October Investment Review: In a holding pattern

By Kevin Miskin, Hottinger Investment Management

With the UK originally due to leave the EU at the end of the month, domestic markets were always likely to be the focus of attention in October. In the event, Brexit was extended by a further three months and a General Election called for 12th December. Boris Johnson and the incumbent Tory government will campaign to “get Brexit done”, the Liberal Democrats and Scottish National Party for the polar opposite, with the Labour Party opting for somewhere in between by offering a second referendum.

Sterling, which recently tested 1.20 versus the US dollar, positively surged towards 1.30 after the UK and Irish leaders agreed there was a “pathway to a possible Brexit deal” at their meeting on 10th October. In fact, sterling was the best performing of the major currencies during the month, gaining 5.3% against the dollar and 2.9% against the euro. The improvement in sentiment was similarly reflected in the bond market, where the ten-year gilt rose by 14 basis points to 0.63%. The Bank of England has flagged that interest rates are likely to remain unchanged until an exit deal is agreed, at which point it would consider tightening policy. In the event of a no-deal exit, rates could go either way as the economic outlook remains highly uncertain – weak manufacturing is counterbalanced by robust employment and healthy consumer sentiment.

The economic dichotomy is similar in the US, where unemployment is at a 50-year low and wage growth solid. Yet, the Federal Reserve’s (Fed) Beige Book, which largely consists of qualitative information, pointed to a slowing economy as the China-US trade war has dampened business activity since early September. Sentiment may have subsequently improved as both parties communicated more amicable statements during October and suspended the imminent set of tariff increases. This improved optimism was reflected in the US Treasury market, where the 10-year Treasury yield rose to 1.77% from 1.66% at the end of September. Simultaneously, the three-month Treasury bill rate fell below that of the ten-year as the Fed unveiled a $60bn-a-month purchase programme to ease short-term funding pressures, thereby reversing the inversion of the yield curve. At the end of the month, the Fed cut its policy rate by 25 basis points and signalled that it would not act again this year, which suggests that it continues to believe the economy is mid-cycle rather than late-cycle.

In Europe, the ECB kept policy on hold as expected. However, its outgoing president Mario Draghi warned that the eurozone economy faces “protracted weakness” due to slowing growth and Brexit uncertainty. He expects rates to remain low and has encouraged governments to turn on the fiscal spigots to drive economic expansion. Despite this downbeat assessment and a disappointing eurozone composite PMI reading, German bund yields extended September’s upward shift across the curve, with the 30-year bund yield moving into positive territory (just).

Economic growth in China continued to slow as a result of the trade war with the US and weaker domestic demand. GDP expanded by 6% year-on-year in Q3, which is slower than expected but still within the government’s target range of 6% to 6.5%.

Global equity markets outperformed bonds on an aggregate basis and ended October at an all-time high, in local currency terms, as measured by MSCI. The outperformance of the Nasdaq, Dax, Nikkei, Hong Kong and Chinese equities suggests that a move back into cyclicals has been underway after the brief rotation in August / September.

The month of October started with a stock market sell-off after the US was given approval by the World Trade Organisation to levy tariffs on $7.5bn worth of goods it imports from the European Union, thereby further escalating trade war concerns. Yet, as the month progressed, US-Sino trade tensions abated and a broadly positive US Q3 earnings season provided a base from which to build. At the time of writing, 40% of S&P 500 stocks have reported, with 80% of companies surpassing estimates, albeit by small margins. The Information Technologies and Communications sectors have been amongst the leading sectors in terms of positive earnings and performance. The technology-heavy Nasdaq gained 3.8% on the month, thereby outperforming the broader S&P 500 index (+2.0%). In Continental Europe, the German Dax led the way (+3.5%), powered by double-digit gains in the auto sector.

The FTSE 100 was a laggard, ending the month down 2.1%, as sterling strength negatively impacted the translated earnings of its largest multi-national companies found in the Food & Beverage and Personal & Household Goods sectors. Meanwhile, Information Technology was the best performing sector, boosted by the private equity bid for Sophos. The more domestically biased FTSE Mid-Cap index gained 0.8%, assisted by greater clarity surrounding Brexit. The forthcoming General Election will be the focus of attention for the next six weeks and will likely create greater uncertainty in the short-term. Yet, at the end of the period we should have greater clarity over the future of the UK economy, which should allow British firms and global investors alike to make longer-term plans.

In conclusion, we retain our conviction that the global economy is slowing 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 than others at their disposal and the Fed seems to be convinced that the US economy is mid-cycle. Unlike in previous downturns, China is reluctant to reflate, thereby removing a key support for the global economy and increasing the likelihood of a recession in 2020.

In terms of asset allocation, we retain our conviction that late-cycle investing bears a heightened risk of equity drawdown and we have maintained our defensive positioning.