian?
Christian Thwaites: Definitely slowing down. The second quarter of 2018 was really the apex of growth. That was just right after the tax cuts. That brought forward a lot of consumption, which tax cuts tend to do. It's been slowing down ever since. The current last print on the GDP of the Q1, I think, was around about, just under three. It looked like it's coming at about two now. Really, it's a story of two parts the economy. Consumers are generally doing well, and unemployment is low. Earnings are not great growth, but people are generally feeling pretty good confidence. We had good retail sales numbers earlier this week, surprise to the upside. And University of Michigan Consumer Confidence out to date was pretty strong. But anything to do with manufacturing, capex, large level constructions, big goods, it's hurting. Hurting because generally global trade and global growth isn't coming up yet.
Hoda Emam: Okay, so US equity markets have soared to new record highs this year. The Bull market commemorated it's 10-year anniversary. What is your outlook for the US Economy? What fundamentals are you paying close attention to?
Christian Thwaites: Well, I think certainly employment is good. We don't see any uptick in that. Claims numbers are coming in about 200,000 - 210,000 pretty steadily. So, employment is good. Earnings, as I mentioned, is quite strong. Hourly earnings is up, weekly earnings, not so much just because the hourly rate might have gone up a little bit but people are working fewer hours. So, that's generally been good for the consumer they're feeling fairly confident. But I think we're going to see a roll off because net exports is trending, not in favor of good GDP growth equals inventory adjustment going on. So, I think we're still looking at the slowdown, which is what the Fed has been obviously been talking about and why they've been telling us that the next Fed rate cut is coming.
Hoda Emam: Okay, Noah?
Noah Wise: I just add that the labor market, as you mentioned, is a very strong and it's a key component to this economy continuing to move forward. We've seen job growth average about 170,000 new jobs per month this year. You look at that compared to new entrants in the labor force, it's about 100,000. We're still growing more jobs than are really needed so we're taking some slack out of the economy and I would just note that really should continue to support the consumer. That the consumer has been a bright spot in this cycle. We would expect that to continue, and I think that's the more important component of growth, looking forward. Not only because of the size of the consumer within the economy, but also because the consumer tends to lead the cycle.
Noah Wise: When you look at business investment, it has been disappointing. It's been a little bit slower, a lot of people are pointing to the uncertainty surrounding trade as a reason for that, but historically, if you look at business investment, it tends to be a coincident indicator, rather than a leading indicator. If there's demand in the economy to support business expansion, that will occur, and that investment will be made to be able to fulfill that demand. So, we view that as less concerning, albeit a little bit disappointing component of growth.
Hoda Emam: Okay, so while we're focused on the outlook for the US, can you give us an assessment of the sectors we need to pay attention to? Noah, I can have you focus on fixed income and Christian, if you can comment on the equities market?
Noah Wise: Sure, I'll start with fixed income. We do take a global perspective and we are seeing, as we mentioned, pretty solid growth in the US, more disappointing growth globally, and the Fed has been pointing to that as a key area of uncertainty and concern going forward. However, when we look at the more recent data, areas out of Western Europe or Japan, a number of emerging markets, we're seeing signs of stabilization. There were some concerns at the end of last year that we could be entering a recession. Some of these large economic regions, that does not look like that is occurring, so what appears to be happening is that we're getting a little bit of a slowdown, but still maintaining positive growth.
Noah Wise: So when we're looking at the opportunities, we're looking at relative values, we're looking at what's available globally. One thing that we think is interesting in the fixed income space is exposure within Europe. As long as Europe is able to avoid a recession, as a US-based investor, we're getting paid around 2.8% to hedge the currency risk back into the US. So, you can take relatively low rates that are prevalent into Western Europe, translate that back into US dollars and still get a pretty good yield in an area that we feel pretty comfortable with going forward.
Christian Thwaites: I think on the equity side, the sectors to still underweight are the ones which haven't performed so far this year, so that's healthcare. Mainly not so much because of the farmer stories and the drug or the devices, but the insurance companies and the hospital management companies. Every time there's a discussion about a change in healthcare, that's a sector which comes under some scrutiny and not in a good way.
Christian Thwaites: And energy, I just think that the current oil prices, there's still a lot of spare capacity in the industry. Except for one or two majors, which are good value, I don't think it's a particularly good sector. But on the ones that we like still like consumer discretionary, although that's heavily weighted by what Amazon is doing. As long as that doesn't come under regulatory concern, like that area.
Christian Thwaites: We like Staples very much. Now, they've been out of favor and they're usually typically a defensive trade but, they have good pricing power and very good cash flow and that's beginning to show up as well. And a little bit on the tech communication side. Obviously, the industry split up last year between pure tech like Apple and the communication guys like Google and Facebook. We still like those even after Netflix's disappointing performance earlier this week.
Hoda Emam: Why?
Christian Thwaites: Good cash flow and amazing margins, I mean, you think about 40-50% gross margins, and a thing. This is a bit of a what if, but if they do come under regulatory scrutiny, I think some of these firms, rather like the AT&T break-up in the 80's, are worth more apart than they might be together, so if you do get a break-up, it'll be disruptive certainly in the short term, but if that is forced on them, I think, some of these individual components could be very valuable as standalone businesses. But we're not there yet.
Hoda Emam: That'll be interesting to see.
Hoda Emam: So what about your outlook for large and small cap stocks?
Christian Thwaites: Small cap's taken a big beating this year relative to large caps, and that's primarily because in the large cap universe, take the Russell 2000, 32% of them are loss making. There's a lot of companies which are in techs. They're sort of building up their presence. BioTech, which doesn't make money until they get FDA approval. Whereas in the S&P, it's less than 5% of the companies don't make money. So, they've been hit harder by the trade just because although they have less exposure to foreign revenues, they've got less other product diversification and abilities to get around it.
