By Tim Sharp, Hottinger Investment Management
Our final investment strategy meeting of 2019 took place in the aftermath of the UK Conservative Party gaining an unexpected majority of 80 seats and announcement of the US ‘phase one’ trade agreements with China. So far this month the, S&P 500 has hit all-time high after all-time high and the UK FTSE 250 has bounced 4.16% on the back of the strong mandate given to PM Boris Johnson by the British voters and the boost this is expected to give to the UK economy through the removal of much of the uncertainty.
The FTSE 100 may only have gained 2.76% since the election due to the strength of the pound, but 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. We believe that Johnson’s desire to have the final deal date enshrined in law will potentially affect long-term plans as there is still a level of uncertainty as to the type of trade deal that can be agreed, but even so, the log jam of short- and medium-term investment should be eased.
Flash Purchasing Manager’s Indices (PMIs) for December continue 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 US inverted yield curve of the third quarter and the resulting market trauma as the peak of potential recession fears. Over half of the global central banks had cut rates by then; the Fed acted swiftly with 3 rate cuts of its own and the ECB resumed quantitative easing. 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. Capital Economics has predicted that the global economy will bottom out in Q1 2020 and a slow recovery in growth will develop thereafter, although unevenly spread across regions[i]. UBS concedes that 2020 will see lower expected returns on equities, but the firm stills expect stocks to outperform other public assets[ii]. In fact, most investment banks advocate for further investment in equities despite lower expected returns, however we feel that forecast earnings in developed markets over the coming year are far 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, which still allows for a late 2020 / early 2021 period of negative growth, meaning that equity investors should start to become cautious around Easter 2020. As we have already published, the global economy has previously relied on China to add sizeable stimulus in order to prevent recessions, but a China that is currently in transition is unlikely to step in at this point in its own cycle. Without a significant catalyst, 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.
Absolute Strategy Research (ASR) continues to have a 2020 US recession as its central economic view, due to monetary overtightening in 2018 that still leaves monetary policy too tight in 2019, rather than supply chain issues leading to a blip in trade – a characteristic of a mid-cycle slowdown. This aligns with our own late-cycle view. Corporate profits and margins are under pressure, balance sheets remain levered and the recent rally in equity markets leaves very few investors positioned for a recession, meaning that such a scenario will have a notable effect on risk assets should it materialise.
Our recent dollar article outlined a scenario for a stronger dollar again in 2020, which also looks like a contrarian argument with many forecasters using the Fed‘s decision to hold rates as a signal that a weaker dollar will boost emerging markets next year. ASR believes there is less room for dollar appreciation against developed currencies, but unless there are clear signs of recovery in global growth outside the US, a broad dollar decline is unlikely.
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, so we have been looking at potential medium- and long-term opportunities there. Furthermore, we have increased our allocation to UK assets, particularly for UK investors, in the light of the recent general election result and the expected increased optimism for the UK to start to close the valuation gap that has opened since the 2016 referendum.
[i] What to expect in 2020 – Capital Economics, The Chief Economist’s Note, 16 December 2019
[ii] UBS House View, Monthly Letter, Chief Investment Office GWM, 12 December 2019