Market Comment 03/10/2019
Market Commentary October 2019
Read our Investment Team's update on global markets as at end September and how this is shaping our approach to risk going forward.
The MSCI UK All Cap NR index returned +0.9% during the three months to the end of September, underperforming the MSCI World ex UK (£) NR index which returned +4.0% in Sterling terms and +1.6% in local currency. The relative outperformance of international markets was driven largely by the decline of Sterling against most major currencies.
Stock markets rallied in July as hopes rose of co-ordinated policy responses to counteract the global slowdown. This optimism was punctured somewhat in August as trade negotiations between the US and China unexpectedly broke down and President Trump surprised the market with further tariffs on Chinese goods. However further monetary policy easing was announced in September by central banks in the USA and Eurozone and this helped support markets.
In Sterling terms, the strongest major regional equity index was Japan where some macro-economic releases suggested that that the economy was doing better than feared.
In Sterling terms, the strongest major regional equity index was Japan (MSCI Japan £ NR index, +6.5%), where some macro-economic releases suggested that that the economy was doing better than feared. Nonetheless, rising trade war risks and tensions in Hong Kong saw Asia ex Japan and Emerging Market equities perform poorly.
Alongside many developed market government bonds, Gilts performed strongly (iShares Core UK Gilts ETF, +6.2%) due to rising Brexit-related fears and expectations that central banks around the world would cut interest rates as numerous indicators that suggested that global growth was slowing faster than expected. Both Investment grade debt (iShares Core £ Corporate Bond ETF, +3.9%) and ‘riskier’ high yield debt (iShares Global High Yield GBP Hedged ETF, +0.8%) underperformed Gilts.
The Brent crude oil price ended September at $60.8/barrel, a decrease of 8.7%% since the end of June. The oil price fell as concerns increased that the weaker global economic growth environment could undermine OPEC attempts to stabilise the oil price going forward, notwithstanding the Iranian attack on Saudi oil refineries during the period.
The gold price rose 4.5% to $1,472/oz during the period on strong ‘safe haven’ demand and declines in the opportunity cost of holding gold as global interest rate expectations fell sharply. Sterling weakness ensured the gold price rose by more for UK based investors (+7.9% to £1198/oz).
In the past, the key to understanding where we were in the global economic cycle was to understand the outlook for the US consumer. Today, given the exceptional growth of the Chinese economy over the past two decades, we now have to assess the outlook for both the US consumer and the Chinese economy to determine the outlook for the global economic cycle. Whilst the US consumer looks well set (for now), it is fair to say the outlook for China is less strong.
The linkage between Chinese manufacturing and the US consumer has been thrown into stark relief as President Trump weighs up whether to continue to go toe-to-toe against President Xi in order to recalibrate global trade flows fundamentally.
We suspect President Trump will continue with his hard rhetoric against China whilst agreeing limited trade deals on agriculture (predominantly pork and soya beans) and, possibly, oil. This means continued tariffs on manufactured goods, with the threat of more to come, which will continue to undermine confidence in the global manufacturing sector, where companies, in general, are reporting reduced demand and higher inventories.
The weakness in manufacturing activity is leading to a noticeable slowdown in overall global economic growth.
The weakness in manufacturing activity is leading to a noticeable slowdown in overall global economic growth. In the past, when this has happened, the Chinese authorities have implemented large scale stimulus programs which have had the result of getting the global economy back on track. This time, however, the signals coming out of China suggest less willingness to go down this route. Whilst Chinese interest rates will continue to be cut and the amount of capital banks have to lodge with the central bank will be cut to encourage more lending, a significant ramp up in private sector lending or infrastructure investment is unlikely.
Thankfully, the services sector which is a much larger proportion of developed market economies remains in good shape. In the US, where unemployment is at cycle lows and wages are growing at a good rate, service sector confidence remains good. One of the key questions, therefore, has to be whether the slowdown in the manufacturing sector will take the services sector down with it. The Federal Reserve has already cut interest rates twice in order to try to stave off such an outcome.
One of the by-products of the fall in interest rates is that mortgage rates in the US have fallen and this is having a positive effect on US housing market activity.
One of the by-products of the fall in interest rates is that mortgage rates in the US have fallen and this is having a positive effect on US housing market activity. Whilst recent newsflow concerning the US housing market is undoubtedly better than expected, and is to be welcomed, the US labour market is beginning to show signs of slowing after a long period of good growth.
Interestingly, one of the indicators used to determine whether there is an enhanced risk of recession is, counterintuitively, a low unemployment rate. If the unemployment rate is close to historic lows, it follows that the economic cycle is long in the tooth. Unfortunately, one has to go back more than 50 years to observe a United States unemployment rate as low as it is today (3.6%).
Another reason for caution is that there are some tell-tale signs materialising that may be indicative of a more difficult refinancing environment. Symptoms include the bankruptcy of Thomas Cook, the Argentinian debt default, the stronger US Dollar and, indeed, the failure of the WeWork listing.
Given all the above, it is difficult to accept the consensus estimate which suggests US earnings are going to grow at a double-digit rate next year. We think the real number could be negative due to lacklustre demand and pressures on company profitability. It does not necessarily follow, however, that the stockmarket will follow the earnings downgrade cycle, but it will provide a headwind to further appreciation.
As markets are not far from their highs, we believe a more prudent approach to risk is required.
As markets are not far from their highs, we believe a more prudent approach to risk is required and so we have been reducing exposure to equities somewhat, whilst we determine whether what we are seeing is simply a pause in the investment cycle or a real turning point. Proceeds from the reduction in equity risk have been reinvested in near cash and strategic bond collectives which will protect capital should the environment get more difficult.
One of the key indicators which we are focussed on is how investors, who are already defensively positioned, react to poor trading updates from economically sensitive stocks during third quarter trading updates. Will investors greet the poor trading statements with relief that they aren’t worse and bid stock prices up on the belief that the well flagged economic downturn is stabilising? Or will investors believe things may get worse before they get better and hence drive those stock prices down still further? If so, a destabilising feedback loop may be triggered and we would look to derisk portfolios further.
But before one gets too pessimistic, it is worth remembering that should the outlook continue to deteriorate policymakers will step in, once again, and deliver more quantitative easing, interest rate cuts and, if necessary, even introduce the policy of ‘helicopter money’ – that is printing money and handing it to individuals to spend – if it is deemed necessary.
Cornelian Investment Team