Investment Outlook for February 2019
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Investment Outlook for February 2019

Take the speculative noise out of the market and one can identify underlying trends with greatly improved clarity. This is what happened at the end of January when the US FED stressed that it would be patient in deciding of future monetary policy actions. Key sentences from the Federal Open Market Committee’s statement on January 30 2019: “…the Committee seeks to foster maximum employment and price stability. In support of these goals, the Committee decided to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent.” and “In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes”. The key word in this statement is “patient” which was interpreted by market participants as a move to a neutral policy stance and the abandonment of the (recently introduced) tightening bias.

The more supportive stance by the FED, and additional supportive policy measures in China acted as major positive factors for equity markets worldwide by the end of January. Meanwhile the earnings reporting season is progressing in line with market expectations although the majority of companies still have to report. According to FactSet, after 22% of the companies in the S&P 500 have reported their results, 71% of these reported a positive earnings (EPS) surprise.

In its recently updated global assessment the IMF foresees GDP growth trends close to long-term trends. The global economic backdrop remains favourable although, reading recent press reports and a number of articles during January, a casual observer might have gotten the impression that the favourable fundamental trends were crumbling before our eyes. Towards the end of the month investors’ attention started to re-focus on underlying economic trends as the market started to absorb fourth quarter profit reports and un-substantiated speculation became less influential in driving share price performances around the world. Although the global economy is experiencing (moderate) weakness in a number of countries (Germany being a prime example), a global recession looks unlikely in the near future in spite of the (sometimes biased) press coverage. The world has woken up from a prolonged “rest period” in the wake of the financial crisis: market participants have to incorporate (the prospect of) normalized market conditions. There will be less blanket market support from central banks and the exposure to business cycles, rather than a boom engineered by central bankers, will resume their traditional role of driving share price performances (up or down!).

Investors willing to take a step back from the daily noise and focus on underlying trends will have noticed that US unemployment, hit a 50-year low in a very strong labour market. Also, corporate profits keep powering ahead in the US: after growing more than 20% last year, one should expect a somewhat reduced growth rate (dictated by mathematical logic) but an earnings downturn seems unlikely. FactSet estimates that earnings will grow high single digit for 2019, not the high number from last year but still impressive. Consumer and business sentiment has stabilized at an historic relatively high level.

Consensus forecasts for 2019 are levelling off but are not turning negative: US GDP growth is expected to moderate over the next two years (as confirmed by FactSet), showing 2.5% growth in 2019 followed by 1.8% next year. The economic expansion is now in its 11th year, which a number of forecasters find difficult to accept: surely “what goes up must come down!” seemed to be the guiding notion and there had been increasing “noise” coming from some economists, market commentators and politicians pointing to the possibility of a looming recession.

China’s reflation supports global growth

Economic data coming out of China suffer from a lack of credibility in the eyes of a many observers but subtle changes in statistics can provide important clues with respect to underlying trends. In this light it is interesting to note that fourth quarter GDP growth was in line with expectations at 6.4% (after 6.5% in Q3) and for the full year 2018 growth amounted to 6.6%; the statistical snap-shot suggests continued favourable underlying growth at a moderately lower pace.

It is important to note that in a centralized economy like China there are additional options to keep growth trends “on track”: Chinese authorities could, for instance, introduce further reductions in reserve requirements for Chinese banks and in recent weeks, observers have been getting excited at the prospect of major tax cuts. Late last year Chinese authorities decreased income taxes by some $70bn. Now, following an economic policy meeting of high-ranking economists in late December a number of commentators expect cuts in both VAT and corporate income taxes that could amount to an additional $219bn of economic stimulation.

Tax cuts would obviously widen the government’s deficit. It should be kept in mind though that China is a high savings economy and has ample room for government deficit spending (unlike many Western democracies). China’s savings rate (46% of GDP in 2017) is one of the highest globally and should support a structurally higher level of deficits than in most western democracies. Also China’s official fiscal balance only captures the central government’s budget and a small proportion of local government deficits. Most government borrowing and spending (capital investment on infrastructure in particular) is implemented at the local level and China’s underlying budget balance has been running at a deficit of around 10% of GDP for years, thereby absorbing financial surpluses of the private sector.

The likelihood of a major jump in credit growth similar to 2009 (when credit growth reached 33%) is seen as low at the moment because the authorities continue to pursue a policy of reducing financial risk at the macro level. The government is also aiming at a structural transformation away from investment growth and towards greater consumption.

Tepid growth in Germany

The European Union was in its sixth year of growth and all member countries continued to grow although the momentum has been moderating. However, according to The Economist, Europe’s domestic growth drivers should show a sufficient dynamic impulse to compensate for more difficult export conditions: the improving labour market, stronger wage growth and fiscal measures should continue to act as the underlying growth engine and ensure that the slow-down does not evolve into a (mini) recession. Overall, Euro area GDP growth is expected to have reached 2.1% last year and is projected to amount to 1.9% this year thereby indicating a modest deceleration.

Analysts are still working out if a German recession is likely or if Germany is just affected by a conspiracy of one-off temporary factors. Whatever the cause of the slow-down, the underlying fundamental trends showed a declining economy for the first time in two years due to weak domestic demand and somewhat softer exports. Importantly, the automotive sector is facing turbulence as new environmental regulations and US trade measures depress demand. RWI, One of the economic forecasters, stated (after lowering its GDP growth forecast for 2018): "The momentum of the German economy is weakening. International demand has become lower and at the same time companies apparently increasingly have problems to find enough workers for their productive processes."

Germany is often accused of being obsessed with fiscal rectitude but what many critics fail to mention is that conservative fiscal policies provide the “firing power” for tougher times when, for instance a European member state has to be bailed out after proliferate government spending on farm subsidies, social programmes etc. In the end, the most likely outcome is one where some increased economic flexibility will be introduced alongside fiscal conservatism in Germany.

Has the FED “caved in”?

Critics of US monetary policy have argued that monetary policy should be dictated by the long-term goal of price stability and that, as a consequence, short-term cyclical considerations are of secondary importance. In this orthodox view the recent change in direction in the Fed’s policy stance can be seen as “caving in” to short term market pressures. The opposing view is that, in the current economic environment, it is not clear how much monetary growth is required to provide the US economy with sufficient liquidity to support underlying (non-inflationary) real growth: in other words: how much “oil” does the economic growth engine need? Technical advances (through ecommerce for instance) blur the picture: orthodox retail sales numbers, for instance, no longer provide a complete and totally reliable picture of consumer spending and price inflation. Some commentators have been arguing that pre-empting inflationary pressures through restrictive monetary policies carries the risk of a policy mistake and could cause an unwanted slow-down or recession.

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The views expressed in this article are those of the author at the date of publication and not necessarily those of Dominion Fund Management Limited. The content of this article is not intended as investment advice and will not be updated after publication. Images, video, quotations from literature and any such material which may be subject to copyright is reproduced in whole or in part in this article on the basis of Fair use as applied to news reporting and journalistic comment on events.