Financial markets have encountered volatility as escalating trade tensions and further evidence of slowing economic growth pushed investors towards safe haven assets. Bond yields extended their decline and stocks retreated following President Trump’s latest announcement to add 10% tariffs to US$300 billion worth of Chinese goods and China’s retaliatory suspension of a variety of U.S. agricultural product imports (exhibits 1 and 2). These moves are the latest in an ongoing trade spat within a lengthening history of mounting protectionism. For a much deeper dive into the protectionism story, its impact on global growth, and the likely trajectory for trade and tariffs from here, our chief economist Eric Lascelles has published an Economic Compass: A primer on protectionism that is worth reading.

The dialogue surrounding protectionism continues to evolve, but it’s unlikely that trade tensions disappear anytime soon. That said, markets and the economy have both managed to withstand prior protectionist actions and central banks are now more likely to provide further accommodation which should help to support risk assets.

Exhibit 1: 10-year government bond yields

Source: RBC GAM

Exhibit 2: Major equity market indices

Cumulative price returns indices

Note: price returns computed in local currencies, except MSCI Emerging Markets Index, which is in USD. Source: Bloomberg, RBC GAM

Protectionism alone is unlikely to trigger recession, but we are late in the business cycle and leading indicators are slipping

Our analysis suggests the economic damage from protectionism is likely not enough to drive economies into recession, but it does add to the mix which already features a business cycle in its later stages and the fact that leading economic indicators have been declining everywhere. Expansions don’t die from old age, but there are other signs that support our late-cycle conclusion. The yield curve is inverted (Exhibit 3), the labour market is tight and central banks are actively easing. Moreover, the latest purchasing managers’ indicators (PMIs) indicated further deceleration in U.S. manufacturing and service sectors. Data was also weaker in Europe, especially in Germany where PMIs are at levels consistent with recession. Leading indicators in the majority of the regions that we monitor are in contraction territory and have worsened in the past three months (Exhibit 4).  

Exhibit 3: U.S. Treasury yield curve

Spread between yield on 10-year and 3-month maturities

Source: Bloomberg, RBC GAM

Exhibit 4: Global manufacturing purchasing managers indices

Note: Based on latest data of 37 countries. Source: Haver Analytics, RBC GAM

Central banks offer support

Attempting to offset the headwinds from trade tensions and slowing economic growth, central banks have responded by cutting interest rates and/or indicating that further accommodation will likely be delivered. Prior to the latest tariff announcement, the U.S. Federal Reserve cut rates by 25 basis points on July 31 citing uncertainties related to trade and slowing global growth as the main decision drivers. The Fed also announced the end of its balance sheet run-off two months earlier than it had planned. Some market participants may have been disappointed with the Fed’s decision, as the idea of a 50-basis point cut had surfaced, but the Fed statement showed no Federal Open Market Committee (FOMC) members favoured a 50-basis point cut, and that two members actually preferred no cut at all. However, softer economic data following Powell’s press conference reassured investors that additional rate cuts are a real possibility. Moreover, central banks in India and New Zealand have since cut rates and a handful of other central banks have also delivered rate cuts so far this year (Exhibit 5).

Exhibit 5: Central bank policy rates

*Deposit facility rate shown for Europe. Overnight call rate shown for Japan. Note: YTD is year-to-date as of Aug 7, 2019. Source: Haver Analytics, Bloomberg, RBC GAM

Bond markets price in gloomy economic outlook

The bond market has priced in a worsening outlook for the economy and investors appear less confident that economic growth will be sufficient to allow central banks to raise interest rates anytime soon. The U.S. 10-year yield fell as low as 1.60%, which is the lowest level since Trump was elected president, and yields in some other regions declined to record lows. In Germany, sovereign bond yields fell into negative territory for all maturities, including 30 years! And in most regions where yields remain positive, the real (or after-inflation) yield on many bond maturities has moved below zero. Our own models suggest that U.S. 10-year Treasury yields have reached unsustainably low levels, more than one standard deviation below our estimate of equilibrium (Exhibit 6). For these reasons, the risk of capital losses is elevated throughout the global sovereign bond market, especially outside of North America.

Exhibit 6: U.S. 10-year T-Bond yield

Equilibrium range

Note: Fair value estimates are for illustrative purposes only. Corrections are always a possibility and valuations will not limit the risk of damage from systemic shocks. It is not possible to invest directly in an unmanaged index. Source: RBC GAM, RBC CM.

Stocks sold off everywhere but continue to offer attractive premiums, especially relative to fixed income

Mounting concerns about the trade relationship between the U.S. and China sent stocks lower around the globe, with emerging market equities leading the declines. The MSCI Emerging Market Index has fallen nearly 10% over the past month and the S&P 500 Index retreated just over 5% from its record high on July 26. Even with these declines, though, most equity markets are holding on to decent gains since the start of the year. The S&P 500 being the best performing market, is still up over 15% year-to-date. It’s worth noting, though, that most of this market’s performance this year has been driven by valuations, as earnings growth has been relatively muted. U.S. large-cap equities, in particular, appear to be pricing in a re-acceleration in earnings growth going forward, but higher valuations make equities more vulnerable to shocks or a deterioration in the outlook for profits. Prior to the recent decline, the S&P 500 had climbed above our estimate of fair value and, while valuations were not unreasonably high, we acknowledge that when stock have been above fair value in the past, lower returns and higher levels of volatility typically result. Outside the U.S., though, stocks are trading at particularly attractive levels and our composite of global equity valuations situates stocks at 13% below fair value (Exhibit 7). Moreover, when compared to fixed income valuations, stocks appear relatively attractive. The dividend yield alone (i.e. ignoring the potential for earnings growth) on most major equity markets is higher than that of sovereign bond yields, and by a wide margin in some regions (Exhibit 8).
In this context, it is possible for equities to outperform sovereign bonds by a healthy amount in non-U.S. markets even if stock prices did nothing but trade sideways for an entire decade!

Exhibit 7: Global stock market composite

Equity market indexes relative to equilibrium

Note: Fair value estimates are for illustrative purposes only. Corrections are always a possibility and valuations will not limit the risk of damage from systemic shocks. It is not possible to invest directly in an unmanaged index. Source: RBC GAM

Exhibit 8: Equity versus fixed income yields

12-month trailing div. yield versus 10-year government bond yields

Notes: Data as at August 7, 2019. Equity indices used for U.S., Canada, Japan, U.K, and Europe were S&P 500, TSX composite, Nikkei, FTSE 100, and STOXX 600, respectively. The German bund was used for the bond yield in Europe. Source: Bloomberg, RBC GAM

RBC GAM Investment Strategy Committee meets next week

We recognize there are a variety of possible outcomes for the economy and markets from here. The macroeconomic backdrop faces a number of challenges including trade tensions, slowing global growth and Brexit. However, if economies manage a soft landing and avoid recession, corporate profits could resume their upward trend and provide fundamental support for risk assets. While bonds have recently outperformed stocks, we think that prospective returns for fixed income markets over the longer term are especially unattractive. With that backdrop, we believe that equities continue to hold better return potential relative to bonds and that investors will ultimately be rewarded for taking on the risk premium associated with stocks.

The quarterly meeting of the RBC GAM Investment Strategy Committee will take place the week of August 12. At this meeting we thoroughly review recent events, their impact on the economy and markets, update forecasts and decide if any changes to our recommended asset mix are warranted. As a reminder, our current recommended asset mix for a global balanced investor is 57.5% equities (strategic: “neutral”: 55%), 40.0% bonds (strategic “neutral”: 43%) and 2.5% in cash.