Markets continue to see daily movements that would have been shattering only a month ago. This is a result of the markets still trying to grasp what the shutdown and covid-19 scare mean for the longer term prospects of the global economy. Looking longer term isn't any easier with the potential for a protracted (U-shape) recovery or a more robust return to normal (V-shape). There are a couple things that are certain in this environment that were true but now accelerated by recent events.
Another deleveraging cycle:
The abrupt moves by the Fed and other central banks in the wake of the crisis moved faster than ever before. In a matter of weeks, central banks had reverted back to the levels of the 2008 crisis response and then some. This was due to the dislocations seen in the liquidity markets, causing a high demand for dollars and seeing all assets fall in unison. This is due to the need for cash to pay back existing debt obligations which have risen over the last decade. The future will bring about more slowdowns and black swans like the covid-19 pandemic did, and the one thing that will be present at these times is the need to raise cash to pay debts. These turn in events will make the sell-offs in assets more acute and require constant market interventions to resolve.
Strong fiscal responses:
As these shocks to the system occur, more and more individuals will save and delay spending. This is not good for an economy that requires GDP growth to stay ahead of debt growth. This means that the governments of these highly indebted countries will need to have a larger role in maintaining the growth rate. This will most likely mean more deficit spending and a higher cost of capital raising through debt.
How do you invest in this type of environment?
There is not one right answer but the theme among all solutions is to break out of the norms that have been the staple of investing over the past 40 years. Investing in large developed markets due to their size and relative safety will no longer be a sure bet. Having more of your money looking for growth and staying out of currencies based in a deleveraging currency will provide better returns for, what we are now seeing, a similar amount of risk.
The Fed is now looking at unlimited purchases as a way to quell the markets, today it had some effect on moving indices in the US positive but the lack of a deal from Congress superseded any monetary news that came out. This is an important factor to note. This is part of a broader theme that monetary policy in the US and globally is not able to counter the impact the corona virus has on the economy. This makes sense since the issues isn't stemming from a financial issue, but is directly causing one.
The only viable way to get the markets on track is to have more countries increase fiscal stimulus to help small businesses and people cover through this time period without the threat of forced deleveraging or extreme savings. This will have to take part in various ways, some controversial, including supplying credit to large companies that are directly affected by the travel bans, direct payments to individuals out of work in the service economy, and ways to extend or lower the costs of debt all around.
The fear is that the last of the leveraging cycles could be coming to an end, but the conditions are hitting a new lower bound giving the developed world more ability to borrow. This will significantly affect longer term growth prospects, but should make the recovery more acute in nature. The longer term prospects for an investor will depend a lot on how this process plays out.
With elections over and the Conservative party taking the majority, Brexit looks like a done deal for the end of January. This cleared up a lot of the uncertainty in the UK markets and saw a rally in the FTSE after the results, the question now is where is the market heading longer term.
Economic slowdowns across developed countries have see central banks cut rates and restart easing cycles near term. This is due to inflation not taking hold as many economists would have expected and the uncertainty around growth prospects. In the UK case, there wasn't a rise in interest rates as we have seen in countries like the US despite inflation staying in relative lock step over the same time periods.
If we look at the tail end of the chart, we can see that there is a sharp divergence in the two inflation metrics, but there is more to the story than simply diverging economies. After Brexit the Pound dropped drastically in value stoking inflationary pressures in the country. As the deadlines of Brexit approached at the end of October we saw more concerns from businesses and citizens in the UK so they held back on spending and investment during that period. In this time period we have seen the value of the Pound fluctuate around the 1.30 mark in dollars. While there is some merit in the currency alone causing inflation rise in the UK along side the US, it cannot be ruled out that the economy was skewed as a result of the uncertainty going into 2019. The Bank of England held off on rate increases in anticipation of Brexit uncertainty causing a slowdown in the economy, postponing rate increases in the event they would have to reverse course as a result of a no deal Brexit.
This lays out some uncertainty in the true health of the UK economy and whether the Bank of England will have to raise rates in the near term. Currently the drop in inflationary pressures and the possibility of a rising pound should allow room for the bank to hold in place. Data pointing to a sustainable rise in inflation however could cause action to be taken faster than the markets are anticipating.
Stocks are reaching record highs this week; this could be attributable to the earnings that came out over the last month except that those earnings reports are on average down. Revenue was essentially flat for the S&P companies so far, led lower by the energy and materials sector. If earnings are not that stellar then why are markets rallying so much. The answer comes down to longer term certainty.
Despite the negative news, slower earnings, and constants talks of bubbles; investors are getting long-term clarity around how the global economy will function in the coming year. At this point in the year most institutional investors are looking to position themselves for 2020. This means generating projections on how the markets will perform and shifting allocations. A brief look at the positive and negative factors going into next year will help understand what will affect market direction in the coming year.
