New article from Tatton Investment Management: Predicaments

3 December 2018

As November draws to a close, global stock markets have provided a positive last week to an otherwise bleak month for investors. And as it stands, it is not just October and November but the whole of 2018 that has turned into a disappointment for investors across almost all asset classes. According to a study by US investment bank JP Morgan none of the 17 major asset classes (equities, fixed interest bonds, etc.) has outperformed the rate of inflation – something that has not happened since they started tracking these figures in 1992.

While this is a somewhat depressing insight for an investment manager, the returns at portfolio level are only slightly negative. Arguably, 2018 was simply the return to a more realistic growth outlook after 2016 and 2017 generated overshooting return levels which were unsustainable. Without a doubt, if we look at portfolio returns across risk profiles from a 2016 starting point perspective, then total returns achieved on an annualised basis look more than acceptable. Even when choosing 2017 as the starting base, returns should not cause too much concern.

The correction to lower valuation levels means that stocks no longer look expensive relative to earnings and the historic context. It can be argued that they are now pricing in a considerable amount of economic slowdown for 2019, which is by no means a given. However, compared to the end of 2017, the outlook to next year is fraught with more uncertainties.

Economic growth momentum has slowed everywhere, even in the US where Trump’s fiscal stimulus continues to boost the economy at the expense of creating public debt burdens for future generations. The trade uncertainties from Trump’s ‘America First’ trade wars and a still unclear shape of Brexit can no longer be expected to be neutralised by elevated business activity levels. To top it all off, central banks have begun to end the extended period of extraordinarily cheap credit, which creates the risk of a credit crunch as higher financing costs lead to increasing default rates amongst weak businesses.

On the last point, the US central bank’s chairman Jay Powell provided some relief by stating in a prepared speech that the Fed no longer sees current interest rates a “long way” below the required neutral position but only “just below”. This suggests that the pace of US interest rate rises might slow or even stop and was welcomed by equity investors with an upward surge in share prices. Interestingly, bond markets had already anticipated this change for a while and therefore simply consolidated at already lowered levels of long term bond yields.

This stabilisation of the cost of credit, together with significantly lower oil and commodity prices could prove a welcome stimulus for 2019 or at least stem the recent slowing trend. If it additionally stops a further appreciation of the US$, which already stalled over recent weeks, then this would be good 2019 news for emerging market economies. Those who muse about the possibility of a ‘Santa Rally’ on the basis that oversold markets should bounce in anticipation of an improved 2019 outlook may nevertheless be disappointed. US$ funding rates have the unhelpful habit of increasing towards the end of the year as lending activity winds down in preparation of year end.

Which once again leads us to politics, where a number of issues could cause headwinds. Here, only the Italian budget issue saw some notable progress, with the EU Commission as well as the Italian government signalling willingness to compromise – along the lines we expected, as outlined here a few weeks ago.
On the trade war issue, we are writing this Tatton Weekly edition before the dinner between Trump and China’s leader Xi Jinping on Saturday night on the fringes of the G20 summit in Argentina. Consensus is that even if they wanted they would not be able to agree ‘a deal’ because the required preparations for such a step have not yet happened. The best that can be hoped for is some form of positive statement of intent to find a mutually agreeable solution. Even the probability of this is very hard to gauge. Trump has a volatile nature as we well know, but beyond this neither side can afford to be seen at home as having caved in to the other side.

On the Brexit front, the 11 days until parliament votes on 11 December are strewn with similar predicaments for the UK’s MPs. Approve the bill for May’s Withdrawal Treaty which would respect the referendum outcome for a Brexit as they promised in return for being given a meaningful vote in the matter – or reject it as it is neither economically beneficial nor sovereignty-restoring. If MPs opted for the latter, they would thereby risk even more political instability and either an even worse economic/dependency outcome or an end to Brexit altogether.

It is understandable that non-political observers will be increasingly concerned that this is leading straight towards a disorderly non-deal crash Brexit which for the economy would likely be the worst of all possible outcomes. At Tatton we stick to what we have said all along: It will get very frightening when it comes to decision time (and it has!) but in the end politicians will chose the least risky outcome for themselves and the country. This might not happen in the first vote on 11 December as MPs may feel obliged to demonstrate their principles towards their constituencies, but there is a high likelihood that the vote will go differently if the bill is returned for a second reading. It should also be comforting for investors that the one notion that has an overwhelming majority in parliament is the prevention of a no-deal exit.

The new fear that poor political management may lead to an even worse outcome for the country in the form of a Labour government under Jeremy Corbyn that repeats the mistakes of the 1970s also needs to be put into perspective. Just as Donald Trump’s administration has not been able to follow through on his wackier ideas and plans like the border wall with Mexico, we should also expect a Corbyn government to be far tamer than his campaign promises. It is also hard to imagine that Labour would gain an absolute majority in a 2019 general election, given their current standing among the electorate.

In summary then, hopes for a 2018 Santa Rally belong to the realms of wishful thinking, but would at the very least require a significant breakthrough in the trade negotiations between Trump and Xi and probably also a smoother sailing in parliament for Theresa May than currently seems possible. So, after two quite pleasing years for investors, 2018 may turn out to be an even more damp squib than we had anticipated. However, if so, then this will at least lay the foundations for a better outlook for 2019.

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