In recent months, equities and bonds have failed to make much headway as measured by the MSCI World Index and the JPMorgan Global Bond Index. This is not surprising as the politics of trade, Brexit and interest rates continue to influence market sentiment while earnings momentum has slowed. After downgrading its 2019 global economic forecasts for the fifth time recently, the IMF warned that “there is no room for policy mistakes and an urgent need for policy makers to cooperatively de-escalate trade and geopolitical tensions.”
When politics is dominating the headlines, investors are often advised to “ignore the political noise and focus on the fundamentals”. Since the Brexit vote and the Trump victory in 2016, some of those fundamentals have generally been supportive, particularly in the US where unemployment is at a near 5 decades low and consumer confidence has been high. This environment has helped global equity markets deliver impressive returns since 2016.
Some of the world’s major economies, including the eurozone and the US have weakened in recent months as the uncertainty created by the these “tensions” has drained the confidence of some corporate managers and put certain investment intentions on the long finger. This changed backdrop has put earnings and jobs at risk. The response from central banks has been to loosen policy, which has lowered the discount rate that investors apply to those earnings and supported equity markets earlier this year.
Cutting rates from their current levels, however, is controversial and not without risks. The ECB’s outgoing president Mario Draghi has drawn fire in certain quarters for distorting incentives and punishing savers with negative rates.
Deteriorating fundamentals are most evident in the slump in eurozone business confidence and growth expectations. With its outsized exposure to trade, Germany, the eurozone’s largest economy, is feeling the effects more than most. The German economy, which has been one of the region’s strongest performers in recent years, has seen GDP expectations for 2019 fall from a relatively healthy 1.6% at the start of the year to just 0.5% now as Brexit and the trade war have sapped the confidence of the country’s industrialists.
Germany’s pain has been most acute within the manufacturing sector, where the car industry and its supply chain have faced Brexit and trade war risk, the challenge of electric vehicles and slowing demand for cars in China. This matters to Germany as the sector accounts for a fifth of the country’s exports. The country’s services sector is also showing signs of evaporating confidence as employment momentum slows.
In response, the ECB followed the lead of central banks around the world by loosening policy. Interest rates have been cut further into negative territory and the ECB has revived its bond-buying programme. Equities rallied in response to the ECB’s actions. The subsequent fallout from the decision has revealed the deep divisions within the region about the current course of monetary policy.
That there is genuine concern about the course of eurozone monetary policy is evident in comments from the head of Germany’s Bundesbank Jens Weideman who spoke of the “financial stability risks of the very expansive monetary policy.” The Dutch central bank chief Klaas Knot believes that “there are sound reasons to doubt its [ECB policy] effectiveness”, while Austria’s Central Bank boss has said that “this loose monetary policy leads to less growth and lower productivity”. It has since emerged that Mr Draghi ignored the advice of the ECB’s own monetary policy committee, who felt that long term rates were low enough without a resumption of bond buying.
Criticism of the ECB’s current policy is not confined to the ECB boardroom: the head of Germany’s largest insurer Allianz said that the ECB’s policy was “making it easy for people to spend money they don’t have”. As if to underline the North/South divide on policy, the CEO of Italian bank Unicredit took the other side of the argument saying “we have negative rates today. So be it. Negative rates are for the purpose of society. Not against or for the banks.”
Germany’s Ifo Institute for Economic Research says that the country may well be in a technical recession if, as they believe, third quarter GDP growth turns out to be negative. And yet, German political leaders are resisting growing calls for a fiscal stimulus package to offset economic weakness and have shown disdain at the highest level for the ECB’s stance.
As the quibbling over ECB policy goes on, a range of high-profile German companies, including BASF, Deutsche Bank, Daimler, Siemens and Bayer have begun cutting jobs to protect earnings and adjust to the new economic reality. If this trend continues, consumer confidence may weaken further and the pressure on Merkel’s government to increase spending will rise. For the moment, the Chancellor is resisting.
