We are certainly living through an interesting period for global markets! Volatility is at extended levels for the first time for a period, trade wars seem to have been in the headlines every other day, and their impact are reverberating around the world.Trade wars are inflationary and kill economic growth, so any signs of resolution are a positive for equity markets.
The US Economy
The US ‘experiment’ with a ‘populist’ President continues to roll on, but 2018 saw Trump losing the advantage of his party controlling both US Houses. We could see the ‘tweets’ becoming more urgent as we move through 2019, if that is at all possible, especially with his lawyer about to spend 3 years in jail. The big question for markets is ‘has US economic growth peaked?’ We are 10 years into the recovery from the 2008 financial crisis, which is lengthy measured against previous cycles. Previous cycles, however, did not see the huge impact of global Quantitative Easing (QE) which is now being gradually removed. US Treasury yields are now rising, with the latest move in interest rates happening, as expected, in December. The question now being asked is ‘how many more rises will there be in 2019?’
Interest rate futures predict just one rise but other forecasters still see up to two or more. Markets are likely to be very focused on data releases and that could lead to volatility remaining at raised, or you could say more normal levels after the recent QE inspired ‘stability’. However, US confidence measures currently remain at high levels both for the consumer and industry. We shouldn’t forget though that 2019 on 2018 will see the stimulatory impact of the Trump tax cuts dropping out of the economic growth equation. Remember that companies have used a fair part of that benefit to buy back their shares through 2018 to the tune of around $1trillion; the much discussed de-equitisation. Have they been buying back their equity right at the top of the market, paying peak valuations? Only time will tell. On balance, we believe 2019 should see the US continuing to grow but at a slower rate.
Asia and Europe
In Asia, Chinese growth continues to gently slow with the perennial worries over Chinese indebtedness at the fore, especially at the regional government level. The US actions on trade will not be helping this ‘new normal’ growth scenario. The reverberations will wash around the wider South East Asian economies which have become more and more dependent on Chinese demand, with Australia being a prime example.
In Europe, Italy also have a populist government and their proposed Budget is challenging the European Union’s GDP deficit rule to the chagrin of the other member states. It is thus somewhat ironic that with rioters on the streets in France, their populist President Macron has announced fiscal concessions that are likely to push their deficit over 3% in 2019. Returning to growth, or rather the lack of it, Q3 saw a number of European countries delivering negative growth, namely Germany, Switzerland, Italy and Sweden. If the same occurs in Q4 they are going to be in technical recessions! Export led countries like Germany are suffering from the impact of the aforementioned trade wars. Meanwhile the EU continues with its protracted negotiations with the UK over Brexit and we must now look at the position in our home market. The first half of the year saw equity markets peak in May and, to use that well used phrase, it has certainly been a ‘year of two halves’.
As the Brexit deadline grows closer, uncertainty has ratcheted up and uncertainty is of course both an enemy of activity and of markets. From the May peak, the FTSE AllShare has fallen over 13%. Volatility remains at elevated levels, valuations are under pressure, profit warnings are prevalent and a growing number of IPOs have been pulled or postponed, whilst issuers wait for more favourable conditions. Capital remains scarce and the competing factors of protecting year end performance and continued redemptions mean that many fund managers remain inactive. Share price moves are being exacerbated therefore, as volumes and support levels reduce. All combined, this suggests that 2019 could be a pretty difficult year to navigate. Nevertheless it is important to say that UK markets are not alone in seeing these trends. Volatility is high globally, with the major US, European and Asian markets all down.
We suspect that an influence on this is the impact of the gradual withdrawal of the QE stimulus and the ending of “free money”, plus of course global trade concerns. Whilst 2017 saw synchronised global growth, 2018 has seen countries knocked off that growth perch one by one. That has had a knock-on effect on equity valuations. Bond yields have been rising as QE has been withdrawn, and now the forecast cash flows from businesses are also coming under pressure, with a resultant impact on share prices. Share prices are effectively the discounted future cash flows that the business is expected to earn.
Returning to the UK, the stock market and the economy are also having to deal with the additional uncertainty of the Brexit negotiations. The uncertainty emanating from Parliament is creating what could be a dangerous period for the economy. In your own businesses, you may well be aware of projects or transactions that are being postponed or cancelled. In addition, you may have begun making preparations for a ‘hard Brexit’ and may be stock piling to protect against supply disruption. The faster we get a resolution to this pivotal moment in the UK’s history, whatever the result, the better it will be for UK plc. Uncertainty is the enemy of activity. The UK equity market is said to have seen $1trillion of outflows since the Brexit vote in 2016 according to EPFR, a data provider. Much of this will have been withdrawn by overseas investors to the extent that the UK stock market was rated the least popular of 22 asset classes in the recent and widely followed Merrill Lynch survey of global fund managers. One has to consider whether UK equity sentiment can get any worse? Are we now at or close to the point of maximum uncertainty?
Investors, and in particular overseas investors including the global macro funds, are arguably substantially underweight in the UK market. Flows of capital move markets and, on a lessening in the current levels of uncertainty, we would argue that even a move solely to a less underweight stance could drive a strong turnaround for UK equities. The UK equity market is by no means expensive with the FTSE AllShare trading on a December 2018 Price Earnings ratio of 12x with a 4.6% yield, a level of yield only exceeded on three occasions in the last thirty years. This also compares favourably with other developed markets.
On a more positive note, from the end of Q1 2018, the UK consumer has seen their disposable income growing after being under pressure for much of the period since the financial crisis. No doubt there will be some rebuilding of consumer balance sheets, but on a recovery in confidence, some of those monies are going to boost economic growth. Remember that the UK economy is 80% services, which helps to size the potential boost. Adding to that, the UK has the most people in employment since records began.
What can we expect in 2019?
2019 will hopefully see an end to the UK specific uncertainty with a resultant improvement in global investor sentiment towards UK equity markets.
An interesting point to consider is that if the Theresa May Brexit deal is voted through, the Bank of England scenario analysis sees UK GDP at +1.75% ABOVE their latest November Inflation Report forecast for UK growth over the next five years i.e. an upgrade. You will not have read that in many articles. Our advice for 2019: Dust off the files and be ready for action! It looks likely the ride will remain volatile, certainly more than we have been used to for the last decade. Volatility by its very nature offers opportunity. With the US continuing to deliver above 3% GDP growth as we end 2018, it would be a major surprise if 2019 were to see it enter a recession. As uncertainty unwinds, as it must with time with equity valuations, particularly those in the UK at attractive trends, we would suggest that the outlook is more rosy than many commentators would suggest.
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