New article from Tatton Investment Management: The middle of the year - a tipping point?

1 July 2019

We’re heading into the end of the first half of the year, so let’s go through where what we were thinking at the start of the year and where we are now.

The end of 2018 saw another bout of market liquidity squeeze and its associated sharp drop in risk-appetite. Investors want more yield to take risk. In other words, risk asset valuations cheapened in both bond credit spreads and equity price-to-earnings ratios. The rationale for investors’ worries was the fear that the slowdown in Asia and Europe was spreading to the US. The stronger US economy’s momentum at that point meant the expectation of contagion was muted but the US’ higher valuations had left their stocks vulnerable.

In our outlook for 2019 we said upside would come from a pause in the US interest rate tightening cycle which could calm liquidity concerns and reverse the squeeze. That return of investor liquidity we thought might be a circle nearly as virtuous as had been the one for 2018’s last quarter.

We also thought that there could be swifter-than-expected resolution to the “hotspots” which were holding back spending and investment, the main hotspots being: 

  • Trump trade war
  • European policy fiscal/monetary policy logjam (exemplified by the Italian budget agreement process)
  • China policy ineffectiveness
  • …and Brexit.
As you can see, this is not an exercise in “I told you so”. None of the above have stopped being a worry.

The risk markets did bounce smartly as we headed though the first quarter, driven by growing expectations of a US monetary policy move and thoughts that the global economy would stabilise. However, economic data continued to worsen, led by the corporate sector. A bounce in capex showed little sign of emerging, indeed, in a lot of places it moved from growth slowdown to absolute decline.

May saw risk markets fall back, but the market liquidity squeeze was not part of it. Jerome Powell and other Federal Open Market Committee (FOMC) members had signalled ambivalence about the direction of interest rates in the first quarter, enough to mean dollar liquidty was more abundant. Renewed fears about global profit declines were not accompanied by a seizing-up of risk-appetite.

And then, through this month, it has become clear that the manufacturing slowdown is deeper and has been more prolonged than expected, and that there are signs this is having impacts on non-manufacturers. The good news is that global employment levels have not followed the capex slowdown although employment growth has stagnated.

Now let’s look to the next half-year.

If business confidence declines are unchecked, it would only be a matter of time before cost-cutting would spread from capex to employment, affecting consumer confidence and spending. The reasonably positive growth in consumption would fade.

Thus, the FOMC and (to some extent) the ECB are starting the monetary engines.  Businesses see profits on a slight declining path. With still-high debt levels, they are not likely to be borrow more. Household credit demand is less responsive to interest rate moves than in the past - the recent sharp fall in the US mortgage rate has produced less housing demand than most forecasts – but it is still flickering.

This is why the state of trade negotiations matters so much now. If businesses can look through this slowdown towards steady demand into 2020, they will hang on to their valuable workforces. If their uncertainty remains high, they may feel forced to cut employment, especially so if the individual companies are rewarded in better share price performance (as is happening among auto manufacturers).

It may be that the G20 this weekend will provide proper comfort to the traded goods sectors to end the current on-off stockpiling process. Clearly, most investors will be happier if Trump and Xi can deliver something soon.

The Chinese economy does appear to have stabilised meanwhile, though policy is inwardly focussed. At the start of the year, we fretted that policy would be ineffective, but it does seem that Trump’s negotiating tactics have made Chinese policy more internally efficient. The ability to stem capital outflow has meant that liquidity has been targeted at the vulnerable smaller companies. The banks have become better at lending in this area, more ably displacing shadow-financing.

Infrastructure spending has supported emerging market commodity producers without creating the boom-like conditions of 2017.

Looking forward, fears of a financial system meltdown have receded. They appear to be in a more resilient position which has the perverse potential to make a near-term trade deal less achievable, and to keep the People’s Bank of China from easing further.

As for Brexit, we appear to be in almost exactly the same place now as in December, a deadline approaching fast with no discernible change in possible outcomes. The FTSE 100 and £-Sterling are pretty much the same level, with a slight depreciation versus the euro. However, it does appear that the new Prime Minister will provoke an outcome. That has the potential to provoke volatility especially in the currency in the next couple of months. An interesting aside is that the probability of an election this year has risen from 30% to 40% in the past two weeks.

To return to global markets and the outlook for the rest of the year.
Markets have been supported by central banks committing to supply liquidity, much as they did in 2016. Bond yields were at historical lows then and are nearly back to those levels on average. They’re lower in Japan, as low in Europe and the UK, but higher in the US. That means that there is some room for the Fed to be more aggressive than the three US rate cuts that the market foresees. Employment is strong, household credit demand is elastic, so consumption is currently stable. Market liquidity shows no great signs of stress, particularly with the US dollar seemingly on a slightly weaker path. Commodities are supported reasonably well by China’s stabilisation.

Optimism over profits has declined but, like in 2016, equity and corporate bond prices have been stable to strong because the yields available on non-risky assets are so low. In other words, valuations are back to (somewhat) expensive levels. The graph below shows reported profits. Analysts now expect profits to be flat through 2019.


The great returns of 2017 may be possible but the burst of optimism that stoked US profit expectations won’t come from the same source. The US Presidential election race will heat up, but the US fiscal position is too stretched to provide anything meaningful in the next few years. Neither should we expect any other country to produce a Trump Bump.

If there is to be a large return of optimism, it will come from a Trump-Xi deal that is both credible and largely tariff-free. The breakdown in talks signalled a gap in trust and positions that suggests tariffs will remain in place to some degree. That could be still be a big positive if both countries were to re-engage on a near-free basis. Fears of rising costs for businesses and consumers would be lessened and it may even promote a spurt of capex. Consumption would be underpinned.

Of course, bonds could easily sell off taking away some of the prospective valuation upside. However, central banks would be unlikely to get hawkish until growth was visible, which would give markets a lot of room for upside. The recessionary scenarios would disappear quickly and those short of risk assets would have to scramble to rebuild positions.
 
The most probable outcome is that the talks will continue, the rebuilding of trust will be hard and that it will take some time for any deal to be thought credible. This will mean a slow grind away from fragility, with markets generating low but hopefully stable returns, supported by central banks committed to providing liquidity, and with corporate confidence coming back slowly as real consumption growth remains positive, but pricing power being weak. Profits move from small declines to low single digit growth. 
 
A less favourable (and less likely, we think) scenario might come from a failure to arrest the draining of corporate confidence leading to a rise in unemployment. That could cause further declines in government bond yields but would also lead to sharper declines in global profits amid rising recession probabilities with equities falling, possibly sharply.
 
Lastly the discussion around modern monetary theory could heat up in both Europe and the US. The recent rise in gold may indicate that some people think stagflation could be on the cards. Bank of America’s Michael Hartnett suggests that this is the biggest contrarian viewpoint. We think this is a low probability but will get talked about more particularly if the trade talks don’t get resolved soon.

Have a great weekend - keep coool, and carry on!

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