February strategy meeting sees short-term risks mounting

By Tim Sharp, Hottinger Investment Management

Global monetary conditions remain tight and the risks for financial markets are weighted to the downside. We continue to believe that there is a tangible risk of global recession within the next 12 months and will maintain our cautious stance in the near term.

The coronavirus has started to affect supply chains, underlining our prediction that the next likely inflection point will be around the beginning of the second quarter. This will coincide with first quarter reporting, the selection of the Democratic candidate for the US Presidency and the forward-looking tendencies of equity markets to be focusing current economic forecasting on Q420.

There is now evidence, as reported by Apple Inc, that the coronavirus is affecting global supply chains and is predicted to have a significant effect on Chinese Q1 growth and the wider prospects of the Asia Region. Japan is now predicted to enter a technical recession in the middle of 2020 – this is based on the slowdown in activity with China, South Korean President Moon Jae-in’s call for “emergency steps” to support the economy and Singapore’s unveiling of a $6.4bn virus-related stimulus package.

We recently highlighted in our China / India article that a 1% drop in China’s GDP will affect global growth by 0.2%, so the fact that the outbreak is having a magnified effect should not be surprising. However, it may only suppress spending in the short term – causing a spike in demand once the worst of the outbreak has been overcome, instead of causing longer-term damage to global growth prospects. It could be argued that equity markets in particular are discounting a v-shaped recovery in trade, growth and earnings, however, equity valuations are looking over-extended, the buy-on-dip mentality seems to be firmly in place, sentiment remains positive and few look as though they are positioned for recession[i].

We feel that current forecast earnings in developed markets over the coming year are too high and open to significant revisions, and we remain sceptical about whether the current levels of central bank stimulus will be enough to boost the global economy, so we believe a threat of significant equity drawdown remains. A squeeze in profit margins has been the reason for the fall in corporate profits over the past year, as wage growth has strengthened across developed markets. The consensus expects 9% EPS growth over 2020, which looks optimistic to us. Absolute Strategy Research (ASR) expects global EPS to decline 4%, with declines of 6% and 9% in the eurozone and US respectively[ii]. EPS growth remains underpinned to an extent by share buybacks that have seen company balance sheets change exponentially as debt is raised to buy back shares. According to Julius Baer, S&P 500 buyback peaked in 2019 at approximately $1trn but is likely to stay high while the cost of equity remains substantially above the cost of debt and the economy continues to expand[iii]. However, fundamentals cannot be ignored indefinitely and a sustained squeeze on profits should be reflected in stock prices eventually.

A strong dollar is a symptom of tight global monetary conditions. There remains a reluctance of international banks to lend US dollars due to the interest differential and it is unlikely, in our opinion, that the recent weakness will last. A weaker dollar would be necessary to support a recovery in global growth outside of the US, and the continuation of a strong risk appetite would be a prerequisite for this depreciation to persist.

The early results in the Democratic candidacy race have been upset by the entry of Michael Bloomberg, who immediately polled in second place behind Bernie Sanders. We continue to believe that the Democratic choice of presidential candidate could have a material effect on investors, due to the strong socialist ideals of some candidates that will frighten markets.

The final risk not being priced in by financial markets concerns the inflation that could result from the squeeze in corporate margins further sustained by the supply-side disruption due to shutdown in China. US Housing Starts and PPI in January both surprised on the upside, and while the FOMC meeting agreed that current policy was appropriate, minutes revealed an active discussion around inflation and financial stability concerns in light of elevated equity valuations and corporate debt.

In the UK, Consumer Price Index inflation rose above expectation in January, at +1.8% vs.+1.3% in December. This was seen to justify the BOE’s decision to leave rates unchanged, although many economists expect inflation to move back down as early as February on the back of lower utility prices. The next potential inflection point in the UK is the March budget, where investors will be looking for commitments to fiscal spending designed to boost productivity. We agree that UK equities are relatively cheap among developed markets, but also recognize that there remains uncertainty as to the final shape of the UK-EU trade deal that may continue to hold back capital expenditure.

Turning to Europe, the euro is the worst performing G10 currency vs. the dollar and fell below 1.08 this month for the first time since April 2017[iv].

 

2 Year EUR-USD Spot Rate. Source: Bloomberg

The second estimate for eurozone Q419 GDP remained unchanged at +0.1% quarter-on-quarter.  There is a growing realisation that growth in the eurozone is weakening again on the back of waning external trade and softening domestic demand, so that the expected pick up in domestic growth over 2020 is unlikely to materialise in the medium term.

In terms of asset allocation, we retain our view that there remains a heightened risk of equity drawdown and we believe that investors will need to become more vigilant around Easter, particularly if the coronavirus outbreak starts to have a material effect on global economic activity in the medium term. The expected support from emerging market economic growth, particularly in Asia, will be tested significantly by the spread of the virus. Greater risk aversion by investors could cause capital flight, leading to pressure on low interest rates.

 

[i] Absolute Strategy Research – Investment Committee Briefing 7th February 2020.

[ii] Absolute Strategy Research – Profits downturn to persist 18th February 2020

[iii] Julius Baer – Asset Allocation Perspectives 5th February 2020

[iv] Capital Economics – Global Markets Update 19th February 2020