Investment Outlook for August 2019
After a prolonged period of low equity market volatility, world equities registered a sudden jolt reminding investors of investment risks inherent in equities. As stated a number of times, even favourable periods for equity markets are never characterized by straight upward price curves and sudden bursts of volatility continue to be an integral part of any market in risk assets.
Recent economic evidence does not point towards substantially increased volatility in economic trends although geopolitical tensions and uncertainty surrounding trade and monetary policies can add to temporary volatility. Underlying trends, however, continue to point towards sustainable global growth this year and next.
As sometimes occurs in periods of climbing equity markets, complacency had been setting in amongst investors extrapolating recent favourable performance into the future and de-emphasizing inherent risks in the process. The Fed’s monetary action was interpreted as a disappointment by those investors who had been positioning their investment portfolios for more drastic monetary easing, and also US policy makers once again managed to direct pubic attention towards international trade tensions.
Equity investors, who may have been lulled into a false perception of sustainable low volatility, reacted drastically thereby driving share price declines of 3 to 4% over a 5-day period at the start of this month. This market reaction has led to some debate amongst observers regarding the sustainability of economic growth trends, and by implication, the investment outlook.
The proof of any sustained favourable backdrop can be provided by the corporate sector in its ability to generate surprises. According to FactSet, the second quarter of this year saw 76% of the S&P 500 companies reporting a positive EPS surprise and 59% of companies reporting a positive revenue surprise. The absolute S&P earnings scorecard was more mixed: the earnings decline for the S&P 500 was -1.0%; an important factor during the second quarter was the strength of the US$ which was mentioned as a major factor by the majority of companies but, one suspects, was mainly related to the translation of foreign earnings into US$ (unfortunately FactSet does not separate currency translation out of the total currency effect in its reports).
Against a background of increased question marks by investors regarding the sustainability of positive market trends, the Fed’s historic rate cut (the first in some ten years) at the start of the month had been widely anticipated and, in the end, disappointed those investors who had been positioning investment positions for a more pronounced policy move. The FOMC statement reads as follows:
“..the Committee decided to lower the target range for the federal funds rate to 2 to 2-1/4 percent. This action supports the Committee's view that sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective are the most likely outcomes, but uncertainties about this outlook remain. As the Committee contemplates the future path of the target range for the federal funds rate, it will continue to monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.”
As often happens in climbing equity markets, some complacency had been setting in amongst investors who were projecting recent favourable performance trends into the future and de-emphasizing inherent risks in the process. The Fed’s monetary action was interpreted as a disappointment by those investors who had been positioning their investment portfolios for more drastic monetary action, and president Trump once again managed to direct pubic attention towards his international trade agenda.
One of the key issues regarding the likely path of global interest rates (and equity markets) is the lack of a clear consensus of the intellectual framework to underpin policy actions. The Phillips curve (suggesting a trade-off between employment and inflation) has, in the eyes of many observers, lost its appeal and no new intellectual dogma has replaced it yet. Speculation regarding the Fed’s policy intentions have, at times, also been caused by contradicting statements from various FOMC members. By way of example, New York Federal Reserve President John Williams caused some confusion by stating that the central bank needed to “act quickly” when the economy was slowing and rates were low, stating that it is “better to take preventative measures than wait for disaster to unfold.”
In the course of July it had become clear that normalization of monetary policies had become unfashionable and that low interest rates were likely to persevere. The outcome of the July Federal Open Market Committee was, in the end, in line with anticipations with the FED reducing its target for the federal funds rate by 0.25% to 2.25% stating a riskier global economic environment. Low inflationary pressures keep possible future rate cuts on the table. The Fed’s statement has been seen as generally supporting loose policies and, importantly, supporting risk assets although a specific conclusion with respect to possible size and timing of accommodative policy actions remains elusive. There does seem to be less certainty now regarding a potential further rate cut in September.
Last month’s Investment Outlook emphasized our view that economic policies, although igniting volatility at times, are unlikely to disrupt the longer term favourable growth outlook for the world economy. Global economic trends have also been characterized by continued downward pressure on interest rates in western democracies and most central banks have been pursuing accommodative policies that go a long way in prolonging the growth record thereby countering negative effects of protectionist trade action in the USA and a number of other countries. Low fixed income yields can be expected to offer a favourable tailwind to interest rate sensitive parts of the economy and the valuation of risk assets. In short, global equities continue to offer superior investment opportunities to most other asset classes and remain “the only game in town”.
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