By Tim Sharp, Hottinger Investment Management
Global tensions and softening economic conditions disrupted the thoughts of many market practitioners as they relaxed on vacation; a combination of previously tightening monetary conditions, the intensifying US-China-EU trade war, and the secular slowdown in China have – we believe – all contributed to the downward shift in global economic activity. In Europe, export-facing manufacturers continue to struggle as China reduces demand for capital goods and car manufacturers wait as the US considers a round of tariffs aimed specifically at the industry.
The data released in August confirmed the trend towards a coordinated global slowdown that we have been signposting for the best part of the year. US Q2 growth came in at 2.1% annualised (vs 3.1% Q4 2018); in China, Q2 expansion was 6.2% annualised (vs 6.4% Q4 2018), and for the euro area the Q2 quarter-on-quarter growth rate was 0.2%, down from 0.4% in Q4 2018. Within the European region, two major economies – the UK (-0.2%) and Germany (-0.1%) – contracted over the quarter, whilst Italy saw no growth.
The rally in global government bonds continued, while in equity markets there was no sign that the great valuation divergence between US equities and Developed Market-ex US equities that has opened since the early 2010s was beginning to close. US Treasuries rallied 3.60% with the biggest gains in longer-dated maturities, where 30-year bond yields fell below 2% for the first time and 30-year German Bund yields joined shorter-dated bonds in negative territory, finishing the month at -0.179%. The US Federal Reserve has done more than any other central bank in ‘normalising’ monetary policy in the last few years; higher rates do not seemed to have constrained US domestic activity but the offer of higher yields has kept the dollar strong despite many predictions to the contrary, which has underlined our decision to be wary about further investment in emerging markets.
The rally in US equities during 2019 (+16.74%) has been based almost entirely on valuation expansion rather than a sustained uptick in earnings. However, the fall in the S&P500 of 1.81% in August stems from the anxiety that central banks will be unable to prevent the global economy dipping into recession in 2020. This means that earnings estimates – although they have weakened significantly throughout the year – are probably still too optimistic (according to Morgan Stanley). European equities were also down -1.34%, and Japan fell 3.80% while emerging markets struggled and fell -5.08%.
Late cycle is a challenging time for investors. The conventional wisdom, for the US at least, is that an inverted yield curve is a leading indicator for recession, and recession – in so far as company earnings are likely to underperform – is usually bad for equities. However, while an inverted yield curve may well be a leading indicator, it is a fairly blunt one. On previous occasions during which the US Treasury yield curve inverted, it took anything between six months and two years for a recession to actually materialise. In that time, equity markets can continue to rally until falling earnings take valuations to unsustainable levels.
Consumption has driven the UK economy since the EU referendum, with households cutting their savings rate and liquidating foreign holdings to keep the economy buoyant. Following the election of Boris Johnson to leader of the Conservative party and, therefore, Prime Minister, a more hardline approach to the Brexit negotiations was generally expected. However, the decision earlier this week to prorogue parliament from September 9th until the new policy agenda is announced in the Queen’s speech on October 14th was largely unexpected and met with widespread opposition.
Given the heightened political risk of both a disorderly Brexit and the election of a Corbyn administration, we believe that UK gilts are overbought. The UK gilt market gained 3.76% over the month and 11.29% year-to-date, with the 30-year gilt yield falling to just 1%. This is notwithstanding the high level of UK inflation expectations, which suggest that inflation could rise towards 3% in the coming months. Nevertheless, the UK controls its own currency and it is not inconceivable that future coordination between the Bank of England and the Treasury could lead to a policy that holds the yield curve down, to the benefit of investors who are already in the market.
As the pound bounced back 0.34% during August after the weakness caused by heightened no deal fears, the FTSE 100 (-5.68%) outperformed the FTSE All-Share (-4.38%) on the downside. That aside, moving towards October 31st we are seeking solutions to protect capital but still maintain upside participation to equities, as well as looking to rotate into large cap UK stocks that have greater exposure to foreign sources of earnings and are better prepared for a hard Brexit.