The rebound in risk assets has largely priced out the macro tail risk of a deflationary spiral, but we are not yet ready to upgrade our macro outlook to a point that justifies wholesale portfolio repositioning into the global cyclical risk wind.
One catalyst for the relief rally has been hope that China’s policy reflation will shore up sagging global final aggregate demand. Chinese policymakers’ efforts to support domestic growth have pushed up monetary aggregates, but there is little reason to extrapolate that trend to any significant boost to global growth until we see evidence that the stimulus is lifting China’s industrial production, capital spending, and retail sales which fuel the import engine that drives the fortunes of China’s suppliers – namely the rest of the emerging world, from manufacturers to commodity producers.
China’s policymakers are tackling incongruous objectives: capping the surge in corporate leverage which is weighing on profitability while trying to sustain the pace of overall growth. For the credit to GDP ratio to stop rising, never mind fall, the 12% level of credit growth needs to converge to the 6% nominal GDP growth. This process will be meaningfully negative for the annual rate of change in credit growth which we call the credit impulse. A negative credit impulse is invariably deflationary, thus offsetting the reflationary thrust of the government spending impulse. The 23% increase in total fiscal outlays in the last 12 months doesn’t constitute meaningful stimulus when netted against the drawdown in non –government borrowing and spending. But globally cyclically geared assets were so beaten up, the weakening in the trade weighted value of the RMB has eased Chinese monetary conditions; this has reduced the risk of further intensification of producer price deflation in the coming months.
The negative impact of dollar strength on US corporate profit margins reduces firms’ willingness to take on more fixed costs. The strong dollar has been a major headwind for US corporate profitability because it has been less a result of the Fed firming policy in response to strong domestic growth and more a function of other central banks easing policy. If the rising dollar reflected firming domestic economic momentum, the yield on the Dec 2019 euro-dollar futures contract (a proxy for US short rates) would not have dropped 300 bps over the last 2.5 years. Instead, the dollar has been pushed up by the fact that all G10 central banks except the UK have eased policy over that period, leading to a breakout in interest rate spreads in favor of the dollar.
Even though the dollar has stopped appreciating, it would likely need to depreciate significantly, particularly against the EM currencies, before deflationary pressure plaguing the profit picture can subside. Until then, deflationary revenue conditions will squeeze profit margins. Cyclical sector forward earnings estimates continue to slide, while defensives are steadily climbing. This trend is liable to persist based on the gap between consumer and producer price inflation. Most defensive sectors are consumer-oriented, while cyclical sectors are business to business. When producer price inflation lags consumer price inflation, as is currently the case, cyclicals sectors underperform.
How significant is the rebound in oil for US credit-sensitive fixed income, particularly high yield? The deterioration in corporate profitability and credit quality has not been confined to the energy sector. Years of low rates spawned a wave of cheap debt issuance to reward shareholders via buybacks, without the commensurate increase in productivity that deploying debt capital into innovation-enhancing capital spending would otherwise have generated. On a volatility and default adjusted basis, the sector is not that attractive.
The rally in risk assets will struggle to breach current resistance levels until the earnings outlook improves. A lift in profit prospects, both in the US and emerging markets, requires a recovery in corporate pricing power to reinvigorate revenue growth at a time when balance sheet constraints are weighing precipitously on margins. Watch for evidence of recovery in industrial activity in China, the global marginal pricing agent for most manufactured goods for export.