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April 18, 2019

Investment Outlook

Tom Elliott

Market sentiment: Good. The second quarter has begun well, with the MSCI World Index of developed stock markets up 2.7% in both U.S dollar terms and local currency terms since 1st April. European stock markets have been particularly strong. Improved economic data from China, where the combined fiscal and monetary stimulus appears to be supporting GDP growth, has been a major contributor to global investor sentiment in recent weeks, together with expectations of a deal (of sorts) to be agreed by the U.S and China over their trade dispute. Early first quarter U.S corporate earnings numbers have come in roughly in line with expectations from a handful of bell weather stocks, helping to reduce fears of an earnings recession (defined as two continuous quarters of year on year earnings decline).


The Barclays Global Aggregate Bond Index of investment grade bonds is down 0.4% in dollars. The VIX index of implied volatility on the S&P500 is at 12.8, a level last seen in early October last year and suggesting investors are relaxed.


U.S earnings recession. Expectations of Q1 and Q2 S&P500 average earnings being lower than the same period last year shouldn’t worry investors. The Trump tax cut boom of last year was well flagged, as was the hangover we’ve seen since. True, stocks are slightly more expensive compared to their 25yr history on the forward p/e, Shiller p/e, and price-to-book. But risk-free rates (ie, Treasury yields and bank deposit rates) are unusually low, and not going anywhere – which justifies more generous multiples than in the past.


Just because the current U.S economic cycle is long in the tooth doesn’t mean it has to end. Note JP Morgan’s Jamie Dimon’s comment last week, on announcing record quarterly earnings for any U.S bank: the U.S economy ‘can go on for years. There is no law that says it has to stop’.


The U.K: a coming Labour-led economic boom and bust?  The U.K may face an election this year if the government continues to be unable to push Brexit legislation through the House of Commons. Opinion polls suggest a collapse in support for the Conservative party (though this may recover under a new leader). There is, therefore, the possibility of an outright majority of M.Ps seats being won by the Labour party, which is led by the confirmed Marxists Jeremy Corbyn, and the shadow chancellor John McDonnell.


The re-nationalization of utilities, railways, and higher taxes on ‘the rich’ all form part of the Labour agenda. And after eight years of fiscal austerity by the Conservative-led government, there is now money in the chest for some increase in spending on schools, hospitals, and pet projects. The budget deficit is low by historical standards, at around 1.6% of GDP. A strong fiscal stimulus to the economy is likely in the early years of a Labour government, boosting GDP growth and the profits and share prices of domestic-focused companies.


Furthermore, a Labour government will benefit from a surge in pent-up consumer and business spending if Brexit is abandoned, on account of a second referendum that many Labour activists are calling for.  


However, if the past is anything to go by, the leadership will find it hard to limit its generosity. It will make spending commitments to all who ask, based on the wilfully false premise that the post-Brexit wave of consumer spending is a structural change in demand, and that the bond market will be relaxed so long as inflation remains low -which is unlikely to happen with so much new spending stimulating the economy.


The U.K might then see a substantial rise in borrowing -not only on investment projects but totemic projects such as nationalisation of companies. Meanwhile ‘tax the rich’ policies will encourage capital flight and emigration, and so reduce the amount of income and other taxes associated with the wealthy. Leading to more borrowing and higher taxes on those who can’t flee. Boom and bust in five years.


Sterling-based investors can and should protect themselves from this by ensuring wide geographic distribution of assets.


China. What are the implications of a current account deficit this year? For some years analysts have pondered the question ‘what happens if China stops buying U.S Treasuries?’. The consensus is that, with a current holding of $1.4 trillion of Treasuries, China will not want to risk destabilising the Treasury market and suffering losses on its holdings.


But perhaps analysts have been asking the wrong question, which should have been ‘what happens when China stops buying U.S Treasuries?’. China is increasingly going to be importing capital as its current account swings into deficit, it will no longer be the creator of excessive savings that have helped keep down global borrowing rates. China will be buying far fewer financial assets abroad, instead, it will be using its foreign currency earnings to pay for imported goods and services -including overseas tourism. Analysts’ who focus on the $378 bn annual trade surplus with the U.S (in 2018) tend to forget that China’s current account surplus has shrunk from 10% of GDP in 2007 to just 0.4% last year, thanks to a boom in imports and overseas travel by Chinese.


Requiring foreign capital to fund its growth, Chinese equity and debt markets will have to be more foreigner-friendly and its companies more transparent over their ultimate ownership. Prospectuses in English, as well as Mandarin, might be seen. Meanwhile, purchases of U.S Treasuries are likely to fall, leading to the possibility of higher long-term U.S and global borrowing costs. Other emerging markets will have to compete harder for investment capital and probably pay more to investors.


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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