Investment Outlook

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October 15, 2019

Investment Outlook

Tom Elliott

Market sentiment: Skittish. Positive news stories are heavily caveated. Can current stock market valuations be sustained as the global economy slows and as corporate earnings deteriorate? Government bond yields continue to hover at near-record-low yields – suggesting to some imminent cyclical recession, while others see it as an acknowledgment of a long term problem of structurally low growth and low/no inflation. Neither interpretation is particularly supportive of risk assets. The VIX index of implied volatility on the S&P 500, also known as the ‘fear index’, stands at the moderately elevated level of 16.3.

The following should be considered an observation, and not investment advice: financial history suggests that investors should remain fully diversified during periods of uncertainty, perhaps accruing cash reserves should a sell-off in risk assets result in buying opportunities. 

Positive news stories, each with a sting in their tale, include:

The Fed. In the U.S, we are seeing a softening from the Fed over its interest rate forecast. Thankfully, last month’s ‘dot chart’ -which showed Fed board members consensus view that the next change in rate will be a hike in 2021- looks less likely by the day. Expectations of another rate cuts this year have grown after the Fed’s Jerome Powell spoke last week of the need to insure against uncertainties over ‘trade, Brexit and other issues’. Note that Brexit is now being considered a potential source of harm to the U.S, and by extension to the global economy. 

Trade talks. A limited U.S/ China trade deal may be signed off next month by Presidents Xi and Trump, after a ‘sort of’ deal was agreed by trade negotiators last Friday. China agreed to buy more agricultural goods from traditionally Republican-voting states, it is seeking a ‘skinny’ deal, limited to addressing its trade surplus with the U.S. The U.S is seeking a broader agreement covering technology transfer, state subsidies, and security issues, which China is resisting. China hopes that Trump’s need to secure any deal ahead of the presidential election campaign will force him to accept the skinny deal. Trump and Xi are expected to meet a the Asia Pacific Economic Conference in Santiago, Chile, on 16-17 November where a final agreement may be signed if Trump does, indeed, feel pressured into getting any deal possible.

German fiscal policy. Germany is finally, and slowly, looking at a fiscal policy stimulus to soften the blow coming from a sharp downturn in manufacturing exports. Its budget surplus of 0.5% of GDP sits oddly, some argue, with an economy that contracted at an annualised rate of 0.3% in the second quarter and which is likely to report a similar contraction for the third quarter (which would make it a recession). However, even if politicians can summon the courage to break the balanced budget rules, it is unclear if the country has the spare capacity to engage in the infrastructure projects that many are calling for. Unemployment stands at 3.1% and the construction sector has full order books. Perhaps the economy has to deteriorate further before fiscal policy medicine can be usefully applied?

Brexit. There is an improved tone to the U.K’s Brexit negotiations with the E.U, following breakthrough talks with the Irish government last week. The risk of a damaging no-deal Brexit appears to be reduced. At a head of state E.U summit this Thursday and Friday, Boris Johnson is likely to explain his complex proposal regarding the Northern Ireland customs border, and also to request re-writing of parts of the political declaration that Theresa May signed up to. These will be in areas relating to taxes, state subsidies and product standards, which the U.K government argue limits national sovereignty. It is possible a deal emerges, for the House of Commons to vote on this weekend. But whether MPs will vote for a deal is another question, and appears unlikely given the strength of opposition to a hard Brexit in Parliament. Therefore, I’m assuming there will be no deal passed by Parliament by 31st October.

According to the Benn Act, the U.K government must seek an extension to Article 50 if no deal is approved by Parliament by Saturday. This will probably be granted by the E.U, who will regard the likely general election and/or second referendum that follows as an opportunity for the U.K to gain a political consensus as to what it wants to do. But for investors, a general election opens another risk: that 1970s style socialism returns to Britain. The Labour party leader, Jeremy Corbyn, is a puppet of a Trotskyite tendency which has taken over control of the party. 

Other issues

Gilts. Sterling has long been a barometer of sentiment towards Brexit, falling when fear of no-deal Brexit increases. Gilts have joined in, but showing an opposite response. Their prices rise (ie, yields fall) on news stories that make a no-deal Brexit more likely. This is because of the damage such an event would do to the economy, with low -or negative- economic growth likely to limit inflation. Gilt prices drop back (and yields rise) when there is the talk of a deal to be done, and the risk to the economy lessens. 

The ballooning of the U.K budget deficit under the current Johnson-led government, with further spending likely to be announced in a 6th November pre-election budget, may be acting as a floor to gilt yields. But the market has reacted surprisingly coolly to the steady increase in spending commitments in recent months. This was highlighted in last week’s warning from the Institute for Fiscal Studies that the government’s current spending plans ‘are closer to what Labour had in its 2017 manifesto than what the Conservatives had in theirs’. That’s the price the government is paying to woe northern Labour-voters, who voted for Brexit and whose support at the next election might help make up for the loss of remain-voting Tory voters, who appear likely to desert to the Lib Dems.

U.S Stock valuations. Below is a rather chilling chart found on Twitter, courtesy of the WSJ. It shows non-financial firms’ profit margins at various stages of past U.S economic cycles and plots where we are in the current cycle (blue line) from a comparison of recent profit margins. The grey bar on the left marks recession. It appears from this chart that the U.S economy is heading in that direction.

So all eyes will be on the third-quarter earnings U.S results season, which starts this week. Poor results from tech (hit by the U.S/ China trade war) and energy (weak prices) are expected to lead the average earnings figure into negative territory for the third consecutive quarter. We will be looking at the results to see how other sectors are bearing up, particularly discretionary consumer spending sectors, such as travel and leisure, that are most sensitive to changes consumer confidence.

How will Wall Street respond to falling earnings? The S&P500 is only slightly below the record high reached in July, at a time when earnings growth appears set to contract further. Therefore U.S share prices appear vulnerable to a sell-off. Will further interest rate cuts from the Fed, which might support the weakening economy as well as dis-incentivise a flight to cash, support the stock market? Will more share buybacks help? We wait to find out. 

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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