Trade war progress:
The phase one of the US and China trade agreement looks likely to be signed. This is a good first step towards the US backing down from the rhetoric on tariffs. As an election year looms it is likely that Trump will look for more victories to boost his credentials in areas of focus. We saw this tactic in the Middle East with a raid on the Isis leader at the time the pullout of north Syria was getting scrutiny.
Fed rate cuts:
The Federal Reserve has cut rates at its last meeting and gave projections that there will be no need for a policy change in the coming year. This was looked at by the markets as a bullish prospect with the Fed thinking there was enough done in terms of 'insurance cuts' to strengthen economic growth and is not concerned about inflation in the near term. In short, a perfect rate environment for growth.
The news initially was positive that the UK got an extension till the end of January. This allowed for more room to maneuver and even plan an election in desired. However, the history of British politics is making the prospects of a smooth 3 months very difficult to imagine. Any stresses in the process can have implications on the 2020 outlook for the UK and Europe as a whole. This could cause many businesses to also pare back expectations for the global economy.
In the US the consumer has been the biggest booster of the markets this year. As economic data has come in mixed over the last year, consumer spending has remained robust. This is attributable to low unemployment and earnings growth which has empowered the consumer to spend more and take on more debt. If the trends in employment and wage growth keeps pace this should continue into the next year. But careful attention will be needed for signs of things slowing down. Current debt ratios in the US show little wiggle room for growth in
The US market has broken into record territory over the last week on the news of trade deals coming to a close and Brexit coming off the cliff edge. The Fed has cut interest rates another 0.25% yesterday as insurance that the recovery will remain intact. All of this is great news for the markets and brings some justification to the recent rally. If there is so much good news in the markets then why are there still signs of money on the side lines, bearish sentiment across news and institutional investors? This comes down to horizon and investment goals.
As a participant in the current market (which almost everyone is in some way) events are justifying why you should remain in the markets. In fact there are very few times that you should be exiting the markets all together, and really none in the past decade that we have seem. What the events should tell investors is more along the lines of where to allocate more capital coming into the market and how rebalancing should be applied. Longer term investors need to be more concerned with making sure they have the right asset mix and to keep their money working at generating a certain amount of yield longer term to reap the benefits of compounding interest. This means that assessments need to be made as to where growth will be in the future while ensuring that current holdings are maintaining the same level of growth.
This leads to the US markets rallying despite the global slowdown. For many European and Asian investors the introduction of more stimulus is giving them cash in place of their negative yielding bonds. While some of this money will move into local stocks and bonds, investors are also looking for growth and a hedge from their currency (which will likely depreciate due to more asset purchases) for more return. This makes the US an attractive location to put money at the time, higher rates (still) than other developed countries, better economic performance, and rising stocks. But these high prices will have another effect on the US markets that could cause investors to look elsewhere, lower longer term returns. Immediate asset price appreciation from foreign investors getting an inflow of cash will lower the expected returns (in yield and earnings growth) on US assets. So long as that number remains higher than other countries we will see money continue into the markets. What many investors are doing now is sitting in cash waiting to allocate money at a cheaper price. This is a sign that other prospects are not available and the US markets returns are not as acceptable to some investors at current levels.
What should investors look for? Stay the course in asset allocation, rebalancing as needed. In terms of cash and future growth, there are assets that are out of favor near term that should be looked into for their 3 to 5 year horizons. Recent news like China announcing a longer term trade deal with the US being unlikely, or European paralysis in terms of economic unity will play important roles in these longer term projections. Shorter term news, such as unrest in Latin America, could prove to be depressing asset prices in the area, allowing for higher than average returns in the longer term.
Strikes on Saudi oil facilities has caused markets to rethink the current series of positive days we have seen. With 5% of global supply put out of action, the estimates of get the production back to full capacity is still unknown (estimates are a few week or a few months). This is having the obvious effects of hitting airlines and seeing a move to rick off plays. How will this change the longer term investment landscape? That will depend on political reactions.
The US is looking to open its strategic reserves and many analysts think the supply of oil can cover the outage until the Saudi plant is back online. The price of oil will probably not fall significantly from here but there are few reasons to see a large spike in price based on supply. Politically, this would be where some adjustments in the portfolio might need action.
There are already talks of the Iranian government being behind the attacks, claimed by Houthi rebels. Some in the US suggest it was even a cruise missile from Iran itself that is responsible for the strike. These allegations, should they come true, will be of greater importance to the overall price movement of oil and the overall markets. Having the threat of war hanging over consumers and companies while the economy is already slowing down in many countries could be the impetus to bring about an actual recession. It isn't a disruption in oil that will affect your portfolio as much as a disruption in confidence.
