Neutral on equities
The principle focus of the Market Pulse this month is our decision towards the end of July to move our model portfolios back to what we regard as a ‘neutral’ position. It will also review what scenarios we envisage for the remainder of this year.
At the beginning of the year, we were fairly confident that equity markets would enjoy a decent recovery from the correction we saw at the end of 2018. Our expectation at the time was for equity returns to be in the low teens as the world’s major Central banks moved to stop tightening financial conditions and year to date, markets have more than delivered.
MSCI Regional Equity Indices (local currency)
Why are Central banks worried?
Post 10 years of stimulus, the Federal Reserve (Fed) tightened monetary policy during 2018 in order to provide policy tools to fight the next recession. The People’s Bank of China (PBOC) also reined in excessive credit growth and President Trump started a trade war. These actions had the cumulative effect of slowing economic growth, particularly in countries outside the US, and led to the dramatic loss of investor confidence we saw in equity markets at the end of last year.
The US has been relatively insulated from the economic impact of this slowdown thanks to the ‘Trump Bump’ fiscal package that the US administration delivered at the end of 2017. However, the market fall in quarter four of 2018 forced the Fed to recognise that normalisation was not possible and that its policy was too restrictive.
Equities duly rallied on the volte-face and the bond market in the US is now pricing in a full percentage point of rate cuts over the next year. Business surveys such as the ISM manufacturing data together with purchasing manager indices from around the world are evidence that activity has stalled and the leading indicators also suggest that at least in the short term this trend will continue.
The US is stalling
While the suggestion of easier policy has done an amazing job of raising asset prices this year, there are limited signs so far that the real economy is seeing a benefit. This could simply be a function of policy lag or it could be that when rates are very low, easy money is a relatively impotent tool for compensating for a protectionist foreign policy.
The dividend discount
With the global economy showing no signs of recovery our decision to pare back the equity weight was based on the view that the trade-off between risk and reward in equities is now balanced. Investors have priced in the lower interest rate environment and our dividend discount model for the MSCI World suggests that equities are fairly priced.
From current levels, the majority of appreciation is likely to be in line with mid-single digit earnings growth rather than multiple expansion and this earnings growth is very much dependent on a recovery in economic momentum in the second half of this year. Although the monetary drag has been resolved, the negative impact of protectionism remains and it seems prudent to us to bank some profits given the uncertainty regarding the anticipated recovery. The US market in particular looks expensive relative to other geographies. The Deutsche Bank macro strategy team believes that the MSCI USA index is now 10% above the level implied by the current business sentiment (ISM) readings and vulnerable to a lacklustre rebound.
Another technical reason to be cautious in the short term relates to the recent debt ceiling agreement achieved by the US Congress. The good news is that the US Government will not shut down at the end of August and that funding will not be an issue as we go into the election in 2020. The negative aspect of the deal relates to US$300 billion in financial reserves that the Treasury will now need to replenish over the coming months.
This contingency reserve can be used by the Treasury to pay the bills and prevent a shutdown when the debt ceiling is reached. The Balanced Budget Act recommendation is that the reserve is maintained at US$400 billion and during the budget negotiations it has been depleted to around US$100 billion. The US$300 billion of additional liquidity that has been injected into the economy over the past few months now needs to be taken back.
Restoring the reserve functionally drains liquidity from the system and the projected drain in this instance is equivalent to an additional 6 months of quantitative tightening by the Fed. A monetary tightening of this magnitude may lead the Fed to be more accommodative than markets currently expect, but as it stands it will be a headwind to growth.
A cash cushion
Although bond yields historically do not bottom until the Fed has stopped easing, we have decided not to add to fixed income at current levels. The interest carry is unattractive and will be quickly offset with capital losses if the equity markets are right and growth recovers later this year.
Gold is a good deflation hedge and is up 11% in US dollars and 14% in sterling this year, but the policy response from Central banks should be enough to moderate deflationary concerns and cap its potential from here. Therefore, a reserve of cash that will provide a barbell of risk-free and risky assets seems a reasonable approach while we navigate the considerable uncertainty regarding the path of growth in the near term. We also still like investment grade corporate debt and local currency emerging market debt as they have historically performed well regardless of whether growth has bottomed or fallen further.
Gold (rebased to 100)
Staying the course
There is a big difference between fair value and over-valued. When equities are expensive, the probability of gains is no longer skewed in your favour and investing resembles speculation. At a fair valuation, like today, investors can continue to expect to compound the risk premium of equities over the long term with normal levels of short-term volatility. Hence our neutral stance.
History suggests the Fed will only cut interest rates after the market has sold off and in this respect, this year is relatively unusual. The only recent parallel is 1994/95 when, post raising rates by 3% the US economy experienced a rapid deceleration of growth and equities sold off 6% in the final four months before the Fed signalled a change of tack. The S&P 500 proceeded to rise over 20% in the first six months of 1995, similar to 2019, and then rose another 14% into the year-end after the first actual rate cut in the summer, netting over 37% for the year!
The similarities between the experience of 1995 and 2019 suggest that being underweight equities would risk missing out on the second half rally. Therefore we are staying the course with equities. However, globalisation was just getting started in the mid-nineties and protectionism is the headwind today. A 1995-style second half rally is unlikely without a resolution of the trade conflict between the US and China and we suspect that the US economy needs to get worse before the administration agrees on a deal. The 'Trump Bump' is also wearing off in the US and the budget deal limits the capacity for egregious fiscal stimulus as we go into next year’s election.
If there is a trade deal, the offset will be that the discount rate is likely to rise and negatively impact valuations. However, the earnings in the price-earnings (P/E) ratio will improve – the magnitude of these opposing factors will therefore determine the impact on asset prices. Europe and emerging markets are more sensitive to the industrial cycle and likely to do best in this scenario while the US will probably lag.
Portfolio returns have been good year-to-date and to be able to pocket some profits is a nice position to be in. The opportunity cost of missing out on the proportion of equities we are selling is small and the odds of above-average gains from here are lower than at the beginning of the year.
For more information or if you have any questions, please get in touch by calling 020 7189 2400.
This article was previously published on Tilney prior to the launch of Evelyn Partners.