Author: Alastair George
It has been quite a ride to the upside in global markets in 2019 to date. The swings in sentiment since October 2018 have been extreme, creating a significant late-cycle trading opportunity as markets bottomed during December. Earlier expectations for profits growth in 2019 were indeed over-optimistic but fears that central banks would ignore weakening economic trends were always likely to prove wide of the mark. Furthermore, US/China trade negotiations seemed to be making progress and likely to be resolved ahead of the start of any US Presidential election campaign for 2020. The cross-asset class rally in global markets may leave the consensus narrative focused on the upside but we now view the short-term bull trade as complete, following the US Fed’s confirmation that rates are on hold rather than on their way down. For the summer of 2019, we believe “main street” will be the bigger beneficiary of improving economic conditions compared to Wall Street. In addition, uncertainty has risen in respect of a resolution of the US/China trade conflict.
It is not just US equities which have posted some of their largest year-to-date returns over the last 10 years. High yield credit spreads have moved notably lower since December and despite central bankers’ warnings on deteriorating credit standards, leveraged loan indices have recouped all of 2018’s losses and now stand at new all-time highs. Equity market volatility has once again fallen to very low levels compared to its 25-year history while the US initial public offering market has been reignited. It is difficult to argue in our view that the recent easing of US and eurozone monetary policy is not already to a large extent priced into global markets.
Yet despite the magnitude of the recent trough-to-peak swings in equities, relatively little from a fundamental perspective has changed since last October. Median earnings forecasts for 2019 have fallen a few percentage points from previously over-optimistic levels and more recently have stabilised. Similarly, 2019 GDP growth expectations have fallen, but also modestly. More recent incoming global economic data has been mixed, indicating improving momentum compared to earlier in the year.
The key change which reversed the abrupt tightening of global financial conditions was the US Fed’s about-turn in its interest rate policy earlier in the year. By pausing US interest rate increases and maintaining a balance sheet size larger than previously expected, the US Fed triggered a substantial easing of broad financial conditions (or more directly stated, a rapid climb in market prices) on a global basis during Q119 and Q219 to date.
The minor equity market wobble since the Fed’s most recent statement last week was indicative however of the liquidity-driven nature of the market rally. We suggest that it may now be a good time to scale back tactical overweight holdings in risk assets such as equities. This is not because we expect a relapse in the economic outlook but because the US Fed has shown it is unlikely to juice asset prices even further in the short-run. Furthermore, equity valuations which were close to their lows of the last three years in December have now returned to relatively elevated levels.
The closing of output gaps in the US, UK and Germany suggests an increasing risk of late-cycle dynamics such as rising cost pressures on corporate profits. It may not have been the case for over a decade but the combination of cost-driven margin pressure on profits and higher real interest rates would be a rather toxic scenario for equity valuations. While this remains a tail-risk scenario for now, it should not be completely ignored in our view. We note for example a significant proportion of the reduction in earnings forecasts for 2019 can be attributed to declining EBIT margin forecasts in the US and Europe.
Trump’s recent tweets on trade tariffs have upset the strong market consensus, which developed following a string of encouraging press reports, that a US/China deal would shortly be reached. Reports now indicate that the Chinese side may have pulled back from certain commitments on technology transfer and intellectual property protection. However, Trump’s megaphone diplomacy seems to have resulted in the cancellation of a 100-person Chinese delegation to Washington this week which was aiming to finalise a detailed trade agreement for signature. It is in our view unclear at this stage whether or not Trump has overplayed his hand and a deal can be signed in the short-term. It is also a reminder that a number of unresolved political risks including the UK’s Brexit process remain in place, despite the rally in markets.