Investment Outlook for June 2019
Towards the end of May the mood in international equity markets had turned bearish, raising the question of whether this represented another episode of temporary draw –downs (which have become a regular occurrence in world equity markets), or whether investors should expect a sustained decline in equity values.
So, has the Goldilocks Market reached the end of its favourable run? An overview of underlying fundamental trends suggest that, although further episodes of draw-downs and market jitters cannot be ruled out, fundamental economic trends are unlikely to cause a structural change in the longer term outlook for the world economy. Although equity markets do not rise in a straight line and hiccups can occur along the line, one can still attach a low probability to an imminent recession in the USA or China based on incoming statistical evidence.
Yields are low or negative across much of the world offering a strong tailwind to interest rate sensitive parts of the economy and the valuation of risk assets; in addition, stimulative measures from a number of key economies can go a long way to counter the negative effects of any protectionist measures. In an environment of low interest rates global equities continue to offer superior investment opportunities to most other asset classes and remain “the only game in town”.
Global trade: Political feed-back moves center-stage
The trade war (increasingly a major market risk after the recent addition of US-Mexico trade as a major factor) seems to have been more important to US financial markets than to the wider economy recently (around a third of the S&P500 companies are sensitive to global trade). Tariffs and the anticipation of tariffs have a major impact on a number of key economic variables such as industrial production, business investment, PMIs, and many financial asset prices. Currently around half of China’s exports to the United States (around $200bn) now face 25% tariffs.
At the start of June it seems unlikely that either party will offer major concessions in the current trade stand-off, and so equity market performance, labour market data, FED policy intentions, and electoral polls are increasingly becoming variables that will affect the negotiators’ stances as time progresses. On the one hand US politicians are watching the timeline to the next elections (US presidential elections are on November 3, 2020) and wonder how their policy statements are likely to influence voters’ intentions. In China the lack of transparency of the political system, and rising nationalist sentiment, add to the fog surrounding these trade negotiations.
Loose monetary policy: A firewall against a global recession?
Over the last two months it has become clear that US monetary authorities have moved fully towards an accommodative stance. As always a detailed analysis of statements by the Open Market Committee of the FED offers the clearest and most reliable source to assess monetary policy. The minutes from the Open Market Committee meeting of May 1 state the following:
“Despite solid economic growth and a strong labor market, inflation pressures remained muted. In light of global economic and financial developments and muted inflation pressures, members concurred that the Committee could be patient as it determined what future adjustments to the target range for the federal funds rate may be appropriate… Members agreed that in determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee would assess realized and expected economic conditions relative to the Committee’s maximum-employment and …2 percent inflation objectives…members noted that decisions regarding near-term adjustments of the stance of monetary policy would appropriately remain dependent on the evolution of the outlook as informed by incoming data.”
The somewhat surprising “hands-off” approach by the FED has been attracting increased scrutiny, with an increasing number of commentators wondering what the appropriate policy response should be in a world where inflation has been drifting to a level below target and job growth is strong (thereby invalidating the basic notion of the Phillips curve theory). The most vocal critics of current monetary policy come from a group that promotes the so-called Modern Monetary Theory (MMT). The central idea of MMT is that governments can, and should, print as much money as they require because governments cannot go broke. Orthodox economic thinking says that such spending would be fiscally irresponsible as the debt would balloon and inflation would skyrocket. Recent evidence from Zimbabwe and other countries facing hyper-inflation are a timely reminder that irresponsible economic policies have not lost their ability to cause economic havoc: the solid reputation of central banks enables them to implement loose policies because they can build on reputations that take many years of credible economic management to establish (and are difficult to resurrect once this credibility is lost).
European economy: waiting to bottom out
The European economy remains “stuck in the mud” and has been showing scant signs of dynamism this year: Economic confrontation in France, a virtual electoral stalemate in Germany, rising populism in Italy and (last but not least) the Brexit process seem to have conspired to sap life out of constructive structural initiatives across the continent. Over the last four weeks, however, the economic news on the continent has shown (tentative) signs of stabilisation in a number of regions.
Preliminary euro zone consumer confidence rose moderately to -6.5 in May (from -7.3 in April), representing the highest level in seven months. In addition, the German economy rose by 0.7% in the first quarter (up from 0.6% in 2018Q4). Encouragingly, the major contributions to the GDP growth in Germany came from household consumption, capital formation and net foreign trade. Household consumption jumped by 1.2 % in Q1 compared to 0.3 % in 2018Q4. Looking forward, Germany continues to be characterized by low financial leverage which provides a cushion against any significant weakening in the world economy: Existing forecasts suggest that Germany’s budget surplus will hit 1% this year and decline to 0.8% in 2020. Government debt is expected to fall from 58% of GDP in 2019, to 56% by 2020.
In contrast to the German economy the European Commission forecasts an Italian budget deficit of 2.5% of its GDP this year, rising to 3.5% in 2020. Italian politicians had told the EC that it would lower some of its spending plans for 2019, so that its fiscal deficit would not go beyond a target of 2%. Initially it intended to increase spending to above 2 % of GDP this year so one can wonder what the ultimate outcome will look like (member states are not supposed to have a deficit above 3% of its GDP). Allowing for some political posturing and eleventh-hour negotiations, the best guess for investors is that, once again, a last minute compromise will ensure (less than ideal) fiscal continuity in the European Union.
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