Market Commentary

Charlie Parker
Charlie Parker
13-02-2020

Overview
It has been a positive 12 months for equities, bonds and precious metals, with US equities, gold and sovereign debt in the vanguard. The first month of 2020 has seen a correction. The US is pretty much flat for the month (+0.4%) with the other major equity markets in negative territory. In the main this has been triggered by the emergence of the coronavirus in China, and increasingly elsewhere in the world. We have some past precedents that enable us to attempt to predict the outcome of the virus and its impact on growth, but we must approach this with great caution. In reality we do not know the extent of the impact. We can be confident though that there will in the short-term be an impact on global growth – focused on China and emerging Asia. The SARS epidemic in 2003 is not a reliable parallel given that the Chinese economy and global reach is significantly greater now than it was 15 or so years ago; we tend to forget just how quickly China has grown.

Given China’s trade ties we expect the effect to be felt first in Asian and Emerging economies but supply chains for companies like Apple and Walmart will be on the list too. In 2003 markets were beginning to recover from the bursting of the TMT (telecoms, media and technology) bubble of 2000, so the SARS effect was short lived.

Perhaps the biggest surprise over the past 12 months has been in bond world and in the UK gilt market in particular. Yields at the beginning of last year were 1.3% and given the flight to safety as the equity markets correct are now down to 0.5% having been as low as 0.4% in September. Again, bond markets globally have reflected the powerful narrative that everyone believes that everyone else believes that the central banks will keep printing as governments promise more and more spending. We should however be mindful of the fact that UK government spending is heading yet higher. Moody’s warned it might cut Britain’s credit rating again, unless there were signs that the government would tackle the high borrowing levels, which just isn’t on the agenda.

In the US, the Federal Reserve have had to pump significant amounts of liquidity into the repo market to keep control of short term interest rates which spiked to 10% from their official rate of 1.5%. Whether or not this amounts to quantitative easing or not is a moot point but the markets have assumed that it is hence the all-time highs in the S&P at the beginning of January. According to the Fed the repo “crisis” was mainly a question of month end funding by the banks but as they slowly started to reduce lines of credit the market started its move downwards now exacerbated by the coronavirus issue.

The UK has left the EU, but we now have potentially another 11 months of wrangling over the fine print. Given the slowing global economy. Germany in particular will not want to see its second largest export market in Europe trading on less favourable terms. The German Bundesbank said that negative interest rates are encouraging banks in take on ever greater risks, expanding their lending to “relatively high-risk businesses” while simultaneously reducing their provisions. German lenders have also increased their exposure to the fast-growing domestic real estate market, while the Bundesbank considers house prices in many cities overvalued by 15% to 30%.

But do the central banks have any other option than to keep the plates spinning and continue to provide accommodative monetary policy through further rate cuts and more quantitative easing and thus support financial markets? For the time being it doesn’t look like it does it?

UK
The UK has now legally left the European Union but the fine print is still to be “negotiated” so expect continued volatility in both equity and currency markets. Post-election spending will help buffer the UK economy from the global slowdown and businesses will be more inclined towards capex and merger and acquisition activity. We believe that ultimately investors in UK shares will be rewarded by the cheaper valuations on offer here than other developed markets.

Sterling strength will be more of an issue for investors in overseas markets but bear in mind that Brexit is still not a done deal and we are still likely to see a lot of volatility in currency markets as we have already seen since election day. On a valuation basis the UK is at its cheapest relative to global markets since the 1990s.

US
The trade war with China has undoubtedly helped the global economy into a downturn especially in Europe, Asia and Japan and the outbreak of coronavirus is not helping either. Because its service and consumer sectors dwarf manufacturing in their contribution to GDP the US is, thus far, the least affected, which may account for the high levels of consumer confidence and the low levels of unemployment. However, both data series often reach such extreme levels as a precursor to a recessionary phase, something apparently beyond the ken of a twittering president.

But could this time be different? If the Fed supply large quantities of QE one effect will be a weaker dollar which will make imports more expensive and create inflationary pressures, which, in turn, should lead to higher wage costs in the economy and with it higher spending power, but at the cost of lower profit margins. Lower rates will help cushion the blow as will QE if it does reach all parts of the economy and not just the financial sector. We suspect the Fed will not use QE in a significant way until forced to by a market dislocation which could well arrive via the bond market.

The US / China trade deal was signed but to no great effect, leaving the main concerns over intellectual property rights and technological “invasion” for another day. This is all about “national security” on both sides of the Pacific.

We are now in election year and the first of the primaries is nearly upon us and Bernie Sanders has started to make some surprising headway. The markets have yet to factor in anything other than a Trump victory in November.

The January correction doesn’t show up on a long term chart and it would take a fall below 2700 to mark a change into bear market territory. However, on a valuation basis the US is a long way above a reasonable price level.

Europe
The European economy has weakened rapidly, led by Germany, unarguably the powerhouse of the EU. Much of this has been triggered by the US / China trade wars, but we mustn’t forget that Trump has his eyes on Europe too, which won’t help either. The spotlight is also on the direction of travel of the auto industry, a very large part of the German economy, where the shift to EV is creating many problems not least of all that battery power may not be the best answer and that hydrogen powered cars will be the real future. There continues to be concerns over the European banking system. Unlike in the US, the European banks did not recapitalise after the great financial crisis. Manufacturing PMI and Business Climate surveys have both picked up which is a positive if the downtrend has in fact ended; a supposition rather clouded by the outbreak of coronavirus.

