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Monthly Market Commentary - July 2019

Central banks are easing monetary policy once again. Bond investors see this as pre-emptive action ahead of a global economic slowdown, perhaps even recession, whereas equity investors anticipate this will fuel a pick-up in corporate profitability by boosting GDP growth. Time will tell, but for now bond yields are at new lows – the German and Swiss governments can borrow at a negative interest rate for up to 50 years, and the UK 10-year gilt ended the month at 0.6%.

Share prices globally push onto new highs. US, Japanese and European markets rose between 0.5% and 1.5% in local currency terms, but were eclipsed by a 2.2% gain in the UK market, where currency weakness helped the FTSE 100 add 161 points to 7586. The pound fell 4% against the dollar to $1.21 on Brexit uncertainty. Despite Middle East tensions, Brent crude fell to $65.

The economic data is surprising on the downside. Business surveys suggest global manufacturing slipped further into contraction in July, for the second consecutive month. Manufacturing weakness broadened across global economies and while there was a small uptick in new orders in the US and China, they remain in contraction territory, implying manufacturing will continue to be a drag on global growth in the third quarter of 2019.

Unfortunately, trade tensions show no sign of abating, at least not until closer to the 2020 US election when a ‘great deal for America’ is anticipated. For now, the President has tweeted that the US will impose a 10% tariff on the remaining $300bn of Chinese imports starting on 1 September. There is scope to raise this to 25% and/or increase tariffs on goods already suffering this rate.

Economists struggle to quantify the lasting impact of existing tariffs ($250bn predominately on capital goods/industrial supplies/automotive), let alone those covered by the latest extension – the majority are consumer goods, which might have a more immediate impact on the US economy. The 7% year-on-year decline of Chinese exports to the US has been surprisingly low. This could mean the impact is predominately adverse sentiment surrounding investment decisions and raised costs rather than lost growth opportunities.

Beyond China, we anticipate US challenges to countries that have benefited from trade diversion such as Vietnam and Europe. Trade tensions unfortunately aren’t limited to the US with the Japanese/South Korea dispute also escalating. An extended trade war, unrest in Hong Kong and Japan/Korea semiconductor tensions mean growth is slowing quite sharply in the rest of Asia. Japan has stabilised, however, with resilience in consumer spending offsetting negative net exports.

Despite the noise surrounding trade, the Chinese economy continues to grow strongly. Annual GDP growth slowed to near 6% in the second quarter of 2019 – services remained flat at around 7% growth, while manufacturing slowed to 5.6%. We expect a similar performance in the second half of the year based on a resilient consumer and government incentivised infrastructure spending. Policy easing will continue in a measured way, partly through monetary measures but mainly from fiscal policy. Currency weakness could be used as a measure against tariffs.

Meanwhile, US consumption rebounded in the second quarter, following the government shutdown and delayed tax rebates. Residential and business fixed investment languished however. The economy looks on track to grow 2.6%, a touch lower than last year but still well above the advanced world average. The growth in jobs is likely to slow while low levels of unemployment will likely keep wages growing at 3%+. Investors will be watching to see if higher labour costs can be passed on by price rises or whether competition forces margin compression.

At the end of July the Federal Reserve announced an end to its ‘quantitative tightening’ balance sheet reduction and cut rates by 25bp to 2.25% – the first cut in nearly eleven years – citing a mid-cycle adjustment and insurance against downside risks from weak global trade. While it is not clear whether easier monetary policy is necessary at this stage or will compensate for slowing global trade it does represent a dovish pivot by the Fed and markets anticipate further cuts.

Euro area surveys point to further deterioration. As with other regions, there is a contrast between manufacturers and consumers. Global trade tensions and even Brexit uncertainty continue to impact the eurozone, though Spain shows some resilience. The extended weakness has prompted the ECB to provide additional – as yet unspecified – support, likely involving interest rate cuts and a resumption of the net asset purchase programme. Despite an apparent scarcity of bonds to purchase, the ECB is not expected to start buying shares like the Bank of Japan has been doing.

The UK appears to be headed towards a general election and possibly further Brexit delays. Protracted uncertainty and global headwinds have pushed business surveys in the manufacturing and construction sectors into recession territory. Hard data has been more resilient, especially the ever-resilient consumer. Boris Johnson’s hard Brexit approach may not work as a negotiating tactic with the EU, especially with his slim majority in Parliament. A snap general election could add further delay to Brexit as polls suggest up to four parties could obtain around 20% of the vote, introducing the possibility of convoluted coalition negotiations.

The Bank of England has shelved ambitions to raise interest rates and could yet be forced to cut rates. Further Brexit uncertainty has rejuvenated currency speculators who are once again selling sterling. A disruptive Brexit with log-jammed trade and financial system distress would see the currency weaken substantially, but this is unlikely given the contingency plans that have been quietly put in place by the EU. Aside from some further short-term weakness in thin summer markets, there is also the risk of a reasonable sterling appreciation should a disruptive Brexit be avoided or postponed for an extended period.

Gold has been performing well, ending the month at $1,414 per ounce, up 10% year-to-date. Traditionally seen – sometimes incorrectly – as an inflation hedge, investor interest is centred on the potential for an unexpected global event risk, such as from the Middle East. Policymakers’ decision to deliberately keep interest rates well below nominal GDP also helps. By depressing real yields, the opportunity cost of holding a zero-income producing asset is reduced. For sterling-based investors, currency moves are an additional consideration, albeit with added volatility over and above holding a safe asset such as short-dated sovereign debt. Until central banks return to normalising interest rates, gold will continue to offer a return opportunity.

Markets have performed strongly year-to-date with US shares reaching a new high at the end of July. Investors have been prepared to look through the sharp deceleration in corporate profit growth in the expectation of an improvement in 2020 once supportive monetary policy kicks in. This optimism has pushed valuations towards the top end of their normal range, leaving them vulnerable to disappointing news. An estimated 3% increase in global earnings this year looks reasonable, but 10% growth for next year appears optimistic. We have become slightly more defensive in our stock-picking in recent months while retaining a focus on quality companies generating strong free cash flow.

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