JPMorgan's head quant, Marko Kolanovic underwent a curious transformation in late 2017 and early 2018: while not fully abandoning his traditional skepticism, at the start of the year he predicted that volatility and tail risk would be modestly higher in 2018 (even if he explicitly said that an event like the February VIXtermination was unlikely just one week before it struck), while pushing a consistently bullish view both heading into 2018 and again immediately after the February crash (so far stock have yet to take out the late January melt-up highs). One other thing that Kolanovic failed to predict was that the ongoing trade war would reach its current level of escalation and mutual retaliation.
Fast forward to today, when in his latest note, Kolanovic explains why JPM has now turned bullish on Emerging Markets (surely the recent acceleration in fiscal and monetary easing by China is the main driver here, even if it is not explicitly stated), updates on the current state of the trade war, and most importantly admits that his optimism may be somewhat displaced, presenting a gloomy scenario that sees a recession come notably sooner than most expect: some time in 2019.
As the JPM head quant writes, his views remain constructive "despite the trade war which we did not foresee to reach the current level of intensity" and explains that a "critical premise behind these views was that economic cycle stays intact this year." It is here that his conviction appears to be faltering and notes that "a number of our clients assume that the cycle is likely to end in 2019 or 2020. Some of the negative sentiment and reasoning behind some investors’ below-average equity exposure (e.g., HF beta) comes from the notion that if the cycle were to end soon, the risk-reward for chasing the last leg up is poor."
So is a recession in the coming year possible?
In his "devil's advocate" rationale of why a recession could hit in 2019, Kolanovic writes that "as the US fiscal boost starts wearing off, Fed hikes will start putting stress on consumers, corporates, and market conditions." And once earnings start slowing down and fundamentals deteriorate, "a market event similar to ‘February 2018’ can finish off the cycle."
Remember this chart? This is what Kolanovic is talking about:
Indeed, monetary tightening historically was and will be a likely trigger for the next recession. The impact of rising rates on financial markets is not well understood given structural changes in the markets – in terms of liquidity and tail risk, leverage, the impact of a strong USD, reliance on bond-equity correlation, etc., which likely make the cycle more vulnerable to rates than in the past.
But does tightening guarantee a recession? Aren't there benefits from higher rates? Kolanovic explains:
It might be beyond anyone’s analytical ability to forecast how rates impact inflation in the age of rapid technological advances, changes in demographics trends, and globalization. For instance, it is not clear there is a mechanism by which hiking short-term interest rates contains the rising cost of college tuition or drug prices. The argument that higher rates build a cushion against the next crisis is also confusing for market practitioners. It may be akin to walking towards the edge of a cliff, only so that you can reduce the risk of falling by backing off (while not knowing exactly where the edge of the cliff is).
So while Kolanovic remains optimistic, he admits that "regardless on views of whether rate hikes are justified or not at this point, a rates-driven end of the cycle in 2019 is a possibility that needs to be kept in mind."
He also lays out an optimistic scenario: one where a recession next year, or even in 2020, is delayed by "waves of fiscal easing globally", something which China has already started but which as we will show shortly may be terminated prematurely. Here is Marko's upside case:
In contrast to this gloomy scenario, there is a much brighter and, in our view, more likely one – the cycle is extended by waves of fiscal easing globally. The US often sets global trends, such as the introduction of QE in the aftermath of the 2008 financial crisis. QE was later replicated (and taken to another level) in Europe and Asia. At the end of his term, chairman Bernanke said that there are limits to monetary policy and that pro-growth fiscal measures need to play a bigger role. Trump fully on-boarded this as a part of his platform. Corporate tax cuts can also be viewed as a part of the trade war. Corporate tax cuts outside of the US might be a necessary step in order to compete in trade, especially after the massive reduction in US tax rates. Fiscal measures are also popular with voters and can help reduce various political tensions, e.g., exposed by the recent rise in populist movements in Europe. For this reason, we think that is quite possible that in coming quarters Europe and Asia will move towards fiscal easing.
The conclusion: Trump's fiscal stimulus - or rather its imitation by the rest of the world - could be the catalyst that pushes back a recession until well into a potential second term for the president, to wit:
Instead of a 2019/2020 recession, we may see a boost to the global cycle driven by Trump-style fiscal measures outside of the US.
While feasible in theory, one wonders just how much debt the world would be encumbered by some time in the 2020s to make this outcome possible, and just what the ensuing and inevitable debt "normalization" would look like just to kick the can for another few years.