Rathbones’ Smith looks at the key macro issues for the year ahead
At the start of 2018 we identified the concerns that eventually weighed on equity markets, but we hadn’t anticipated the big drop in valuations that would follow. We still believe some caution is warranted, but not the kind of fear that seemed to take hold as 2018 drew to a close. So what are investors’ biggest concerns today, and will they continue to drag down equity markets in 2019?
- A looming US recession - This year’s hullabaloo seems to be about whether or not the US will fall into recession in the next 12 months. To be sure, we expect the US economy to expand far more slowly in 2019, reflecting tightening monetary policy, an adverse export climate due to protectionism, an overvalued dollar and the sugar-rush nature of Donald Trump’s tax cuts. Still, our favoured indicators suggest that there is a less than 5% chance of a recession occurring in the next three to six months. Indicators that provide visibility beyond that are hard to find, but our quantitative estimate of the chance of recession in the next 12 months, based on the yield curve, has it at less than 25%.
- The case for defensives – We believe there’s quite a case building for tilting exposure towards stocks, factors and sectors with more defensive attributes. This is because (i) the rate of change of our global leading economic indicator is negative and we don’t expect it to bounce; (ii) the growth of money and deposits circulating in the major developed economies has also fallen to the slowest pace since 2011, after adjusting for inflation; (iii) there is a significant possibility that the business cycle transitions from expansion to slowdown (although not recession) in 2019.
- The case against value - Some investors are wondering if so-called “value” stocks are about to have their time in the sun again, after being out of favour for most of the last eight years. We’re doubtful. Value stocks do tend to outperform when bond yields rise, but not if interest rates are rising during the slowdown phase. We have also noticed that the performance of value stocks relative to “growth” stocks has moved in sync with the performance of banks relative to technology companies. We have acknowledged the risk of regulation to technology firms, but even against this backdrop banks may still struggle to beat them as liquidity tightens and money growth slows. This supports our current view that value will struggle to outperform growth.
- Don’t fear the Fed - The two biggest risks are, to our mind, likely to remain US monetary policy and the Sino-US trade war. We have remained sanguine about the path the Fed is likely to tread, holding that structural impediments will prevent it from raising interest rates more than two or three times in 2019. The December Fed Open Market Committee meeting provided the confirmation we were looking for. Quantitative tightening (QT) is not likely to make a significant difference to asset prices. QT is proceeding in an orderly fashion, well flagged to the market. The pace is very slow indeed. When the Fed started to shrink its balance sheet in October last year, it held c.$2.5 trillion of Treasuries and $1.8 trillion of mortgage-backed securities (MBS). Today it holds c.$2.25 trillion of Treasuries and $1.65 trillion of MBS.
- An uneasy truce - Investors had held out hope for a de-escalation of the Sino-US trade war, hopes that were briefly lifted following an apparent ceasefire reached at the G20 summit in late November between Presidents Trump and Xi Jinping. But we can’t bank on this cessation of hostilities lasting. A resurgence in tariffs between the two sides would squeeze global trade, hampering economic growth and making it harder for China to reform itself and keep its debt problem in check – especially if it has to pour more stimulus into the marketplace.
- Value in emerging markets – Last year we looked for some outperformance of emerging markets, though we did also give this caveat – unless the dollar continues to strengthen. It did, and emerging markets have struggled this past year. Yet the dollar looks unlikely to climb higher as we enter a new year. Sentiment was not helped by some local crises brought on by the structural weaknesses of Turkey and Argentina. But as we’ve noted these were local issues, and broad emerging-market asset price weakness is presenting some value opportunities.
- Europe’s fragility exposed - Europe’s fragility was exposed again in 2018 by a still precarious banking sector and an Italian polity that refuses to acknowledge the paramount need for reform. As we enter 2019, business and consumer sentiment has softened and GDP growth has slowed again. An expansionary Italian budget has caused debt-laden Rome to clash with Brussels, and Italian government borrowing costs to surge. Importantly, borrowing costs in other peripheral European economies stayed low. It is more a national than international issue and there is no evidence to suggest Italy could be the cause of a region-wide recession.
- Brexit’s unknowns - We now know that a can-kicking, bare bones deal is the only deal that the government intends to present to Parliament. The most likely outcome is still the “never-ending story”. In fact we believe the odds of this have increased to 56%, from 40% previously. To be clear, the never-ending story may ultimately end in either a soft or hard Brexit down the line. Indeed, we think it probably increases the chance of a softer Brexit. Unfortunately, this never-ending story would mean that the cloud of uncertainty hanging over the economy would remain, continuing to weigh on UK financial markets and delaying business investment. The next likely scenario, at 21%, is still a no-deal/hard Brexit. (See here for our latest Brexit update including our Brexit Decision Tree: Shedding light on Brexit ‘unknowns’ part II).
Ed Smith, Head of Asset Allocation Research
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