By Tim Sharp, Hottinger Investment Management
Global monetary conditions remain tight and the risks for financial markets are that we may indeed be in late cycle, which could mean a global recession is likely within 12 months. This remains our base scenario and will be the reason we maintain our cautious stance in the near term, with the next likely inflection point around the beginning of the 2nd quarter. This will coincide with 1st quarter reporting, the selection of the Democratic candidate for the US presidency and also takes into account the fact that equity markets historically tend to try to predict economic outcomes 9 months ahead based on current economic forecasts.
Stock markets started the year strongly, buoyed by positive sentiment following agreement of a Phase 1 US-China trade deal and the strong majority of the Conservative party in the UK general election. US stock markets continue to lead the way, with technology stocks once more at the forefront of market movements. The S&P 500 is flat on the year while the tech-heavy NASDAQ was up 1.5% on the month despite anxiety at the outbreak and spread of the coronavirus in China, Asia and more widely, which has checked performance in other stock markets. European indices are down on average 2.5%, Japan 2.9% and the UK 3.0%. The strength in UK equities seen towards the end of 2019 had largely played out by the start of the year, when the focus returned to the relatively short time period available for a new trade deal between the UK and Europe to be agreed. Our most recent investment strategy meeting took place on the last day of the UK’s membership of the EU, with withdrawal taking place at 11pm on January 31st. This leaves the parties just 10 months in which to agree a deal within the existing timetable.
Government bonds have rallied since the outbreak of the coronavirus, which threatens to reduce Q1 GDP in China to 3.5% year-on-year from the 5.5% year-on-year predicted[i] with obvious knock-on effects to its largest trading partners including Asia Pacific, Japan and Europe. 10-year US Treasury yields have fallen from 1.92% to 1.51% and Gilt yields from 0.82% to 0.51%. The safe haven qualities of the US Dollar have also seen it strengthen 1.1%, once more painting a rather different scenario to that forecasted by many investment banks coming into 2020, albeit in the light of an unexpected epidemic. A strong dollar tends to reflect tight global monetary conditions and high funding costs will discourage foreign banks from lending dollars, meaning this position may persist.
The coronavirus is predicted to have a significant effect on Chinese Q1 growth, particularly due to the fact that it came to light just before the Lunar New Year celebrations. This will also affect the prospects of the Asia region as a whole, which many had predicted would be the catalyst for maintaining positive growth globally. However, this may only suppress spending in the short-term, with the possibility of a spike in demand once the worst of the outbreak has been overcome, rather than causing longer-term damage to global growth prospects, but which of these scenarios will materialise is currently an unknown. The reaction of financial markets indicates to us the vulnerability investors feel when faced with the potential of a worsening slowdown, leaving the risks firmly tilted to the downside.
The slowdown in corporate earnings over the last year has led to non-residential fixed investment falling in the US. Many forecasters predict that the 4th quarter of 2019 will be a low point in earnings and economic momentum will turn positive this quarter. However, if earnings continue to fall then the capital expenditure recession will persist, putting further pressure on the benign economic scenario being painted. This is why we see 1st quarter earnings as coming at an important time for markets.
European Q4 GDP came in weaker than expected, not just in Germany and Italy but also in France, which had been more robust in the past despite strikes and protests. The coronavirus is likely to weigh on January’s sentiment – surveys showed a small improvement in Eurozone activity, meaning that the expected economic recovery there will be slower than forecast and any sudden rebound is unlikely.
In the UK, November GDP was weaker than expected at -0.3% month-on-month, with both the services sector and industrial production faring poorly, resulting in many revising Q4 forecasts downwards. Furthermore, December inflation figures also came in below consensus and although January PMIs showed a bounce since the election, levels are still at or below long-term averages. The Bank of England’s Monetary Policy Committee will come under further pressure to cut rates over the coming months in order to support the economy.
At the FOMC meeting, the Fed left US rates unchanged and the statement following the meeting was much as before, suggesting that monetary policy remains appropriate despite the emergence of some new downside risks. Chair Powell did describe the coronavirus outbreak as a serious issue but it appears not to be serious enough to affect policy at this time. This reinforces our view that central bank reaction to a worsening economic scenario will be slow and too late to prevent recession.
In terms of asset allocation, we retain our view that a global economy in late cycle bears 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 significantly tested by the spread of the virus. Greater risk aversion by investors could cause capital flight, leading to pressure on low interest rates.
The remaining “known unknown” for investors is the US presidential race and reactions from the Trump administration to potential changes in economic performance that may affect chances of re-election. Furthermore, the Democratic choice of presidential candidate could have a material effect on investors as the current leading candidates have more socialist ideals that may frighten markets.