“On the 1^st July, the US economic expansion became the longest on record, entering its 121st month since the end of the 2009 recession (which according to the National Bureau for Economic Research ended in June of that year), and surpassing the previous 120 month record – the March 1991 – March 2001 expansion – which ended with the bursting of the dot com bubble.” Zero Hedge article, 1^st July 2019

Last quarter review

As widely anticipated by the markets, the Federal Reserve (Fed) at its July Federal Open Market Committee (FOMC) meeting, cut US base rates for the first time in more than a decade. Even though the US economy looks to be continuing to grow quite strongly at around 2.3% per annum (with the Atlanta Fed’s “GDP Now” model forecasting 2.0% annualized for this third quarter), Chairman Jerome Powell would appear to have paid heed to President Trump (who wants a weaker dollar), and / or the bond market (whose yield curve inversion is suggesting future growth will slow and a likely recession occur) and begun to move to a more accommodative monetary stance.

However, thanks to a rather mixed message from Jerome Powell during the press conference following the FOMC decision, Wall Street stocks fell having expected the Fed Chairman to confirm that this was the first of a series of cuts in order to boost the economy, rather than a potential one-off as he appeared to imply. Subsequent analysis by market commentators however, suggested that the cut is likely to be the first of several and that the Fed Chairman who until relatively recently was totally gung-ho on continuing to increase rates is simply putting a brave face on the Fed’s policy U-turn.

The day after the Fed cut rates, on August 1^st, US stocks plunged and US Treasuries soared after a combination of poor economic data (the US July ISM manufacturing index came in at a three-year low) and trade tensions between Washington and Beijing escalating, as President Trump announced he will hit the remaining Chinese imports with a 10% tariff (effective from September). The yield on the 10-year and 30-year US Treasuries fell to their lowest levels since late 2016, and the 2-year note yield slumped to its lowest since November 2017.

In London, the Bank of England’s Monetary Policy Committee (MPC) voted unanimously to hold the interest rates at 0.75 percent, and reaffirmed its pledge to gradual and limited rate rises under the assumption of a smooth Brexit and some recovery in global growth. Notwithstanding this, the central bank lowered its GDP forecasts for 2019 and 2020. 

While the UK stock market fell the day of the MPC meeting, largely reflecting the news on Wall Street concerning the US manufacturing data and new Chinese trade Tariffs, the market has had an exceptionally positive run since the start of the year, with FTSE 100 up more than 10%, on the back of a combination of resilient economic data, pleasing corporate results and potentially lucrative company mergers. Sterling, by contrast has continued to fall against most currencies, largely on the back of Brexit concerns, but adding further to the share values of a large percentage of FTSE 100 constituents for whom the majority of earnings come from overseas.

Economic growth in Germany continues to disappoint, with GDP expansion in the first quarter a mere 0.4% after having been negative in the previous quarter, and the news is little better from the two other large economies France and Italy (0.2% and 0% respectively in the 1^st quarter). The comments from ECB outgoing president Mario Draghi summed up the impotence of the European central bank that is now faced with an EU economy that has begun to resemble the low growth expectations that have been the norm in Japan for at least two decades!  

The ECB press release of the 25^th July stated, “At today’s meeting the Governing Council of the European Central Bank (ECB) decided that the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0.00%, 0.25% and -0.40% respectively. The Governing Council expects the key ECB interest rates to remain at their present or lower levels at least through the first half of 2020, and in any case for as long as necessary to ensure the continued sustained convergence of inflation to its aim over the medium term.”

China, while seemingly locked in a trade war to the death with America, has continued to grow at an extraordinary rate of expansion for such a large economy, because never before in the history of the world has an economy valued at $13.6 trillion (i.e. as large as the combined EU nations) grown at an annualised rate of 6% or more, as China has been for some years. Chinese equity markets meanwhile after a strong run recently fell again last quarter, but market focus has arguably switched to the yuan and whether in light of continued economic aggression from the Trump administration, China might play its trump card (pun intended), and devalue its currency as the ultimate retaliatory weapon!

