Monthly strategy meeting upholds the late cycle view

By Tim Sharp, Hottinger Investment Management

Events in global markets in the month running up to our latest monthly investment strategy meeting suggested that investors were feeling more optimistic about the prospects of phase 1 of the US – China trade deal being agreed in November. The outperformance of the Nasdaq, Dax, Nikkei, Hong Kong and Chinese equities suggest that a move back into cyclicals after the brief rotation in August / September has been underway.

Global Purchasing Managers Indices (PMIs) readings have been pointing to slowing manufacturing and service sector growth, with the global composite reading around 51.2. This is consistent with very slow growth and its lowest reading since 2016. However, employment data remains strong, giving hope to investors that the consumer may well save the world from recession. Earlier in the year it looked as if the US consumer would again ride to the world’s rescue, however, real consumption growth has slowed from 4.6% annualised in Q2 2019 to nearer 2.5% in Q3 2019, with many expecting this to continue into next year.

Mario Draghi’s final ECB meeting kept policy on hold as expected, but he is likely to voice his support for fiscal easing. October’s Eurozone composite PMI rose marginally to 50.2 vs. 50.1 in September. This was below consensus and disappointing after the significant fall in September, suggesting that there is very little economic growth in Europe at present. Over half of the world’s central banks have cut rates this year and it is likely that we will see another cut from the Fed FOMC in either the November or December meeting.

By the end of Q2 2019, the US economy was already decelerating. Expanding by 2.0% on an annualised basis is a level much closer to the country’s trend rate and heralded the end of the very high rates of growth of 2018, fuelled by tax cuts and government spending.

The effect of slashing corporation tax last year and the change in the treatment of capital expenditure (CapEx) has now waned as the deadweight of new tariffs and growing uncertainty over the international trading environment have combined with the waning effect of the tax cuts. In Q2 2019, investment spending actually fell by an annualised 1.0%, the sharpest fall since Q4 2015. This coincided with poor S&P 500 profits, which came in below forecast and well below the levels required to justify current valuations. In September, the ISM PMI signalled that the US manufacturing sector may be shrinking, as a reading below 50 was recorded for the second successive month.

The outlook for the UK economy remains highly uncertain. As our committee met at the end of last week, the UK was in the middle of a debate on the latest withdrawal agreement put forward by the Johnson government, but the outcome is unlikely to prevent GDP growth from dicing with recession, with manufacturing remaining weak. Employment remains strong and inflation remains relatively high – so much like in the US, the tiring consumer remains the main source of strength. The rally in sterling during the Brexit negotiations has caused significant underperformance in the FTSE 100 this month, but it is true of all UK firms that it is difficult to make medium to long term plans without a clearer pathway for the economy after a Brexit resolution.

During this month’s strategy meeting, the key views debated included concerns over the continuing slowing of the global economy with little sign of an inflection point in the cycle. This has led to more aggressive policy responses from central banks globally, however, the ECB and BOJ have fewer tools at their disposal and the Fed seems to be convinced that the US economy is mid-cycle. Our most recent website article highlights the view that China is reluctant to reflate, and that the global economy has relied on China stimulus on previous occasions to stave off recession. The implication is that the aggregate response is unlikely to be enough to prevent global recession in 2020.

In terms of asset allocation, we retain our conviction that late cycle investing bears a heightened risk of equity drawdown. This risk exists in the United States, much of Europe and the UK. We have taken a number of defensive measures over the last 12 months: increasing allocations to cash, precious metals and government bonds; cutting emerging market exposure; rotating sectors within equity and making use of capital protecting structured products.