December Investment Strategy - It is getting (a bit) clearer
- Good news on two major headwinds which defined 2019: trade war, and Brexit.
- Sentiment is perking up, but the actual data flow may not reflect this quickly. The global manufacturing recession is entrenched.
- Central banks can afford to be on hold. In the case of the European Central Bank, there is no alternative anyway at this stage.
- The risk rally can continue as uncertainty recedes.
- UK markets have plenty to catch-up but a super strong pound would not be in the interests of the corporate sector.
- High yield and emerging markets are the most attractive fixed income assets.
Global macro risks receding
As 2019 is drawing to a close, the major global macro risks are receding. The US will not implement the round of tariff hikes on Chinese products scheduled for 15 December while the UK elections have produced a large Conservative majority which should endorse the withdrawal agreement negotiated with the EU. These two outcomes had been largely expected on the markets for some weeks, but there seems to be a case for even more cautious optimism in both cases.
Our 2020 outlook is based on the end of the trade war escalation, but there is now going to be a partial roll-back of the tariff hikes already implemented. We have to be cautious because the legal text of the Phase One deal between China and the US has not been released yet and it may be very tempting for Donald Trump to re-heat the trade issue during the campaign, but at least the current tone is encouraging. In the UK, the unexpectedly large majority makes Boris Johnson less dependent on the most Eurosceptic elements of his party. This should give him space to renege on the manifesto commitment not to extend the transition period beyond next year. It may also provide more room for manoeuvre in his negotiations with the EU on the Free Trade Agreement which will now be the basis of the relationship across the Channel.
This negotiation will still be no walk in the park. Now that any chance of the UK ultimately staying in the Union has gone, the EU can be tougher in its handling of the talks and will try to defend its interests against any British attempt to diverge on environmental or social standards while still benefiting from easy access to the Single Market. Still, after delivering this clear victory to his party, Boris Johnson has some capacity to impose some compromise on his rank and file.
This better news-flow won’t translate into significantly stronger macro data quickly. There is still a global manufacturing recession going on, and it will take time for the improvement in sentiment to filter through to hard data. New manufacturing orders are low in the US and in Europe (Exhibit 11), while inventories are still on the heavy side. But at least the deterioration should stop, as well as the contagion to services. For the second half of 2020 we are more circumspect, focusing in particular on the decline in corporate profitability in the US and Germany, and the US elections could trigger some wait and see attitude in corporate America, but we should enjoy a respite in the first half of 2020.
Exhibit 1: Manufacturing recession far from over
Central banks: comfortably numb
The recent news-flow justifies the Federal Reserve (Fed)’s pause in the monetary stimulus. They have brought the monetary stance back into accommodative territory and the most interest-rate sensitive sectors, such as construction, have perked up. Jay Powell can sit back and relax for quite a few months. In Europe, the data and news flow are optimal for Lagarde from a communication angle: it is bad enough to justify the September package, and not catastrophic enough to call on the European Central Bank (ECB) to do more. The ECB is likely to “look inward” for quite a few months as the “strategic review” begins. We suspect some Governing Council members would like a “technical hike” in the deposit rate this year, but we don’t think they can find a majority as this would trigger a counterproductive currency appreciation.
Markets more positive but still circumspect
The durability of the global economic expansion will remain a theme for investors as we head into 2020 but it seems risky assets will continue to perform well. The UK election result removed the risk of either a further period of uncertainty over Brexit or a radical government that would have been very disruptive for the corporate sector. The initial positive response from UK markets should be sustained given the improved prospects for the economy. While primarily a local UK issue, there will be broader implications for investors as the passage of the Brexit bill will remove a major source of uncertainty. A US-China trade deal further adds to bullish market prospects.
It’s difficult to continue to hold a bullish view on risk as we enter the 2020s. However, neither the length of the bull market nor high valuations are necessarily barriers to further equity market gains and credit outperformance of rates. Global monetary policy will remain supportive. The message from the Fed in December was that it would take a period of sustained higher inflation for the central bank to hike rates. The ECB will keep its policy settings unchanged while it navel-gazes over its operating model and policy framework over the next year. It is safe to assume that the Bank of England (BoE) will not do much with rates in the wake of the election – it won’t want to stoke a much stronger pound. Without a shift to monetary tightening, the long period of equity outperformance can persist.
Despite the long list of things investors have had to worry about in recent years and the fact that some of them remain concerns, higher beta sectors have rewarded investors. Japanese stocks have started to outperform Europe and the US in recent weeks, growth has reasserted its dominance over value and CCC-rated US high yield has started to claw back some underperformance in the bond market. In general, emerging market bonds have outperformed despite concerns about political instability in Latin America. These higher beta performers look set for further gains until the next wall of worry is met.
Investors will be sensitive to events and developments that could cause the risk rally to reverse. For this to be meaningful we would argue that some significant deviation of the macro outlook from our base case would be needed. Any evidence of renewed weakness in the manufacturing sector would be a trigger for more recession-like trades, particularly given where credit and equities are valued. Yet this is not the core scenario for the early part of next year. Credit spreads can narrow and equity markets can move higher on the back of some positive momentum in the earnings outlook.
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