Christian Thwaites: Small cap now relative to large cap is looking pretty cheap on a performance basis. So, on a counter argument, it's counter-intuitive. We actually think it's a pretty good time to get into small caps.
Hoda Emam: Okay. Noah?
Noah Wise: In the fixed income space, one area that we think is interesting from a US sectoral standpoint is financials. It's an area that still is not really favored by the market. I think there are some pretty deep scars from the financial crisis and concerns around banks and insurance companies. When we look at the balance sheets of these companies and their earnings potential, it's actually very, very favorable. In part, because of the regulatory backdrop, but also because they recognize what happened during the last down cycle and not wanting to return to where they were then. This has been a very strong balance sheet position.
Noah Wise: You can contrast that versus a number of industrials, particularly less cyclical consumer-oriented industrials that have taken the current low interest rate environment and very rationally have rewarded shareholders. And they've done that through making acquisitions and buying back their stock, increasing dividends, but doing it in the debt-funded basis and increasing leverage on the balance sheet. And so, that is an area that is a little bit more fragile than what we saw in the last cycle and is an area that we are less favorable on.
Hoda Emam: All right, so let's look to the Central Bank outlook. Tell me how the expectations for the Federal Reserve's outlook has affected market direction?
Christian Thwaites: Well, January was the turning point. We got four Fed cuts pretty much on time every quarter in 2018, and probably the last one wasn't necessary. Sorry, they're increases. And then in January, the Fed seemed to turn on a dime and just say, "Okay, well the economy's closing. We're going to step off the gas a little bit." And since then they've had a little bit of a mixed story, but it's that they're going to be data-driven, but now they say they're not going to be data-driven. They're doing an insurance cut. And basically, they've been talking a very easy monetary policy all this year.
Christian Thwaites: It started in January with Powell's testimony and then the Fed Governors talking about every other five minutes saying basically that they felt the inflation wasn't hitting the targets which they would like to see. The rest of the economy seems to be doing well, so let's put in an insurance cut of about 25 basis points, which was priced into the market probably about three or four months ago. We've got another two weeks before that goes. The Fed has been very dovish, perhaps too much, and the rest of the global central banks are doing the same thing.
Noah Wise: I'd take that one step further because I think you're exactly correct. You look at January and then they made this pivot, right? You talk about a pivot to a pause from this hiking cycle into January and then changing the recommendations, changing how they were communicating with the market, and indicating that they were going to wait and see how those previous hikes impacted financial markets. And we've really been off to the races since then.
Noah Wise: Equities in the US, looking at the S&P year to date up about 20%. You look globally, most large indices are up double digits, right around 10%, whether that's in Asia, Latin America, or Europe. If you look at the fixed income markets, the high yield market is up 10% year to date. The investment-grade market, looking at the aggregate index, up almost 7%. When you see that uniform positive market performance, that really indicates that there is a key factor that may be lifting all the boats, and we think that is Fed policy. We think that is the significant decline in interest rates.
Noah Wise: So you saw that shift from hikes to pauses in January, but then in the second quarter, they took it one step further, and they actually started indicating Fed cuts rather than just a pause. And you can see that with risk assets in the second quarter not doing as well early in the second quarter. Had a bit of a sell off, concerns about trade. The Fed steps in and starts talking about cuts, and then we ended up in the second quarter in a much stronger position, and now we're hitting all-time highs across a broad number of indices. So that all tells us that a dovish shift into these insurance cuts per Fed policy is having a really big impact across a wide spectrum of assets.
Christian Thwaites: That's an interesting point. If you just bought a 10-year treasury in September last year at 3.2% and held it to today, you'd be up about 12% with a duration of about nine at that point. That's a very good return in a US treasury. And if you bought credit with a spread tightening as well, you're up even higher than that. So, it's been very fast, very quickly with both equities and bonds doing rather well.
Christian Thwaites: Everything's sort of hinging next on how the central banks can outdo each other in dovish talks. But even today, with the 10-year at about 2.1%, the US rate is still well... It's the only major country with a 10-year rate over 2%. So, it's well above German bonds, Japanese government bonds. So, the spread for those may indicate that there's more room to move down.
Hoda Emam: Okay, so the Federal Reserve meeting is highly anticipated. It's just around the corner. The Central Bank is widely expected to cut rates as we head into Q2 2019 as we mentioned. What are your expectations for the Fed in the short term and then looking into 2020?
Noah Wise: If you look at the Fed, the cut at the end of this month is really baked into the cake. The question is are they going to cut once or are they going to cut 50 basis points? So, 25 or a 50-basis point cut? Our view is that the Fed is likely going to move 25 basis points. We just recently had the New York Fed President Williams out talking about some academic research that would imply that it is better to cut aggressively and early, because if you do more early, then you may have to do less later. The market took that as a sign that 50 basis point cuts was quite likely.
Noah Wise: Very quickly after that, we saw them walk that back and say this is academic. This is not the view of the policy committee. And so I think what that is really signaling is that they have gotten the center of the FOMC to move to cutting and easing with this idea of insurance cuts, but they have not gotten everybody to move into that really aggressive very dovish stance, so I think that is the consensus that they've been able to reach is that we're likely to get a 25 basis point cut early in the third quarter and then we'll see how it plays out. The key for the rest of the year after this, looking into September and the December meetings, is going to be this push-pull between the macro data that we get. If we get significantly stronger and an uptick in growth in the back half, then they will likely have to do less. If they don't, then the Fed is likely to have to cut again either in September or December.
