The second quarter of 2019 began positively with markets continuing their upwards trajectory but the old adage of ‘sell in May and go away until St Leger day’ seemed once again to be playing out as global stock markets fell dramatically. Data had begun pointing to a slowdown in global growth, not least in the Purchasing Manufacturers’ Indices, (a sign of the prevailing direction of economic trends in the manufacturing and service sectors). Key to the downward trend in economic indicators, is the expected reduction in global trade, brought about by the imposition of tariffs by President Trump, representing a possible end to the era of globalisation and its related market efficiencies. Uncertainties also surfaced in respect of increased oil prices and rising inflation in the developed world, combined with historically low unemployment figures (and thus pending wage growth). These pointed towards the spectre of rising interest rates, traditionally bad for bond prices (as their coupon becomes less attractive relative to cash) and bad for equities (as the cost of capital rises). But these fears were short lived and, in June, we witnessed those concerns receding somewhat with oil prices seemingly range-bound (contained to below $75) and new data showing US inflation falling, supporting the Federal Reserve’s rhetoric that rates will now fall again, much to Trump’s delight.
We should expect markets to be jittery. No longer do we have the post global financial crisis life support of quantitative easing, a mechanism that lifted all boats and smoothed asset price fluctuations with cheap borrowing. Indeed with this support gradually being withdrawn in the US, the sheer length of the economic recovery (without a recession) has caused investors to question when the longest expansion in the world’s largest economy will die out. Yet there is actually no regularity of that experience. Australia is in its 30th year of uninterrupted expansion despite being more dependent on cyclical industries. So what would make the US’s expansionary phase a victim of old age?! In our view there are three key factors that could kill a business cycle a) if returns on capital decline as investment becomes excessive and returns fall to below the cost of capital, b) if central bank policy was to tighten, or c) if an asset bubble arose due to loose monetary policy.
None of these ring true, in our view. Credit remains plentiful and cheap and real growth activity is close to the average 3.5% growth over last 10 years and similar to the 30 year average before the 2008/9 crisis. This is what drives corporate profit and is supportive of equities. Central banks across the globe do not look likely to tighten; with inflation turning down below target again in the US and benign in Europe, there is no incentive or requirement to do so. And finally, whilst an asset price bubble could happen at some point, we believe there is currently no evidence of mispricing of risk assets. Accordingly we conclude that the current trend rate of expansion should continue.
One point, which has intrigued investors though, is that bond market pricing seems to be telling us otherwise i.e. that a recession is potentially around the corner. Analysts look at the ‘yield curve’ and prophesise a recession when short term interest rates rise above those for 10 year money. In a normal environment you would expect to get paid more for locking up your money for 10 years than you might receive for instant access. The inverse suggests low confidence in the future but, in reality, this established theory may no longer ring true. Yields have typically been 2-3% over the last 10 years whilst equities performed well. Bond prices (and thus yields) are focused on the outlook for inflation and monetary policy now and not so linked to economic activity. The fast and slow growth periods of the last 10 years have not impacted inflation and central bank policy has not been reacting to the economic cycles but, rather, to the lack of inflation and thus remained very accommodative. So we can expect low interest rates to continue despite average growth. Could inflation break out and prompt interest rate rises? Perhaps over the next 3 years it may accelerate due to a combination of de-globalisation, re-shoring to a higher cost of production environment, deteriorating demographics, full employment, ongoing easy monetary policy, fiscal expansions etc. The bond market is, however, taking the view that structural inflation is not yet playing out and that central banks, in any event, would be deliberately slow to respond for fear of choking off more important economic growth. Accordingly, risk assets, like equity and property, can be less worried about rising rates and benefit from that confidence.
At our June asset allocation meeting, the Investment Committee decided to continue our existing strategy, but with some minor adjustments. As the impact of tariffs on global trade is felt more acutely in Asia and Emerging Markets, (with China, Mexico and more recently South Korea, Japan and India particularly in Trump’s crosshairs), we are reducing our equity exposure here, having already reduced our Japan allocation which has assisted portfolio performance. Our decision is further supported by the fact that earnings expectations for Emerging Market companies continue to trend lower and at a faster pace than any other equity market. Whilst valuations remain moderately attractive, we believe that the impact of global trade tensions will continue to weigh on earnings in the medium-term, with limited probability of a sharp recovery.
We remain worried about Europe as monetary policy does not seem to be working, with 3-4 years of sub-zero interest rates not having the desired stimulative effect. This is because it is counteracted by tightening fiscal policy (imposed by Maastricht conditions) and a credit transmission system that has not been fixed since the crisis, such that EU banks remain inadequately recapitalised. On top of this there are the tensions within the EU such that, when there is a slowdown or weakening of economic activity, it results in the periphery countries (e.g. Italy) suffering a tightening of credit conditions. So in summary, fiscal and monetary policy becomes more impactful when economic activity weakens, combined with a deterioration in credit conditions due to weakness in the banking system, just at a time when greater liquidity is needed – the opposite to US and China.
As regards the UK, and in particular the current negative investor positioning given the still very wide range of possibilities around Brexit, we believe this is poised to reverse. The UK is at its politically most uncertain juncture and a resolution to the Brexit path should now begin to evolve. This removal of uncertainty should have a meaningfully positive impact on asset valuations, which, together with dividend yields, are attractive. This is particularly at the FTSE100 level, given that the index is comprised of firms with a substantially global revenue base. We believe that the greater risk over the next 18 months is to a sharp market rally in UK equities given the removal of uncertainty – regardless of which way the Brexit outcome emerges. As such, we are moving from our underweight to a neutral position.
FTSE All-Share Dividend Yield
UK Forward P/E Ratios
Within Fixed Income, corporate fundamentals and credit valuations remain strong, but developed market sovereign long term yields are uninteresting. We remain underweight with a focus on eking out value in investment grade issues and the shorter maturity end of the market where income is higher.
Within other diversifying assets, we are beginning to increase exposure to hedge funds in preparation for the end of the bull market and to take up some of the slack in the underweight fixed income allocation. We have noted the quantum of capital that has been pulled out of the hedge fund market, with some funds thus becoming unviable and closing. This reduction in saturation of trades, and thus competition for the same return streams, should enable certain strategies to return to profitability. Gold is also a useful hedge against the impact of the end of the Fed’s hiking cycle, while China is seen reallocating its US Treasury reserves here.
In conclusion, we believe our multi-asset approach is well poised to benefit in a world of slowing but still positive growth. Returns should broadly track our long term expectations, although expectations are lower than in the credit expansion years of late and with a little more volatility than clients have become accustomed to during those years of financial system repair.