You wouldn’t think it to listen to President Trump, but the US economy is less reliant on trade than most other large economies. Its fundamentals have been better than the eurozone’s and this has been reflected in the outperformance of its equity market during this cycle. But there has been a decline in confidence among its company managers of late and many are pinning it on the trade war with China, which has cost US companies and consumers billions of dollars.
It is over a year since the US first imposed tariffs on $34bn of Chinese goods. Since then the trade war has escalated to the point where the US has imposed tariffs on $300bn of Chinese imports and is threatening to levy tariffs on essentially all imports from China, while china has tariffed $185bn of US goods.
President Trump has just announced a “phase 1” agreement that involved China increasing its purchases of US agricultural produce – a key constituency for the president as the US enters an election year – and strengthen its intellectual property provisions. In return, the US will suspend the imposition of further tariffs. The equity market’s muted reaction so far indicates that investors expect the trade war to persist for some time yet. The increasingly hawkish tone from the Democrats on China reinforces this view as it makes it more difficult for the president to get a quick deal for political purposes.
Weakening fundamentals and falling bond yields are having an impact on the complexion of equity markets. In the first half of the year, Technology, Industrial and Materials stocks were among the best performers while bond sensitive sectors such as Utilities lagged. Since mid-year, market leadership has flipped, and cyclical sectors have underperformed while Utilities and Real Estate have been strong performers.
This change is not reflective of a typical move from high-growth stocks to their cheaper counterparts: by and large, Growth stocks are continuing to outperform Value stocks as investors pay up for growth when the world economy is weakening. Rather, it could be viewed as a measure of investors’ concern about the fundamentals. Our own proprietary model of QUALITY is showing that stocks with the highest QUALITY ranking continue to outperform through all this political and economic uncertainty. At a sector level, the search for low volatility earnings is evident in the 12m forward P/E valuation of US Utilities, which has risen from 10x in 2009 to 20x today.
While the overall market valuation has returned to the level last seen before 2018’s fourth quarter selloff, and is in line with the average of the past five years, earnings momentum has stalled over the past few quarters. This makes the upcoming earnings season an important marker for the direction of equity returns from here into next year. Without at least the expectation of renewed earnings momentum, it is difficult to see equity markets regaining the valuation highs seen at the end of 2017.
Of course, a more permanent settlement in the trade dispute would be welcomed by investors and company managements, who have important capital allocation decisions to make. Such a resolution would provide some fresh impetus to equities, particularly those cheaper Industrial stocks.
As economic fundamentals have been slowing during 2019, the equity market has chosen to take its direction from the more benign interest rate environment delivered by the central banks. All else being equal, it is true that lower interest rates are supportive of equity valuations. Our bond team believes that the fall in yields that we have seen so far this year already reflects the worsening fundamentals and that yields may not have much further to fall.
Rising interest rates from these ultra-low levels need not scupper the equity bull run if they are reflecting reduced geopolitical tension and improved visibility for corporate managers and investors.
As with equities, the direction and magnitude of bond performance are highly dependent on the outcomes of political processes. This is not an ideal environment in which to call the direction of yields. What we can say is that bonds will continue to be a diversifier of equities regardless of how the politics plays out.
The interaction of political processes, such as Brexit and the US/China trade war, with the behaviour of consumers and companies makes for a volatile and unpredictable environment for investors. These processes are inherently deflationary after all, whatever the politicians might say. However, we must remember that there is also a feedback loop in play here. As economies weaken, the pressure builds to resolve these impasses. The resulting clarity would provide a tailwind for equities and lift some of the burden on economies.
When building equity portfolios, we prefer to focus on investing in profitable companies that deliver consistent results in the long run, while allocating capital wisely. In the current environment, we also believe that bonds will continue to play a diversifying role in balanced portfolios.
*Davy Asset Management - “Quality Matters” White Paper – Chantal Brennan, Paraic Ryan, Hannah Cooney: 2016.
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