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March 20, 2019

Investment Outlook

Tom Elliott

Market sentiment: Firm. Many reasons support optimism on risk assets: Chinese media reported ‘substantive progress’ on the U.S/ China trade talks, and there is hope that Beijing’s fiscal stimulus policy will shore up weakening GDP growth. Falling core government bond yields -with the 10yr U.S Treasury ending last week at 2.60%- reflect the more dovish tones coming from the Fed and the ECB, which should help the U.S and global growth. And as risk-free rates fall, stock market valuations appear more attractive. We have seen a slight recovery in eurozone economic data, and there is increasing confidence that the U.K will avoid a chaotic no-deal Brexit. In addition, developed stock markets benefit from a large number of corporate share buyback programs that are currently in progress.


The VIX index of implied volatility on the S&P 500 stands at 13.5, back to levels last seen in October. Assuming that the Fed remains ‘data dependent’, as it recently promised to be, U.S Treasury and global bond yields will remain subdued, helping this outbreak of tranquillity amongst risk assets to persist.


Watch out for slower U.S growth. In the interest of balance, there are some less helpful themes that investors should be aware of. Such as the risk of panic in the U.S high yield bond market, on account of the excessive quantity of very low investment grade debt (BBB rated) in issuance. This threatens to swamp the high yield market should a wave of downgrades occur. And we have the continual risk that Italian banks may precipitate another eurozone financial crisis.


But foremost is the risk of a greater-than-expected weakening of U.S GDP growth, which will hurt corporate earnings of domestic-orientated companies in the U.S and so test current stock market valuations. Recent economic data suggests that this, rather than a bounce upwards in inflation as wage growth picks up and so causing the Fed to resume its interest rate tightening, is the greater risk facing the U.S economy.


Investors have long anticipated a weaker phase in U.S growth this year, just because the sugar-rush of the Trump tax cuts that boosted growth last year was bound to fade. This perhaps explains why, after an initial negative reaction, investors took the weak February jobs growth data (just 20,000 new jobs created), along with weak consumer spending data, on the chin. Furthermore, the Fed is now openly supporting growth and is no longer seen as carelessly raising interest rates, irrespective of the impact on the economy.


But economists are relentlessly downgrading their GDP estimates for the first quarter, suggesting that the slower growth is worse than anticipated. Last week the Atlanta Fed estimated of first quarter GDP growth will come in at just 0.2% at an annualised rate (from a previous estimate of 0.5%). Consensus estimates of around 2.4% GDP growth this year look somewhat optimistic. Meanwhile, headline inflation remains mute, despite some encouraging wage inflation lately. CPI in February came in at just 1.5% y/y (compared to 2.4% over 2018 as a whole) – well below the 2% target rate, and helping to justify the Fed’s January U-turn on policy.


The U.S remains the world’s largest economy in USD terms by some margin, and if the second quarter fails to see a strong pickup in demand there will be worries that the U.S economy may be heading for European-like GDP growth this year. This will have a negative impact on the global economy, and also encourage protectionist policies from the White House (which needs little encouragement).


What does this mean for investors? Given the positive themes mentioned above, particularly the more relaxed monetary policies of the Fed and the ECB, stock markets may well be able to cope with a degree of weaker-than-expected U.S GDP growth. But diversification away from the U.S stock market may be a helpful defensive move for investors, particularly given that Wall Street’s valuation is much higher than for other stock markets (the 16.5 times price earnings ratio on the S&P500 compares with 12 times for the FSTE All-World ex U.S index). While few global investors would relish selling the U.S and putting the proceeds into the slow-growth economies of Europe and Japan, emerging market equities still offer attractive valuations relative to both their history and to developed stock markets. And do remember to always hold bonds in your portfolio, they like miserable news!


Brexit. The U.K government continues to try to persuade the House of Commons to accept its Withdrawal Agreement Bill and the political declaration on the future of U.K/E.U relations. A third vote is expected on Tuesday or Wednesday of this week if the government whips can be sure that enough members of the DUP and European Research Group (arch Tory Brexiters) will swallow their distaste for the Irish backstop and vote in favour. If it succeeds then May will ask the E.U for a three-month extension to Article 50 in order for Parliament to pass the necessary legislation to give Brexit effect.


This would give a further boost to sterling, which rose two and a half U.S cents last week after the House of Commons voted against a no deal Brexit (a largely symbolic vote, but one that helped reassure investors).


If the vote is not held by Wednesday, a much longer delay to Brexit is likely – possibly a few years. This is something Brexiters dread because these other options to May’s deal will be probably be explored by Parliament and the E.U that might include a softer Brexit than that which the existing Bill offers, such as a Norway Plus arrangement. Other options may include a second referendum or a general election that might deliver a House of Commons capable of passing Brexit-related legislation. Not led by the Conservative party, but perhaps by Labour whose Brexit current position (in so much as it is discernible) is to remain in the customs union permanently.


A long delay to Brexit would also boost sterling since the possibility of no Brexit would grow. In fact, it is difficult to see a downside to sterling, unless a no deal accidentally slips through on account of divisions within the House of Commons over an alternative to May’s Brexit deal.


A multi-asset portfolio for the long term. We favour a long-term run approach to investing, whereby investors choose a suitable combination of global equities and bonds (depending on their risk profile and investment horizon) and leave the portfolio unchanged. Regular re-balancing ensures winners are sold and losers are bought – which financial history, and common sense, supports. The chart below shows a typical long-term balanced portfolio based around 60% global equities and 40% global bonds. Financial history shows this combination to offer good returns relative to risk (ie, volatility). Investors should try to be as diversified as possible, perhaps using the 60/40 model as their guide. Multi-asset funds based on this principle are available, often with different ratios of bonds and equities depending on the level of risk suitable for an investor. Note that the chart shows neutral weightings for the long-term investor, it does not incorporate any near-term weighting suggestions made in previous paragraphs.

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