Investment Outlook

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November 12, 2018

Investment Outlook

Tom Elliott

Market sentiment: Remaining apprehensive. The U.S mid-terms are out of the way, and the market appear sanguine with the prospect of gridlock on Capitol Hill. But October’s sell-off has scared investors, despite continuing decent fundamentals for global stock markets. Tellingly, the VIX index of implied volatility on the S&P 500 ended last week at 17, equidistance from the 24 it reached on 24th October during the sell-off, and the low of 10 seen during the calmer days of early August.

Outlook for capital markets. The dollar is likely to continue to strengthen as higher U.S interest rates and bond yields suck in foreign capital (see below). Globally, risk assets, such as stocks and property, will have to compete with higher risk-free rates as European and Asian bond yields rise in order to attract investors who are tempted by higher U.S rates, and as the ECB and the Bank of Japan conduct their own forms of monetary policy tightening.

Fundamentals remain supportive. However, a bear market for stocks is unlikely to set in over the coming months Global growth is at a decent pace (the IMF predicts 3.7% GDP growth this year and next) which will support profits growth. The financial sector is healthy, and able to absorb an increase in debt defaults should the global economy weaken significantly. Stock markets are no longer overvalued, bar a few sectors in the U.S (eg, tech). Despite the recent interest rate hikes, real interest rates (ie, after taking inflation into account), are only slightly positive in the U.S and remain negative throughout Europe and in Japan. As a matter of financial history, the 12 months following U.S mid-term elections have always been good for Wall Street even if the president’s party loses one or both houses of Congress.

Perhaps the biggest risks facing investors are the uncertain consequences of:
1) Tighter monetary policy, primarily from the U.S but in the euro zone and Japan too, which increase real interest rates to levels that attract investors out of stocks and not cash.
2) A more aggressive Trump on trade talks and foreign policy, given that any significant domestic policies will probably be near-impossible to enact with the Democrats controlling the lower house. 
3) Threats to E.U unity from Italy, as its government appears set on a confrontation with the euro zone authorities over budget deficits. Given that half of Italy’s outstanding government debt needs to be rolled over in the next five years, the potential of a re-run of the Greek debt crisis, but on a larger scale, exists. 
4) China needs to manage slower GDP growth, and a transformation of the economy towards services and consumption, while knowing that a usual tool by which to manage such change -currency devaluation- would make trade negotiations with the U.S only harder.

Trade talks. The next date in our diaries is the 20th November Buenos Aires G20 summit, at which Presidents Trump and Xi Jinping will – it is hoped-  set a date for a sixth round of talks. The U.S will be looking for a serious response to the 140 specific demands that it handed the Chinese in May at the first round of talks. If not, a further round of tariffs is due to come into force on 1st January. Trump has the support of many Democrats to pursue a tough line with China. 

The danger to the global economy is not just a potentially sharp drop in U.S/ Chinese trade, disruption to the supply chains of leading U.S companies, and rising prices in the U.S. There are global implications, with Chinese and U.S production that formerly went to each other’s countries possibly being diverted to Europe and Asia, pushing down domestic prices, and prompting retaliatory action. President Trump may be encouraged to re-open his complaints of unfair trading against South Korea, Japan and Germany, and undermine security alliances in the process.  

Of course, there will be winners. Protected industries that benefit from tariffs on imports will be able to raise their selling prices. China and the U.S will look for new suppliers of basic materials. But trade wars tend to exert deflationary pressures overall, with currency devaluation often used to support exports. And this is perhaps China’s greatest weapon: the risk that it responds to weaker GDP growth with a devaluation of the RMB, allowing it to fall below the psychologically important RMB 7 to the dollar level.

Why are Treasury yields likely to rise if inflation is still weak? September’s CPI inflation came in at 2.3% year-on-year, its second monthly decline. The Fed’s preferred measure of inflation, the PCE, came in at 1.6% last month, well below the Fed’s 2% target. So why the continued talk of U.S interest rate hikes, and higher Treasury yields? 

On Thursday the Fed reiterated its commitment to a December interest rate hike. Following guidance from the Fed, the market anticipates three more in 2019 and one last hike in 2020, in the current cycle. Driving the Fed’s tighter monetary policy is suspicion that the tight labour market will sooner or later lead to strong wage growth, that pushes up inflation. October’s strong payroll data of ten days ago appears to support this view, with 250,000 new jobs created last month (compared to an expected 170,000), while unemployment was steady at a multi-decade low of just 3.7% wage growth came in at 3.1%. 

Many U.S companies reported wage growth eating into profits growth in their third quarter earnings statements, something that is also being seen in the U.K. (While this undoubtedly good for capitalism in the long run, since wage growth will help support demand and perhaps neutralise populist politics, in the short term it threatens a re-valuation of future expected corporate earnings, and share prices).

Rising inflation and interest rates will eat away at the real value of bonds, with the long end of the yield curve particularly vulnerable since investors’ capital is tied up for longer. Hence long dated Treasuries may well suffer worse than short-dated, should the Fed’s inflation fears come about.

Separately, Trump’s ‘disappointment’ with Jay Powell, for voting to raise interest rates in September, has put the spotlight on the Fed’s chairman. If he is seen to encourage an easing of monetary policy, perhaps by delaying December’s rate hike, he now risks the Fed’s reputation as a politically neutral institution. 

Second, supply and demand. There is a large increase in the supply of U.S Treasuries as the government runs a growing budget deficit (driven by the December 2017 tax cuts). It is scant consolation that Democrat control of the House of Representatives now means a second wave of tax cuts is unlikely – the U.S is currently heading for a whopping 2018 budget deficit of 4.8% of GDP, more than twice that of the U.K. At the same time the Fed’s quantitative tightening (Q.T) program means it is no longer buying $50 billion worth a month of Treasuries that it was this time last year. These supply and demand factors both contribute to higher Treasury yields than would otherwise be the case. 

Investors’ response. Unsurprisingly, many investors are adjusting their fixed income portfolios towards short-dated Treasuries and dollar liquidity funds (ie, cash). However, should the Fed be wrong about inflation – perhaps on account of slower economic growth next year – they may want to have exposure to longer dated maturities, which will rally most if there is an easing of inflation and interest rate increases.

Falling oil price. The speed with which the oil price has fallen from a cyclical high of $86 a barrel in early October, to Friday’s close of $70 (for Brent), has surprised everyone. The oil price is now in an official bear market, which is taken to be a fall of over 20%. This mostly reflects the White House’s attempts to manage the consequences of its sanctions on Iranian oil exports. Waivers to a host of countries that import oil from Iran have been issued, as Trump worked to stop oil spiking ahead of the mid term elections. Saudi Arabia and other Gulf states were urged to increase supply, which they done along with Russia.

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