Investment Update Q2 2019

The party goes on; just jazz, not rock and roll 

As the longest upward run for stock markets in history starts to slow, our message stays the same: stay invested, but stay away from racier companies and sectors.

When we wrote to you in December, equity markets were in a state of panic. By our estimation, their behaviour suggested a 30% chance of a US or global recession occurring in the following three months. We were not convinced, and cautioned against capitulation: the more reliable, less noisy macroeconomic indicators suggested a negligible chance of recession in the following three to six months, and by extension, a negligible chance of a sustained, 20%+ fall in stock markets – a so-called bear market.

Since then, markets have recovered strongly. Yet as we reach the end of the quarter, investors appear to be growing nervous once again. We recognise that some risks have increased, but our message is the same: stay invested for now, albeit with a firm bias towards more defensive parts of the market. That means stocks with less sensitivity to the ebb and flow of economic growth, whose profits tend to tick along at a lower pace like the proverbial tortoise in Aesop’s fable.

The deceleration of economic activity probably isn’t over, but we expect it to continue to resemble a moderation, in which equity markets continue to rise but defensive segments outperform, rather than a crash in which all parts of the market underperform cash. Investors have set a low bar for global earnings growth in 2019 – analysts’ consensus is just 4%. We believe that this is beatable, particularly from midway through the year.

A more dovish take

Regular readers will know that since 2018 we have been more sanguine than many of our peers about the interest rate path the US Federal Reserve (Fed) was likely to tread, positing that structural impediments would prevent policymakers from raising interest rates above 3-3.25%. And since 2017, we have also been more sanguine than many of our peers about the potential impact quantitative tightening (QT) – the unwinding of the Fed’s post-crisis purchases of bonds – may have on financial markets. We suggested that the Fed would end QT earlier than expected, as both a larger economy and changes to the way in which the Fed conducts interest rate policy mandates a considerably larger balance sheet today than in 2008. Our belief in continued accommodative rates has underpinned our decision to stay invested.

Yet even we were surprised in March when the Fed declared it was more or less finished raising rates, and that QT will end in September. Investors should have been pleased; after all, a monetary policy mistake has been topping lists of their biggest concerns for some time now. Instead, markets were roiled. Investors seemed to say, ‘what does the Fed know that we don’t?’

The party goes on; just milder

Historically, the Fed has almost invariably tightened rates too much, taking them to a level too high for the economy to continue at full employment. Torturing the old metaphor, it not only takes away the punchbowl, but sends in the bouncers and calls everyone a cab. Investors are finding it hard to believe that the Fed has exercised more restraint this time – that policymakers have just locked up the hard liquor and thrown on some Kenny G. But they have shown restraint already this cycle: they waited 12 months after the first rate rise in December 2015 to raise them again, as global growth and global trade slowed and the manufacturing sector sputtered, much like today.

Moreover, our analysis does not suggest that short-term rates have tightened too far already. They appear comfortably below what we call the “neutral” real rate – the interest rate consistent with an economy at full employment without excessive inflation. It may come as no surprise that the neutral rate is difficult to measure. We use a number of approaches and none of them tells us that actual rates are too tight. The Taylor Rule – a simple, workhorse model for monetary policy that seeks to balance inflation with spare capacity in the economy – also suggests that today’s policy rates are appropriate (and quite possibly too low, depending on your measure of spare capacity).

Finished or on pause the lesson is the same: history suggests that markets will continue to rise for the foreseeable future, but that defensive sectors and styles will outperform more cyclically sensitive ones.

What is ‘the yield curve’ telling us?

After the Fed’s March meeting, the yield on the one-year Treasury bond moved above the 10-year bond yield. In the parlance, the yield curve inverted. Again, this is indicative of investors’ “what-does-the-Fed-know-that-we-don’t?” reaction. Shorter-term bond yields are more sensitive to central bank policy rates, so a dovish shift in Fed policy should have arguably steepened the curve (long-dated yields go higher relative to short-dated). Instead investors responded with more fear about longer-term economic health.

