Q4 2019 Quarterly Outlook

Read our full MFP Quarterly Investment Outlook Q4

Ghosts of Japan

Growth has been consistently slowing across the globe. In the past two issues, we dealt with the impact of China’s slowdown, as the world’s marginal buyer goes through the necessary pains of transformation and the impact of elongated cycles on growth. In this outlook we will take a look at the factor we think is weighing heavy on output and productivity: debt.

Karl Marx once famously predicted that “capitalism will eventually collapse under its own weight”. He was –almost- correct. However, it is not monopolies which threaten the system, as he had originally thought, but rather its propensity to create too much debt. The question we are faced with is: has debt finally reached growth-crashing levels, perpetually pushing rates down, to the point where deflation becomes a secular threat? In other words, has the global economy become “Japanised”?

Debt in and of itself is not bad. Credit is the lifeblood of the economy, especially if the borrowed funds are directed towards endeavours that lead to further growth. Debt frees up capital not being used and puts it to work. The only stipulation is that the original capital stays safe.

However, debt has certain thresholds beyond which the interest payments can pose a great threat on growth itself. For companies, that level is idiosyncratic and has to do with individual growth levels. For countries, where growth often tends to correlate, Carmen Reinhart and Kenneth Rogoff (“Growth in a Time of Debt”) set a broad sovereign debt level at 70%-90% to GDP, before debt becomes a threat to growth. For Euro countries (which cannot print money individually) the level is closer to 50%-70%, and for emerging markets the common wisdom says it is closer 50%. Of course, other factors also play a role. The average cost of debt, who owns it (internal or external), whether it is in a soft or a hard currency “can we print money to inflate it away?”) and of course whether growth can make a comeback and help authorities pay off their debt. Internal idiosyncrasies and attitudes towards debt can also have an impact. In many western democracies a deficit is a good thing, as it helps prop up social services –and thereby votes. In some countries, however, debt is frowned upon. Characteristically, in Germany, the word for debt is “Schuld”, the same word as “Guilt”. Conversely, in the UK, a “Gilt”, or government debt, was a piece of paper with a gold (gilded) edge, to make it more attractive.

Asset Allocation

Global economic data suggests that the slowdown in global manufacturing especially capital goods) is accelerating, and the services sector is now following this trend. The US has joined the cohort of large countries which now see their economy slow. Inflation remains at bay and unemployment in developed markets is near all-time lows, however we could see some pressures ahead as companies eat into their backlogs. Consumption is dented and capital expenditure is suffering as a result of weaker trade. The trend favours countries with strong internal demand vs those more dependent on asset-heavy exports.

Risks for global growth are increasing: Trade wars, Brexit uncertainty and the Chinese slowdown, along with the fact that the cycle is well into its 10th year, may unnerve investors. On the back of this feeling, central bank accommodation is increasing, and the Fed’s persistent assuaging of investor anxieties certainly helps those investors willing to buy on a dip. This has helped risk assets remain at high levels, contributing to a dichotomy between the economic and market signals.

Our latest investment committee in September felt that uncertainty has increased. Markets and economies seem at odds with each other and the question we faced with is “when and how will that gap close”. Additionally, probabilities of a disorderly Brexit have climbed. Therefore, we decided against changes in the asset allocation, as we feel the portfolios are positioned exactly for this sort of environment. We don’t maintain strong geographical preferences at this point, awaiting for more visible catalysts going forward. We still believe that the cycle, for the time being, remains intact but it is showing increasing signs of maturity.