New article from Tatton Investment Management: The Elephant and the Little Old Lady

5 August 2019

It was the best of times, it was the worst of times. Dickens’ immortal line roughly sums up the differing actions of two of the world’s major central banks this week. In the US, the Federal Reserve looked at a stable and growing economy more vibrant than most around the globe and with very few domestic risks: they decided to cut interest rates. Back at home, the Bank of England foresaw a sluggish and shaky economy with looming dangers and a 33% chance of recession: they decided to leave interest rates unchanged.

It appears that up is down, black is white and central banks have decided to rewrite decades of monetary wisdom. Well, not quite. The different approaches of the Fed and the BoE reflect the very different purview that policymakers are taking. The Fed has much more room to manoeuvre than the BoE, with their benchmark funds rate some 1.5% above the BoE’s, even after the latest cut. And the Fed has come to believe that their remit extends much further than that of the BoE: it is effectively the world’s central bank. Their statement and subsequent press conference acknowledged as much. They remain the elephant. Meanwhile the BoE has moved from centre-stage, in the mid-2000s, to the periphery of Europe. The old lady of Threadneedle Street is not ageing well.

None of the central banks’ actions was unexpected. An aggressive pace of Fed rate cuts has been priced in by capital markets for a while now. Anything else would have caused an upset. In fact, the initial market reaction suggests they expected more – in terms of outlook at least. US equities fell, while bond yields and the USD went up – though these moves were later reversed. The initial disappointment came from the fact that the Fed signalled that further liquidity would be economy-dependent rather than guaranteed. According to JP Morgan Research, we should not expect another rate cut if the US economy improves between now and September.

But market expectations could themselves influence the Fed’s decision. Steven Blitz (of TS Lombard, a research group to which we subscribe) suspects that the shape of the US yield curve between 3-months to 10-years (the plot of US Treasury bond yields at different maturity dates) will be the Fed’s guide. By the beginning of September, if the curve is slightly positive (3 -month rates below 10-year yields), a rate cut will happen but no more should be expected. If it is inverted, more rate cuts will be forthcoming. Still, he suspects that implied market interest rate expectations of three rate cuts over the next twelve months are too aggressive, as he sees an upcoming economic rebound.

From our point of view, we don’t expect market expectations to change until a global economic rebound is clear in the data. And the latest data are showing no signs of that yet: this week’s Purchasing Manager Index sentiment surveys were stable or weak again.

Equity markets are likely to remain no better than range-bound until economies improve. We’ve reached a stage of “equilibrating”. In the past two months, weak economic data have caused investors to expect more money to be injected into the economy. The chart below shows that Price-to-Earnings ratios were supported or pushed to higher levels (via a decline in the discount rate which increases the future value of dividends, and a hope that stimulus would cause greater growth in those future dividends). The broad market is trading around 19 x last year’s reported earnings, a bit above the 10-year average. However, if the Fed is likely to decrease rates only if economic growth is weaker than expected, the discount rate benefit is offset by the probability of disappointing profits and dividends.

Back to the UK. In a now all too familiar headline, sterling had a dreadful week. The new Prime Minister bolstered his Brexit credentials by announcing a cabinet full of hardliners, boosting the likelihood of a no-deal Brexit and sinking the value of the pound in the process. But none of this fazed equities: UK-listed stocks outperformed other markets – even after adjusting for the fall in sterling – up until Thursday. There will inevitably be more gloomy Brexit headlines, but it seems a lot of pessimism has been built in. UK markets could even outperform if investors become less optimistic about other regions.

In global news, the US-China trade war rages on. At one level, Donald Trump seemed to be currying favour with Xi Jinping in referring to the Hong Kong protests as “riots”, which gained positive responses from Chinese media.

But the high-level trade talks in Shanghai lasted half a day and came to nothing, despite US Treasury Secretary Steve Mnuchin and Robert Lighthizer (Trump’s top trade negotiator) attending. Neither side foresaw a speedy resolution, but the tariff announcement (made overnight Thursday 1st) shows how badly it all went. The threat to impose a 10% tariff on a new list of imports by September 1st has been met by much stronger responses from the Chinese. Both sides have become entrenched in their positions, with no movement to close the gaps.

Trump may see China as currently in a weak position. The latest PMIs were not terrible but still stuck well below the neutral level of 50. Stock markets are underperforming, and autos sales are still weak. The situation has forced another “small” bank bailout by the government, and the People’s Bank of China is clearly concerned – promising to provide near term liquidity (particularly for small businesses) but trying not to fuel the growing property bubble. An easing of trade pressure would help China.

For Trump, however, this may be counterproductive. The value of the Renminbi is a key signal of China’s willingness to negotiate (stable means willing). It moved sharply weaker overnight, towards the Y7/$. This situation seems to have caught investors out, especially in those regions deemed to be most at risk. Most markets went lower on the news, with Asian emerging markets taking a sharp hit.

Even so, with a US election on the horizon, it’s possible that President Trump could still be looking for another trade truce – if not a deal – before next spring.

As we and others have suggested, the other side to that could be Trump setting his crosshairs on another target: Europe. TS Lombard has even suggested that the president might intervene in currency markets to weaken the value of the dollar against the euro – thereby giving American exporters a price advantage. Given the dire state of the European economy, with the latest data showing continued weakness, that would be an extremely aggressive and potentially devastating move. The very threat of it may be enough to stir European politicians into action – prompting a fiscal response at long last. Regardless of what else happens, that would be a welcome development for the EU economy.

Despite all this, political risks and economic disappointments have not yet sunk market sentiment. Instead, for the past few weeks, central bank policy has dominated investment news. That speaks volumes about the fragility of the underlying economy. We will need to see genuine growth coming through soon to justify markets going even higher– not a huge ask, and a relatively positive US earnings season gives some reason to be upbeat. But with recent data being disappointing, we are resolutely neutral
 

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