By Tim Sharp, Hottinger Investment Management
Following an August when investor fears focused on a growing risk of recession causing a significant bond rally, September saw these fears reduce as a slew of unexpected positive consumption data releases in the US created optimism. The impetus during the month saw equities broadly outperform bonds as investors backed out of government bonds although the significant rotation from growth stocks to value stocks suggested that investors were looking for more reasonably priced equity exposure at this time. The S&P500 halved the August decline finishing up 0.69% in September whereas the US Treasury index lost 0.93% in price terms in September.
The back-up in bonds at this stage reflects a reaction to an over-bought scenario where many investors may have thought that global recession was imminent and that the Fed and other central banks would respond more aggressively than they have proven. Having fallen to 1.498% in August US Treasury 10-year yields rose to 1.666% in September although still significantly tighter than 2.015% at the beginning of the quarter. However, it would be premature to call the top of the market for bonds when so many uncertainties and risks abound, both in the US and worldwide. The 2nd rate cut by the Fed during the month was greeted with disappointment in political circles, as was the cautious statement, and largely priced in by markets who are hoping that the return of central bank stimulus will support risk assets as well as global growth.
Our main concern remains the state of the global manufacturing cycle, which is centred on China and South East Asia and has deep tributaries that run across Eurasia and into Europe. There is evidence that global capital goods orders have been decelerating in all the major world regions mirroring data that suggest that global trade volumes have stagnated. Weak capital goods spending (CAPEX) is worrying because CAPEX is a major driver of productivity growth, which is becoming an increasingly important driver of economic growth as population expansion slows and the global labour force ages. The importance of any perceived progress in China – US trade talks were highlighted during September when positive news regarding delays to new tariffs in lieu of the resumption of talks led to the Japanese Nikkei Index jumping 5.08% despite the dollar/yen exchange rate also strengthening 1.7%. The Q3 Tankan Survey showed that business conditions were holding up better than expected and labour markets remain tight. Although the outlook for capital spending remains cautious in line with the global CAPEX story, economists do not expect a near term cut in rates.
In Europe, Germany’s industrial sector appears to be in recession although the economy in general may have avoided a technical recession in Q3. Although services have been stronger on the back of strong real wage growth, we remain sceptical that this will be enough to keep European growth above trend. In its recent meeting, the ECB cut interest rates and pledged to resume bond buying, but it also did something more unexpected. By raising the deposit rate on excess reserves to 0% while lending reserves under TLTRO III at -0.5% under certain conditions, the ECB is effectively subsidising European private sector banks, if they increase lending to non-financial companies. Loan demand is weak so it is doubtful how effective this policy will be beyond supporting European banks’ equity prices.
European equities finished the month up 3.61% on the back of the ECB decision, however, the prospect of further bond buying failed to prevent the German 10-year Bund yield reacting to profit-taking rising from -0.702% to -0.573% over the month. There remains a deep division amongst European central bankers whether Draghi was right to carry out this round of stimulus leading to the resignation of the German ECB council member Sabine Lautenschlager in protest over loosening monetary policy.
The outlook in the UK remains highly uncertain both economically and politically. Following the Supreme Court judgement that the prorogation of parliament was unlawful tensions are running high in the House of Commons as the Conservatives continue to push for Brexit withdrawal on October 31 despite the passing of the “Benn Act”. Markets reasoned that the chances of a “no-deal” Brexit had reduced, and markets reacted accordingly with the sterling index gaining 1.50%, UK Gilt index gaining 0.50% and the FTSE All-Share bouncing 2.75%.
Economic data shows unemployment remains at 3.8%, inflation is at target and third quarter GDP may be just enough so that the UK avoids technical recession. UK soft data looks concerning even within a European context, with weak manufacturing sentiment combined with lukewarm feelings among producers in the country’s services sector. Strong real wage growth remains a bright spot in a country where investment and exports remain limited and there have been limited signs of increased government spending.
We continue to believe that the global economy is late cycle rather than mid cycle with heightened risk of an equity drawdown in developed equities. We would concentrate on defensive positions that offer an element of capital protection; government bonds and gold at the expense of emerging markets and cyclical stocks.