Author: Alastair George
The recent modest relapse and rise in volatility in global equity markets since the beginning of August has highlighted yet again the headwinds of the US/China trade standoff, slowing global economic momentum and Brexit. The moves in bond markets over the same period have arguably been more significant, reflecting fears the US Fed in particular is lagging behind events. The US 2y/10y yield curve slope is once again close to zero, indicating bond investors sense a coming recession.
Doing nothing is always a valid option in portfolio management, after having carefully considered all other possibilities. We have been suggesting a relatively cautious portfolio positioning since mid-year as market sentiment had improved significantly while economic fundamentals turned more negative as the known risk factors of Brexit and US/China trade proved increasingly intractable.
At this point it is not valuation concerns which drive our cautious positioning, as equity valuations outside the US are becoming less demanding following multi-year period of sub-par returns. Especially in the context of very low or negative long-term bond yields, free cash flow and dividend yields on many European and UK equities are at levels which may attract long-term value investors.
However, for the immediate future we are still concerned that downgrades to 2019 estimates are continuing at a pace which, if sustained, would imply zero profits growth for 2019 compared to 2018. In the circumstances, equities are likely to struggle to deliver meaningfully positive short-term returns, absent a surprise resolution US/China trade or Brexit. Furthermore, central banks in Europe and the US are now widely expected by markets to continue to ease monetary policy over coming quarters, which means that monetary stimulus is already largely discounted within market prices.
The recent increase in market volatility observed during August reflects the well-known but still wholly unresolved risks which investors had chosen to ignore or downplay during Q218. Overly-ambitious expectations for a 50bps US Fed rate cut were not realised and the wait-and-see approach of Fed policymakers has caught momentum traders off-guard. Further increases in US tariffs on Chinese goods quickly followed, confirming that US/China trade talks have stalled. Yesterday’s deferral of US tariffs on consumer goods for the US Christmas season does not reassure but instead reminds us that there is an ongoing political pantomime with some quite serious economic repercussions.
Source: Refinitiv, Edison calculations
The recent decline in China’s renminbi past the symbolic CNY7 to the US dollar has only increased talk of a currency war. The US move to label China a currency manipulator will also be unhelpful for trade negotiations. In the background, the UK continues to stumble towards the critical no-deal Brexit date of October 31, with the outcome largely dependent on the technical procedural manoeuvering of a government pushing for a no-deal Brexit and a UK Parliament seeking to block it. Brexit uncertainty remains unresolved despite the change of UK Prime Minister and UK cabinet.
Over the last six months investors have also been implicitly asked to discount the increasing risk of political interference in the Fed’s monetary policy which has contributed to the strength of the gold price. The one-sided verbal jabs from the US President towards the US Fed Chair are quite unusual for a developed market, at least since the international consensus in respect of the benefits of political independence of central bank became well-established. Nevertheless, the Fed is in our view likely to continue to cut rates in the face of evidence of further weakness in the global economy. In this regard, we note the recent ZEW survey in Germany indicates a further below-consensus decline in optimism and China’s industrial production figures for July were also well below expectations at 4.8% year-on-year, the weakest for 17 years.
It may be frustrating but in our view the reality is that as the risks have not gone away, global equities have become stuck in a trading range. We expect most, if not all, investors will now be familiar with the data showing a slowdown in the global economy and US foreign policy is never far from the headlines. However, just because a risk is familiar it is not less dangerous; the risk at present may be complacency. We therefore remain cautiously positioned in terms of the outlook for global equity markets, noting finally that governments still appear overly focused on domestic populist agendas and oblivious to the very evident risks to global growth.