Easy Money

With US interest rates increasing, the days of easy money are coming to an end and markets know this. The bond yield rises of mid-October took US 10-year Treasuries to 3.25% the highest in 7 years. This was the start of the rout in stock values which some analysts thought would be short lived as US corporate earnings results have been very strong in Q3. The resilience of the market was tested by the range and potency of uncertainty that the global economy is currently faced with.

Many analysts expected Donald Trump’s late cycle stimulus in corporation tax reductions and government infrastructure spending to give equities a boost through to at least mid-2019. But faced with uncertainties, many are of Trumps own making; the president is now looking at a stock market correction on his watch.

US corporate earnings have been very strong this year up 20% in many cases over last year. For example, Amazon a real growth stock delivered a US$ 3bn profit for three months of trading in Q3. Despite this level of profit the stock fell 18% in October from its September high as tech stocks were particularly hard hit. Through October the FTSE 100 lost 8%, the S&P 500 lost 9% and Japan’s Nikkei 225 fell 12% in value. October’s movements were notable for the number of days that returns were negative for example the S&P 500 posted losses for 13 days over the three-week period of volatility.

The trigger for this asset drop was Federal Reserve Chairman Jerome Powell warning that the Fed planned to push interest rates above the so called ‘neutral rate’ in order to prevent overheating. Markets were not quite ready for this and therefore brought into close focus the credit costs and restriction in play. The Fed is reducing its balance sheet of bond assets by US$50bn per month while the European Central Bank (ECB) is planning to bring its €80bn per month bond purchasing programme to an end this December.

The market falls in October were similar to those that triggered losses back in February and March. Both started with a spike in US bond yields and a concern about the pace of US interest rate rises. In March strong corporate earnings and declining wage inflation reassured markets and the stock values recovered and grew further. Again, in October the stock sell off was heavy for fair value and economic fundamentals.

Third quarter corporate earnings announced in October have been very good and have helped bolster markets after the heavy falls. The Q3 earnings from the S&P 500 companies were up 21.5% year on year with very strong performance from Comcast, Microsoft, Twitter and Telsa. However, results from major tech stock like Amazon and Google fell below expectations.

President Trumps entrenched trade war with China has hit corporate profits around the world. US Company’s reporting strong results are being impacted by new tariffs and higher labour costs. The Federal Reserve is tightening money supply and rising interest rates to rein in inflationary pressure building due to Trumps stimulus, all of which is pushing up the value of the US$. A high US$ is hitting emerging markets as US$ denominated debt is getting more expensive to service. Raising interest rates and expected inflation is forcing bond issuers to improve yields to attract investors. High yields means falling bond prices and more expensive borrowing costs for consumers, companies and governments.

Added to the slowing of economic growth in Europe and China, the potential increases in 2019 of crude oil price caused by the sanctions placed upon Iranian oil exports, plus the political and economic impact of a potential disorganised Brexit and an Italian bond crisis. It is no wonder stock values have been challenged.

This end of cycle reality check has come sooner than some commentators and analysts had predicted mainly due to the strength of the US economy. Markets are now facing realities previously put aside. The world has got used to low and falling interest rates and with cheap money households, corporations and governments have borrowed so much so that the levels of global debt is now US$247tn which is up from US$173tn at the time of the 2008 financial crisis. The world is mortgaged at over three times global annual GDP.As this debt pile starts to get more expensive, the consequences will make life a lot harder for a world where growth is slowing.

It is commonly agreed that economic cycles end in recession because central banks get base rate settings wrong by misreading the trends and turns in economic data. Global indicators are showing that annualised growth is falling from 3.4% in Q2 to 2.4% in Q3 even in the USA there are signs of slowing in car and home sales.

We will await any reaction from the Fed over any retreat from its publicised course of action. This has of course happened before when quantitative tapering was postponed due to the negative reactions in emerging markets in May 2015. Commentators are not expecting any significant change in policy unless US 10-year treasury yields go over 4% and recently they have fallen back slightly to 3.21%. The Fed is more concerned about inflationary pressure and is likely for now to stick to its plan of four more rate rises of 0.25% before the end of 2019.

Wall St and the other world markets have enjoyed a upswing in equity values due to strong Q3 earnings growth and the suggestion of an resolution to the US China tariffs war. However, analysts are of the view we may have seen the best of the cycle and with the reversal of QE we have moved into a new territory. Markets will have to cope without easy money as central banks end their support and start taking money out of the system for the first time in nearly a decade. It is estimated that the Fed will have taken US$ 900bn out of money supply by the end of 2019.

Investors are concerned about the 2019 outlook but earnings are still forecast to be healthy. The combination of solid earnings as well as a resumption of extensive corporate share buyback will provide comfort for US equity investors.

The USA’s loose fiscal but tightening monetary policy combined with the US$ repatriation policy and trade tariffs will lead to difficulties starting as we can see in the emerging markets and will, if not managed, spread to developed markets.

There is a dilemma for investment strategy when world events are conspiring to accentuate the negatives. Any post correction defensive move reduces a portfolios recovery opportunity but does add protection against the threat of further more significant falls as has happened in the past. Remaining within an established risk related asset allocation strategy provides diversity and opportunity for the recovery of lost value but does not provide additional capital protection in times of higher volatility.

Our established position is to remain invested in a suitable risk-controlled asset allocation using our biannual rebalancing to reinforce risk control. The world however is entering a tipping point phase and therefore in the balance of outcome we will be continuing our progressive de-risking of all portfolios to reinforce downside protection. With this in mind we are increasing our holdings in cash, index linked bonds, short duration high yield bonds, longer dated higher yielding investment grade bonds and introducing some gold while also maintaining our normal equity diversity.

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