Investment Update Q3 2019

When we wrote to you in March, equity markets were recovering strongly from the turbulence at the end of 2018. Concerns about global growth returned in May, but since then the US equity benchmark has reached a new all-time high, while most other Western indices rose above March levels.

At the same time, government bonds have also rallied strongly, driven by expectations of both weaker economic growth and inflation, as well as greater demand for ’safe haven’ assets. Are higher equity prices and higher government bond prices contradictory? Is the bond market seeing something that equity markets aren’t?

Indisputable weakness

Let’s be frank: we have more reasons than at any time since the financial crisis to be worried about the 12-month outlook for the US and global economies. A broader swathe of economic indicators – measuring the recent past, present and future – have fallen to indisputably weak levels than we’ve seen for many years.

For example, US industrial production is contracting quarter-on-quarter. The volume of Korean exports is also contracting, as are orders of Japanese machine tools, and global sales of microchips. The German manufacturing PMI – a much-watched measure of business confidence – is below 50 (commonly seen as the threshold between ‘boom’ and ‘bust’), as are a number of other manufacturing PMIs around the world.

Don’t cash in your chips just yet

But we shouldn’t infer from these signals that it’s time to cash in the chips. A mild contraction in many of these indicators is not actually unusual. Quarterly US industrial production growth has been negative five times now since the recovery began in 2009, sometimes for prolonged periods. This is the third time Korean export orders have shrunk; same goes for Japanese machine tools and global microchip sales. It’s the fourth occasion that the German manufacturing PMI has crossed below that boom/bust threshold. The fact is, just below 50 isn’t actually consistent with bust.

The bottom line is that our analysis does not suggest that these weak indicators and the poor macroeconomic momentum they point to are suggesting that a recession within the next 12 months is more likely than not. For sure, a recession may turn out to be the way we’re heading, but such a conclusion is not currently supported by our analysis and hypothesis testing of monetary and business cycle indicators. In other words we can’t conclude that this isn’t just another mid-cycle slowdown.

Defence is the best offence

Under this scenario, equity markets should continue to rise, but they will be led by lower risk regions, sectors and styles of company management – defensive parts of the market that tend to be less geared to the gyrations of the economic cycle, which we’ve favoured since September last year. And that’s exactly what has been happening.

With this established, bond markets and equity markets look less disconnected. The cyclical concerns of the bond markets are also reflected in the return differentials within equity markets.

Furthermore, equity market valuations are negatively correlated with government bond yields (which move inversely with bond prices) in a very systemic manner. Government yields are a component of the discount rate used to translate tomorrow’s company earnings into today’s price. Lower bond yields, all other things being equal, mean more of tomorrow’s earnings in today’s price – or, in other words, higher valuations. Our analysis suggests that US equity valuations are exactly where their historic relationship with government bond yields suggests they should be. UK valuations are someway below.

Of course all other things aren’t always equal. If bond yields are falling because the economy is heading into recession, then the other component of the discount rate – the equity risk premium, which is the additional compensation investors require to compensate for the risks around tomorrow’s earnings – will move sharply in the opposite direction, thereby lowering valuations. But as we’ve just set out, we do not believe that the economy is clearly heading into recession.

An ounce of insurance…

US interest rate futures perhaps suggest that the market is expecting the Federal Reserve (Fed) to behave as though we are heading into recession. They are pricing in three to four rate cuts of 0.25% each by early 2020. And the downward shift in those interest rate expectations in May was of a magnitude rarely seen outside of the end of the business cycle.

We think that the market has misinterpreted recent comments from America’s central bank. The Fed’s message, which it has reiterated a number of times in June, is that they might cut interest rates if the outlook worsens. Their base case is that the economy will hold up, but they have become concerned about the risks to economic stability posed by the trade war and weakening global growth. “An ounce of prevention is worth a pound of cure,” said Chairman Jerome Powell.

With this in mind, one to two rate cuts may be likely, but three to four rate cuts would be wholly inconsistent with the Fed’s framework, and with their favoured measures of domestically-driven inflation and employment. We used this approach to correctly refute last year’s market consensus that the Fed would continue to raise rates throughout 2019. For example, the New York Fed’s Underlying Inflation gauge, the Cleveland Fed’s trimmed-mean PCE (personal consumption expenditure) inflation index, or the Atlanta Fed’s Sticky CPI have been relatively firm this year. Meanwhile, unemployment is near an all-time low, the participation rate is creeping upwards and private wage growth (as measured by the Employment Cost Index) looks set to reach 3.5% by the end of 2019.

Of course, there is a risk that equity markets may sell off if they believe monetary stimulus is not enough.

Trade war

Other risks to global markets include the ongoing trade war. Over the weekend of the 29 June Presidents Trump and Xi will talk trade when they convene in Osaka for the G20 summit of global leaders. We have low expectations. We anticipate the White House will hold fire on applying 25% on the remaining $300 billion or so of America’s imports from China currently untouched, but we do not expect the whole matter to be resolved.

The rhetoric used by Chinese leaders to discuss the trade war is increasingly drenched with the same bellicose nationalism used in Washington. After the May round of talks collapsed, China’s State Council Information Office released a ‘white paper’ stating that the US government “should bear the sole and entire responsibility” for the failure, claiming that, “the more the US government is offered, the more it wants.” Speculations that Liu He might be replaced by VP Wang Qishan as chief negotiator bolsters our case: Wang is the Party’s tough guy, famed for his role as anti-corruption tsar.

