Investment Outlook

read on...

June 27, 2019

Investment Outlook

Tom Elliott

Market sentiment: Nervousness persists. Investors are conscious that we are late in the U.S and global economic cycle, and this perhaps tempts them to see too much gloom in each piece of negative news flow. Surveys of fund managers show little appetite for equities at present but are nonetheless sticking with them: the most common alternatives -bonds and cash- yield so little that selling is not considered a viable option. Stock markets everywhere have welcomed the recent batch of central bank policy statements, all of which have hinted at, or made outright commitments to, cutting interest rates or using other monetary policy tools should growth conditions warrant it. 

The willingness of central banks to step in to protect growth from a geopolitical, or economic, shock, is made easier by the continuing absence of an inflation problem. With central bank’s ready to ease policy – the Fed may start its rate as soon as July- a persistent period of below-trend GDP growth, with weak corporate earnings growth, appears more likely than a U.S, or a global, recession, limiting the extent of any stock market correction. This economic cycle could have a very long tail. 

Looking for the trigger. Those looking for a trigger to end the current U.S economic cycle are not short of pegs to hang their arguments on. Could the trigger come from geopolitics, such as the U.S/ China trade dispute curtailing global trade and unwinding the benefits of decades of increased globalisation? An oil shock arising from a blockade of the Straits of Hormuz? Or from a slow-burner economic issue, such as low rates of corporate investment in the U.S? Perhaps the trigger will come from a China growth slowdown, followed by a renminbi devaluation that creates a fresh U.S and global deflation scare similar to that of July 2015? 

The Fed to the rescue! The turnaround in Fed policy over the last six months has been astonishing, given the continuing strength of the U.S economy. Certainly, leading indicators have disappointed (such as last week’s weak Philadelphia manufacturing index), and the Fed is acutely conscious of the current nervousness in financial markets and it believes this has a negative impact on sentiment in the real economy. 

But consensus expectations of 2.2% GDP growth this year, against 2.9% in 2018, suggest a modest slowdown after the one-off boost given to the economy last year by tax cuts. Not an oncoming recession. Indeed, given the tightness of the labour market there is a risk that inflation -currently running at 1.8%- takes off if the Fed eases policy too much. The Fed funds futures market is pricing in a rate cut next month, with a 50/50 chance of a further two by the year-end. Judging from Fed comments recently, much will depend on the progress of U.S/ China trade relations. This weekend’s meeting of Trump and Xi Jining, at the G20 summit in Osaka, may be a pivotal moment. 

What does Fed easing mean for investors? The expectation of rate cuts from the Fed has already led to a bout of dollar weakness and a rally in gold (because gold benefits when the opportunity cost of holding it, such as bank account cash rates, fall). If geopolitical and economic news deteriorates, more than one cut this year appears a certainty and the negative effect on the dollar will be limited only by the response of other central banks.

Fed easing should boost U.S consumer and business confidence, and so support domestic-based corporate earnings and stock prices. A weaker dollar will support exporters, though hurt those companies who rely on imports. Lower risk-free rates from bank account cash and Treasuries will also benefit the U.S and global stock markets as the attraction of cash and Treasuries will deteriorate still further. Emerging market debt and equity may outperform their developed peers, as dollar-denominated debt becomes cheaper to service (and roll-over) in local currency terms.

The ECB is the weakest link. All the major central banks are able to buy assets and so pump liquidity (ie, cash) into the real economy. In addition, the Fed and -to an extent- the Bank of England- have room to cut interest rates since both currently have rates well above zero. However, the ECB differs and is the weakest link in the global monetary system. Interest rates are already negative, with a distorting effect on the banking system. Furthermore, there are potentially not enough government bonds available to buy from countries such as Germany, the Netherlands, and Finland, in order to maintain the central bank’s commitment to buying bonds from all member states in proportion to their GDP. Because of this, we may see the dollar appreciate most against the euro.