Japan appeared to at least temporarily awaken from its decades old deflationary slumber as the economy advanced 0.6 in the first quarter following an upwardly revised 0.5 percent growth in the previous period. Net exports contributed positively to the GDP expansion for the first time in four quarters, as imports of goods and services plunged 4.6 percent, the biggest decrease since the first quarter of 2009.

Japanese stocks (as measured by the benchmark Nikkei 225) however, were little changed last quarter and over the past twelve months are down slightly. While there are undoubtedly opportunities in selective stocks and sectors from time to time in Japan, as a long-term allocation it has been just as disappointing as the economy since 1989, when the Nikkei reached its record high of almost 40,000, compared to the current 21,540! 

1. GDP Data shown are to the 31^st March 2019; Interest Rate, Equity & Bond Index Data are to the 30^th June 2019; 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

The UK has a new prime minister in Boris Johnson, who wasted no time in appointing seventeen new members to his cabinet, most of whom like him had been in favour of leaving the European Union when the Brexit referendum occurred in June 2016. In the brief period since the new Prime Minister took office, he appears to have taken an extremely hard line with the EU in Brussels and has advised that if they are not prepared to offer concessions on the deal negotiated with his predecessor, then the UK will on the 31^st October effect the “hard Brexit” option by leaving the union with no deal.

The foreign exchange market (FX) is taking the possibility of this very seriously, and sterling has fallen further against most currencies, and as low as 1.21 versus the US dollar (USD), and 0.91 versus the euro (EUR). Arguably with inflationary pressures in the UK proving relatively benign (RPI is running at 2% per annum currently), sterling’s fall could be perceived as a real positive, by improving the UK’s competitiveness in export markets.

 Indeed it could also be argued a weak pound has helped the balance sheets and earnings of many of the UK’s largest companies listed on the UK stock exchange, since according to research undertaken by Schroders (a major asset management group) in March 2017, just 29% of the revenues of the FTSE 100 come from the UK. Therefore investors in these stocks should have little concern for the comments of some top economists in late July suggesting that a no-deal Brexit from a Johnson led UK government might result in sterling falling by as much as another 13% and taking the pound almost to parity with the dollar and euro!

For those of us going on holiday to the US or within the euro zone, it is of course rather more painful as the pound in our pockets that bought $1.45 or €1.31 before the Brexit referendum in the summer of 2016, now only buys us $1.22 or €1.09. Ouch! 

BOE governor Mark Carney and his colleagues on the MPC were doubtless tempted to raise interest rates at their August 1^st meeting in order to support sterling, and limit the increased cost of imported goods, like food and fuel, which could eventually lead to inflationary pressures. However with the Fed, now headed the other way and cutting interest rates, and the ECB known to be contemplating additional future stimulatory measures to try and devalue the euro further, the MPC almost certainly did the right thing by holding interest rates steady at 0.75%.

The UK equity market appears to be seeing the positives of a lower sterling, and buoyed by a spate of recent takeover activity (including Just Eat in an £8.2 billion proposed merger with Dutch rival Takeaway.com, and the London Stock Exchange’s £22 billion bid for data business Refinitiv), the FTSE 100 index closed at 7600 at the end of July, up almost 13% since the beginning of the year. The momentum from the takeover activity could see the UK’s large cap index at some point in the next quarter break its record all time high of 7877.5 achieved on the 22^nd May 2018.

Over in the US markets appear less sure about the future direction of monetary policy after the FOMC press release explained that, “in light of the implications of global developments for the economic outlook as well as muted inflation pressures, 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 labour market conditions, and inflation near the Committee’s symmetric 2 percent objective are the most likely outcomes, but uncertainties about this outlook remain.”

