Perspectives

2020: a year of living dangerously

st  
3
EcoPerspectives // 1 quarter 2020  
economic-research.bnpparibas.com  
United States  
2
020: a year of living dangerously  
The dichotomy between economic and market trends has widened, in a context of accommodating monetary policy and rising  
corporate debt. Risks taken by institutional investors (pension and investment funds, life assurance companies) have increased, as  
has the vulnerability to any adverse shocks or changes in expectations. 2020  an election year  is unlikely to bring calm. Welcome  
as it is, the truce in the trade war with China takes in the bulk of existing tariff increases, without producing any fundamental changes  
in the position of the US administration and its limited appetite for multilateralism.  
One is taking off, the other coming in to land. Whilst the US  
1
- Growth and inflation  
economy has been on a slowing trajectory for more than a year now,  
with the industrial sector dropping into recession, the equity market  
is still setting new records. In 2019, the Standard & Poor’s index of  
the 500 biggest listed companies gained nearly 30%; at 3,230 on 31  
December it was 106% above the record high of October 2007. The  
Nasdaq tech stocks index surged by 35% in 2019, taking its gains  
over the past seven years to 200%.  
GDP Growth (%)  
Inflation (%)  
Forecast  
Forecast  
2.9  
2.4  
2
.4  
2
.3  
2.2  
2.1  
1
.9  
1.9  
21  
1
.8  
1.7  
Higher, faster, riskier  
Is this irrational exuberance? The fact is that in the United States,  
rising equity prices display a fairly distant relationship with the  
slower growth in earnings, resulting in stretched valuations (Figure 2  
17  
18  
19  
20  
21  
17  
18  
19  
20  
1
and IMF, 2019) . With interest rates remaining low, equities’ gains  
Source: National statistics, BNP Paribas  
are based on an amplification of the leverage effect. In its latest  
Global Financial Stability Report, the IMF highlights the importance  
of borrowing in M&A activity and in share buybacks. The increase in  
the weighting of goodwill in total assets, and the high multiples used  
in LBO (leveraged buy-out) deals reflect increasingly ambitious bets  
2
- Increased risk taking  
(*)  
S&P500 P/E (lhs)  
(**)  
▪▪▪ High-Yield Spread , basis points (rhs)  
25  
2
on the future . Increased risk taking can also be illustrated by the  
2 000  
narrowing of spreads on high-yield debt (Figure 2), a market sector  
that the IMF also considers to be overvalued.  
2
0
5
1
500  
In the current phase of rising asset prices, institutional investors  
1
(
investment and pension funds, life assurance companies) have  
1 000  
played an increasingly important role. Whilst banks have, overall,  
slowed the expansion of their balance sheets and improved their  
resilience since the 2008 financial crisis, institutional investors have  
expanded their activity, taking a growing share of financing. They  
have also widened the scope of their quest for returns, in a context  
of falling interest rates on sovereign debt, the traditional core of their  
investment portfolios. A reallocation has taken place, away from  
cash and investment-grade bonds, to less liquid and more risky  
assets such as unlisted private debt, real estate and infrastructure.  
This has produced greater vulnerability to negative shocks or  
changes in expectations.3  
10  
5
500  
0
0
2
002  
*) P/E: Price / cyclically-adjusted earnings per share  
**) Yield on speculative-grade corporate bonds yield on 10-year Federal  
2005  
2008  
2011  
2014  
2017  
2020  
(
(
Government bonds.  
Source: Refinitiv, BNP Paribas  
In these early weeks of 2020, the increase in tensions between the  
United States and Iran does not appear to have provided a tipping  
point. Markets have been bolstered by the prospect of continued  
monetary accommodation , and hopes for the settlement of the  
trade war between China and the USA.  
4
1
International Monetary Fund (2019), Global Financial Stability Report, Chapter  
, October, pp 1-4. In September 2019, the IMF’s valuation model suggested  
1
that US equity valuations were more than 2.5 standard deviations above fair  
value.  
2
Ibid, pp 25-37. 60% of LBO debt is for deals valuing the target company at  
more than six times annual operating income.  
Ibid, pp 41-49.  
4In 2019, the US Federal Reserve cut its Fed Funds target rate by three-  
quarters of a point, taking the upper bound from 2.50% to 1.75%. Since October  
3
st  
4
EcoPerspectives // 1 quarter 2020  
economic-research.bnpparibas.com  
Pressure on margins and investment  
3
- Debt grows, margins shrink  
A scenario of calmer waters ahead is far from guaranteed. Granted,  
a deal between Washington and Beijing was signed on 15 January.  
