Investment Outlook

read on...

January 21, 2020

Investment Outlook

Tom Elliott

Market sentiment: The rally in risk assets, which began in the autumn, has continued into January. The MSCI World Index (of developed stock markets) is at a new high, led by the U.S, but all major markets have made solid gains in local currencies. Emerging markets have performed in line with developed markets. 

Why the bullish sentiment? The anticipation of the signing last week of the ‘Phase One’ trade agreement between the U.S and China has been a large contributor to investor optimism, with trade war-sensitive sectors leading most markets (eg, tech in the U.S). Tensions with Iran have calmed somewhat. Recent solid U.S fourth quarter banking results, and earnings outlook statements, indicate optimism over the American economy and the consensus view remains that we will see a pick-up in global growth from the spring. 

Meanwhile, monetary policy remains supportive: imminent interest rate cuts are expected in China, and in the U.K now that several interest rate hawks on the Monetary Policy Committee have become dovish. The Fed and the ECB both appear set on an extended pause of interest rates.

But investors need to remain circumspect. The recent IMF downgrade to its global GDP growth estimate for 2020, from 3.4% to 3.3%, reflects weaker than previously expected recoveries in the economies of India, Brazil, Mexico, Turkey, and Russia. Sure, the downgrade may be statistically irrelevant but investors watch the direction of travel as much as the pace of change.

There is not much confidence in the U.S/ China trade deal. The agreement between the U.S and China merely freezes the current trade spate -including the 25% tariffs on $250bn of U.S imports from China- with tensions between the two countries unlikely to ease significantly in the near term, no matter who is U.S president after November’s election. More broadly, the fall in global trade that has occurred over the last year looks set to persist as the Chinese economy becomes increasingly less reliant on imports of foreign I.T and high-end consumer and capital goods, uncouples from that of the West. Is ‘peak globalisation’ behind us? Something for the delegates meeting in Davos this week to ponder, perhaps.

Lower interest rates in China and the U.K over the coming months, if they come, will reflect weak growth prospects due to long-term problems. This will mute investors’ response to policy easing. China, as a combination of attempts to reduce credit growth in the economy and shift growth away from export-orientated sectors to domestic goods and services, coincide with the statistical ‘base’ effect by which it becomes ever-harder to maintain a constant high rate of GDP growth. In the U.K, as weak investment and household spending persist due to Brexit uncertainty which will remain until new trade agreements with the E.U, U.S, etc are in place. 

U.S valuations. Some investors fear that U.S stocks are now ‘priced for perfection’, thanks to the four-month rally that we have seen. The S&P 500 and other major stock market indices are at, or near, all-time highs. The current trailing price/ earnings ratio (p/e) of 25 times for the S&P 500 index has been higher just three times since 1875: in 1895, 2000 the tech bubble and in 2009 (source: Robert Schiller ‘Irrational Exuberance’). 

Are U.S passive funds vulnerable to tech concentration? We are seeing an over-concentration of a few mega-tech stocks in the S&P 500 index. This has been highlighted by Alphabet joining Apple, Amazon, and Microsoft in the elite group of U.S companies with a $1tr market capitalisation, with Facebook, not far short. Together the four $1tr plus companies have a 15% weighting in the S&P 500 index, while the whole I.T sector has a weight of 24%. A falling-out of love of tech by investors, perhaps in response to a harsher regulatory environment, will, therefore, have significant repercussions for U.S stock market indices. Passive funds that have to mirror the indices will have to take the blow head-on.

The regulatory alignment debate is at the heart of the Brexit dilemma. There is a political imperative for the U.K government to demonstrate that Brexit means a hard Brexit, and this trumps the economic risk. Regulatory alignment is at the heart of this.  

The U.K Chancellor of the Exchequer (ie, finance minister), Sajid Javid, has told business to give up hope of continued product regulatory alignment with E.U. This is, in part, to demonstrate to the E.U that the U.K will not settle for a trade deal that maintains the status quo, just to achieve the goal of having a deal in place by the December 2020 deadline. 

It also reflects pressure from Washington, which has long argued that any trade deal with the U.S must involve agriculture and pharmaceuticals, both of which are more lightly regulated than in the E.U. Interestingly, the German defence minister let slip over the weekend that the U.K, France, and Germany agreed to trigger cessation of the Iran nuclear deal last week after the White House threatened trade tariffs if they stayed in.

Former Prime Minister Theresa May had conceded regulatory alignment, in all but name, in order to get the departure agreement with the E.U through the House of Commons. This was done in order to minimise disruption to the U.K economy, but she was criticised by many of her own MPs for trying to push through a soft Brexit as a result. The more pro-Brexit Prime Minister Boris Johnson, helped by his 80 majority of MPs, can afford to ignore the now small number of Europhile MPs still willing to make their voices heard. He is able to pursue a harder Brexit with fewer ties to Brussels, perhaps resulting in a so-called ‘Canada-minus’ trade agreement with the E.U.

The auto, pharma, aerospace, and food & drink industries have all made clear their preference for the U.K to continue to operate under E.U rules, in post-Brexit Britain. This is in order to avoid having to create different U.K and E.U variations of the same products. E.U regulations are considered the tightest in the world in many sectors, and so make exporting to many non-E.U countries easier. The E.U has made it clear that a commitment to such alignment will be needed if it is to offer zero tariffs, and zero quotas, trade to the U.K. 

But the U.K government thinks regulatory alignment cedes too much control to the E.U. Remaining under the auspices of the European Court of Justice (ECJ), which polices regulatory matters, would leave the U.K subject to E.U rules and so would not respect Brexit.

Critics of the E.U argue that Brussels is overly-fond of regulation, and applies the precautionary principle too readily (in which a company has to prove that a new product will not cause harm). British author Matt Ridley’s book ‘How many lights do it take to change the world’ (IEA, 2019), illustrates this point well. Untying Britain from ‘nanny state’ rules could unleash a wave of innovation. 

However, the U.K civil service has its own reputation of adding to, and ‘gold-plating’, E.U regulations. It is not axiomatic that ditching E.U regulations will unshackle the country’s inventors. Second, the U.K may be forced to adopt U.S product alignment in return for a trade deal with Washington, certainly if food and pharma are on the negotiating table. Britain may simply be switching one foreign rule-setting for another, with as little control over the regulations affecting U.K export-led sectors as under the E.U.

Multi-asset should be at the heart of investing. Last year was a good one for many multi-asset portfolios, as both stocks and bonds made gains. The continuing uncertainty over the direction of stocks and other risk assets suggests multi-asset portfolios may continue to be the asset class of choice amongst global investors, given that they offer a welcome diversification of risk as well as of return.

<< International Investment Strategy