Review of the quarter
The equity and credit markets are coping with trade uncertainty remarkably well. Conversely, the government bond market paints a bleak picture of the outlook with yields having plunged near previous lows. If both are correct, the market is expecting more Quantitative Easing – printing money to drive bond yields down so tempting people to borrow and spend. The problem with that view is that yields are already very low – and even negative, whilst spending now simply robs future growth.
Central banks are coming under increasing interference from politicians. Trump is lining up the US Federal Reserve to shoulder responsibility for a weaker economy. Core inflation is also soft. In Q2, markets have priced in 3 cuts in the US by year end, an extraordinary shift from the 2 hikes priced for 2019 only 9 months ago!
Still, the US will slow as fiscal stimulus wears off, and the trade war bites. US consumers are in good shape: household debt is, historically, on the low side and unemployment is near 50-year lows. But if the corporate sector should cut jobs as well as capex, consumer confidence would weaken.
Beijing’s commitment to achieving its economic ambitions accelerated in Q2. Early caution in boosting monetary and fiscal stimulus is fading. Infrastructure projects are increasing and taxes are being cut. The currency is depreciating, making export more attractive.
Europe, in particular Germany, has proved very exposed to the tariff war through its reliance on global trade and capital expenditure, both of which have plunged. The European Central Bank (ECB) has little ammunition left and governments have little appetite to run fiscal deficits. The German government prefers to run fiscal surpluses in good times and wind them down in bad, even though the borrowing costs are now negative to 15 years out.
Meanwhile, further declines in sterling demonstrate the impact of ongoing Brexit uncertainty on overseas investors. May’s replacement will face the same thorny issues. Any deal remains difficult when parliament remains divided, as does the country. A general election risks a Labour government, which could focus on less market-friendly practices.
Historically, it has been prudent to reallocate a proportion of a portfolio from equities to fixed interest as the cycle matured and the central bank raised rates. That has been our position for some time. Central banks, however, have mostly kept rates low and bond yields are paltry, providing little incentive to use them as a defensive asset.
Valuations are near their historical norms in most parts of the developed world but we think expectations of earnings growth are somewhat optimistic. Consequently, we retain a defensive bias in equity portfolios. Portfolios favour larger firms and are fairly evenly split between growth and value stocks with a focus on robust balance sheets.
Asset class performance comparison
In sterling terms, the FTSE All-Share index returned 3.26% in Q2 compared to the FTSE All-World’s 6.53%. Emerging markets returned 3.76%, Asia ex Japan 5.70% and Japan 2.88%. Growth stocks outpaced value stocks. UK Government bonds (Gilts) made 1.31%. World corporate bonds returned 2.31%. Sterling fell against the dollar in the quarter which boosted returns from overseas markets. The best returns came from the S&P 500, up 6.79% in sterling, on expectations of a strong rebound in profits in the second half.
Our view remains that economic growth and profits will disappoint and this would cause lower equity valuations. So far markets have remained resilient, supported by central banks’ easier policy. Much depends now on the outlook for earnings.
Government bonds have got even more expensive. 10-year yields are 2% in the US, 0.8% in the UK, -0.3% in Germany, and -0.15% in Japan. Negative yielding bonds total over $12 trillion globally! Trump’s policies continue to damage both the US fiscal and trade balances. We can add low interest rates to the mix now. We remain underweight dollar assets and continue to prefer the better long-term dynamics of emerging markets with a focus on the engine of global growth, Asia.
Although we expect some easing in the softer economic tone late this year, we think earnings may disappoint. Highly rated growth stocks tend to be very sensitive to earnings misses. There remains upward pressure on wages and inflation in the short term, given low unemployment, higher oil prices, and tariffs. That said, exceptionally low interest rates force investors into riskier assets so any corrections are likely to be short lived.
Outside the US, developed economies are already in low growth mode. China is boosting stimulus to counteract tariffs. The scale of these are still less than previous bouts of stimulus so China won’t pull the world out of a slowdown but should stop it getting worse. We remain concerned about the level of debt and leverage in the global financial system but that looks like an issue for 2020. Trump’s stimulus is fading. He will want a good economy ahead of elections in November next year. We should expect a short-term resolution of the trade conflict but longer term a new cold war is likely as the US tries to stop China from taking over the role of world leader in technology.
Our long-term view remains that economic growth and inflation will stay in significantly lower ranges compared to history. Demographics make that almost inevitable. Future returns are likely to be lower than long run averages.