Both the markets and the prominent commentators and analysts seem divided on whether the US economy is headed for a recession, and by dint of that whether the decade old Wall Street bull market is about to end? We looked at many of the arguments in favour of a recession in last quarter’s market view, including most importantly the powerful historic signal from the US Treasury yield curve inversion, which since 1953 has correctly predicted the end of economic expansion nine times out of ten.

However pre-emptive action by the Fed in 1966 proved the bond market’s signal on that occasion to be a false one, and it’s possible the Fed’s U-turn on monetary policy that commenced on the 31^st July will avert a recession this time. There are plenty of prominent names on Wall Street who think so including Stephen Auth, the CIO of Federated Global Equities in New York.

Stephen Auth is famous for having called a new bull market on Wall Street in late 2008 (a little early by his own admission) and also for going on record in Barrons in December 2018 when the S&P 500 had plummeted to 2450, and saying it would have recovered to 3100 within six months! He is also on record as suggesting that the US began a new secular bull market in 2013 which could conceivably last two decades, going through to 2033, but that we should expect corrections regularly of 10% and even occasional 20% drawdowns which should be perceived as ideal opportunities to load up on the dips, as indeed he and his colleagues at Federated did in December 2018.

Interestingly Auth, when recently interviewed on Real Vision, cited three powerful reasons for his almost perma-bullishness, which included US earnings on a forward-looking basis are historically cheap when you factor in the two deep earnings recessions of the last decade, and which cloud the more backward-looking models like the PE10. Secondly, he thinks you have to realise the Fed is determined to do everything to prevent a recession and therefore a bear market, and so barring an accident should manage to do this, and finally most bears just haven’t woken up to the fact that the digitisation of America that has been going on for at least two decades is a major deflationary factor suppressing all attempts at inflation, and allowing companies to continue growing earnings productively.

Forward Outlook

There can be no denying that historically the bond market has been a mostly accurate barometer for predicting US recessions, but just maybe this time the Fed is going to be able to get back ahead of the curve, and avert an outright recession. Certainly most economic data in the US currently supports this, although some indicators are suggesting otherwise and the recent escalation in the trade war between China and America is a worrying negative that we must monitor carefully.

On balance, we continue to believe that we have not yet reached the end of this business cycle and that therefore additional gains can be obtained from global equity markets and particularly in the UK where valuations are still relatively modest from an historic perspective. While media headlines scream sterling is plummeting as a result of the continuing Brexit uncertainty, the reality is that UK companies listed in the FTSE 100 make more than two thirds of their profits from overseas enterprises in foreign currencies and the pound’s weakness keeps adding to these returns.

In addition, there is ample anecdotal evidence to suggest that foreign investment is pouring into the Britain and therefore regardless of the eventual Brexit outcome, the UK and especially London will continue to be a very attractive place to do business. While there can be no denying some UK growth stocks are possibly towards the more expensive end of their valuation metrics, there are plenty of value stocks now ready to take on the baton as we approach the latter stages of this business cycle.

Similarly in the mid and smaller capitalized sectors of the UK economy, potential value exists, although the future weakness of sterling will likely play a more adverse role for some of these companies, especially if they have to import a lot of raw materials. It is a similar picture selectively with undervalued stocks in Europe and especially in the US where record highs in leading indices such as the S&P 500 are often by dint of the strength of some of the major tech stocks which represent a large percentage of the market’s capitalisation.

Monitoring developments in the trade war between the US and China, as well as trying to determine the likely direction of key indicators, such as sterling and the dollar, oil and fuel prices, and yields on government debt as well as future Fed monetary policy, will play a key role in advised portfolio asset allocations going forward. During the rest of 2019, we envisage gradually moving portfolios from a biased growth equity exposure to more value oriented stocks, while maintaining some exposure to more defensive assets including fixed income, property and other lower risk alternative investment options.

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.

Copyright © Ash-Ridge Asset Management 2^nd August 2019.

Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.

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