Investment Outlook

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September 27, 2019

Investment Outlook

Tom Elliott

Market sentiment: Uneasy. A flash crash in momentum stocks last week, volatile oil prices, and Fed intervention in the dollar rep market (to ensure the market has enough cash at hand), lead to investor confusion. The possible impeachment of Trump doesn’t itself bother investors, but if it leads to delays in policymaking -esp. a trade deal with China and in infrastructure spending decisions- markets will worry. Trump announced this week that a deal may be done ‘sooner than anyone expected’ when negotiators meet again in October, and stock markets rallied a bit -showing the sensitivity of markets to the China trade war story. 

Eurozone economic data is poor, led by a slowdown in Germany whose export sector is a casualty of decreased global trade. Christine Lagarde, now head of the ECB, is leading the pressure on a reluctant Germany to run budget deficits, and so bring fiscal stimulus to the eurozone. 

Government bond yields are volatile, on uncertainty as to whether the global economy is entering a recession, or merely resting prior to the resumption of growth. Or is it, perhaps, decelerating to low but stable levels of growth that might persist indefinitely (the Japanese scenario)? Bond market uncertainty, in turn, gives a confusing message to other financial assets which are priced off the risk-free rate of government debt.

Central banks are generally in easing mode, as they should be after the OECD last week reduced its forecast for global growth this year from3.2% to 2.9%, and for next year from 3.4% to 3.0% (anything below 3% is regarded by most economists as dangerous). 

But central banks lack consistent messaging: last week the U.S Fed gave an interest rate cut with one hand, but with the other indicated a rate hike may be its next move in 2021. The ECB is renewing its quantitative easing scheme and taking interest rates further into negative territory, but many of its north-of-the-Alps board members openly question whether such policies hurt the eurozone economy more than they heal it, by weakening the banking sector. Members of the Bank of England interest rate-setting committee have begun talking of a rate cut in the event of a prolonging of Article 50, but the central bank is known to fear an inflation surge both in the event of a no deal and of an agreed deal (though for very different reasons).

A global recession is less likely than a ‘pause that refreshes’. Most recessions are triggered by either asset bubbles bursting or by a surge of wage inflation. We are seeing neither at the moment in the industrialised economies. In the absence of an economic or political shock to the global economy, it is more likely that we are entering ‘a pause that refreshes’, aggravated perhaps by the U.S/ China trade dispute. This could easily reverse if a U.S/China trade deal is announced, and/or Germany declares a fiscal expansion policy to avert a recession. 

By historical standards government bonds, U.S stocks, and much global real estate may appear to be in a bubble after a rapid price growth in recent decades. But can we compare current asset prices to those of previous economic and investment cycles, given the unusual monetary policy being followed by the main central banks? With the Bank of Japan and ECB at negative nominal interest rates and the Fed and Bank of England at ultra-low rates (though still positive), current valuations on anything that offers a positive yield may be justified. And justified for as long as the global economy requires the current unorthodox monetary medicine. 

Equally, it is hard to see wage growth creating general CPI inflation in the U.S, or in any major economy at present. In the U.S, average hourly wages rose 3.2% in the year to September – low, considering that the unemployment rate of 3.7% is at a 50 year low. This feeds into modest inflation expectations from the Fed, who see approximately 2% CPI inflation for the indefinite future.

Brexit. Undeterred by a Supreme Court ruling that he lied to the Queen over the reasons for prolonging Parliament, and having lost all seven votes in the House of Commons since becoming Prime Minister and sacked 21 of his own MPs so losing his Parliamentary majority, Boris Johnson is in a surprisingly chirpy mood. Indeed, he appears willing to defy Parliament again and to ignore the do-called Ben Act that expressly prevents a no-deal Brexit at the end of October. The U.K could soon be in a position whereby the government allows the U.K to leave the E.U, with no deal, contrary to the express wish of Parliament as set down in law. 

He is undaunted in his willingness to cause offense: calling the Ben Act the ‘Surrender Act’, and the MPs who voted for it ‘saboteurs’. The Ben Act’s proponents fear that Johnson is too keen for a no-deal since it plays well with Brexit voters. The E.U says that the U.K has failed to deliver any new meaningful proposals that might end the need for an Irish backstop, despite constant claims from Johnson that ‘good progress’ is being made in Brussels. 

Johnson’s war-like language is designed to position himself as a patriot, struggling to defeat the Europeans and the Europe-loving British elite (which includes Parliament), on behalf of ‘the people’. Aids in Downing Street has made clear this will be the language of the election campaign. Its practical purpose is to shift the blame if he fails to win a deal from the E.U by the deadline of 19th October and to win over Brexit voters who might otherwise be tempted to vote for the Brexit Party in the next election.

Sterling has risen a little since the Supreme Court asserted that the executive rules through Parliament, not by bypassing it. The ruling has led to more parliamentary time available to opposition MPs, to tighten up the Ben Act and so prevent any loopholes being used by the government in its attempt to force a no-deal on 31st October. 

But economists and the FX market are increasingly concerned that a prolonged period of dithering by the U.K may be given a further extension if Article 50 is extended once more. With damaging consequences for investment and future growth prospects. What, exactly, would be the point? Would a general election deliver a government able to push through the House of Commons a deal that may not differ much from the one Theresa May was offered? Unless a second referendum is offered, with the explicit binary position of Leave with no deal, or Remain, the log jam could persist under a new government.  

Investors can help protect themselves from market uncertainty through exposure to a broad range of assets, currencies and geographic regions. The mantra of an investor should always be ‘diversification’ – this is especially pertinent in today’s uncertain market conditions. 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. 

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