Christian Thwaites: This Fed has been saying for a while that it's data-dependent, and it now seems to switch gears on that. But the major data point which they're not hitting, of course, is inflation. So, this dual mandate, employment and inflation, they seem to think that employment is near maximum effective rate, but inflation, they keep on missing this 2% by around about 25 to 50 basis points. Using the one that they follow, which is the PC, personal consumption expenditures. So that's really, I think, the reason why they're talking about a cut because the rest of the data doesn't' really support that. And so, it's this well we're doing it because we think something might happen.
Christian Thwaites: And the something, of course, is the trade talks and whether or not they instigate more uncertainty and a possible bigger slowdown on the world economy. So, it's rather strange. I think we've got some very dovish speakers, Bullard and Clarida now, and Williams. The hawks we're not from like Esther George. Powell's sort of somewhere in the middle we think. And don't forget, the voting changes in January again, so these guys maybe have one, possibly two cuts ahead of them and then we get a possibly even more dovish Fed coming in January. So, it looks like things are going to be easy for a while, but I think a lot of it's in the price. So, there's some margin for disappointment.
Hoda Emam: Yeah, and I think if there's something we've learned from the Fed in the past is that what happens in theory doesn't necessarily happen in... What happens in real life could be very different. And I think it's going to be really interesting if academia and the Fed continue to clash heads a lot. That will provide a lot of interesting news for us.
Christian Thwaites: Yes, and it's mostly around the impact of the Phillips curve, the labor/wage trade-off, which the Fed models mostly say the lower unemployment goes, the more likely there is to be wage inflation. That's a subject for a lot of intense debate right now.
Noah Wise: And they've definitely shifted on that debate further and further away from the Phillips curve. You've heard some outright statements talking about the Phillips curve barely has a pulse anymore. This relationship, there is almost no correlation and there has not been for quite a while, and it continues to break down more and more as we move forward. So that idea between the labor market and consumer price behavior is tentative at best.
Christian Thwaites: It's interesting because we've got a 60-year low on unemployment. Claims at 200,000. They actually ticked below 200,000 once or twice, and with a labor force participation of 68%, something like that. Five years ago, I certainly would have said wage inflation's going to be hitting 3%-4% in real terms. It's barely hitting 2%. So there is this sort of breakdown of a shortage of workers, and maybe it's showing in other forms of non-cash compensation, but it doesn't seem to be showing up in wages, and that's the part which seems to have been broken down and changing the nature of that trade off right before us.
Hoda Emam: So, Noah, you mentioned insurance filings a little bit ago. So, when it comes to the Central Bank filing insurance claims, what does it mean for fixed income markets right now?
Noah Wise: I really do think this is the key, not just in fixed income, but in risk assets more broadly in the second half of 2019. We talked about what's baked into prices along the yield curve here in the second half, and the expectations at this point are basically for three Fed cuts by the end of 2019. There's actually a higher probability, an implied probability of four cuts than there are of two cuts right now. So, it puts the Fed in a very difficult position. You look historically, whether or not the Fed has engaged in aggressive... The key is are these insurance cuts or is this going to be a sustained easing cycle. Insurance cuts would be a 25-basis point cut, maybe two 25 basis point cuts and then a pause, something more akin to 1995 or 1998. And does that allow the cycle to extend?
Noah Wise: Today, with the market pricing in already three cuts, maybe four cuts for this year, that would imply a bigger easing cycle and a bigger negative outcome for the economy. So, it puts the Fed really in a difficult position, and a position that they've essentially put themselves in. It'll be interesting to see this year, but if you do not get, we think, significantly stronger macro numbers in the back half of this year, the Fed is going to be left in a position where if we're just getting as expected types of numbers, it's going to be hard to cut more than 25 or 50 basis points. That's going to disappoint the market and we think that that could lead to a bit of volatility in the second half of this year.
Noah Wise: Insurance claims, this idea of these insurance cuts. Just that the market has basically already filed the claims at this point. And now it is incumbent upon the Fed to really mail those checks, and we will see if they're able to do that here in the back half of this year.
Christian Thwaites: Yeah, if they don't deliver on this 25-basis point cut then they've got a serious communication breakdown problem. It's interesting the shape of the yield curve looks a bit like a Nike swoosh right now. So, you've got the front end of the curve at the Fed funds at 2.50%, 90-day bills at 2.2%, something like that. 10-years about 20 points below of that, so I think what's going to happen is that the front end of the curve will come down a little bit, a better shaped curve. I'm just not sure if the 10-year will move at all because the 25 basis points is so baked in. But as Noah said, if the economy weakens a little bit more and the Fed says well, maybe another 25, possibly another 25 above that, a total of 75, then we'd see a rally on the 10-year as well. But for now, I think, a lot of the short-term price movement is certainly priced in.
Hoda Emam: Okay, so let's shift our focus to Europe for a little bit. The EU has slashed its growth and inflation forecast for next year. What is your outlook for the ECB heading into the second half of 2019?
Christian Thwaites: They meet next week, and I think that they will indicate that the rate will drop. They use a bit like the equivalent of Fed funds rate, but they've also got something roughly equivalent to the interest on excess reserves, so does the bank. But that, they think, may go down to minus 0.5. Now it's zero. That makes life very hard for European banks, but I think the message from Draghi, as he exits, is we'll continue to do whatever it takes, that famous statement from five or six years back. They'll do the LTROs, which is their version of QE. They may even do it on more sovereign bonds, which they've not tended to be doing. They may even do it in equities like the Japanese banks.
