Investment Update Q1 2019

From greed to fear – where next?

Treading a cautious middle ground between complacency and angst.

At the start of 2018 we identified the concerns that eventually weighed on equity markets, but we hadn’t anticipated the big drop in valuations that would follow. We still believe some caution is warranted, but not the kind of fear that seems to have taken hold as the year draws to a close.

This time last year, investors were making a hullabaloo about synchronicity. More economies accelerating at the same time would power equity markets ever higher in 2018, they said. We had two big problems with this consensus. First, it was far from clear that growth was likely to be unusually synchronous; second, while we could identify a strong, positive correlation between different measures of synchronicity and corporate earnings growth, we found no relationship between synchronicity and equity returns.  

Our more tempered outlook was for “earnings to be supported by decent – if still unremarkable – economic growth.” We declared that “monitoring the trade-off between growth and monetary policy will be the single most important job for investors as the year unfolds.” And we have been writing about the risks posed by populist trade protectionism since mid-2016. We advocated remaining invested, but with a cautious positioning. 

We were correct on earnings: profits underlying the MSCI World ex US index are on track to grow by circa 7% in 2018 – decent but unremarkable; in the US they stand to grow by 24%, due to the one-off boost from corporate tax cuts.

We also identified correctly the concerns that most caused markets to roil. The two big peak to trough falls occurred from February to March and from October to December. The first was driven by concerns that inflation would force the Federal Reserve (Fed) to raise interest rates too far, too fast and choke off economic growth. The second was driven by concerns about the escalating Sino-US trade war as well as the impact quantitative tightening (QT – the withdrawal of quantitative easing (QE)) could have on markets. (Some commentators claim that the latest sell off was also about the fear of rising interest rates, but we refute that notion: (i) interest rates on US Treasury bonds are lower now than they were before the equity sell-off; (ii) equity sectors that typically perform poorly when interest rates rise, such as real estate or home construction, have been among the best performers in the US.)

Yet we were wrong about the extent to which those concerns would drive down valuations: they more than offset the growth in underlying earnings. So what are investors’ biggest concerns today, and will they continue to drag down equity markets in 2019?

A looming US recession?

This year’s hullabaloo seems to be about whether or not the US will fall into recession in the next 12 months. To be sure, we expect the US economy to expand far more slowly in 2019, reflecting tightening monetary policy, an adverse export climate due to protectionism, an overvalued dollar and the sugar-rush nature of Donald Trump’s tax cuts.

Still, our favoured indicators suggest that there is a less than 5% chance of a recession occurring in the next three to six months. Indicators that provide visibility beyond that are hard to find. Using the yield curve (the difference between the yield on a longer-term US Treasury bond and a shorter-term Treasury bond), we estimate that there is a 19-25% chance of recession occurring by the end of 2019. The yield curve inverted (shorter-term yields higher than longer-term yields) in anticipation of all of the last nine recessions, while sending just two false signals.

However, investors must be careful. The length of time between inversion and actual recession is very inconsistent. And it is always long. Since the mid-1950s the yield curve has inverted on average 14 months before a recession. Equity markets only lead recessions by three to six months. Selling equities as soon as the curve inverts could cause you to miss out on rising equity markets for rather a long time (since 1980, US equities have returned 12% on average in the 12 months after inversion). In short, the yield curve is a poor timing tool to help with the equity/bond allocation conundrum. The most important investment implication of an inverted yield curve is that defensive parts of the market are likely to outperform.

The case for defensiveness

Indeed, there’s quite a case building for tilting exposure towards stocks and sectors with more defensive attributes. The annual rate of change in our global leading economic indicator has been negative for a few months now. We don’t expect it to bounce. In other words, global economic growth is likely to be reasonable for the time being, but growth is slower than last year. This second derivative has an exceptionally strong correlation with the performance of cyclical sectors relative to defensive ones. The growth of money and deposits circulating in the major developed economies has also fallen to the slowest pace since 2011, after adjusting for inflation, and this may weigh on cyclically exposed earners too.

