The investment situation today is somewhat similar to early 2016. Does this mean we are due for a massive rally in world equities of some 40% over the next two years? We ask the question since this is what happened between the beginning of 2016 and the end of the third quarter of 2018. Well we are not that bullish but there are similarities today with early 2016 which make us constructive on equities.
Starting in June 2015 and running through to June of 2016 the Fed lowered its estimate for future rates significantly by almost 1.5%. Also in early 2016 China ramped up fiscal stimulus with a large programme of government spending. Fast forward to today and how do things look? Well in March of this year Fed Chairman Powell said that it may be some time before the US central bank needs to adjust its monetary policy. These comments came as he unveiled another dovish outlook. The effect of these comments can be seen below as the orange line, which represents the likelihood of a cut in interest-rates by the end of 2019. This rose significantly in March and remains elevated as at the time of writing.
Also since the beginning of this year the Chinese authorities have been working hard to inflate their economy. This is having an effect and already the China current activity indicator has increased to 6.6% in March from 5% in December. However, this is probably where the similarities end since there is one big difference between then and now. It is unlikely that Donald Trump will be able to unleash the same fiscal stimulus which he unleashed in 2016/2017, which provided the third motor back then. In fact the US economy does appear to be slowing this time.
Nevertheless it is not just China that is showing signs of stabilisation. This interesting chart below from Goldman Sachs shows that for countries that comprise the bulk of global GDP, economic activity shows signs of stabilisation.
So things are not that bad and could get better. There has been slow but apparently real progress towards a US/China trade deal, and chaotic progress towards staving off a “no deal” Brexit. If both those two issues are resolved positively it is likely that global industrial production momentum will bounce towards 3-4% per annum by the third quarter from around zero in January.
What about the yield curve? Should we not be worried we hear you ask? As you know the real big news at the end of the March quarter was the inversion of the front end of the US treasury yield curve (5 years minus 1 year).
This normally precedes a recession. The two big post-war exceptions are October 1966 and October 1998, when the Fed responded to a slower economy, muted inflation pressure and a sharp equity sell-off by cutting rates, after which the yield curve re-steepened and the stock market did exceptionally well. We are not saying we are for sure in such a scenario but it is interesting to note that the inversion we have seen does not always lead to bad outcomes.
As with any positive narrative we do accept that there are dangers lurking in the wings. Probably the three biggest negatives are: (i) There could be a dark side to the expected China-US trade deal. Although without understanding the nature of the eventual trade deal it is difficult to know exactly, there is a scenario that could lead to a dollar shortage, rising US and Chinese stock markets but lower equity markets elsewhere. (ii) Chinese growth is still reliant on debt and that may not bode well in the long term. (iii) The simmering unrest in Europe (yellow vests in France, Brexit issues in the UK) has the potential to flare up and unleash even more “populism” which could be negative for risk assets. Athens’ downfall was inevitable; as Durant
writes in The Lessons of History: “The middle classes, as well as the rich, began to distrust democracy as empowered envy, and the poor distrusted it as a sham equality of votes nullified by a gaping inequality of wealth” – does this feel familiar?
In conclusion although we are still constructive on risk assets we are avoiding large over-weights to risky assets and maintaining a market weight position in equities since valuations are on the high side but the cycle, we believe, is not yet coming to an end. Given that we could be wrong we have been using the recent rally in the markets to make our bond allocation even more defensive and add investments that can act as a hedge in the event that the global industrial production cycle does not pick up.
Martin Newson
CEO, CIO