Christian Thwaites: So what I think the message is going to be, fairly dovish. Then Lagarde takes over, and I think she's going to be a very impressive central banker. She's not an economist. She's a lawyer. So is Powell, but I think she's been around, obviously the IMF and the French Treasury and everything else for years, so she's extremely well connected. I think what she'll do is there'll be a continuation of the policies, and we'll see very easy money in Europe for quite some time.
Christian Thwaites: Growth is not particularly spectacular. Germany and Italy are going to come in maybe 0.5% with 1% on an annualized basis. Spain and France are doing a little bit better. So, the outlook about a year from now will look better because the base effects will be in their favor. I'm quite bullish about Europe over the next year or so, but I think it's going to be a difficult few months as they get through this next easing cycle.
Hoda Emam: Right.
Noah Wise: I'd add on the ECB, I guess, a couple of things. First, certainly a slowdown is occurring there. You look at the Eurozone, broadly about 2% growth, just under that in 2018. They're likely to come in right around 1% year over year growth for this calendar year. And that's why you're seeing this pivot in the European Central Bank as well to more dovish policy.
Noah Wise: But the other aspect is that they are seeing what the Fed is doing in the US, and they recognize that they can't stand pat if the Fed is going to be moving easier, in part because of what that could mean with the currency and how that could impact particularly in more export-oriented economies and Germany in particular. So, you have a big slowdown in Germany, the last thing in the world that they want right now is a big rally in the Euro. That kind of ties their hands, and I think Draghi on his way out would have loved to have been in the position that Janet Yellen was in. She was able to start the hiking policy, kind of get back to some semblance of normalization, get off the lower zero-bound.
Noah Wise: I think Draghi hoped that when he was leaving, he would be able to do the same thing. Conditions did not allow him to do that, and instead, he's probably going to be in the exact opposite position where he's returning to QE, more negative rates, and an easier policy. And so, when you look at what is expected from the ECB here in July, I think you're exactly right. It is going to be signaling more dovish policy, and quite likely, some parameters thinking about what type of assets they may be purchasing. And I think government bonds, first and foremost, but then also likely corporate bonds as well, which they have engaged in last round of QE, so I think you have that to look forward to in the back half of this year, which should be supportive for European credit.
Christian Thwaites: I think his point about the Euro is really, really important. Trump might be winning the trade war, but he sure as heck is losing the currency war. The dollar is strong, and as Noah said, if the Fed keeps the rates down, that's going to strengthen the Euro. All things being equal, that's the last thing the ECB wants and most of what German and French and other European exporters need, as well, So, I think they'll be making sure that the Euro doesn't take off and strengthen too much. So that's going to be a major concern, I think, of the policy going forward.
Hoda Emam: And I noticed that Mario Draghi and President Trump were butting heads on Twitter based on some of his decisions.
Christian Thwaites: I'm surprised Trump was butting heads with anybody. He seems to be a very neutral, passive guy.
Hoda Emam: It seems quite odd, huh.
Christian Thwaites: That's not a match that matters, really. You've got a guy who's on his way out and he's got a very good track record as a central banker.
Noah Wise: This idea of Trump, I've heard it talked about as working the refs, and he's probably looking at that shift first from hiking cycle in the US to a pause and now Fed cuts, there's some argument that maybe, kind of like a basketball coach on the sideline working the refs and being able to get those Fed cuts, so maybe he's viewing that as having been successful, and so maybe he's trying to work the refs overseas as well. We'll see, I think that his success there is going to be much, much less likely.
Hoda Emam: So looking ahead to 2020, can you give us your take on volatility and whether you think it will continue to provide opportunities for active managers, specifically in fixed income?
Noah Wise: Absolutely. We really do believe that. We think that active management within fixed income, there are a number of reasons why it pays. Clearly, talking my own book as an active fixed income manager, but it is also something that I really do believe that there are a number of inefficiencies in the fixed income marketplace that are with us today and will continue to be with us going forward.
Noah Wise: One that I'll highlight is related to this idea of volatility, and I think that you can expect more volatility, and we'll get into the politics in a little bit but that's one source of potential volatility. Another one that's very, very important is the yield curve, which you talked about earlier. We saw important parts of the yield curve invert earlier this year in the first quarter and the second quarter, be at three-month five year. There's a lot of research supporting that that's an important part of the yield curve to look at in terms of a cyclical indicator. Similar with the three-month ten-year yield curve inversion.
Noah Wise: Both of those would imply, and what we have seen in the past, is a correlation between inversion and then subsequent volatility. So when you get yield curves that are inverted, it tends to, on average, lead to higher than average volatility later on, as early as six months, as late as a couple of years, and to look out, we have these yield curves inverting in the first quarter and second quarter as you look into the first half of 2020 and think that we could have another episode if not, then earlier than then.
Noah Wise: And the reason that's important, particularly as an active manager, is that it creates dislocations and a different relative price movement across sectors. So, the ability to add value for clients by making tactical shifts into sectors where it may not be key underlying fundamentals that are shifting but significant differences in valuations. And so, it gives an opportunity to be able to generate alpha and attractive risk-adjusted returns when you have this type of volatility in the marketplace.
Hoda Emam: Okay, Christian?
Christian Thwaites: No, that's an interesting point about the fixed income. On the equities side, VIX is the most followed volatility indicator. It's also a really bad indicator because it's implied volatility. It kind of reads what's going on in the options markets and then implies from that. I don't take any notice of it until it hits about 25, so it can double from 10 to 20 and people talk about the VIX doubling, but I don't think it really makes much difference to the equity markets until it starts hitting 25/35s/40s, which is obviously what we had in 2008, and '09, and also temporarily last February when one of the VIX ETFs collapsed. Two of them actually.
