Summary of key points
- Since New Year, equity markets have recovered some of the steep decline that occurred in the December quarter of 2018. Both the decline and the partial recovery have been driven by shifts in sentiment rather than much in the way of major change in economic conditions, although significant economic change may be on the way in the next two years. The shifts in sentiment have been driven by reactions to statements by political leaders such as Trump and Xi, and policy makers such as central bank chiefs Powell and Draghi.
- Trump escalated the rhetoric on the trade dispute with China before reaching a truce on new tariffs until 1 March, to allow for a negotiation of some sort of settlement. Markets remained concerned about the fragile nature of the truce and the potential for a resumption of trade hostilities which could cause a major slowdown in economic growth worldwide.
- Chairman Powell of the Federal Reserve merely repeated the long-standing position that the Fed would increase short interest rates further in 2019 and continue to not replace the $US 50 billion of bonds that are maturing each month, thereby continuing the process of quantitative tightening. This prospect of an ongoing reduction in liquidity heightened concerns for many investors that it may become too difficult to adjust their allocation to equities as we progress into 2019 and 2020 and approach the next recession. Many promptly shifted funds from equities to bonds with the effect that the US ten-year bond yield declined even though an increasing supply from the US Treasury (to fund the fiscal deficit) is being met with reducing demand from central banks.
- With the exception of the self-inflicted wound that is Brexit, Trump is a common factor in most of the dramas that are concerning investors: US-China trade negotiations, US Federal finances and the government shut down, the independence of the Federal Reserve and its interest rate policy, the increasing scale of US bond sales. We do not expect the disruptor-in-chief to depart the scene nor change his modus operandi any time soon. Short run equity market volatility will remain the norm for some time to come. This will include some useful bear market rallies in 2019, which will allow investors to reduce the allocation to equities if they wish to, at better than expected prices.
- While the shape of the yield curve, a good forward indicator of recessions and downturns in equity markets, has flattened, it has not yet inverted or turned negative and so it is not yet signaling recession or a more severe equity market downturn.
- While the equity markets are better than fairly priced from a longer-term point of view and, both monetary and fiscal policy are still supportive of economic growth as well as financial asset prices, equity market momentum has definitively turned negative. More significant falls are quite possible over a shorter-term horizon out to three years.
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Firstly, growth in GDP and in earnings per share are likely to slow as the effect of the trade dispute impacts volumes of trade and global supply chains. The recent downgrades in revenue outlook for both Apple and Samsung are a foretaste of a wider slowdown over the next year or so.
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Secondly, notwithstanding recent falls in bond yields, the sheer volume of borrowing needed by the US government combined with the retreat of major central banks from holding bonds, will eventually push up the long-term bond yields, reducing the value of future cash flows from investments and with it the prices of financial assets.
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Thirdly and most importantly, central banks have shifted from quantitative easing to quantitative tightening (QT). The tide of monetary support for asset prices is turning, albeit gradually over the next few years. By itself QT may not produce a recession, but it will impact financial asset prices, just as the effects of QE went mostly into asset prices rather than economic growth between 2009 and 2018.
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In such conditions, investors with a shorter horizon of one to three years will feel more comfortable reducing their equity exposure. This may best be done during the periodic rallies in prices which will occur during a period of increased market volatility which we are likely to see in 2019.
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In such conditions, investors with a shorter horizon of one to three years will feel more comfortable reducing their equity exposure. This may best be done during the periodic rallies in prices which will occur during a period of increased market volatility which we are likely to see in 2019.
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Investors with longer term horizons and an ability to tolerate equity market downturns and await the recoveries that follow, should remain invested at benchmark or neutral weight in equities, but be aware that there may be further falls of up to 20% in the next two years. Some longer-term investors may want to consider the opportunity of using short term rallies to move some of their portfolios into cash pending reinvestment at lower prices after subsequent market declines. It is important to remember that it is very difficult to get both legs of such market timing moves right.