Christine Lagarde has now taken up the reins at the ECB. She will need to use all her political skills to persuade the other members that further rate cuts and QE are necessary although how effective that plan will be is becoming ever more doubtful. The central banks are running out of ammunition and Draghi again commented at his final press conference that accommodative fiscal action will be needed requiring something of a volte face from the EU Commission and the northern European economies. By “fiscal measures” they mean much more government spending which will mean more debt issuance which will no doubt end up back at the ECB. Let us see how that turns out.

The European indices have collectively failed to regain the pre financial crisis peaks and have been range-bound ever since.

Japan
On a yield of 2.3%; a level last seen in 2012, with earnings are expected to grow by 7% a year for the next two years and trading on 13 years’ earnings the Japanese market represents very good value. Confidence and manufacturing surveys have been trading sideways since 2010 and although the series have been deterioration of late, they are in better shape than the major western economies.

In the short term the market has had an impressive run but is well above the long-term trend mean and is at significant resistance at 24000 that has repelled advances twice in 2018. The sales tax hike has brought retail sales forward and a negative print for GDP is likely for Q4 which may well be an opportunity for seekers of value. A break above 24000 would confirm our suspicions that this market is due for a significant rerating.

Asia Pacific & Emerging Markets
The Asian and Emerging economies will be the main contributors to market returns in the years to come. A burgeoning middle class with access to cheap borrowing will be the drivers. They have been and will continue to be far more volatile than their western counterparts; currency issues – dollar strength in the main and corporate governance will exacerbate this trend, not forgetting to mention the coronavirus outbreak- but higher volatility generally comes with positive outcomes; higher prices in the long term.

The question is whether the institutional buyer, vital for long term traction in any market, is being put off by the lack of concern many emerging market sovereigns have regarding property rights. A surprising number have been burned in Argentina, including the IMF whose bail out came with the wrong set of strings attached. Investing in these markets requires an idiosyncratic outlook; passive investing won’t help you here.

For much of 2019 dollar strength (the green line on the chart) has been a headwind. If we do indeed see dollar weakness, then that would provide some impetus, as we saw between 2002 and 2008, but it won’t necessarily overcome the effects of a global economic slowdown and a protracted trade war in the short term.

Oil
$50 is still providing support for crude and this is currently being tested as the effects of the coronavirus epidemic are suggesting a further economic slowdown and with it reduced demand for energy. Again, a depreciating dollar would be a positive for the oil price again as evidenced by the period from 2002 to 2008.

Gold
Gold has enjoyed an impressive rally and the long base formation since 2013 has resolved to the upside. The rally however has attracted much speculative attention and rising real yields towards the end of 2019 looked to have capped the upside potential. However, with the US yield curve inverting again real yields are set to fall which is generally good for index linkers, gold and infrastructure. When inflation eventually starts to pick up (we may see more deflation in the short term) the prospects for gold will be on much firmer ground.

Bonds
With bond yields at all-time lows, significant sovereign debt issuance in the pipeline and narrow spreads on corporate and high yield debt, the bond complex is not providing enough return for the risks taken. The conundrum for the Fed is that the government just cannot afford to pay significantly higher rates on its debt. We expect they will continue to reduce interest rates and that bond yields in the US may reach towards the zero bound.

This will maintain US sovereign debt as a risk off asset. The story will be the same in the UK, Europe and Japan, as well as China, as central banks continue to supply cheap liquidity. At some stage in the future this will generate inflation and increasingly negative real yields which will mark the end of the long bond market rally that started 40 years ago; but not yet a while we suspect.

Summary
Central banks globally are slowly loosening monetary policy by cutting rates and / or making financial asset purchases and this is providing a prop for many equity and bond markets. Governments, encouraged by lower rates, are likely to increase spending but will it be productive enough?

  • Government bonds are very expensive – but the flight to quality aspect (risk off) has not yet disappeared.
  • Spreads on corporate bonds, both investment grade and high yield have begun to rise, but still don’t provide sufficient return for the risk taken. There is also significant concern over liquidity risk, despite central bank buying (Europe and Japan) and regulatory stress testing. “Liquidity is a state of mind.” Credit quality is the key here.
  • Equity markets have been buoyed up on cheap money supplied by the central banks. The coronavirus outbreak is causing concern and as we have moved into election year in the US, we expect more volatility.
  • Property is attractive, as a real asset offering a higher spread against most fixed interest markets, but with the gating of many UK “bricks and mortar” funds in 2016 and one fund in December 2019, due to large redemptions, their attractiveness is now questionable. REITs are equities in disguise, but in the long term infrastructure is another potential inflation hedge.
  • Christine Lagarde has taken over from Mario Draghi and is firmly in the dovish camp, so expect continuing accommodative policies.
  • The Nikkei index is not expensive, but short term over bought; domestic issues are preferred.
  • Emerging and Asia Pacific markets are not overly expensive either as a selective long-term position, but they will nevertheless continue to be volatile and affected by the coronavirus outbreak, dollar machinations, currency devaluations, trade wars and Chinese economic weakness as we are seeing currently.
  • Gold is an insurance policy against central bank monetary policy mistakes. Eventually they will create inflation and gold will come into its own.
  • Commodities have potentially reached a bottom relative to equity markets, but no upturn yet. Oil has fallen significantly; confirming the bearish outlook for the global economy. Or do we get a rebound on Fed QE and dollar weakness?
  • The trade war “settlement” was a damp squib but spending promises ahead of the US election will look positive for the economy.
  • Global economies are still fragile and any shock to the system is likely to be met with further central bank “largesse”. As ever, we observe closely for signs of success… or failure

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