Christian Thwaites: So it hasn't really been an issue. You see the VIX... I guess its 19 right now, but I really encourage people not to pay too much too attention to it. But equity volatility hasn't been much of a story this year.
Noah Wise: Yeah, certainly not this year.
Christian Thwaites: There's a lot of price movement, but from the implied measure on the CBOE, Chicago Board, it just seems to be something that goes up and down a little bit but not so turning any major stories. So, I think it tells you that the equity markets are reasonably confident about where it is and where it's going.
Hoda Emam: Okay, so the current rate environment and elevated equity valuations pose unique challenges. The shift in the political landscape is also notable across major economies. So, let's take a look at the UK and give us your perspective on the potential consequences of Brexit. I want to hear your comments on this.
Christian Thwaites: Well, I'll leave the gilts market to you, but I think... I personally it's the longest suicide note a country has ever written to itself. I think there's going to be dire economic consequences. People have said that. People have said that at the vote, before the vote, after the vote now. But hey, it's going ahead.
Christian Thwaites: I think we'll have a new Prime Minister. We, we'll have a new Prime Minister at the end of this week, I think? Where Boris Johnson will take over from Theresa May. One of his stances has been that the October 31st deadline will be met. Deal or no deal. And that's obviously got enough to get him pushed into the Prime Minister position. I think it's a very unrealistic position to take, but what we're looking at now is on three options really. On October 31st, the UK leaves the EU with no deal. That means everything goes to WTO, World Trade Organization standards and tariffs, which is good for goods but terrible for services.
Christian Thwaites: Or it's essentially a re-engineering of the Theresa May deal, which is what the EU has put on the table and don't seem inclined to change it very much, which is keep most of the trade benefits but there's some changes on free flow of immigration and this Northern Ireland deal.
Christian Thwaites: And then the third and remote option is that there's some sort of referendum again or the Tories get kicked out on a vote of no confidence because they're a minority government, so the other parties have coalesced together and have a vote of no confidence.
Christian Thwaites: But neither of those options is particular appealing as an equity investor. Particularly with the UK having a lot of mining stocks, and industrial stocks, and export driven stocks. And I don't think it's going to be particularly good for Sterling either. We've been out of the UK pretty much since June 2016 when is when they voted to get out and see absolutely no reason to put money into the UK on an equity basis.
Noah Wise: Yeah, I would just say regarding Brexit, very little has changed. The key underlying issue is that there's not a majority for one of the three particular outcomes to either remain, keep things as it is, to have this soft Brexit, or to have the more aggressive kind of hard exit scenario. You have somewhere around a third, a third, and a third, but you don't have an absolute majority in either, and that's why this just keeps dragging out longer and longer and longer.
Noah Wise: So we're going to get to a point eventually where you have to make a decision. And I don't believe that they're going to be able to get support, whether it was Theresa May or there's Boris Johnson, to be able to get people over the hump from any of those three camps, enough people to support one of those outcomes. And so eventually I believe that that outcome is either going to be another referendum that hits two specific proposals. That's the big issue with the leave. You have half of the people that want to leave, and leave means one thing to them, and the other half leave means something entirely different.
Hoda Emam: That's such a good point.
Noah Wise: So you need a specific concrete proposal, and you have a remain and you have a specific leave concrete proposal, and if you cannot get that done with the existing Parliament, then you either need a new legislature that can get this done or you have to take it direct referendum again, put it in front of the people and say, "Three or four years ago, this is how you voted when you didn't know what you were voting for. Here's something specific that you actually know what you're voting for," and see where people actually stand this time around.
Noah Wise: Does that happen before October 31st? I have no idea. We've heard the same things previously that there's a drop-dead date. We've had that for almost a year now of timelines where it absolutely has to get done by this date, and we keep having the Lucy pulling away the football from Charlie Brown type of scenario where it does not occur, and the deadline keeps getting extended. So that's how I see the ultimate resolution. Until we get there, I don't think it's really actionable.
Hoda Emam: I find it so interesting about this long debate of whether people really understood what they were voting for. And it's just, one camp says, "Yes, they knew exactly what they were getting themselves into. They knew the implications on the economy, immigration." And then another camp says, "No, they had no clue what the consequences were going to be."
Christian Thwaites: I don't think they had a clue. It was basically a yes/no. Do you want to stay? Do you want to leave? And the people, there was this famous bus that went around saying, "Instead of sending $320 million a week to the EU in Brussels, we can use it for the National Health Service." Which was a totally made up number and not even close to the reality of tradeoffs. And I think people voted on the back of immigration and the feeling that Brussels bureaucrats were making laws and passing laws, which superseded Parliamentary autonomy, neither of which were true. So, I think a more nuanced referendum would be very helpful. I hope we get that. That's certainly better than the straight yes/no, but in answer to your question, I don't think quite people knew what they were voting for. But now they've entrenched themselves because no one says, "Oh, I made a mistake. Let me rethink that again."
Hoda Emam: Of course not.
Christian Thwaites: So there's only double down.
Hoda Emam: So let's bring it back home to the US. As we head into an election year in the US, the news cycle is sure to ramp up. The line between politics and policy will continue to be blurred. What is your global outlook when it comes to growth specifically?
Noah Wise: So if you look globally, we'll touch on a couple of things from the political side that could impact this, but our expectations globally for growth we've been tracking roughly 3.5%. 3.6%/3.7% more recently on a year over year basis globally. But in a very narrow band post crisis. In the US, we do think that this mid to high 2% growth probably tracks down closer to 2% as we get into next year. Europe, again, expect about 1% growth and a little bit under 1% growth in Japan. So those are the big economies.