On 31st October Mario Draghi (Mr ‘whatever it takes’) will cease being head of the ECB. His replacement may be less inclined to intervene to save a eurozone member from a financial crisis, particularly if Draghi’s replacement is the current head of the Bundesbank, Jens Weidmann, who as a board member of the ECB has been a persistent critic of the central bank’s loose monetary policy. Where might the next eurozone crisis come from? Probably from Italy, which has a combination of a government that constantly tests the resolve of the E.U’s institutions and a weak banking sector. 

Bank of England. Try as it has, the BoE has failed to raise interest rates beyond 0.75% in the current cycle. Still, that is three 0.25% rate cuts available if needed. A number of reasons suggest they will be. External factors will include the geopolitical and global economic issues mentioned above. Domestic factors focus on the risk of a no deal Brexit adversely affecting the economy, evidence of weak second-quarter economic growth, and low consumer and investment confidence. A surprise fall in inflation in June -despite a decade's low unemployment rate of 3.8%- gives the Bank license to ease, should it wish.

Boris Johnson and Jeremy Hunt on Brexit. It appears likely that Boris Johnson will win the Conservative Party’s leadership contest and become Prime Minister. Both he, and rival Jeremy Hunt argue that they will try to persuade the E.U to re-open the Withdrawal Agreement and substantially alter or abolish the Irish backstop, and get Parliament’s endorsement by 31st October. 

Where they differ, it seems, is that Boris promises to take the U.K out of the E.U in the event of failing to renegotiate a new deal. This, he says, will not hurt the U.K economy much since trade can progress uninterrupted under GATT rule 24 (an argument dismissed by WTO trade officials and the Bank of England’s Mark Carney, since using GATT rule 22 will require trade talks with the E.U to be in progress, and for the E.U to agree to its use). Hunt is offering more flexibility on the date of departure, acknowledging that time will be needed to get a new deal with the E.U and win over Parliament, which can be interpreted as a willingness to seek a further extension to Article 50.

Five Brexit options for the new Prime Minister. The idea that a new Prime Minister can rid itself of the Brexit problem if he goes for no-deal on 31st October is false. 12 Conservative MPs have committed themselves to vote against the government -and so bringing it down in a vote of no-confidence- should it try. This means Brexit will linger for a long time yet, perhaps for years. Below I suggest five options for a new Prime Minister (with acknowledgment to comments made last week by Ivan Rogers, Britain’s former ambassador to the E.U). Only one – a second referendum- offers an immediate end to the Brexit issue, but this is unlikely to happen:

Bad for the economy, sterling, and U.K assets in general:
1) Look set to allow the U.K to leave without a deal, leading to some Remain-supporting Conservative MPs to vote against the government and so bring it down, leading to an autumn general election and -possibly- Labour leader Jeremy Corbyn entering 10 Downing Street and inheriting the problem. He leads a party as divided over Brexit as the Conservatives. 
2) The new Prime Minister might actually relish a general election, believing in his powers of oratory to win over wavering Remainder voters. This is achieved by making unreasonable demands on the E.U to re-negotiate the Withdrawal Agreement and the Irish backstop, as a pretext for calling a general election at which he will ‘Stand up for Britain’, and possibly win a popular mandate and a Parliamentary majority for a no deal Brexit.

Continuing uncertainty for the economy, sterling, and U.K assets in general:
3) Seek an extension to Article 50, in the forlorn hope of discovering a new solution to the Irish border question, leading to accusations of betrayal from Brexiters and more Tory voters drifting to UKIP, making success at a later general election harder.
4) Re-submit to Parliament the existing Withdrawal Agreement, and the political declaration on the future relationship, with minor tweaks (changes so slight that the E.U agrees that they do not constitute a re-writing). Again, leading to accusations of betrayal and fuelling support for UKIP. 

Good for the economy, sterling, and U.K assets in general:
5) Call a second referendum, again leading to accusations of betrayal. Now considered unlikely this side of a general election, but more so if a new government takes over. 

A multi-asset portfolio for the long term. Many long term investors favour investing in a combination of global equities and bonds since the two asset classes have a relatively low correlation with each other and so offer diversification benefits. Below is an illustration of a typical 60% equities/ 40% bonds fund. The exact ratio of equities and bonds will reflect a client’s risk profile and investment horizon.

<< International Investment Strategy