Finally, while employment and personal incomes continue to grow faster than their underlying, long-term trend, consistent with the expansion phase of the business cycle, they may be nearing their limits. Again, defensive sectors tend to outperform during the subsequent phase of the cycle, the slowdown phase.  

Some investors are wondering if so-called “value” stocks are about to have their time in the sun again, after being out of favour for most of the last eight years. We’re doubtful. For sure, value stocks do tend to outperform when bond yields rise, but not if interest rates are rising during the slowdown phase.

We have also noticed that the performance of value stocks relative to “growth” stocks has moved in sync with the performance of banks relative to technology companies. In other words, banks and technology stocks can be seen as a proxy for value and growth, respectively. We have been writing throughout 2018 about the risk of regulation to technology firms (see our Insights magazine), but even against this backdrop banks may still struggle to beat them as liquidity tightens and money growth slows. This supports our current view that value will struggle to outperform growth.

Don’t fear the Fed

The two biggest risks are, to our mind, likely to remain US monetary policy and the Sino-US trade war.

We have remained sanguine about the path the Fed is likely to tread, holding that structural impediments will prevent it from raising interest rates more than two or three times in 2019. The December Fed Open Market Committee meeting provided the confirmation we were looking for.

Quantitative tightening is not likely to make a significant difference to asset prices. QT is proceeding in an orderly fashion, well flagged to the market. The pace is very slow indeed. When the Fed started to shrink its balance sheet in October last year, it held c.$2.5 trillion of Treasuries and $1.8 trillion of mortgage-backed securities (MBS). Today it holds c.$2.25 trillion of Treasuries and $1.65 trillion of MBS.

Our meta-analysis of the academic literature on the effects of QE suggests that all four phases lowered the 10-year Treasury yield by between 1.05% and 2.37%. So, assuming the impact of QT is symmetric, the 8% reduction in the stock of assets as part of QT is unlikely to have made much of an impact.

An uneasy truce

Investors had held out hope for a de-escalation of the Sino-US trade war, hopes that were briefly lifted following an apparent ceasefire reached at the G20 summit in late November between Presidents Trump and Xi Jinping. But we can’t bank on this cessation of hostilities lasting.

With his tweet in early December boasting that he was “a tariff man”, Donald Trump arguably broke the resolve of investors. Just days earlier, the two sides had agreed to put further tariffs on ice for three months, with China reportedly phasing out 40% tariffs on US-made cars and buying more American agricultural supplies.

But this was always going to be fragile. Mr Trump’s aggressive tweeting implied that little headway had really been made and that – if it had – he was virtually ripping that understanding up and pushing even harder for more. Putting Mr Xi, his Chinese counterpart, in such an antagonistic position makes an acrimonious end even more likely. A resurgence in tariffs between the two sides would squeeze global trade, hampering economic growth and making it harder for China to reform itself and keep its debt problem in check – especially if it has to pour more stimulus into the marketplace.

Value in emerging markets

In last year’s outlook we looked for some outperformance of emerging markets, though we did also give this caveat – unless the dollar continues to strengthen. It did, and emerging markets have struggled this past year. Yet the dollar looks unlikely to climb higher as we enter a new year. Sentiment was not helped by some local crises brought on by structural weaknesses of Turkey and Argentina. But as we’ve noted these were local issues, and broad emerging-market weakness is presenting some value opportunities.

Europe’s fragility exposed

Europe’s fragility was exposed again in 2018 by a still precarious banking sector and an Italian polity that refuses to acknowledge the paramount need for reform. As we enter 2019, business and consumer sentiment has softened and GDP growth has slowed again.

An expansionary Italian budget has caused debt-laden Rome to clash with Brussels, and Italian government borrowing costs to surge. Importantly, borrowing costs in other peripheral European economies stayed low. It is more a national than international issue and there is no evidence to suggest Italy could be the cause of a region-wide recession.