As we have discussed at length before, an inverted yield curve is an authoritative harbinger of recession. It has inverted in anticipation of all of the last nine recessions, while sending just two false signals. However, investors must be careful. The length of time between inversion and recession is very inconsistent. It is always long. Since the mid-1950s the yield curve has inverted on average 14 months before a recession, and the window has been getting larger over time. In contrast, equity markets have peaked just four months before recession, with no change in the window over time. Selling equities as soon as the curve inverts could mean missing out on rising equity markets for rather a long time. Since 1980, US equities have averaged 12% in the first 12 months after inversion. The most important investment implication of an inverted yield curve is the same as the one that accompanies a pause or end of Fed tightening: historically, between the dates the yield curve inverts and equity markets eventually peak, defensive parts of the market tend to outperform cyclical ones.

The yield curve is just one of our three core leading leading indicators – data with a long history of heralding US recession many months before one starts, and by association, a bear market in equities. The other two, the real (ex-inflation) growth rate of money in circulation and deposit accounts, and the difference between real interest rates and the "neutral" rate of interest, have not started flashing. They have actually improved a little at the last reading.

Theoretically, the yield curve proxies the (risk-free) difference in returns/costs from borrowing short and lending long. This, very broadly, is how banks make money, so it influences their willingness to extend new loans and boost wider economic activity. Some also interpret the curve as a proxy for the difference between the return on capital and the cost of capital in the economy more broadly. There are other ways to proxy this, such as listed equities’ return on capital employed minus the corporate bond yield (the profitability of the company less its borrowing costs), for example, or nominal GDP minus the Fed’s policy interest rate (the same concept just for the whole economy). Both of these alternatives are much more optimistic about the prospective profitability of new investment projects. This, yet again, reinforces our preference for staying invested, but defensively positioned.

European woes

The eurozone economy grew just 0.3% in the second half of 2018, the weakest outturn in any six-month period since its debt crisis in 2011-12. We have regularly emphasised that the structural nature of Europe’s economic malaise makes it difficult to time the outperformance of its financial markets. Even though various indicators suggest that growth will rebound, we remain very cautious.

Industrial production weighed heavily on fourth-quarter activity (although January numbers are much improved in France, Spain and Italy). Yet employment growth was reasonably robust, wages are growing and household lending is increasing, which together should support consumption spending in 2019. A regional recession is not the certainty that some commentators have suggested it to be. The European Commission’s economic sentiment index, the IFO Institute’s survey, the purchasing managers index (PMI), and the Belgian business confidence index (a good gauge of internal eurozone demand), together suggest that annual GDP growth will hold in the region of 1-1.5% over the next two quarters.

European governments appear to be getting more interventionist. France and Italy are relaxing fiscal policy, while Germany is orchestrating a potential merger of its two largest banks. Interventionist governments may deter investors.

Trade wars

Germany has been particularly hard hit by slowing global trade. This deceleration is about a loss of economic momentum more broadly, but it is also due in part to the US-China trade war. Investors seem to be optimistic about a resolution. US companies most exposed to Chinese sales have outperformed the S&P 500 by c.10% since the start of the year, and Chinese domestic shares have outperformed global markets by c.10% too. We are less optimistic of a lasting resolution in the near term, although a truce to tide the parties over is likely within six months. In a sign of progress, the US and China have reportedly arrived at a currency agreement, and a proposed new foreign investment law, if enforced, could increase American market access in China. But there are five other structural issues that are yet to be decided and the two presidents have not scheduled a final signing summit. The deterioration in North Korean peace talks perhaps also works against any quick resolution.

The fog of Brexit

As we write, Parliament is about to hold a series of indicative votes to help break the government’s impasse. The outcome of these votes, and, moreover, their consequence, is a matter of some debate. Rather than add to the uncertainty, we thought it might be more helpful to remind you of how the UK economy has fared since the referendum, as well as our position on a “no-deal” Brexit.

On the eve of the referendum, the consensus among economists was that UK economic output would be a cumulative 2% lower than it would have otherwise been between the referendum and the end of March 2019, should the UK vote to leave. And that’s the way it appears to have panned out.

The economy grew at just 0.2% in the fourth quarter of 2018. The new monthly GDP data showed a bounce in January, but this data series is too noisy to look at month by month, and the three-month moving average is still 0.2%. It’s not all doom and gloom: lots of jobs were created in the fourth quarter and annual growth of regular pay in the private sector has reached 3.5%, a post-crisis high. Sadly for anyone with a day job, that’s still someway short of the average growth observed before 2008.

