1st Quarter 2019

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

Ludwig von Mises, one of the fathers of the Austrian School of Economics, writing in “Human action: a treatise on economics” published in 1963.

Last Quarter Review

As anticipated by the market, the Federal Reserve (Fed) raised the US base interest rate by a further 0.25% to 2.50%, at its December Federal Open Market Committee (FOMC) meeting. Its statement cited economic activity continuing to rise at a strong rate, while job gains remain strong, and the unemployment rate remains low. The FOMC also stated that household spending has continued to grow strongly, but growth of business fixed investment has moderated from its rapid pace earlier in the year, while indicators of longer-term inflation expectations are little changed, on balance.

It is the fourth rate hike this year, but there have been many including President Trump, whom are convinced the Fed is tempting fate and potentially providing the catalyst for a recession through inadvertently inverting the US Treasury (UST) yield curve with its normalisation strategy. Wall Street stocks did not react well as all major American equity indices, which had been slightly positive before the FOMC’s statement, fell sharply prompting other global equity indices to also decline.

Having hit new all-time highs during the third quarter, US stock indices were down sharply this quarter, with the S&P 500 ending down almost 15%, while the Dow Jones Industrial Average (DJIA) fell 13% and the tech heavy Nasdaq Composite index was down almost 18%. Understandably, equity markets elsewhere followed Wall Street’s lead, with the Nikkei in Japan down almost 17%, the Dax in Germany falling 14% and the Shanghai Composite in China which had already been in a bear market for some time falling another 11% during the quarter.

The FTSE 100 dropped more than 10% during the quarter, amid concerns about Brexit negotiations, the US-China trade dispute, tightening financial conditions for companies and the darkening outlook for global growth. However, the UK economy on balance remained resolutely strong with the latest available economic data showing its rate of growth had accelerated in the third quarter from 0.4% to 0.6%, whereas in most European Union (EU) countries, it has been decelerating with Germany for example seeing a 0.2% quarterly “contraction” compared to 0.5% growth previously.

Despite all the Brexit uncertainty, the London Stock Exchange (LSE) easily remained the busiest stock-market in Europe with a total of £37 billion raised by some 600 companies during the year, while Frankfurt, London’s nearest rival was a distant second with just £29.5 billion raised. The LSE money was mainly from existing listed companies raising more cash, but included almost £10 billion raised by 79 companies that floated, 19 of which were tech companies, the highest number in five years, which will have excited those whom believe the UK can one day rival the US for internet stock issues.

The economic slowdown in most developed markets (the US and the UK being the exceptions) during 2018 has been exacerbated by the trade war between America and China, after President Trump imposed tariffs on $250 billion worth of Chinese products, and the Middle Kingdom responded with tariffs of its own. After much sabre rattling and threats of further escalation, what had until recently appeared to be an impossible cold front between the two economic superpowers, looks like it is hopefully beginning to thaw.

On the 14th December, the Chines state council said it would temporarily cancel an extra 25% import tariff on American cars, and President Trump tweeted, “China wants to make a big and very comprehensive deal. It could happen and rather soon.”

More recently on the 29th December, the American President tweeted, “Just had a long and very good call with President Xi of China. Deal is moving along very well. If made, it will be very comprehensive, covering all subjects, areas and points of dispute. Big progress being made!”

On the negative side, the collapse in the oil price during the quarter, as the Brent contract fell more than 35%, is arguably further proof of a slowing global economy.

Key Economic & Market Data 2018 Q3 GDP 12 month GDP Base Interest Rate - End Dec 2018 Equity Index - Last Quarter Equity Index - Last 12 Months Sovereign Bond Index - Last 12 Months
% % % % % %
USA 3.40 3.00 2.50 -13.97 -6.24 +1.05
UK 0.60 1.50 0.75 -10.42 -12.48 +0.50
Euro Area 0.20 1.60 0.00 -10.79 -14.37 +0.79
China 1.60 6.50 4.35 -11.60 -24.58 +7.53
Japan -0.60 0.00 -0.10 -17.02 -12.04 +0.83
Germany -0.20 1.10 0.00 -13.78 -18.26 +1.94
NB. GDP Data shown are to the 30th September 2018; Interest Rate, Equity & Bond Index Data are to the 31st December 2018; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.

Current Considerations

Ludwig von Mises made his simple yet profound observation, about there being no means of avoiding the final collapse of a boom brought about by credit expansion, in1963. Little did he know then, that just a few years later, an extraordinary action by American policymakers would ensure the wheels were set in motion for the beginning of the longest and potentially most dangerous credit cycle in history.

The decision by the United States in August 1971 to abandon the dollar’s last direct link with gold, which had effectively anchored the value of real money since trading history began, set in motion the modern era of debt. The global economy has only really in the last decade begun to fully appreciate the repercussions of this, while investors had hoped that the lessons of Lehman Brothers’ demise, and the credit crunch of 2008 would result in western policymakers finally realising you cannot prop up an economy that is struggling under the weight of its own debt, by creating even more debt.

Sadly, this has not occurred as the amount of total debt globally has continued to increase almost uncontrollably, as highlighted in a research paper by McKinsey & Company in 2014, titled “Debt and not much deleveraging”, that showed that in the fourth quarter of 2007, total global debt (government, financial, corporate and private) was $149 trillion, but by the second quarter of 2014, this had increased by $50 trillion to $199 trillion. This happened despite the much-trumpeted austerity supposedly occurring throughout the developed world, and while McKinsey has not updated its research, unofficial estimates now put total debt at anywhere between £225 trillion and $275 trillion!

