Chief Investment Strategist
While rising interest rates, the ending of “cheap money” and a maturing economic cycle have been evident for some time, these factors – combined with growing uncertainty on US/China trade tariffs, the Brexit stalemate, slowing growth in China, Italy’s budget deficit and deteriorating relations between Saudi Arabia and the West – sparked a global equity sell-off in October. Regionally, the falls were relatively indiscriminate, which is typical during a ‘risk-off’ phase, and we saw the usual divergence with highly valued growth companies particularly hard hit. In the US, for example, the technology and biotech-biased Nasdaq 100 declined 9% whereas the more broadly based S&P 500 fell by 7% to 2,711. The Nikkei 225 also fell 9% to 21,920 although the FTSE 100 and FTSE Eurofirst 300 fared better with 5% falls to 7,128 and 1,422 respectively. This was the worst monthly performance for the FTSE 100 since May 2006. The upward trend in bond yields slowed marginally in the US with the 10 year Treasury ending the month unchanged at 3%. UK bond yields rose to a new year-on-year high of 1.7% before closing at 1.4%. After touching a near three-year high of $86 per barrel on fears that US sanctions would restrict Iranian supply, Brent crude dropped to $76.
Global growth estimates for 2018 are unchanged at 3.3% while 2019 has been marginally downgraded to 3.2%. Some deceleration was anticipated but the impact of trade tariffs remains very uncertain. Business investment has been a key element of global growth as tight labour markets force companies to restructure their operations, boosting demand for technological solutions. It is debatable how much is structural rather than cyclical but the cycle has probably peaked, with the result that growth will be supported by consumption. Fortunately, this is continuing to increase at a relatively strong rate.
US GDP growth surprised on the upside over the summer but dropped to 3.5% in Q3. Excluding distortions from the pre-tariff rush to build up inventories and net export drag, consumer demand rose a healthy 3.1% and is expected to remain strong into the first half of 2019 when tax cuts will drop out of the equation and higher tariffs and energy prices will start to slow progress. Unless corporate tax savings are reinvested in improved productive capacity, ‘Making America Great Again’ will have come at a significant price as the budget deficit heads towards an unsustainable 5% of GDP. The notable exception to the current benign picture is housing where weakness is a combination of labour shortages and higher input and mortgage costs. Given the strength of the dollar, the drag from net exports could also increase. Meanwhile, the strong jobs market and the likelihood of a further acceleration in wage growth has prompted Federal Reserve governors to remind investors of the gap between guidance and the three interest rate rises that financial markets are currently discounting.
GDP growth in China has also decelerated as the authorities attempt to tackle the complex shadow banking system. Typically, ‘good quality’ banks have been expanding borrowing off-balance sheet by selling high return products to wealthy customers and recycling the monies to highly indebted corporates via a series of opaque structures. Without reducing the regulatory pressure on shadow banking while also combating the threat of trade tariffs, the authorities have modestly loosened monetary policy. It is also expected that fiscal measures targeting infrastructure projects will be reintroduced – a potentially retrograde step in the context of the long-term transition plans for the economy. These measures should underpin GDP of 6.4% but, if US tariffs were to rise 25% across the board, growth could fall by as much as 1%.
Elsewhere, growth in the advanced economies is losing momentum, albeit from a lower starting point. In Europe, Spain and Ireland continue to lead the pack and activity has picked up slightly in France. However, despite the strong domestic economy, Germany appears to be losing ground, reflecting its exposure to the slowing Chinese economy and global trade. Many EU countries are facing political problems – not only Germany and France but also Italy, where the recently announced 2019-21 fiscal plans do not comply with EU rules. Italy’s budget deficit is mainly the result of structural spending rather than short-term, growth enhancing tax cuts. This means sovereign spreads have widened – raising the cost of servicing already high levels of government debt – and Moody’s has downgraded its credit rating to one notch away from junk bond status. The balance sheets of Italian banks are likely to face a challenging period.
The UK economy continues to grow at a modest but slowing pace as the deadline for a Brexit agreement approaches. Business investment is significantly lower than in other global economies and this is likely to impact competitiveness in the brave new world. Despite the Northern Ireland ‘back-stop’ problem, a ‘no-deal’ scenario still appears unlikely but the transition phase is expected to last for years and could lead to a new government attempting to restart negotiations. Sterling continues to track Brexit news and, with inflation above target and low unemployment, the Bank of England remains on a tightening path. Improved government finances and revised forecasts gave the Chancellor some scope to engineer a small fiscal boost in the Budget.
History suggests that a 10% consolidation in equities is not only a frequent occurrence but also ‘normal’ over the course of an investment cycle. Similarities with previous cycles include GDP growth peaking as stimulus measures (the phasing out of quantitative easing, normalisation of interest rates and gradual absorption of US tax cuts) fade or are unwound as well as a mild pick-up in inflation, more heavily geared corporate balance sheets and over-exuberance by some leveraged investors. However, many cyclical warning signs – highly leveraged mergers and acquisitions, high bank loan growth and geared investment bank trading – are absent at this stage. Higher costs as trade tariffs feed through the supply chain and lower sales are not a helpful combination and companies will find it difficult to maintain profits growth at recent levels. Earnings estimates for 2019 already reflect the more challenging outlook and management guidance during the results season has not raised alarm bells. Valuations have de-rated significantly as investors adopt a cautiously optimistic approach.