Investment Outlook

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July 23, 2019

Investment Outlook

Tom Elliott

Market sentiment: Somewhat schizophrenic, with equity and bond markets both supported by anticipated interest rate cuts from the Fed, though reading different things into what the cuts might signify. The U.S / China trade war has come off the headlines, though remains very much alive, to be replaced by a growing sense of crisis in the Gulf that is focused on Iran. Investors have been moving into quality assets within assets classes, favouring defensive plays. 

The two contrary views expressed by the markets. U.S stocks have taken heart from a recent upturn in domestic economic data (particularly the June jobs report), and from the prospect of the Fed and other central banks easing monetary policy over the coming months. This, it is argued, will help the current cycle of U.S economic growth continue its record-breaking run. And it will support global growth at a time when China’s expansion is slowing as the government attempts to weaken the economy off credit. Trump wants a percentage point of cuts this year to help boost his campaign for re-election, though it is not thought this has much bearing on the Fed’s decision making.

The U.S Treasury market, meanwhile, is indicating that a recession is around the corner. The inverted Treasury yield curve is cited as ‘exhibit number one’ for this thesis. Furthermore, the Fed’s failure to bring core inflation up to its 2% target, and lack of meaningful real wage growth despite decades-low unemployment, suggest to some the impending ‘Japanisation’ of the U.S economy. By which is meant a prolonged period of low to no economic and corporate profits growth. If so, the Fed’s summer rate cut will be the first of many and it is only a matter of time before the optimistic stock market investors are overwhelmed by a combination of overvalued equities and weak corporate earnings.  

Which to believe? One can incorporate both ideas into a portfolio by owning growth-sensitive stocks and misery-loving government bonds. This multi-asset approach is standard amongst long-term investors.

Cash. A small cash position has a useful role in a portfolio. First, cash smooths portfolio returns, reducing volatility. Second, while European currencies won’t currently offer a return to speak of, U.S dollar cash will currently give a return of a couple of percentage points if invested in liquidity or money market funds. Third, a cash position means that investors can take advantage of cheaper asset prices during a market correction. 

This last point has broader ramifications. Holding cash with the intention of deploying it during a period of falling asset prices helps deter us from panic selling during such a downturn. The very human instinct to sell in a falling market is tempered because there is a part of us that sees an opportunity to buy and utilise the cash. Financial history shows that investors who remain fully invested over a number of cycles outperform those who try to ‘time the market’, and who often end up selling late and buying back into the market too late into the recovery rally.

Oil and Iran. While the U.S/ China trade dispute poses the most serious long-term geopolitical risk to stock markets, interference by Iran of western shipping in the Gulf is generating volatility on oil markets and concern amongst investors. True, today’s $67 a barrel for Brent is well below last October’s high of $85. But this may change if the Straits of Hormuz are blocked by Iran, halting oil and gas supplies bound mostly for Asia. Global spot prices will rally, with some economists speculating that it could be the straw that breaks the current U.S economic cycle. 

However, this fear seems to be an extrapolation of twentieth-century economic history, which may not be repeated for the following reasons. First, manufacturing, power generation, and transport are all less hydrocarbon-energy intensive than they were in the 1970s and 1980s, and all have a smaller share of GDP than in the past as services have grown. Second, it is not in the Gulf states interest to promote renewables and more shale prospecting. Therefore Saudi and other Gulf states are likely to increase production, along with Russia, if prices remain high for long. Third, Gulf of Mexico oil production is back on track following repairs to rigs damaged by Hurricane Barry. Finally, peaks in the oil price this century have not been associated with recession. When Brent peaked at $140 in the summer of 2008 it did not trigger a global manufacturing recession. That job was left to the banks.

Of course, if the U.S/ Iran situation escalates into military conflict the global economic outlook will deteriorate substantially if oil and gas installations across the region are attacked. But Trump does not want to be dragged into another Gulf war, and a U.S attack on Iran is considered unlikely. 

It is disquieting to learn from leaked U.K diplomatic memos that Trump’s hostility to the Iran nuclear deal may stem from nothing more than it was signed by his predecessor, Barak Obama.

Prime Minister Boris. One wishes Boris Johnson luck in the role he has long craved. He has promised to negotiate a new Brexit deal with the E.U, ahead of the 31st October deadline, that does not include the Irish backstop yet still enables the U.K to make trade deals with third-party countries. Sterling and other U.K assets will rally if this is achieved. But given the refusal of the E.U to renegotiate the Irish backstop, it seems unlikely to happen. Of course, the E.U may blink if no-deal Brexit appears likely to do serious damage to its members, something that Boris is counting on. 

Assuming, however, that there is no deal with the E.U, and he is not stopped by Conservative party rebels, Boris may then decide to let Brexit happen by default on 31st October. He could then call a general election in early November, as the Prime Minister who ‘delivered Brexit’. Sterling and U.K assets may weaken in this uncertainty. But longer-term, the Brexit discount on these assets is likely to fade as the country adapts to life outside the E.U, and we should perhaps remember the investor’s mantra: where there is chaos, there is an opportunity.

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.

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