«Corporate debt is a problem, but it's not a systemically important problem that typically precedes a recession»: Peter Berezin.

«Corporate debt is a problem, but it's not a systemically important problem that typically precedes a recession»: Peter Berezin.

«Owning bonds will be very painful»

Peter Berezin, BCA's Chief Global Strategist, believes that central banks underestimate inflation risks. He expects a revival in global growth and likes European and emerging market equities.

Gregor Mast and Sandro Rosa

Deutsche Version

Peter Berezin is not worried about the weakness of the global industrial sector. «If anything, the global economy is going to see a revival in growth over the next few quarters», says BCA's Chief Global Strategist.

Falling interest rates and the service sector which is cooling but still expanding give Berezin grounds for optimism. He considers the trade dispute to be the greatest risk. But he believes that both the US and China have an interest in reaching a deal before the next US presidential elections.

Berezin prefers equities to bonds. In the longer term, he expects painful losses for the latter because central banks underestimate inflation risks. He recommends gold as a hedge.

Peter Berezin

Peter is currently BCA Research’s Chief Global Strategist and Research Director. Since joining BCA Research in 2010, he has served as Managing Editor of The Bank Credit Analyst as well as helping to develop and launch BCA Research’s Equity Trading Strategy. Peter focuses on analyzing global economic and financial market trends. Prior to BCA Research, Peter worked as a Senior Global Economist with Goldman Sachs. Peter has also spent time in the research department of the International Monetary Fund. He has a Bachelor of Arts in Economics from McMaster University, a Master of Science from the London School of Economics, and a PhD in Economics from the University of Toronto.
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Mr Berezin, is the global economy headed for a recession?
I don’t think so. If anything, the global economy is going to see a revival in growth over the next few quarters. Financial conditions have eased significantly over the last six months largely due to the decline in government bond yields. Historically, easier financial conditions tended to translate into faster growth.

Are easier financial conditions enough to trigger higher growth?
It is quite encouraging that the weakness in the global manufacturing sector has not infected the service sector all that much. The service data has weakened, but not significantly so. That’s very reassuring because in past recessions, the service sector deteriorated in tandem with manufacturing.

In past recessions, manufacturing was leading services.
It didn’t always. In 2015 and 2016, the manufacturing sector was very weak, but there was no recession. Manufacturing bottomed in spring of 2016 and began to rebound. The current growth slowdown really has been a story about manufacturing, and more specifically, it’s been a story of weakness in certain parts of the manufacturing sector such as autos.

Are you expecting the manufacturing sector to recover?
Manufacturing cycles typically last about three years – 18 months of weaker growth followed by 18 months of stronger growth. The manufacturing cycle peaked in January 2018 – so we have had 18 months of decelerating growth. Provided that the trade war doesn’t heat up significantly, manufacturing is going to rebound later this year. That’s going to drive global growth higher.

At what point would you start to worry about a recession?
Recessions normally occur because there are significant imbalances in the economy. In the US, recessions typically begin when there is either financial market overheating or economic overheating. In the last few cases, it has been financial market overheating with the Dotcom and housing boom that turned into bust. Sometimes it’s economic overheating – the inflation rate begins to move up and central banks need to hike rates.

Are there no imbalances today?
The imbalances are not that glaring either in the US or globally. In fact, the private sector globally is still a net saver. Usually recessions begin when the private sector is living beyond its means, i.e. when its spending exceeds its income. When the imbalances are muted, manufacturing cycles typically don’t morph into recessions.

The corporate bond market has grown massively, some of the recent IPO’s where ridiculously overpriced. Aren’t these imbalances to worry about?How systemically important is the corporate bond market? Could it generate a broad based downturn? I don’t think so.

Why not?
The corporate bond market is not important enough. The majority of corporate debt is held by pension funds, insurance companies, ETFs or mutual funds. Highly leveraged institutions such as banks generally aren’t major holders of corporate debt which limits the danger. In 2015, credit spreads blew up, and yet what was the impact on the financial system? Almost nothing. Corporate debt is a problem, but it’s not a systemically important problem that typically precedes a recession.

