Investors seem to be a little less convinced about reflation trades now than they did at the turn of the year.
Back then the rise in inflation (which would spike if Trump’s fiscal stimuli came through), prompting investors to sell bonds and buy equities, was the single big issue that framed any conversations between brokers, investors and traders.
Economic indicators still point decisively to the upside: the surveys of households and corporates across most of the developed world generally paint a healthy picture. Lead indicators of industrial production and global trade suggest that activity is generally firming up and the long recovery is continuing, and even accelerating in places.
At a company level, optimism seems to be flowering too: global corporate earnings expectations have pushed higher over the last year, with expectations for Emerging Markets leading the way (along with UK multinational companies, where a high level of overseas earnings has driven forecasts higher as a function of Pounds’ falls).
This is a relatively unusual state of affairs since the financial crisis of almost a decade ago. For so much of the time since, corporate earnings have been buffeted by one headwind after another. Today’s picture, of broadly rising profit forecasts across all major markets, is a welcome development.
But investors appear less certain: it’s been heavy going for global stocks over the past month or so and most major markets have struggled to make much ground since late February or early March, although Europe is standing out as a notable exception. It’s been most challenging for ‘Trump trades’, as confidence in the US President’s ability to deliver the anticipated tax plan and infrastructure spending has dissipated: US small-cap stocks have now trended sideways since December after their post-election surge and US bank stocks have fallen by around 10% from their peaks in early March. Bond yields, meanwhile, have ticked lower again – despite the decent economic data, and a further rate hike from the Federal Reserve (Fed). Have investors given up on reflation and economic growth strengthening if not to the point where US GDP reaches 4%?
We suspect not – but there are clear risks that still need to be navigated.
Investors need to be convinced that the optimism reflected in the leading indicators is translating to strength in hard economic activity data and corporate profits. There’s some evidence, particularly on strong corporate profits for Q4 2016, but there’s a lingering sense that positive surprises have been more apparent in surveys (such as the Purchasing Managers Index surveys of corporate intentions or consumer confidence surveys) and less so in official data releases.
A lag is understandable, but investors will likely feel better when that validation comes. We have lived through a prolonged, albeit shallow, economic upswing and there’s a temptation among some observers to point to the calendar and suggest that a slowdown is due. We should be wary of such simplistic arguments – economic cycles usually end because of tight policy or external shocks, rather than dying of old age. However, as time progresses and the Fed continues its slow procession of rate hikes and the temptation to call an end to a long-in-the-tooth cycle grows, we should be watchful that markets could over-interpret normal random weak data points as heralds of the next downturn. This may matter particularly over the next couple of months, where it may be hard for survey data to continue to surprise on the upside. Now we are in Q2, we can no longer count on the base effects from 2016’s Q1 slowdown that created relatively low hurdles for year-on-year data to surpass in 2017.Economic cycles usually end because of tight policy or external shocks, rather than dying of old age.
Stockmarket valuations may seem at odds with the flickers of doubt about the resilience of growth, in the US in particular. Most stockmarkets have become markedly more expensive (relative to corporate earnings) over the past couple of years, with the US equity market leading the way. Valuations there are substantially higher than other markets and have reached multiples last seen in the early 2000s. Expensive assets can of course become more expensive (as we have seen with Gilts, and index-linked Gilts in particular) and high valuations do not, by any means, have to suggest imminent trouble, but they do leave markets vulnerable to a change in sentiment or a change in the run of data. Betting against the US stockmarket has been a losing game for most of the last decade, but we think the challenges are real enough both to be running a lower level of risk in portfolios, and to tilt the emphasis a little away from the US and towards cheaper markets.
Markets are also still focused on political risks – understandably in view of the shocks of the past year. Of course, an overplayed risk can be the source of rewards for investors, affording attractive entry points where assets are too cheap as a result of the market pricing too great an impact from political risk or too high a probability of the feared event materialising. Our objective should not be to attempt to avoid all political risk, but to look for opportunities where markets are mispricing risk – too fearful, or too complacent.