%
Net debt of non-financial companies (lhs)  
▪▪ Net operating income of non-financial companies (rhs)  
of added value  
5%  
‘Phase 1’ of this agreement will bring a pause in the escalation of  
tariffs and, on the Chinese side, an increase in imports, notably of  
farmed products, guarantees on respect for intellectual property  
rights and greater market openness in the financial sector. The fact  
remains that the roots of the conflict  the battle for technological  
8
7
6
24%  
2
0%  
6%  
5%  
5
leadership  go deep and that any real de-escalation in a possible  
1
‘Phase 2’ has been pushed down the road, most probably beyond  
the presidential election on 3 November. Most of the tariffs enforced  
by the Trump administration will therefore continue to apply in 2020.  
This will take the average tariff on imports from China from 3% (in  
5%  
12%  
8%  
2
017) to 19%, increasing the cost of Chinese imports by some  
55%  
1985  
6
USD70 billion .  
1990  
1995  
2000  
2005  
2010  
2015  
2020  
Shaded areas: periods of recession  
For US companies, the additional costs come at a moment when  
the effects of the 2018 tax cuts are diminishing and no longer serve  
to offset narrower operating margins. Pressure on earnings is rising,  
whilst the leverage is increasing; such a configuration often  
precedes or comes alongside an inversion in the US economic cycle  
Source: BEA, NBER, Federal Reserve (Flows of Funds)  
4- The leverage effect  
To understand the link between financial leverage and the return on  
equity, the balance sheet and profit account of companies can be  
written as follows:  
(
Figure 3 and Box 4). The tide has already clearly turned in the  
shale oil and gas sector, which has seen marginal returns fall and is  
cutting capacity in response.  
(
(
1) A= E +D  
Although employment and consumer spending are showing little  
sign of slowing, company investment has been falling since the  
autumn of last year. It is now the main vector by which the US  
economy is coming in to land. Surveys of purchasing managers  
2) NP = EP - I  
Where A is the total economic asset, D the total net debt, E the  
shareholder equity, NP the net profit, EP the economic or operating  
profit, I the interest rates burden (for simplicity, income taxes are  
ignored).  
7
suggest that this trend had not improved as we moved into 2020 .  
GDP growth has slowed, with the respective New York and Atlanta  
Fed’s nowcasts suggesting a rate between 1% and 1.8% per year.  
By definition, the financial leverage is equal to the net debt to equity  
ratio, e.g. :  
(3) L = D / E,  
The economic return of asset (er) is the ratio of operating profit to total  
economic asset:  
er = EP / A ;  
The return on equity (roe) is the ratio of net profit to equity :  
(
4) roe = NP / E  
= (EP I) / E  
2
019, it has also increased the size of its balance sheet in response to tensions  
following (2)  
in the repo market.  
5Even while it was negotiating with the USA, the Chinese government  
announced its plan to replace, within three years, foreign IT equipment  
=
=
(re.A i.D) / E  
where i is the market interest rate  
[re.(D + E)  i.D] / E following (1)  
following (3)  
(computers, software, etc.) in use across government with Chinese equipment.  
roe = er + (er  i).L  
See Financial Times (2019), Beijing orders state offices to replace foreign PCs  
and software, Dec. 8.  
6Estimated impact in 2020. Under the terms of the Phase 1 agreement, the US  
administration cancelled proposed tariffs on a final list of products (list ‘4B’),  
consisting mainly of consumer goods, and also cut the tariff rate applied in  
September 2019 on USD 100 bn in imports from 15% to 7.5%. The earlier tariff  
increases (25% on USD 250 bn in imports) have been confirmed. In the final  
analysis, nearly two-thirds (65%) of US imports from China will be subject to  
tariffs.  
Le financial leverage L raises the return on equity above the  
economic return if it exceeds the market interest rate. The leverage  
effect declines with the rise in market interest rates and/or the fall in  
economic return. In a case of reversal (er < i) the return on equity  
comes under pressure, which could speed-up the deleveraging  
process.  
Source: Vernimmen (2010), BNP Paribas  
See: Brown C.P. (2019), Phase One China Deal: Steep Tariffs Are the New  
Normal, Peterson Institute for International Economics, December 19.  
7At 46.8 in December 2019, the industrial orders index calculated by the Institute  
for Supply Management (ISM), which has traditionally been strongly correlated  
with company investment, is at its lowest since April 2009.  
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