By Tim Sharp, Hottinger Investment Management
Equity markets ended the year in an upbeat mood, buoyed by the UK Conservative Party gaining an unexpected majority of 80 seats and the announcement of the US ‘phase one’ trade agreements with China.
UK equities led the way during the month; the FTSE All-Share gained 3.2% on the back of the strong mandate given to PM Boris Johnson by the British voters and the boost this could give to the UK economy through the removal of much of the uncertainty. The more domestically-oriented FTSE250 index of mid-cap stocks rallied 5.2%, thereby comfortably outpacing the more internationally-exposed FTSE100 index, which was held back by a further strengthening of sterling. Many investors are relieved by this result and the expectation is for an almost immediate increase in inward investment into the UK economy from corporate, private and retail sources. Prime Minister Johnson’s desire to have the final deal date enshrined in law could affect long-term plans, as there is still a level of uncertainty as to the type of trade deal that can be agreed. Nevertheless, the log jam of short- and medium-term investment should be eased.
The detente between the US and China was reflected in their respective equity markets; the Shanghai Composite Index gained 6.2% while the S&P 500 returned 2.9%, having hit all-time high after all-time high during the month. In other major regions, European shares gained 1.1% and Japan’s Nikkei 225 index gained 1.6%.
Given the more growth-friendly political environment, it was unsurprising that rates continued to back-up; the 10-year US Treasury yield rose 14bps to 1.92%, the 10-year gilt climbed 12bps to 0.82% and the negative yield on the benchmark German bund narrowed to -0.19% from -0.36%.
The US dollar – often viewed as a safe haven currency – reversed some of the year’s gains during December, depreciating by 1.9% to 1.1229 versus the euro and by 2.6% to 1.3263 versus the pound. Dollar weakness also contributed to gold ending the year at a two-month high of $1,517.
It was a relatively quiet month for economic releases. Flash Purchasing Manager’s Indices (PMIs) for December continued to show a loss of momentum in developed economies during the last quarter. PMIs were higher in the US, lower in the UK and flat in Japan and the Eurozone despite the manufacturing recession in Germany and Italy, which seems to be squared away by better numbers in France. Capital Economics reports that forward-looking measures also suggest export volumes will stagnate in Q1 2020, while G7 jobs growth will soon move sharply lower.
As many investment banks and market analysts start to publish their forecasts for 2020, it would seem that the majority see the inverted US yield curve of the third quarter and the resulting market trauma as the peak of potential recession fears. The combination of this swift action by the main central banks, the US-China trade agreement and the UK general election result has led most to believe that risk assets are once more underpinned, and to conclude that the global economy will most likely stave off recession. In fact, most investment banks advocate for further investment in equities – despite lower expected returns – largely based on expectations of even poorer returns from government bonds. However, we feel that forecast earnings in developed markets over the coming year are too high and open to significant revisions. Most of the scenarios being painted are still plausible within a late cycle environment, so the question then becomes: When will recession hit?
Anecdotally, an inverted yield curve tends to point towards a recession within 12-18 months, meaning that equity investors should start to become cautious around Easter 2020. Without a significant catalyst, as has been provided by China in the past, we remain sceptical about whether the current central bank stimulus will be enough to boost the global economy, so we believe a threat of significant equity drawdown remains.
In terms of asset allocation, we retain our conviction that late-cycle investing bears heightened risk of equity drawdown. We are looking at the correlation between equity markets to investigate the possibility of reducing drawdown through diversification. Our investigations suggest that China and Japan show low levels of correlation to US and European markets. Furthermore, in the light of the recent general election result, we would increase the allocation to UK assets, particularly for UK investors, in view of the expected increased optimism for the UK to start to close the valuation gap that has opened since the 2016 referendum.