By Tim Sharp, Hottinger Investment Management
The S&P 500 has had its most successful half year since 1997, rising 17.35% following signals from Fed Chairman Jay Powell that the Federal Open Market Committee (FOMC) is on the verge of a rate cutting cycle. Based on 12-month earnings estimates, the index is trading at 17x, vs its 10-year average of 14.8x, last reached just before the sell-off in 2018. This shows that upward revisions in earnings have not been forthcoming, as Philip Georgiadis reported today in the Financial Times.
Markets have been pricing in more aggressive monetary easing from the Federal Reserve, as indicated during the June FOMC meeting mid-month, when Powell was quoted as saying “an ounce of prevention is worth a pound of cure”. The S&P 500 gained 6.89% on the month, leaving the Euro bloc (4.93%), the UK FTSE 100 (3.68%) and Japan’s Nikkei 225 (3.27%) languishing in its wake. Markets now expect three or four 25bps rate cuts by the end of December, which may mean a cut at four of the next five meetings of the Federal Reserve Board. Despite falling inflation in the US providing cover for rate cuts, the Committee expressed scepticism about the likelihood of the expected 100bps in cuts happening, which, if it turns out to be well-founded, could cause a tanrtrum in equity markets and a rise in bond yields.
The move by markets to expect central banks once more to bail out risk asset markets was matched by the European Central Bank (ECB), indicating that further stimulus could be forthcoming. Regardless of whether investors bought equities, corporate bonds, developed market government bonds or indeed gold, the latter of which rallied 7.96% to $1409/oz, these investment decisions would have yielded a positive return in June. The threat of lower rates in the US pushed the dollar index down 1.66%, which partly explains the rise in gold and the strong performance from emerging market equities, which were up 5.70%.
This leaves the financial markets with a dilemma as to whether the global economy is in late cycle or indeed mid-cycle. This is because the timing of the next round of stimulus will either catch the falling global economy and keep the expansion going, or it will merely soften the effects of the weaker environment now showing itself but fail to prevent an economic downturn. In line with research from Morgan Stanley, we think that interest rate cuts in late cycle will likely coincide with declines in equity markets shortly afterwards. Central banks often overshoot with rate rises and these take time to work their way through the economy; by the time the rate cuts come through, the economy is often in a slower gear. If, however, we are mid-cycle, rate cuts – such as those seen in the 1990s – might actually support equity markets.
Global manufacturing Purchasing Managers’ Indices (PMIs) remain suppressed, as hard data on shipping volumes and inventories suggest that global trade is slowing. Export and import growth in China has dimmed, and European industrials in major exporting countries continue to disappoint despite a brief glimmer of hope in April. Notwithstanding a boost to the US growth outlook through retail trade and industrial production prints, the country is unlikely to sustain the current 3%+ annualized rate of growth.
The extent of the effect of the US-China trade war on the global economy became more evident in June with the release of global manufacturing statistics. Manufacturing surveys around the world have been falling – most notably in the US, China, Japan and Europe – leaving global new orders at the lowest point on record and business optimism pointing to falling output. South Korea, often used as an indication for the global market, saw exports fall year-on-year by the biggest margin for 3 years. In the UK, the PMI data fell to 48 in June vs 49.4 in May, the lowest level since 2013, suggesting a fall in output for 2 consecutive months. Many industries are suffering from the continued Brexit hangover as inventories are run down after the build-up prior to the original leave date in March, but many are also pointing to continued weakness in global export markets.
The UK continues to be dominated by the Brexit narrative and the Conservative leadership campaign that will decide the next Prime Minister before the deadline to leave the EU on 31 October. It remains to be seen whether and how either candidate will be able to negotiate a deal with the EU, persuade Parliament to leave without a deal or indeed unite the Conservative party to solve the impasse. Effective government has largely ceased in the UK, so companies will be relying on the Bank of England to join the central bank moves to add further stimulus to reinvigorate the economy. Uncertainty saw the pound fall back into negative territory for the year in June, weakening -0.65%, and gilts were unchanged despite the rally in sovereign bonds in other developed countries.
The G20 meeting on the last weekend of June saw the US and China agreeing to continue trade talks with no escalation in tariffs, taking away the immediate fears of financial markets, with the added good news that the US softened its rhetoric surrounding the security questions of trading with Huawei. The ongoing uncertainty will continue to weigh on sentiment, but we can expect short-term relief that the can has been kicked a little further down the road.
We join the many investors who have decided to wait and see whether central bank policy manages to reaccelerate global growth or fails to prevent it slowing further, which will offer an indication as to how late in the economic cycle we currently find ourselves. Equity valuations are elevated and US 10-year bond yields have reacted to the Fed’s comments by dropping from 2.26% at the end of May to 2% by the end of June, as asset classes once more become correlated and some traditional relationships break down. A rate cut in July is likely, which should provide opportunities for profit-taking, however the longer-term outlook from the Fed meeting should really inform the global picture for the second half of the year.