Jerome has recognised a policy error

While we were compiling the research for our 30th Edition portfolios last November, we were concerned about several factors that were unsettling world markets.

On the back of some outstanding growth figures for 2018, Jerome Powell the Chairman of the US Federal Reserve praised the economic success and stated that the Fed intended to raise US interest rates once in December 2018 and a further three times in 2019. Each rate rise was expected to be a 0.25% increase. World markets reacted badly to the news that borrowing costs would rise and heavily corrected in October. At the same time, President Trump escalated the trade dispute with China by imposing even higher and more extensive tariffs on Chinese imported goods. The impact of a full-blown trade war was a serious threat to global growth. In Europe, the chances of a disruptive UK exit from the EU had become real and the Italian coalition government was seeking to push through an illegal budget against the rules of the EU. With the world economy slowing anyway, these threats were ones that we took seriously and therefore sought to defend our portfolios to a greater extent than usual.

Only a few months later and much has changed in the investment landscape. Jerome Powell had recognised that he had sought to over tighten money supply and subsequently announced that the Fed will not raise interest rates this year and will also end their bond selling Quantitative Tightening (QT) programme in September 2019. Clearly, Powell now thinks he made a policy error in trying to control inflation more that the economy needed. Many economic historians will say that ‘bull markets do not die of old age; the Fed kills them’. This is a reference to past growth periods when early interest rate rises caused the end of a bull run. The Fed nearly did it again.

The trade dispute between the US and China has become more of a truce, in order to allow a period for negotiation. So far, it would seem these negotiations have progressed but as yet, have not avoided any escalation in tariffs.

China was not expecting to be fighting a US trade war while its economy was slowing significantly, hence the authorities in Beijing have launched a number of stimulus packages to boost growth. Some taxes and VAT have been reduced to encourage spending. Banks have had their lending criteria eased to promote borrowing and the government has launched a new infrastructure spending programme. This stimulus has seen the Chinese economy improve and is starting to affect the Asian and emerging markets positively.

The Italian government reached a settlement with the EU over its proposed budget deficit of 2.4% and settled for 2% deficit which is within EU budgetary rules. This issue however may return to threaten European bond markets again in October when the Italian budget is next debated and agreed. The success of the Northern League (Liga) in the recent European Elections will likely spur the coalition to further challenge the EU.

A no deal Brexit is very much back on the agenda of the MP’s contesting the Conservative Party Leadership. However, our next Prime Minister will be faced with the same issues and problems encountered by Teresa May. The new Prime Minister may with ‘honeymoon support’ get a revised Withdrawal Agreement or a managed exit through the House of Commons and avoid a further delay to Brexit, but this is still a huge challenge with the House still opposed to a no deal.

The form of no deal that could gain sufficient support to bring the Conservative Party and the DUP together, is an agreement with the EU to leave on WTO terms but at the same time invoke Article 24 so that both the UK and EU can continue to operate on a free tariff basis until a final trade deal is concluded. These trade negotiations taking into consideration a permanent solution for the current backstop arrangement for Northern Ireland. Article 24 of the WTO General Agreement on Tariffs and Trade (GATT) has a clause that allows nations to request a free trade agreement while they negotiate the terms of the final deal.

With the concerns of Q4 diminishing, world markets have responded very positively so far in 2019. The year to date returns on leading stock markets have been impressive. Major global equities have delivered significant returns. From 2nd January to 5th June, the FTSE 100 is up 7.4% the S&P 500 is up 11.8%, the Hang Seng up 7.0% and the Nikkei 225 up 6.2%. This rebound after the heavy losses in October and December is attributed to the Fed ending its rate rise policy, the trade truce and Chinese stimulus.

So, what can we expect going forward? Despite strong total returns since January, allowing markets to hit new all-time highs, there is still a sense of uncertainty. Global growth is behind trend, even if PMI data has been predominately positive. While growth is slowing, low inflation and low interest rates are still supportive.

Europe is perhaps the economy that now looks the weakest and it has fewer controls over its fortunes. The Eurozone and Japan are still battling with inflation that is well below target. Only the USA has inflation that is on target and has wage growth that is rising, but even here a pick-up in inflation in the near term looks unlikely.

This lack of growth-led inflation has pushed the major central banks toward supportive monetary policies. The starkest was the full reversal by the Fed from a 0.25% rise in December and three more 0.25% rises in 2019 to a policy of no further rate rises this year and the end of QT by September. We may have hit the high point in US interest rates and any expected rate cut will be supportive of growth and limit the chances of a major US slowdown.

In Europe, the ECB ended its Quantitative Easing (QE) programme in December and in March it announced further target lending. The ECB did want to raise interest rates up from the current -0.4%, but it is now expected that interest rates will remain unchanged until 2020. With the Eurozone weakening, the next rate change may be to again lower interest rates. As rates are already negative, this will have a limited impact on economic activity. There is some good news however, with Europe witnessing growth in jobs, wages and household spending.

The sense of uncertainty comes from the fact that the balance in global economies sits in an uneasy equilibrium, calling for caution, even if the policy environment is supportive of risk assets. This uneasy equilibrium can lead to volatility returning to markets which we witnessed in late May and early June.

The US annual inflation rate rose to 1.9% in March and 2% in April up from a two-and-a-half-year low of 1.5% in February. There is a chance that the US economy will witness higher than expected inflation due to very good wage growth and consumer demand. Still, inflation will have to pick up substantially from the current rate of 2% to get the Fed reconsidering its rate rise policy. Our expectations are of a rate cut before any rate rises.

Europe remains the most vulnerable region. The uncertainty of Brexit has hit investment levels. There are concerns about the sustainability of the Italian public finances and its banking sector. The political success of populist and nationalist parties in May’s European Elections has shaken up politics in Europe. Added to these issues are the ECB’s bloated balance sheet and negative interest rates which limit the policy flexibility to support the Eurozone in a time of difficulty.

The ongoing Brexit delays and uncertainty has led to investors steering away from the UK even if the FTSE 100 has so far this year risen by 7.4% to the 5th June. Valuations are attractive and dividends are strong. Investment growth is likely to improve and we can expect markets to be comfortable with a Brexit deal even if it is delayed, but not a hard Brexit.

With interest rates low and now on hold, the bond markets look more appealing. However, government gilts are still expensive on a cost to yield basis. The principle reasons to hold gilts are for a protection from a worsening economic environment and for asset diversity. However, there are better options in the fixed interest market. The most notable are global high yield and investment grade bonds. Corporate fundamentals still look reasonable and margins are currently good, but these may be put under pressure with higher wage costs. Default rates are expected to rise marginally in 2019 but only back to their historical averages.

Since QE, the correlation between equity and bond returns has grown closer. Last year’s sell- offs in equity markets was accompanied by poor bond returns. The usual negative correlation between equity and bonds is not assured, so therefore we will hold gilts as a diversifying asset.

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