Investment Outlook

read on...

November 28, 2019

Investment Outlook

Tom Elliott

Market sentiment: Risk on! The MSCI World Index of developed stock markets is up 3.2% in USD, and 3.7% in GBP, since the start of November. The S&P 500 index stands at a record high, led by cyclical stocks, and Wall Street’s strong autumn rally has, in turn, helped to lift global stock markets. U.S economic data over the last fortnight confirms that a recovery is taking place, after a weak summer and early autumn. Strong household consumption continues, and this appears to be limiting the downturn seen in the manufacturing sector (eg, this week we saw October’s durable goods sales enjoy a better than expected rebound). Eurozone economic data has also beaten rather low expectations, led by French consumption. Core government bond yields are stable, after having corrected in September. Gold, an asset class for worriers, end-of-the-financial world prophets and old fashioned monetarists who fret about inflation risks, is still slowly pulling back from its late summer highs of $1,500 an ounce. 

How sustainable is the rally?

As always with late-cycle economic upturns, and accompanying stock market rallies, there is a lack of confidence in the durability of the recent uptick. It is interesting to note that yields are rising amongst the weakest U.S junk bond issues, with Ice Data Services yesterday reporting that 12% of the issues in its index (200 bonds) offer yields of 10% or more over the equivalent Treasuries. This high number of distressed loans suggests investor unease in one of the riskiest parts of the capital markets. Emerging market equities, usually considered to be a leveraged play on developed world growth prospects, have significantly lagged developed stock markets. They are up just 1.1% month-to-date in USD (although the lag is less pronounced over a three month period).

And if the economic uptick is sustainable, how much of it is already priced in by the markets? Wealthy private investors are reported to continue to hold a lot of cash, suggesting on-going scepticism. Lipper report that money market funds now hold $1 trillion, the highest amount since the financial crisis a decade ago. Financial history suggests that holding large cash positions over extended periods is an under-performing strategy, but its appeal is understandable.

To be fair to the bulls in the market, it is difficult to see how this economic cycle – which began for the U.S in 2009- will end. Usually, economic cycles end with inflation. Central banks raise interest rates to kill off the animal spirits that drive credit growth, which in turn drives demand and economic growth. Or, as in 2007, a debt problem somewhere in the economy triggers a freezing up of the availability of credit within financial markets. Neither inflation or problems with debt (putting the stress in junk bonds aside), appear to risk the U.S economy at present. 

So we are left with geo-politics as a potential trigger, in particular, the U.S/ China trade dispute. At its extreme, this risks causing a recession in China and a severe global economic downturn as supply chains are disrupted as tariffs and quotas are introduced. But it is more likely that this problem will simply fester on. Trump is unwilling to sign off on a ‘Phase One’ deal that covers too few of America’s concerns, and few in Washington believe China’s assurances that concerns over state aid, technology transfer, and security issues will be included in any Phase Two series of negotiations that might follow. But Trump is equally unwilling to increase tariffs on Chinese imports, and/or broaden their scope, ahead of a U.S presidential election. Maintaining consumer confidence will be a priority, and raising consumer prices as a direct, or indirect, result of tariffs undermines that.

Remain diversified! Now is not a good time to jump on the risk bandwagon. Uncertainties abound. If it runs further, enjoy it and take profit by re-balancing into more defensive sectors and asset classes that have seen weakness lately. Such rebalancing should, in any case, be a regular activity in a properly diversified investment portfolio. 

Brexit, sterling cont. A Conservative majority in the House of Commons now looks a likely result to the 12th December U.K election. A You Gov survey suggests a very workable majority of 44 MPs. This should ensure a quick passing of the legislation that is needed for Prime Minister Boris Johnson’s deal (the Withdrawal Agreement) to come into effect, with Brexit now promised for some time in January. 

One thing that is helping the Tories is the awfulness of the policies presented by the opposition Labour party, and its leader Jeremy Corbyn. His vision of a socialist utopia suggests little understanding of C20th European history, or of current day Latin America. His fetishism with terrorists is, to say the least, peculiar.

But it is hard to see a Conservative majority at the 12th December U.K election ending sterling volatility or even giving it much of a boost. This because Johnson has hoisted himself on yet another Brexit petard. In order to secure the Brexit party’s agreement to stand down many of their candidates, to keep arch-euro sceptics in his own party happy, and ensure the votes of those who think his deal is a ‘betrayal’ of Brexit, the manifesto emphasises a deadline of 31st December 2020 will be imposed on negotiating the second part of Brexit, which includes any free trade agreement (FTA). If there is no deal, the U.K will simply stop adhering to E.U regulations and a no-deal Brexit will take place.

If this becomes happens sterling, domestic-focused stocks, and the value of many other U.K assets will weaken. The investment will continue to be subdued, hampering economic growth.

However, few independent trade analysts believe than an FTA with the E.U can be done in such short time. Johnson is known to favour a so-called ‘Canada minus’ trade deal, which would be the loosest possible arrangement, so allowing trade deals to be made with the U.S, Australia, New Zealand, and Japan by the end of 2023. This means more departures from existing E.U rules will have to be negotiated than had the U.K left the E.U under Theresa May’s deal, that favoured a closer arrangement with the E.U.

Aside from the problem that such complex trade deals have never been completed over a few years, no third party will enter detailed negotiations with the U.K government as long as Britain’s final trading arrangement with the E.U is unsettled. For instance, there is little point in the U.K offering the U.S access to its agriculture sector (and thereby lowering its food quality and animal health rules), if the final FTA with the E.U has food staying closely aligned to E.U regulations. This may happen: rather confusingly from the American point of view, the Tory manifesto also promises not to compromise on environmental, food or animal welfare standards. Yet agriculture is a number one priority for the U.S in any trade deal. 

<< International Investment Strategy