A good day in the markets on the back of positive service numbers out of Europe and more signs that Brexit will be delayed.
The defection of MPs from British prime minister Boris Johnson is causing relief in European equities because of the prospects of a Brexit delay coming as a result. Johnson wants to leave the union at the end of October "come what may" which has seen the Pound and British equities drop over the past month.
The Services numbers coming out of mainland Europe were optimistic (with exception to Italy) which will not likely stop the cutting of the rates and easing by the ECB, but could support a more measured approach over time. The real success of the stimulus program will come from the Eurozone members ability to coordinate fiscal with monetary stimulus. In the past this has been difficult with core countries like France and Germany resisting deficits to boost spending. With Germany suffering from a the slump in trade and France having a government with a pro integration leader, there is opportunity to avoid a downturn.
From an investment standpoint this is good news for long term buyers that there is more potential coordination than we have seen in the past slowdown. The fact that there will still be cuts, and the majority of the heavy lifting done by the ECB in the interim, it might be a bit early to look at certain stocks like the banks (see last post). Buying into any dip will not be as risky so long as the countries of in the Eurozone (notable Germany) start to warm towards fiscal stimulus and work together.
German elections have shown promising results for the mainstream parties already in power (CDU and SPD) but also saw more gains from the anti immigration party (the AFD). This comes at a time when the German economy has contracted in the second quarter and could enter a recession in the 3rd. This is in contrast with France who has seen their economic numbers beat expectations over the summer. This trend in Germany underperforming and France being resilient is due primarily due to the fact that the German economy is heavily reliant on exports while the French economy has a good portion of internal demand.
Longer term, this could prove to be a good thing. In the past when the eurozone was slowing down, the lack of unity on what action to take to stimulate a 2 speed Europe caused austerity to be the only viable option. This was due to the core countries not wanting to subsidize stimulus for the periphery countries. Now that Germany is in the same boat and in need of more stimulus, there could be more direction on the French president's desire to integrate the Eurozone economies more. This unification of fiscal stimulus will allow the euro to become more competitive against the US and China as they start to build a more unified economic model.
If these changes occur it will help to stem the negative yielding debt we have seen in countries like Germany as their credit worthiness is coupled together with Italy, Spain, and other countries. As these levels of debt rise, and inflation starts to take hold, we would see a gradual rise in the yield curve across many countries. This would most benefit the banks in the countries as they will have the ability to lend at profitable rates. With the book value of some of these banks at steep discounts, there could be some longer term buys in play. A rush into the market is not needed to gain on these opportunities as the ECB is looking at more rate cuts and stimulus to boost growth. If we get the old core countries like Germany to start looking at fiscal stimulus however, we could be at a good buying point.
Today is the heavily marketed Fed meeting where the markets are looking to get some insights into the easing (almost no one expects a hike) timetable for 2019. This is coming off the back of the news from the ECB, where Draghi is proving not to be a lame duck and has started to talk up easing policy should the markets continues in the current trend.
With all of this easing talk (and some positive tweets about the trade negotiations) we are seeing US markets nearing their all time highs which is great news for investors but raises some questions about the near future. Should more money be allocated to US stocks in the coming months? Should money be taken off the table? The answer to these are all based on the underlying reality vs the projections of the markets. A Fed cut is a good thing under the assumptions it is in anticipation of a slowdown in the second half of the Year. With the Fed getting ahead of any negative data in the US, the markets will be able to avoid the sell-off that would accompany an adjustment in growth expectations. If the cuts come as a reaction of negative data in the markets we will see the markets adjust to the news until they can determine that the easing policies of the Fed have been effective. Some argue that it would be harder to turn sentiment with only 250 basis points to cut so getting ahead of the data is key.
Insights into this will come from the Fed "dot plot" where the members of the FOMC all predict where interest rates will be at certain times in the future. For the early scenario to be in play we should see significant moves downward in these dots as the voting members change their expectations. A lower expectation of the longer term interest rates will point towards the committee feeling they will be unable to avoid the slowdown with early cuts and there will be a longer trend in "lower for longer" along side other major economies.
You can't look at the UK market or the currency without taking into account the current state of Brexit. The postponement of the deal to October and subsequent election caused the Pound to drop. The stock markets have been taking this news fairly well staying in line with other major indices. The question now comes down to the data. Will there have to be a pronounced decline in UK data to prompt the British government to take early action against the threat of a no deal Brexit? News today shows that steps are trying to be made to prohibit that from happening, but without a sense of urgency it will be important to see how the vote goes.
Like many investors are probably thinking, I like the UK as an investment opportunity but am holding off in light of the political threat to the markets. This paralysis is going to seep into the economy as uncertainty continues. For this week I am going to keep an eye on the BOE governor to see what he thinks monetary policy will have to do in this interim period, and after.