Exactly when, or through what catalyst, the next credit crisis occurs is something none of us can know, but many believe that the actions of the Fed this year through what is arguably an ill-judged premature monetary tightening stance, will hasten the onset of the next economic downturn, and with it an equity bear market. Is it possible that the long deflationary trend that has been in place in the US and elsewhere since the collapse of the Dotcom bubble at the beginning of the millennium still holds sway, or are the Keynesian economists who dominate the thinking in the Eccles building of the Fed in Washington DC, and virtually everywhere else in global central banking, correct in their expectation of serious future inflation threats that must be curtailed through higher interest rates?

Despite the Fed’s confidence in the continuing strength of US economy, several key data suggest activity is slowing, and that the so called, inflationary threat cited by the Fed as its reasoning for normalising interest rates is almost non-existent. Of course, it is only fair to say that many doomsayers have for several years been predicting the collapse of the US and global economy, when debt levels were far lower than currently, and many of these are now reluctantly conceding that no one really knows at what level debt leverage becomes unsustainable!

Nevertheless, historically the US Treasury market has proven a consistently reliable predictor of economic recessions and so it will be interesting to see over the next several weeks and months how the UST market responds and whether we shall see the yield curve invert. During 2018, the yield curve of the US debt market did not invert but did flatten considerably, and history suggests that the inversion of the spread between the benchmark 10-year UST and the 2-year UST has usually resulted in economic recession at some point during the following twelve months or so.

Interestingly, recent research undertaken by the San Francisco Fed suggests the UST 10 year minus 3-month spread is an even more reliable indicator of a recession on the horizon, and that if this spread falls below + 0.40% (+ 40 basis points), there is more than a reasonable possibility of a decline in economic activity. The 10 year minus 3-month UST spread following December’s interest rate increase fell from + 43 basis points (bps) to just + 37 bps the following day!

At the end of December 2018, the spread between the 10 year and 3-month UST stood at just + 24 bps. Meanwhile the historically more widely followed spread between UST 10 year and 2-year issues has not yet inverted and stood at + 21 bps on the last trading day of the year.

Incredibly history shows that the Fed, has on several past occasions ignored the inversion of the UST yield curve, and continued raising interest rates. This happened, in both 1989 and 1999 under the guidance of Alan Greenspan, when on both occasions the Fed suggested that the inversion of the yield curve was irrelevant, only to be proven wrong by the subsequent recessions in 1990-91, and 2000-01, which they sadly failed to recognise, until they were long underway.

Similarly, in 2008, the Fed, then led by Ben Bernanke suggested the yield curve inversion prior to the collapse of Lehman Brothers was unimportant only to be proved wrong by the subsequent recession. So unfortunately, the Fed appears to have an historic blind spot when it comes to UST yield curve inversions, and it will be most interesting to see whether during 2019 Jerome Powell continues the Fed’s normalisation of interest rate strategy or, unlike two of his predecessors, actually heeds the bond market signals and ceases raising rates?

Forward Outlook

So, as we begin the New Year, we shall be earnestly watching for definitive signs of a US recession. The most accurate historic benchmark, namely the UST market is not yet signaling this, but it is getting very close to doing so.

Another important bellwether, namely the oil market has rather worryingly been behaving like a drunken manic depressive, with the price pendulum in the space of just a few short months during the second half of 2018 swinging from more than $85 a barrel (Brent contract) to just $45 at the end of 2018. The rapidly rising price in the late summer had threatened the economic survival of several emerging economies as well as proving a major headwind to oil dependent developed economies such as the US, while the recent collapse in price, suggests global economic growth is seriously stalling.

The US dollar, by comparison has been relatively strong throughout 2018, which usually results in a depressed gold bullion price. However, the recent strength of gold during dollar strength adds fuel to those who believe bullion behaves like the canary in a coal mine, and is signaling serious economic worries on the horizon.

What is apparent, is that the long bull market in US Treasury bonds that began decades ago in the early eighties, and which many respected analysts had suggested was over, looks to still have some life left in it. Similarly, the prices of benchmark German and UK government bonds have been rejuvenated recently, and suggest that, for now at least, investors’ appetite for riskier assets such as equities has slowed.

However, the fundamentals for the economies and the listed companies of both the US and UK remain positive. This is especially true in the UK where the valuations of companies prior to the equity market setback of the last quarter were at best fully priced, and are now offering attractive longer-term opportunities.

Therefore, provided the Fed does not end the party prematurely by continuing to unnecessarily raise interest rates, thereby inverting the UST yield curve, and provided the US and China continue the positive dialogue on resolving the trade wars, there is no reason why the equity bull market on wall Street cannot continue, especially as the demographic ratio, that we have looked at previously, remains positively skewed. In this scenario, some of the unloved and ignored companies in the UK equity market, and particularly in the mid and smaller cap sectors offer value, subject of course to the UK government not making an even bigger mess of Brexit.

Despite the lack of definitive evidence of increasing inflation either side of the Atlantic, we remain cautious on both UK gilts and US Treasuries, along with corporate debt, where the low additional yields over government bonds suggest we are not being adequately rewarded for the potentially asymmetric risk. We also retain some exposure to commercial property where appropriate for diversification purposes.

As ever, monitoring and determining the macro picture including the likely direction of key indicators such as the dollar and Treasury yields will play a key role in advised portfolio asset allocations going forward. If and when a more defensive investment strategy becomes necessary, we shall of course advise accordingly.

For now at least, we remain positive towards sectors of the market where we believe relative value exists. As always, investment risk is at the forefront of our advice and, whilst it often necessary to undertake adjustments in portfolio allocation in order to maintain individual preferences, we are confident that our advised portfolios remain well placed in meeting our client’s needs.

With very best wishes to all our clients and their families for a healthy, happy and prosperous New Year!