The economy has taken a different route than the one most economists expected, however. Household spending has been rather stronger, while business investment has been rather weaker than anticipated.

When households are uncertain about the future, they usually save a little more and spend a little less. This didn’t happen after the referendum. The household saving rate fell to an all-time low while consumer credit grew at a pace so rapid that the Bank of England expressed concern about its effect on financial stability (it has since become more relaxed). Perhaps that’s not too surprising since most people, “leavers” and “remainers”, were pretty certain that some sort of deal would be reached. Even if sentiment remains calm, we question how much further savings rates could possibly fall.

Business investment has been exceptionally weak since the referendum, while it has been growing strongly elsewhere in the world. A recent study by the Centre for Economic Performance at the London School of Economics estimated an extra £8.3 billion of UK-based investment poured into the EU between the referendum and the end of September 2018. To the extent that this investment would otherwise have taken place domestically, this represents a legion of lost opportunities for the UK, and is difficult to explain by anything other than a Brexit effect. Higher outward investment has been accompanied by lower investment into the UK from the EU. The study found that new EU investments in the UK fell by 11%, amounting to £3.5 billion of lost investment.

There is a risk that this trend continues under a protracted period of uncertainty or accelerates in the event of “no-deal”. This would be concerning, for inward foreign investment is extremely important. Modern economic growth is about “technological transfer” – in English, learning from others and improving on it. We can see that at work inside firms: the productivity of UK firms with no inward foreign investment is almost half that of firms with foreign investment.

That said, we believe the idea that foreign investment will fly out and trade will collapse to a destabilising degree in the event of a “no-deal” is rather far-fetched. As we highlighted in our 2016 report, If you leave me now, there are plenty of reasons why companies choose – and will continue to choose – to invest in the UK that have nothing to do with access to the EU. Accounting firm EY reports that a significant amount of planned business investment will be in research and development (R&D) which is geographically agnostic. And there are reasons for optimism: while overall business investment has been weak since the referendum, R&D investment has been holding its own.

A no-deal Brexit is likely to hurt the economy over the short to medium-term, however. We agree with the consensus reached by a range of forecasters: growth will likely fall to between -1% and 1% in 2019 depending on the level of disorder characterising the “no-deal” environment.

To be clear, our aversion to a “no-deal” Brexit is in no way a judgement on whether Brexit is right or wrong for the British polity, in all of its many social, economic and juridical facets. It is simply a narrow expression of the empirically-grounded difficulty of substituting trade with countries further away for trade with one’s nearest neighbours, with or without new trade pacts. It is also based on the behaviour of firms and households since the referendum so far. In the long run, if lots of non-EU trade deals are struck and the EU fails to capitalise on further integration, the UK economy may be better off. But for the next few years at least, the likely impact of “no-deal” would be grave.

The good news for investors is that Brexit is not a globally systemic event, like the financial crisis of 2007-08 or the European debt crisis of 2011-12. Only 3% of the revenues earned by US companies originate in the UK; just 6% for non-UK European companies. Although Europe will also feel a pinch from a “no-deal” Brexit, the bulk of the adjustment will fall squarely on the shoulders of the UK economy, with very little impact on global growth and therefore the outlook for earnings growth of non-UK companies. Moreover, the typical UK investor is a global investor. Even if a portfolio held only the companies listed on the UK’s FTSE 100 index, 70-80% of the underlying revenues originate overseas.

Furthermore, any weakening in the pound will boost returns from those overseas revenue streams, when translated back into sterling. The pound is likely to fall on news of “no-deal”, but it has already fallen so far that even in this scenario it is significantly undervalued versus other major currencies and further downside should be limited. On a long-run basis – the only timeframe over which we believe currency forecasts can be made with any certitude – sterling is very undervalued.  And once the dust settles, the longer-term outlook for the pound is one of appreciation, even in the case of “no-deal”.

So as much as you can, try to block out the daily dangers dreamt up for the 24-hour news cycle. Focus on the longer term and stay invested, albeit with a bias to lower risk companies.


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