In the US, the market’s surge after Trump’s election victory perhaps started to price in too much complacency and too much optimism over his ability to drive policy change through Congress. Markets are right to price in some probability of corporate tax cuts, infrastructure spending and deregulation, but after the failed attempts to repeal Obama’s healthcare policy and to impose migrant bans by executive order, the risk of policy being delayed or diminished seems greater now than two or three months ago. This reinforces our slight degree of caution on the US.
Political risks are obviously still elevated in Europe too. On the continent, we see much to like in an accelerating economic cycle and a long-awaited pick up in corporate profits – and stock market valuations are still reasonable. However, there remains scope for volatility in France’s complex election race. The polls still strongly point towards a Macron win, which would likely be taken well by the market. However, doubts persist and some observers fear that because the polls ‘failed’ on Trump and on Brexit, they could fail again on Le Pen.
The polls still strongly point towards a Macron win, which would likely be taken well by the market.
There are two reasons why we think that’s probably not the case.Firstly, it didn’t really fail on Trump – Clinton won the popular vote, by a similar margin to the national polling, but Trump triumphed due to the Electoral College structure and regional distribution of votes. That’s not an issue in France, where the result is about a simple majority. Secondly, polling didn’t really fail on Brexit – polling was close, with several polls predicting a Leave win in the run up to the election. Many observers (including us) expected a late swing back to the status quo, which ultimately didn’t happen – but that is a failure of interpretation, not of the polling. The Brexit outcome was within the range of possibilities the polls pointed to.
By contrast, in a potential Le Pen versus Macron run-off, polling has consistently been around 40% versus 60% for months, with little change and a much wider margin. It would be a spectacularly huge miss by the polling (from all companies, for months) if Le Pen did win, which is a completely different situation to the US and UK in 2016. Still, there are complexities and scope for late shifts in this race. The far left candidate Mélenchon is experiencing a late surge in the polls. And if this surge continues, it could open up new scenarios where we have very little polling evidence to go on. We are comfortable taking the risk in our more adventurous portfolios, but for cautious portfolios the scope for some volatility ahead of the vote justifies a reduced exposure to Europe.
At home: Article 50 has been triggered, but not much else has happened yet. Sterling remains largely range-bound against major currencies. Some commentators see a softening in the tone of the Prime Minister’s rhetoric in recent weeks, downplaying the idea of UK as offshore tax haven or the possibility of leaving with no deal in place, and acknowledging the possibility of transition deals, payments to the EU, maintaining compatibility with EU regulation and maintaining some degree of migration. This may reflect a real softening of the negotiating stance in the face of a united EU-27 and a dawning understanding of the EU’s priorities, which is (above all) to head off existential threats to the union. The real beginning of negotiations between the UK and EU still lies ahead and we expect a tough process.
Offering the UK as good a deal on trade as it has now, while allowing the UK to opt out of freedom of movement, is incompatible with that stance, even if it means some economic pain for the EU. The real beginning of negotiations between the UK and EU still lies ahead and we expect a tough process. For now, public opinion appears to have shifted little from last summer, allowing the government to maintain its course towards a hard Brexit, leaving the Single Market and the Customs Union, risking economic pain from the disruption to cross-Channel trade and deterring inward investment as uncertainty persists. It remains to be seen whether public opinion holds, or whether the recent evidence of weaker consumer activity, softer housing markets and rising inflation are straws in the wind foreshadowing a shift.
Overall, we find the trade-off between risk and reward a little less appealing than a few months ago. Portfolios have delivered good absolute returns in the first quarter of the year while taking lower than usual risk, and we think it remains appropriate to run a fairly modest level of risk. We favour cheaper equity markets, selected opportunities in corporate or Emerging Market debt and alternative strategies (many with low sensitivity to equity markets), but pair this with a healthy buffer in safe havens such as gold and US Treasuries, and a high reserve of cash. Cash, of course, provides next to no return itself in today’s low rate environment, but we place a high value on the optionality it brings. In other words, it gives us the ability to buy favoured assets at attractive prices when confidence wobbles and markets take a backward step.
Deputy Chief Investment Officer
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