The possibility of a phased US/China trade deal, a third 0.25% cut in US interest rates and solid third quarter corporate results improved stock market sentiment in October and bond yields rebounded from multi-year lows. Wall Street rose 2% and pushed into new high ground while higher growth/technology-focused indices were up nearly 4%. In local currency terms, Japanese equities gained over 5% and Asia ex Japan 4% but the FTSEurofirst 300 rose just 10 points to 1,555. The FTSE 100 fell 160 to 7,248 although more domestically-focused small and medium sized companies were steady.
Following the defeat of the UK government’s Brexit timetable, speculative positions were closed and sterling ended up 5% at $1.29. Gilt yields backed up marginally in line with global bonds while reduced inflation concerns saw index-linked gilts fall over 5%.
US trade policy still dominates the outlook for global growth in terms of both the direct impact of higher tariffs and the repercussions for investment decision-making and supply chain configurations. The cancellation of the Asia-Pacific Economic Cooperation summit in Chile in mid-November has delayed signing the first phase of a trade deal but both sides say they are willing to reconvene. Any agreement would be a step in the right direction particularly if this includes a cessation of trade tensions – although suspending new tariffs scheduled for December 15 appears more likely than removing existing ones – or some commitment by China on intellectual property violation. However, the US will be reluctant to lift investment restrictions on national security grounds and the sustainability of any deal beyond the 2020 presidential election means uncertainty will continue.
Global growth to remain in line with long-term average
The economic slowdown caused by contracting global trade volumes and the widespread manufacturing downturn shows few signs of bottoming out. Global GDP growth is expected to be 2.7% this year and next (v 3.2% in 2018) but this is still in line with the long-term average.
Despite weak commodity prices, developing economies should continue to grow by over 4% in 2020 while advanced economies are expected to be below average at 1.5%. Although China slowed to 6% growth in the third quarter, with unemployment edging up and real disposable incomes rising less than GDP, the measured approach being taken suggests stabilisation rather than further deterioration. A domestic funding squeeze may see India slip below 6% annual growth, while Taiwanese and South Korean growth is largely dependent on an improvement in global trade.
US consumer continues to offer support
Fears of a possible US recession after next year’s election have eased and – with the American consumer underpinning activity in advanced economies – GDP growth of 2.3% this year and 2% in 2020 should be achievable. The tight US labour market means wage growth is likely to exceed inflation. However, corporate investment remains weak reflecting the trade slowdown and housing activity has been largely flat apart from a modest uplift following recent interest rates cuts. The Federal Reserve’s decision in late October completes a “mid-cycle adjustment” and rates are probably now on hold until a “material reassessment” suggests otherwise. Budget challenges and pending impeachment proceedings mean pre-election tax inducements are not on the agenda.
Advanced economies disappoint elsewhere
Elsewhere, growth in the advanced economies is very low. Although GDP is expected to expand by 1% this year, Japan faces challenges in 2020 as the increase in consumption tax reduces domestic real purchasing power. A supplementary budget for typhoon disaster relief will help but is unlikely to prevent GDP growth dipping below 0.5%.
The Eurozone continues to disappoint with business surveys indicating that some economies may slip into recession as a result of the global trade downturn. In Germany, exports and investment have been hit by the triple challenge of China re-configuring its supply chain, US/China tariff wars and Brexit. Although hiring intentions remain strong and a tight labour market means wage growth is trending upwards – supporting relatively resilient domestic demand – in an environment that lacks pricing power companies will be unable to absorb higher costs indefinitely and unemployment will rise. The stimulus measures announced by the departing President of the European Central Bank maintained an accommodative monetary stance but at some point the German government may have to reverse its commitment to no net borrowing and introduce a fiscal stimulus package.
By contrast, the French economy is performing relatively well, helped by tax cuts. Italy also appears to have escaped contagion from the industrial slowdown in Germany and the political situation appears more stable albeit government finances are unsustainable and real economic growth potential is limited. After a period of relatively strong growth, economic activity in Spain is expected to slow as the impact of tax cuts fade and demographics change.
Fresh UK political uncertainty ahead?
As elsewhere, the consumer – supported by real wage gains – is keeping the UK economy afloat even with weak business investment and contracting exports. Attention is now focused on the December 12 general election, with many seeing this as a proxy for a second referendum. Polls are currently indicating that the Conservatives will win a sufficient majority to implement Brexit early in 2020 with a transition period when trade terms are negotiated with the EU.
Although the ability to threaten and implement a “hard” exit after transition is likely to mean further uncertainty and the deferral of investment decisions, this could be counterbalanced by fiscal stimulus comprising large tax cuts and spending increases – potentially equivalent to a 1%-2% rise in GDP.
If the polls are wrong, however, the outcome could be a Labour, Liberal Democrat and Scottish National Party “Remain alliance” with Jeremy Corbyn as Prime Minister. Staying in the EU combined with a fiscal boost targeted at public services and infrastructure would also increase GDP. Sterling remains a wild card as any short-term appreciation might reverse in the event of a hung parliament accompanied by policy wrangling. Looking further ahead, fiscal profligacy without improved productivity could lead to higher inflation and rising interest rates in which case we may have seen the low point in bond yields.
Conclusion
Unusually, equities and long-dated bonds have both performed well this year. Bonds have been boosted by concerns that tightening financial conditions and disruption to trade could tip the US economy – as well as the world – into recession. In actual fact, interest rates have been cut and there are few indications from corporate statements that higher tariffs and declining trade volumes are having a significant impact. Third quarter results were better than expected with more companies beating expectations, and by a larger margin, than historical averages. Year-on-year revenue growth is 3% although earnings are down 4%.
Detailed scrutiny shows that companies exposed to international markets are reporting larger declines as a result of the strong dollar. There also appears to be a change in sentiment towards those targeting revenue growth and those focusing on profitability. The failure of a number of high profile new issues suggests investors are now putting more emphasis on sustainable profits and dividends rather than aspirational high growth. Valuations are not cheap but equities remain relatively attractive.