On the other hand, in March and April China passed a new Foreign Investment Law and three new intellectual property laws that encode far more protection for foreign trademarks and trade secrets. These go a long way to meeting US demands, but seem to have been unacknowledged by the US, at least in public. The door for negotiation is by no means shut, but the threshold for an agreement has been elevated significantly, and the gap between Washington and Beijing is widening not narrowing.

If the trade war escalates further, our analysis suggests that Beijing is likely to do more monetary and fiscal stimulus. And as the threat to Xi’s promise to double per capita GDP between 2010 and 2020 increases, the more likely that is. Some commentators assert that the stimulus applied so far has failed to lift growth. Such a conclusion does not consider the counterfactual; without it economic activity would likely have decelerated further. Our quantification of the real level of economic activity that underlies – and often belies – the official GDP figures suggests that growth is holding up reasonably well. The current slowdown is a far cry from the sharp deceleration of 2015.

Iran

Tensions between Iran and the US have escalated after two attacks on oil tankers in the Straits of Hormuz and the shooting down of an American drone. Uncharacteristically, President Trump has projected calm. Perhaps this is unsurprising: a 2018 survey of public opinion by the Chicago Council found that two-thirds of Americans supported the nuclear deal with Iran that Trump ripped up. War and higher fuel prices are not an obvious vote winner.

Nevertheless, further escalation is a wildcard risk. Renewed sanctions on Iranian oil are unlikely in our view to drive up the oil price by an amount that could threaten the global economy. Oil prices are still some 10% below where they were a year ago. But military conflict and the closure of the Straits of Hormuz would be another matter entirely.

Almost 20% of the world’s crude oil is transported through the Straits, and nearly 35% of liquefied natural gas. Some could be rerouted through pipelines in the Gulf Arab states, but even so closure would amount to the largest shock to the global energy supply since WW2 - much greater than the Arab-Israeli war and embargo of the early 1970s and Iranian Revolution a few years later. This would send the price of oil spiralling upward. Although not all oil spikes derail global growth, there is a good case to be made that it would today, given eroding confidence more broadly. A 50% increase in the oil price tends to lower global GDP growth by 0.3% after one year, according to Oxford Economics’ global model.

The US economy is not as vulnerable to oil prices as it used to be. Just ten years ago, the US imported considerably more energy than it exported. Today it’s reliance on imported fuels is much, much reduced. In fact in one week in December of last year, the US exported more oil and fuel than it imported for the first time in 75 years. But that doesn’t mean that the US economy is now relatively immune to changes in the price of oil. There are very significant distributional implications. Most consumers are still likely to be worse off as fuel prices rise, and consumers account for around 70% of expenditure across the whole economy.

Furthermore, only 12 states produce more energy than they consume. This will certainly weigh on Trump’s mind heading into the 2020 election. Only two of the 12 ‘swing’ states are net producers. Sure, they are large states – Pennsylvania and Texas – with large allocations of Electoral College votes that ultimately decide who’s President. But they still only account for 38 of the 108 Electoral College votes among the swing states. In other words, making voters feel worse off by driving up oil prices with a war that few of them want gives the White House huge incentive to try to de-escalate the situation.

Brexit

Sadly, we still can’t last three months without commenting on the B-word. We wrote to you last quarter with a longer comment on the economic implications of the vote to leave so far, highlighting the profound effect it has had on business investment. And we plan to publish more after the Conservative Party leadership race has been settled on 22 July. Briefly, the next leader has three plausible options come October:

1. Find the votes to pass May’s Withdrawal Agreement, which the EU are highly unlikely to renegotiate, having secured some tweaks to the accompanying ‘political declaration’ which sets out the nature of the future relationship. As we have discussed before, this still does not lift the cloud of uncertainty shrouding UK business as neither document provide clarity on trade or capital markets.

2. Extend the negotiating window yet again. The leadership contest will finish just before Parliament’s summer recess, which is scheduled to last until early September. The new government will therefore have just seven weeks before the October deadline once it reconvenes. A recent research trip to Brussels revealed a willingness from the EU Council to accept another delay to March 2020. The end of March 2020 is the latest date that the Multiannual Financial Framework for 2021-2027 could be signed off, and a deal with the UK must be reached by then.

3. Withdraw from the EU with no deal. Parliament may try to block this, in which case it may grant the government an extension and tell it to return to Brussels, or Parliament may declare ’no confidence’ and bring about a general election.

We take this opportunity to remind investors that the earnings streams underlying your portfolios are primarily global, not British, in origin.

Consider the downside and the upside

Of course we are vigilant of the risks and remain cautious. Business cycle indicators only take us so far and we need to ask what they are not telling us as much as what they are. The intensifying trade war makes many of us especially nervous. Yet at the same time, we must acknowledge that there are also upside risks to equities as well as downside ones. The Fed has pressed pause on its rate tightening cycle, China is likely to add further fiscal and monetary stimulus and, finally, equity market expectations are already quite depressed (consensus analysts’ expectations for growth in FTSE 100 earnings per share in 2019 are just 1%). In other words, despite the weak data, there is a risk that equities could rise as well as fall.