Investment Outlook

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August 12, 2019

Investment Outlook

Tom Elliott

Market sentiment: Nervous. Investors have been wrong-footed by the Fed, which cut interest rates on 31st July by 25bp as expected, but it pulled back from promising further cuts. This is despite falling inflation in the U.S, rising trade tension with China, and a weakening global environment. The Fed’s caution reflects a fear that a tight labour market may trigger an inflation shock. Investors have no such fears, and are worried that the increasingly inverted U.S yield curve is predicting a recession over the next 18 months. 

A fall in the Chinese renminbi to below seven to the dollar has opened a new front in the already fractious U.S / China trade dispute, with fears of a weak RMB spreading deflationary pressure across the world. European economic data has been weak, with the U.K recording its first quarterly GDP contraction for seven years, in the second quarter. Stock markets and high yield bonds have weakened, while a rush into safe assets which has led to a strong rally for core government bonds and gold. All German government bonds now offer a negative yield, the U.K 10 year yield stands at a record low of 0.48%.

The VIX ‘fear index’ stands at 19, well above recent low of 13 seen in late July.

Investors should not try to second guess the market, or central banks. Financial history demonstrates the long-term advantages of maintaining a multi-asset balanced portfolio through an economic cycle. 

Is the Fed wrong? It was not long ago that analysts were predicting a fall-out in the global bond market. A rise in inflation in the developed world, a normalisation of interest rates, and an oversupply of Treasuries would surely lead to falls in bond prices and to higher yields. 

But the bear market in bonds has not happened. Instead, we are now seeing fear of ‘Japanification’ (permanently low inflation, growth and interest rates) spread to the euro zone and even to the U.S. One fixed income expert from PIMCO, Joachim Fels, last week forecasted negative Treasury yields in the next prolonged economic downturn. Markets fear that the Fed may not have got the message, and are still fighting a non-existent risk of inflation. An over-cautious approach to cutting interest rates may lead to a harsher economic downturn than taking prompt action today. 

It is worth noting that the two traditional triggers for inflation, as learnt by central bank policy makers through their economic text books at college, are, a) too much money creation by banks, which is the monetarist explanation of inflation. Or b), a tight labour market that pushes up wages and increases demand for goods – the so-called Philips Curve. But despite massive money creation by central banks over the last decade, and tight labour markets in the U.S, Germany and the U.K, inflation is below central bank targets in most major economies. 

U.K interest rates. The Bank of England is sitting on its hands until Brexit is done on 31st October, before deciding whether to cut, or perhaps raise, interest rates. It is caught in trap: a no deal Brexit would see sterling fall further, justifying central bank intervention -including rate hikes- to stabilise the currency and head off imported inflation. But it will be under intense pressure to hold rates, or even cut them, if the economy continues to weaken. The second quarter GDP growth was down 0.2%, the first contraction in seven years. Yet a rate cut, with sterling already weak, would severely hurt the currency. Fear over imported inflation could rapidly be joined by a balance of payments crisis.

Brexit and E.U surrealism We wait until the first week in September, when Parliament resumes, to see what sort of political opposition will face Prime Minister Boris Johnson and his plans for Brexit. He appears to want to pursue a new deal with the E.U, despite drawing the same red lines as Theresa May and adamant that the Irish backstop must go. He has said that a no deal Brexit is ‘one in a million’. But in order to keep the Tory Eurosceptics happy, he has filled his cabinet with ministers who appear blasé about the economic and political harm of a no-deal. Indeed, the same day that Boris said a no-deal is ‘one in a million’, his Brexit minister Michael Gove, expressed the view that a no deal Brexit is inevitable. The confusion led to a further lurch down for sterling, which remains very sensitive to the Brexit debate.

The E.U’s stance on the Irish backstop is slightly surreal. Its spokesmen argue that the Good Friday Agreement will be at risk if a hard border goes up between Northern Ireland and the Republic of Ireland. The U.K government is adamant that it respects the GFA and won’t build a hard border. Therefore, it will be left to the Irish -cajoled by the E.U – to do so, if the E.U believes there is a risk of smuggling from Britain into the E.U with an open border after Britain leaves the E.U. The chances of the Irish doing so are remote.

U.K (and Danish) mortgage rates continue to fall. U.K property is finding support from cheaper financing. Mortgage rates have benefited from the fall in government bond yields (gilts), since these are key drivers of mortgage rates. Another driver is competition, and a technical feature of the market is playing a strong contributory part in the on-going fall in mortgage rates. This is the regulation, which came into force in January, that banks have to separate (‘ringfence’) their U.K retail operations from international activities and investment banking. The result is an excess of retail deposits that can only be used for domestic lending, and which are going into cheaper mortgages. For example, one the most competitive three year fixed mortgages for the buy-to-let market, with a 60% loan to value (LTV) had an interest rate of 2.03%. A near-identical mortgage, from the same provider, is now charging 1.74%.

However, the U.K is a long way behind the ultra-low mortgage interest rates to be found in continental Europe. Last week the Danish bank Nordea launched a 20-year mortgage at 0%, days after announcing a 10-year mortgage at -0.5%. 

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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