Noah Wise: In emerging markets, it's a mixed bag. There’re some countries that we do expect to do a little bit better, but it's always idiosyncratic. There are some trouble spots, but overall our expectation is still this growth around 3.5%, maybe a little bit lower as growth moves a little bit lower in some of the more advanced economies. But not a big issue.
Noah Wise: Trade is obviously a big risk to this outlook. But as you mentioned, politics more broadly, we have other things that are on the docket in the US. Obviously, the 2020 Presidential election, the nomination process for the Democrats. That, at this moment, the markets are not focused on, but if you fast forward six months from now, that's going to be a very big topic. And as we get into more debates and we start winnowing down the field from the 20+ individuals that are currently seeking the nomination, when we start to figure out who the two or three players are likely to be for the Democratic nominee, that could really impact things as people start to discount who it is and what their policies could mean in the event that they win. So that is a risk that right now I don't think is at all getting priced into markets, but I think that's something that could lead to some volatility going forward.
Noah Wise: And then the other aspect is related to taxes. The Tax Cuts and Jobs Act, the TCJA that passed in 2017 provided a lot of stimulus as you noted in 2018. That was really the big boost to growth. A little bit less, but still a net positive contributor to growth in 2019. And that starts to shift as we look into 2020. So that's another area that we think likely causes US growth to start moving back down towards trend rather than a little bit above trend where we've been more recently. And so that's a risk and something that we don't see at all as likely to be reversed. We don't think there's going to be another round of stimulus, obviously, with the Democrats controlling the House.
Noah Wise: And then the other aspect, the last component is the debt ceiling that's coming up here. We think that something is likely needed to get done in early September, is the signal. So, you put that political football in the middle of an election cycle. We think that both sides are going to take that football. They're going to run around with it a little while as they do every single time, and then when push comes to shove, they will eventually likely punt it. But that could cause a bit of a hiccup and a little bit of volatility here in the third or early fourth quarter of this year, as well.
Christian Thwaites: Yeah, I think on global growth, Noah's exactly right. You've got China at 6%, slowest it's been since 1992, but it's a $13 trillion economy now, so that's slowing down is reasonable. And then you've got the US at sort of 2%, and you've got the European block at 1%. So, your weighted average is coming out about 3%/3.5%. And that's ticked down a little bit, primarily because, about 20 basis points, because of the ongoing trade pressures and growth.
Christian Thwaites: So, I think all of that slowing down is baked in and hence the Central Bank policy is in as we discussed earlier. I think on the political side, the gist of it obviously talk on healthcare. That's why some parts of the healthcare sector have been under pressure, but there's no real concrete tangible policy on the table. There's a lot of headline policies, but I think in terms of details, we're not there yet and don't expect to be for another few months.
Christian Thwaites: What is coming out of probably both sides is the fact that government debt is growing, and the deficit is growing. We've got this extraordinary situation right now where government debt is going this way and unemployment is going this way and they normally track each other on an inverted basis, so we've got probably a little less room for fiscal stimulus if we do need it at some point. And I don't think the Democrats are coming off the gas at all in terms of cutting spending or being able to increase taxes. The debt ceiling coming up in September is a bit of a concern. The market is not overly worried right now, but the Treasury is busily doing all of the quick fixes that they can do before they actually technically run out of money.
Christian Thwaites: So I think politics, we'll see a lot of headline stuff. We heard a story this week with the Tweets and the Democrats seemingly split between a more left-wing side and a more centrist-right. But I think until we get something more tangible, and know who we're up against, and who their nominees are going to be, it will be Trump and transient influence on the market.
Hoda Emam: So another bit of news that's making headlines or has been making headlines for a while now is the US/China trade dispute.
Christian Thwaites: Sure.
Hoda Emam: Is there an end in sight?
Christian Thwaites: The Beige Book came out on Tuesday. This is the Federal Reserve's survey of its 12 Districts, and they ask companies and businesses what's on their mind. And went through and counted it, and they said trade and uncertainty and tariffs came up about 31 times, 37 times. This time last year, it was also 30 times. So, the businesses have been living with this for about 12 months now.
Hoda Emam: Wow.
Christian Thwaites: I think there will be a trade deal. I don't know what it's going to look like. Sure, it'll address the IP side. Sure, it'll address purchasing of agricultural commodities. Boeing will get a few more sales at some point, but right now it's at this standoff and we don't really know what the details are. But I do think some sort of deal will get done. It might be a deal like the Canada-Mexico one where its headline effect is actually magnified. Its actual real details are not much different from what's going on right now. But I do think we'll get some sort of deal. If nothing else, the market's finding it difficult to sustain this level of uncertainty.
Hoda Emam: So, Noah?
Noah Wise: Yeah, I would concur that I think that's eventually where we end up with, some type of deal. What the deal looks like, it's anybody's guess. But I think the key point is that we're likely to have two sides that both recognize they want to avoid a certain outcome and they will come to some type of resolution. I think Trump is looking at the markets, and as long as the markets are giving the green light, you have really loose financial conditions, equity markets are hitting all-time highs, he's under no pressure to back off from the trade war. I think it's a bipartisan, very popular stance to take and so, obviously when you're going into a reelection period, that weighs in heavily. And particularly in important in some of these swing states, Midwestern states, you look, it's very less of a Democrat versus a Republican issue. People do want to see the US continue to get more aggressive with trade policy with China, so it's very popular and as long as the equity markets are not forcing Trump's hand, I would expect to continue down this route. But eventually still end up with a resolution likely before the election here in 2020.
