Investment Outlook

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November 26, 2018

Investment Outlook

Tom Elliott

Market sentiment. Apprehensive. The S&P 500’s recovery following October’s sell-off has since evaporated. As of Friday, the index stood in correction territory, down 10% from its 20th September all-time high of 2,930. Investors fear that the U.S economy will slow in 2019, as borrowing costs rise and Trump’s one-off tax cuts of December 2017 have steadily less impact on household spending and corporate investment. Weaker than expected third quarter growth in Japan and the E.U (notably in Germany), coming on the heels of disappointing growth data from China, has all contributed to a sense of gloom surrounding risk assets. Unsurprisingly, it is growth-sensitive sectors, particularly tech, that have led the recent pull-back in stocks. Tech has an additional problem in the form of the U.S / China trade dispute, which risks disrupting supply lines for U.S and Asian tech companies. Core government bonds -always lovers of gloomy news and nervous market sentiment - have rallied a little, perhaps anticipating weaker inflation pressures and some easing of central bank monetary policy.

Fed policy supports dollar cash, not much else. The Fed’s gradual normalising of its monetary policy, through steady interest rate hikes and the reversal of its quantitative easing program, has contributed to the increase in market uncertainty this year. In addition, other central banks are following the Fed with the ECB and the Bank of Japan both reducing their monthly purchases of assets. Reflecting the tighter monetary conditions, the VIX index of implied volatility on the S&P 500 rose sharply in early October, and has not yet reverted back to the summer lows. Investors are nervous, and dollar cash and Treasury bills are king.

But investors would be wrong to despair of bonds and equities. Central banks and markets are responsive to economic data. And, as the Fed has recently observed, U.S and global GDP growth appears likely to weaken next year. The market has interpreted this as a signal that the Fed may slow down its interest rate hikes after December’s expected 25bp hike. This has contributed to an unexpected fall in Treasury bond yields (and rise in Treasury prices) in recent weeks, and some weakness in the USD, despite the reversal of its quantitative easing program that is reducing demand from the Fed for bonds. 

Clearly bond investors are modifying their expectations for U.S growth and inflation over the coming years, and are expecting an easing of Fed interest rate policy. And with U.S inflation remining subdued October’s small rise in CPI inflation came after two consecutive monthly falls- the Fed is actually in a position where it can ease up on its monetary tightening. Perhaps the biggest inhibitor is politics: with Trump laying the blame for the recent stock market falls with the Fed, being seen to ease policy now may be taken as a signal that Jay Powell can be intimidated by the White House. If Trump wants easier monetary policy from the Fed, he should stay quiet.

Meanwhile at the ECB…ECB president Draghi will soon have to reappraise plans to end quantitative easing in December. An Italian political, fiscal, bond and bank crisis is approaching, like a car crash in slow motion. (The great sadness of this problem is that it is entirely avoidable, and has been created by the Five Star and League coalition government).

More dovish talk from the Fed, and other central banks, would soon end the current sense of paralysis seen in many leveraged sectors such as property, and in global tech stocks globally. It also, incidentally, justifies our continued recommendation to always hold fixed income as a part of a properly diversified portfolio. 

The Brexit deal – suitable ambiguous. The two documents agreed by E.U and U.K governments on Sunday were the Withdrawal Agreement and the political declaration on the future relationship. Together they constitute the ‘Brexit deal’ that now has to be agreed by Parliament. It is disliked by Brexit and Remaining MPs alike, because of its ambiguity. It places the U.K in a neither-in-nor-out relationship with the E.U, if no solution to the Irish border problem is found by the end of the transition period in December 2020 (possibly to be extended to end of 2022). 

The British government looks like it will lose the vote. Should this happen, then a no-deal beckons, and the U.K risks leaving the E.U next March a fully sovereign nation but at a price that the public may not care for. There will be temporary economic chaos, and long term access to E.U markets will be on WTO rules, a substantially worse footing than as a member of the E.U. An alternative scenario is that a ‘no’ vote by Parliament may lead to a second referendum on Brexit. However this idea is hated by Brexiters, and many Remainers are also nervous of alienating voters by asking them to reconsider their vote of two years ago.

But the very ambiguity of the deal should make it interesting to both Brexiters and Remainers to support. There is still everything to play for.

The Withdrawal Agreement, with its Irish backstop, points inevitably to full U.K membership of the customs union when the transition period expires. This is because there is currently no technology solution to the conflicting commitment made by Brexiters to maintain an open Irish border, while at the same time wanting to make third party trade deals.

Norway? With membership of the customs union, and Northern Ireland still under single market rules for many sectors, unionists and business will not wish to see divergent regulations emerging in the U.K. They will become natural allies of the Remainers. The logical progression is for re-application to the single market for the whole country, with an exception on immigration. The E.U has always vowed not to allow a division of the four freedoms (movement of labour, capital, services and goods), but it has a long history of conceding opt-outs. Membership of the customs union and the single market would bring the U.K very close indeed to being a member of the E.U (closer, in fact, than Norway), but with no voice in rule making and undoubtedly having to pay into its budget. 

Canada? Equally, some Brexiters have seen the deal as a stepping stone to a loser relationship with the E.U, once the transition period expires. They are waiting for the technology to develop that will allow an open Irish border. This will allow the to have a free trade arrangement with the E.U, similar to Canada. But it will not lead to frictionless trade with the E.U, which Theresa May has said is a Brexit objective, since customs forms will need to be completed and, as with any trade agreement, there may be quotas and tariffs in some areas of trade. 

Both options imply years of further wrangling between the E.U and the U.K. But the open-ended, and vague nature, of the political declaration on the future relationship guarantees that anyway. The Brexit deal as it currently stands appears to buy the government – and the country- more time in which to think through what sort of Brexit it wants.

A multi-asset portfolio for the long term. We favour a long-term run approach to investing, whereby investors choose a suitable combination of global equities and bonds (depending on their risk profile and investment horizon), and leave the portfolio unchanged. Regular re-balancing ensures winners are sold and losers are bought – which financial history, and common sense, supports. The chart below shows a typical long-term balanced portfolio based around 60% global equities and 40% global bonds. Financial history shows this combination to offer good returns relative to risk (ie, volatility). Investors should try to be as diversified as possible, perhaps using the 60/40 model as their guide. Multi-asset funds based on this principle are available, often with different ratios of bonds and equities depending on the level of risk suitable for an investor. Note that the chart shows neutral weightings for the long-term investor, it does not incorporate any near-term weighting suggestions made in previous paragraphs.

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