So you’re not worried about high corporate debt levels?
Fundamentals in the corporate debt market are stretched, but they are not that bad. The net interest companies pay as a share of profits is still quite low largely due to very low interest rates. The level of debt as a share of GDP is quite high, but as a share of assets, it’s in-line with its historic average. It’s true that companies have been loading up on debt, but their assets have also been growing. The corporate sector is generating a lot of free cashflow – still around 2% of GDP based on national accounts data. Every single recession in the last 50 years has begun when the corporate sector cashflow was in deficit.

Is there anything which worries you?
I would put the trade war as the number one risk to my bullish view. China is another risk. The Chinese housing market has shown some weakness over the last few months, and the government is not stimulating enough. It’s a puzzle why they don’t stimulate more as that would increase their negotiation leverage with US president Donald Trump.

Will the trade war be resolved?
Both parties have an incentive to cool things down and perhaps even to reach some sort of a deal. Donald Trump knows the economy is his best selling point to voters. If you look at the polls, the only area where voters give Trump relatively high marks is on his handling of the economy. If this trade war continues to intensify, the economy and the stock market will weaken, and Trump will be blamed for that. That would jeopardize his chances to secure a second term. Trump needs to deliver that deal.

And from a Chinese point of view?
It’s clear that despite their efforts to inoculate themselves from the trade war by stimulating the economy, the trade war is still hurting the economy. And I think they are also quite worried about whom they will end up with negotiating trade if Trump doesn’t win the election. If you look at online betting markets, Elizabeth Warren is in first place, Joe Biden is well behind her in second place.

Should that worry China?
The Chinese, as much as they dislike Trump, would have an even harder time with Warren. True, the demands Warren makes on the Chinese are different from Trump's. Trump is more concerned about reducing the bilateral trade deficit, Warren will focus more on social issues. Do the Chinese really want to negotiate over human and worker rights with the US? Probably not. The old expression “Better to have the devil you know” applies. The Chinese will be looking to make some sort of a deal with Trump in order to get this issue behind them.

Is Elizabeth Warren not also a risk for the stock market?
Warren might be good for American workers, that’s debatable, but I think it’s not debatable whether she is good for US stocks. She’s not. Most US equity sectors would feel quite a lot of pain if she were able to pursue and implement her agenda. She has promised to ban fracking or to introduce universal healthcare which would basically cut most private health insurers out of the loop. She has promised to tighten regulations around the banking sector and to go after defence contractors. I do worry that over the next 12 months an electoral victory by Warren is going to become a risk that is increasingly priced by investors.

Talking of risks: Isn’t there a risk of an escalation in the middle east which could trigger much higher oil prices?
The recent attack on Saudi Arabia does expose the vulnerability of Saudi oil installations. And there is definitely a risk that attacks like this become part of a trend. Of course, today’s spare capacity in the energy sector is not as high as it was a few years ago and that makes global oil markets more vulnerable to disruptions. Having said that, I think we do need to put things into perspective. The effect of an oil shock on the global economy today would not be as severe as in the past.

There are a few reasons for that. The global economy today needs half as much oil to produce one unit of real GDP as in 1990. So global growth is less exposed to changes in oil prices than in the past. The second point is oil prices fell a lot – so even an increase in prices may not bring them into restrictive territory. The third point is that unlike in the past, we do have US shale oil which could at least to some extent pick up the slack if Saudi Arabia and OPEC produced less. And unlike in the past, oil shocks do not tend to increase core inflation all that much. As a result, central banks can respond to oil shocks as negative shocks to income and ease rather than tighten monetary policy. That means the effect of oil shocks on the economy is not as damaging as it once was.

What should an investor do?
My recommendation is to overweight equities relative to government bonds over the next 12 months. Stocks are not particularly cheap, but they are certainly not very expensive either. The MSCI All Country World Index is trading at around 15,5 times forward earnings which is not too bad. Outside the US, stocks are trading at close to 13,5 forward earnings which is actually pretty cheap.

What return can an equity investor expect?
The earnings yield is a good proxy for the expected long term real total return from stocks. Today, the earnings yield is around 5% to 6% in many markets. That’s not bad considering that bonds are yielding negative in real terms and indeed negative in nominal terms in many markets.