Noah Wise: And the other thing I would say from China's standpoint, because it is a two-person game theory type of situation, is China is also in a little bit better of a position. Financial conditions have been easing there. It's been a little bit better spot than they were a year ago. And you're starting to see some of the benefits from the stimulus that they have put in place, both fiscal and monetary. I think if you start to see, we've seen some stabilization in Chinese growth and then you start to see a little bit of an uptick, they also are not going to feel like they really need to get this resolved in the short run. So, I think this is an issue that will stick with us likely through at least the back half of this year.
Hoda Emam: So as this tit for tat conflict goes on, there are some countries that are benefiting. Right?
Noah Wise: Absolutely. As I'll jump in, just a couple of quick points, but very strong data supporting that countries in Southeast Asia, other export-oriented countries are really benefiting. Vietnam, in particular. There have been a lot of stories in the press that have been showing the export benefits to places like Vietnam. The biggest constraint there is simply capacity and how long it takes to shift these supply chains from China and to be able to diversify where the supply chains are. So that's a long term, and I think regardless of the outcome of this trade dispute, I think it is a big wake up call for US business or global corporations in general recognizing that they had too many eggs in one basket.
Hoda Emam: There's other options.
Noah Wise: There are other options, and the other aspect of that is that you look at a lot of these other countries, places like Vietnam 20 years ago have seen the success of China. They would not be as open to this investment that they're now receiving had China not already gone through this process.
Hoda Emam: Oh that's a good point.
Noah Wise: So I think they've seen the success of China and they recognize how they have been able to improve their economy over the last couple of decades, and so I think that they're following suit. If China had not done that first, I think would have been a bigger challenge, but that is a long-term secular trend that we can expect for decades to come.
Christian Thwaites: Yeah, two points. 90% of Apple's products are made in China. They have said that they're going to move about 30% of their supply chain to Vietnam and India. It's going to take them 18 months to do it, so it's a long process. These fabrication plants are fairly sophisticated, pieces of machinery and they have to be set up. And not just the factory, but the infrastructure to be able to get them through the roads, over the bridges, through the ports, and through the airports. So, these are all things that are going to follow through, but I do think that they're beneficiaries.
Christian Thwaites: Of course another beneficiary, I don't know if you agree with this, is, of course, Mexico. That was initially the first one two say well this is all going to be good for Mexico because they'll be able to come in under the NAFTA and now the new trade agreement. Then we had that Tweet about linking tariffs to border control. That seems to have gone away right now. But earlier this week, we just saw record number of vehicles, 1.8 million. Now the US only buys about three or four million cars a year. It buys more trucks than cars, but that's probably about 40% of US car purchases are now being made in Mexico and shipped across the border. And so, I think that's certainly good for Mexico's trade balance and employment, and they're a short-term beneficiary.
Christian Thwaites: But this is at the margin. There aren't a heck of a lot of huge beneficiaries of this. We've got a good example with the steel industry, which was one of the first to get the tariffs. Steel employment arrested a little bit, but it's now lower than it was before the tariffs. Prices are much lower. Stock prices have fallen 80%-90%, so I don't think even when you get something as insulated as that, I'm not sure there are many benefits.
Noah Wise: Yeah, and certainly not domestically. You'll see announcements here. You used to see, particularly, the auto companies talking about, "Okay, we may keep this plant open, or we may not be opening this plant." They're not even pretending to do that anymore. It's extremely unlikely. The cost differential for a number of these manufacturers is so significant that the economics do not work out for bringing a lot of that manufacturing back to the US, so I don't think the US is a huge beneficiary here. It's really other lower cost producers, and I would definitely agree with you in terms of Mexico.
Noah Wise: Early on, there's capacity and already the infrastructure in place, so I think they were really early beneficiaries. People looked around and said, "Okay, what's the low hanging fruit? Where can we move production to where can we increase production without having to increase investment dramatically?" And Mexico definitely stood out as an early beneficiary.
Hoda Emam: Okay, so looking ahead, we've highlighted the equity market and the role of the Federal Reserve is playing in affecting market direction. Let's take a look at treasuries. There has been plenty of attention on the yield curve inversion and the concerns about an impending recession. Noah, is it starting to feel like 2007?
Noah Wise: Yeah, I would argue that it is not, and there are a couple of reasons. One, I will say the yield curve inversion is something you do want to pay attention to. It matters, and it matters particularly if the inversion is along a couple of the more important nodes. The San Francisco Fed did some research and looked at which yield curves are most predictive and had the highest likelihood of indicating slower growth going forward.
Noah Wise: One of the nodes was the 10 year-3 month and we've been inverted there, so I think you ignore that at your own peril. But this time could always be different. Right? That is a risk, and it's a risk both ways. I think you need to be aware of it. You need to recognize it. But you also have to recognize the areas that are a little bit different. And there are reasons to think that the line on the yield curve this time around maybe are lower than they have been in previous cycles, and therefore a yield curve inversion is easier to happen or to occur this time around. QE, central banks buying longer term government bonds and depressing yields certainly an important factor there.
Noah Wise: But I do think you don't want to also move too far in that direction because it is an important signal because of how many times lengthy yield curve inversions have indicated trouble in the economy going forward. So, it's something that we're looking at. We continue to monitor very closely, and it is, I think, one if not the biggest red flag cyclically going forward.
Christian Thwaites: Yeah, it's a concern. So, we know that the yield curve is inverted before recessions, but it's thrown up a couple of false signals, and we're only talking about seven or eight data points since 1945. Yeah, it's happened five or six times, but there's been a couple of times when it didn't happen. The other thing is that it doesn't tell you anything between when the yield curve and when the recession happens. It's been as much as 2.5 years. It's been as little as six months, so it doesn't give you much warning on that. So, I view it as well the absolute levels are low.