Some commentators are talking somewhat hyperbolically that Italy may cause the rapid disintegration of the euro system. This does not reflect the Italian government’s political capital or the sentiments of the average Italian voter. It’s worth bearing in mind what happened in Greek politics in 2015. The extremely euro-sceptic Syriza that came to power in January had transformed themselves to a europhile party in just eight months! Why? They ultimately understood that default would be devastating economically and that it would end their careers.

An update on Brexit’s unknowns

In August we produced a Brexit decision tree, which suggested what we are calling a “never-ending story” was the most likely scenario. By this we mean a Brexit deal de minimis, with the salient details still to be hammered out during an extended negotiating period.

We now know that a can-kicking, bare bones deal is the only deal that the government intends to present to Parliament. The “Irish backstop” – an insurance policy to ensure Ireland’s border with Northern Ireland remains open – makes ratification contentious. Essentially it means that Northern Ireland would stay aligned to the rules of the EU single market programme at the end of the transition period if no deal was agreed. It would also involve a temporary single custom territory, which would keep the whole of the UK in the EU customs union until a wider deal or a technological solution can be agreed by both sides.

We don’t know if the deal de minimis will pass Parliament. But as we noted when we first published the decision tree, there is still information in saying “we don’t know”. The most staunchly pro-Brexit Conservative MPs may be brought around if the alternative is a second referendum and the risk of no Brexit at all. Given the bare bones nature of the rest of the deal, they may feel it is better to guarantee Brexit and then shape its nature subsequently. 

Europhile Conservative Dominic Grieve and some fellow rebels, such as Nick Boles or Damian Green, would prefer to maintain a Norway-like close relationship with the EU. If such an arrangement is tabled, a grand coalition in the House could form to pass it, but given the parliamentary arithmetic it would probably need some of Theresa May’s loyalists to join the mutiny.

We believe a second referendum is a more likely outcome. It could also arise if Mrs May is unable to extract any extra assurances from the EU about the nature of the Irish backstop, given that the government has started to reveal a reluctance to avoid an “accidental” hard Brexit. We do not pretend to know what nature it would take – a choice between remain, no-deal or including Mrs May’s deal as an option. We’ve assigned equal odds to all three. 

The most likely outcome is still the “never-ending story”. In fact its odds have increased to 56%, from 40% previously. To be clear, the never-ending story may ultimately end in either a soft or hard Brexit down the line. Indeed, we think it probably increases the chance of a softer Brexit, but we’ve constructed this decision tree with a one-year time horizon. Unfortunately, this never-ending story would mean that the cloud of uncertainty hanging over the economy would remain, continuing to weigh on UK financial markets and delaying business investment. The next likely scenario, at 21%, is still a no-deal/hard Brexit.

You may recall that we left a general election out of our decision tree, even though it could theoretically sever any number of branches. We excluded it because a new government may just loop us back to the top of the tree, and a Jeremy Corbyn-led government may have much bigger implications than Brexit.

As before, we assessed the impact of each outcome on five key asset classes: sterling, UK-listed multinational companies, more domestically focused UK companies, and both conventional and inflation-linked UK government bonds (“gilts” and “linkers”). We haven’t changed anything here, other than the probabilities we assign to each scenario and therefore the probability-weighted outcomes.

On balance, sterling is still likely to appreciate and UK multinational companies should also do well. Performance is likely to be unusually volatile until one of our scenarios is certain: risk-adjusted returns could be unfavourable. Nevertheless, the exercise shows that there is some risk of sterling gains, which could erode returns from overseas assets given the current political outlook. “We don’t know” doesn’t lead us to “sell the UK”.

For a more detailed analysis from our Brexit decision tree, see our recent InvestmentUpdate: Shedding light on Brexit unknowns part II at

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