By Tim Sharp, Managing Director, Hottinger Investment Management
A brave new world outside of the EU failed to materialise in the UK as deep-seated differences continue to prevent a majority in Parliament signing up to the withdrawal agreement. Prime Minister May has managed to secure a flexible extension, but there is a real possibility that the UK will participate in European elections on May 23 and Nigel Farage has risen again in the form of the Brexit Party.
The UK economy was strong during the first quarter, arguably due to inventory building and contingency measures aimed at mitigating any fallout from the prospect of EU withdrawal, but now we fall back into the continued uncertainty that causes corporate long-term planning to be kept on hold. The labour market remains strong and basic wages are on the increase so inflation prospects keep the Bank of England on its toes, although it is difficult to see how the central bank can plan economic measures with Brexit uncertainty potentially affecting the wider economy until October. Export orders fell to their lowest level since August 2018, and the second-lowest reading since October 2014, as there are indications that international businesses are re-routing their supply chains away from the UK. The pushing back of the exit date from the EU means that UK equities will remain unloved, although we think that the upside potential remains for when certainty over the environment in the UK returns.
Continued strength in equities and risk assets generally in April can largely be accredited to promising data emanating from attempts by the Chinese to stimulate their economy once more and continuing optimism regarding the imminent signing of a US–China trade agreement. We have previously highlighted the close ties between Chinese and European trade, so it is probably unsurprising that European equities enjoyed the most positive reaction, gaining 4.5% over the month compared to 2.25% for the FTSE UK All-share and 3.9% for the S&P 500. Eurozone GDP data also suggested that Italy has emerged from recession while Spain, Germany and France also showed healthy improvement despite the gilets jaunes protests.
Q1 US GDP figures in April came in strongly at 3.2% (annualized), but they obscured signs of underlying weakness. Contributions to GDP from consumption and non-residential investment declined markedly last quarter, with a collapse in imports and a rise in inventories artificially raising the GDP figure. Core US inflation has fallen from its 2% target, which we think is largely due to low producer price inflation in China that has passed through to US imports. On the plus side, this gives cover to the Fed to maintain its dovish stance, lowering the chance that it delivers a surprise interest rate hike during the year.
The April FOMC meeting failed to deliver the rate cut that would have proved the existence of a “Powell Put” to investors, thereby disappointing equity markets. After earnings expectations were revised sharply lower during Q1 2019, there was a solid start to the Q1 earnings with many companies able to deliver positive surprises as part of the usual analyst manipulations. This has led to the return of the outperformance of cyclicals vs. defensives in April but we would argue that the long-term prospects for consumption and investment will see earnings struggle in the second half of the year.
The fact that the S&P 500 is up over 17% so far this year – standing at 2,923.73 – leaves it close to the 2019 predictions of many investment bank analysts (which ranged between 2,400 and 3,000) despite evidence that all major equity markets have seen significant outflows this year. As the rally continues, there is a risk of investors feeling as if they have missed out on potential gains and re-entering at higher levels, thereby creating a “melt-up” in equity markets. Although irrational behaviour by market participants can never be ruled out, this is classic end of cycle anxiety and, should it occur, our discomfort with current dynamics will deepen further.
In previous reports, we have expressed a level of scepticism over the perceived opportunity in emerging markets due to our uncertainty surrounding the expected weakness in the US dollar. Over the past week, many FX analysts have reversed their position on dollar weakness (at least in the short-term) in the face of a stubbornness in the currency to yield. Three of the main currencies (USD, EUR and GBP) have all maintained their position on a trade-weighted basis largely at the expense of the Chinese Yuan over the last month, which has seen emerging markets underperform in dollar terms.
We have raised awareness in the past of the potential impact of the growing level of passive investment in financial markets and we further suggest that this growing investment phenomenon is masking the fundamentals of price discovery in equity markets. More investigation is needed, but there are early signs that this may be affecting the effectiveness of factor investing generally. Long-short funds have been subject to negative momentum and high correlation with long-only equity, meaning that their risk-adjusted returns have been substandard. In the last month, we have re-balanced away from these long-short funds to corporate bonds and more traditional fixed income products.
Our investment strategy committee, which consists of seasoned strategists and investment managers, meets regularly to review asset allocation, geographical spread, sector preferences and key global market drivers and our economist produces research and views on global economies which complement this process.
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