Christian Thwaites: The other thing the Treasury is doing, you might know more details about this, but they've been funding a lot of the increased debt at the short end of the market. A lot of bills insurance. And they've been keeping relatively the 10-year starved of supply, so that also can affect the yield curve. But I would conclude by saying it's something to watch for, but I don't think it's the kind of bullet-proof, fool-proof recession indicator a lot of people said it is.
Hoda Emam: There's a lot of factors, and I think one of the biggest differences between 2007 and now is just the housing crisis alone. The situation, the big bubble that we had, it's totally different now.
Noah Wise: And not just housing. I would take it one step further. At a large misallocation of capital in the housing market. Incredibly important because of how that was financed. It was financed through banks or non-bank credit lenders in 2007, kind of the shadow bank type of concept. And that is important because that leads to a higher likelihood of a systemic outcome like we had in 2007. That is not present this time around. If you look at banks, and we talked a little bit earlier about this, that the fundamentals are much stronger. Whether it is investment banks, whether it's commercial banks, or whether it's in insurance companies. They have a much sounder fundamental position. Much less leverage in the system on the financial side and that means that when we do have a shock, and there will be a shock.
Noah Wise: There will be a surprise, something happens, maybe it's trade, maybe it's geopolitical and its related to issues in the Middle East, or maybe it's something else. When that domino falls, then you're not going to necessarily have the rest of those dominoes fall because the financial system is in much better shape. And I think that's a very, very important and key distinction this time around than last time around.
Noah Wise: The place where there's a little bit more concern, again, is in the industrial side. And while that could be very painful for investors either in equities or in credit for some of these companies that end up having, after the fact, taken too much leverage, really gorged themselves on these low rates and taken a little bit too far with acquisitions and buybacks. Those companies and the investors in those companies may get hurt, but it doesn't lead to that critical next domino. It doesn't cause a likely seizure in credit availability throughout the financial system because of how much a better position that the banks are in.
Christian Thwaites: I agree. The other component, of course, is the consumer. Very heavily leveraged in 2008. A lot of mortgage, consumer debt, home equity loans, about every kind of source of debt was tapped out. The US consumer now has been very, very shy about taking on additional debt. As a percentage of total income, or GDP, or their net worth, it's much, much lower. Mortgage debt is lower. Consumer debt, in the form of credit cards, other kind of long-term loans. Auto loans, that's the one area which people think is high, but I don't think it's a concern. So, we haven't got the consumer really strung out with high levels of personal debt, and that makes it a much safer environment for any kind of upset in the economy.
Noah Wise: I think you're absolutely right. If you look at, you mentioned, auto loans. You do have a bit more debt on the auto side. Student loans is the other area where you have a bit more debt this time around. But when you combine all of the consumer debt, and you stack it up, and you put it together and take a look at it, what you see is where is consumer debt? Where is the bulk? The vast majority is in mortgages. That is the key consumer debt piece. And mortgage debt is still significantly lower, as you say, as a percentage of income or as a percentage of the economy. That's the one that really, really matters.
Noah Wise: So maybe you have certain components, parts of the economy where you could have credit extended a little bit too much and maybe it hurts that little component, but it doesn't lead to a full systemic system-wide issue that could tip the economy into a recession. So, I think from that standpoint, we're just in much more stable footing that we were last time around.
Hoda Emam: Okay, Noah, Christian, just to wrap it all up. Are there any other comments you have to summarize your thoughts on the mid-year outlook?
Christian Thwaites: Well I would say we've had a good run. Certainly, as you've mentioned earlier, 19% on equities, about 15% on international and emerging markets. Small cap around about 13%-14%. Treasuries, 10-year bond at about 10% or 11% on a 12-month basis. So, expect some sort of correction. We've got the summer doldrums. Trading is thin. You could see a spike. Don't be worried about that. I think the market isn't particularly... It's not cheap like it was in December, but it's not overly expensive, especially with rates going down. So, I think it's a question of hold to the course on the equity and long-term investment side.
Hoda Emam: Okay. Noah?
Noah Wise: I would just add to that, completely agree. A lot of the returns, I think, brought forward the first half of this year. If you would have gone back at the end of 2018 and asked investors what would you want to see out of markets, whether it's treasuries or credit or equities, we've gotten more returns than I think people were really targeting for the entire year, and we've done that in the first half of the year. So, in terms of the opportunity going forward from this point, I think it's a little bit more diminished.
Noah Wise: And then the other aspect is it comes back to the Fed. Can they continue to mail out the checks that the market is really asking for? I think they're going to be more challenged. That to me, along with the other political issues, the yield curve signals, that we can expect more volatility here over the next six to 12 months, and I think that leads to opportunity for active management to be able to generate alpha through active management.
Noah Wise: And then the other aspect is just the importance of diversification. Right? Different markets are going to be reacting in volatile periods differently. So, ensuring that you have your proper diversification in place will give you the opportunity to act from a position of strength when this occurs rather than on your back foot and having to be defensive. So, having sufficient diversification and then being able to act to take advantage of those opportunities when they occur.
Hoda Emam: So many great points made today. Thank you, guys, so much for joining here today, and thank you for watching. I was joined by Noah Wise, Senior Portfolio Manager at Wells Fargo Asset Management and Christian Thwaites, Chief Strategist at Brouwer & Janachowski Advisors. From the NASDAQ Entrepreneurial Center in San Francisco, I'm Hoda Emam for Asset TV.