Price-Earnings-Ratios are low because margins are high. Won’t margins revert to the mean at some point?
In the US, margins are higher today than almost at any point in the past. However, the source of that upward trend in margins is the technology sector. S&P 500 margins outside technology have basically been flat – they are not higher now than they have been on average.

Are high technology margins sustainable?
You can make a case that today’s tech margins reflect different fundamentals than in the past. Today, there are a lot of companies that effectively function as natural monopolies either because of network effects or because of technological advancements that give them the ability to have monopoly like margins. It’s not at all clear whether profit margins for companies like Facebook, Apple or Google will come down anywhere close to the historic average for S&P 500 companies. If they stay elevated, then profit margins for the entire market will stay elevated.

Even if the regulator challenges their monopolistic power?
Certainly, there can be a political backlash. Elizabeth Warren has come out and said she wants to break up Amazon, Google and Facebook. A few weeks ago, she even added Apple to the list. If we get this left wing populist surge that focuses on big tech, tech margins might come down and in aggregate S&P margins would fall.

What regions do you prefer?
Regional equity allocation is to a large extent a function of where we are in the business cycle. Over the next 12 to 18 months we could at least temporarily see a shift in leadership away from the US and towards emerging markets and Europe.

What is the reason for this shift?
As global growth picks up, the dollar will probably start to weaken which is going to reduce financing costs for borrowers with dollar denominated debt in emerging markets. A lower dollar will push up commodity prices. In that environment, the more cyclical sectors of the stock market – energy, materials, industrials and financials – could start to do well. That probably means that Europe and EmMa start to outperform the US.

Have you made that switch yet?
No. We’re looking for more evidence that global growth is near a bottom. You can make a case that global growth is in a bottoming phase, but it hasn’t shown any clear uptrend yet. If the data does begin to improve, then we will upgrade.

Would you then expect value stocks to finally rebound?
It’s hard to see a rebound for value stocks that excludes financials. If financials begin to do well, then value stocks are going to do well. In the environment I envision, financials could do well at least temporarily. If global growth picks up, if the dollar weakens, if commodity prices rise, global bond yields are likely to rise, and if global bond yields rise, that’s going to be good news for financials because that probably translates into steeper yield curves. In general, financial stocks tend to do better when yield curves are steepening.

Are there any pockets of opportunity in fixed income?
In an environment in which government bond yields are rising, corporate spreads may not widen, but yields could still go up simply because the base rate is rising. Within a fixed income portfolio, I would be overweight corporate credit relative to safe government bonds. Within government bonds, I would be more overweight low beta bond markets.

Can you explain that?
Government bond yields are going to rise more in some markets than in others. Historically the US treasury market has been a higher beta market meaning that when government bond yields in general are falling, they are falling more in the US and vice versa. So my guess would be that over the next 12 to 18 months, treasury yields will rise more than say German bund yields, and so treasuries will end up underperforming German bunds - certainly on a currency hedged basis.

That’s not a consensus call. Many investors like treasuries as they still provide some yield.
If a foreign investor buys treasuries and hedges the currency risk, there’s not that much yield left.

What is your view on gold?
On the one hand, a weaker dollar is bullish for gold. On the other hand, real bond yields will rise as global growth accelerates, and that’s going to be negative for gold. My best bet is gold will probably move sideways over the next 12 months.

And longer term?
Longer term, I like gold as a hedge against inflation risk because I think that central banks today are underestimating the likelihood that their economies will eventually overheat and inflation will break out. Owning gold in a high inflation environment is a very sensible thing to do.

Is there a risk inflation will get out of control?
Eventually, yes. Perhaps not anywhere close to what we saw in the 1970ies, but there is a very high chance we’re going to end up with central banks that have been too loose for too long. Inflation is a highly lagging indicator. Usually inflation doesn’t peak until a recession has already begun, and usually it doesn’t bottom until recovery is well underway. Right now, we’re still in that phase where the economy is overheating under the surface but inflation has yet to break out. But eventually, I think inflation will move substantially higher, and owning bonds in that environment will be very painful.

The comeback of inflation would support your value call as well.
That’s right. Longer term, I do like value versus growth.