The February Market Pulse

In the December edition of the Market Pulse, I optimistically looked forward to a better 2019 while the January edition reviewed the drivers behind the vicious decline in equity markets last year and the likelihood of a significant inflection point higher. In life and markets it is important to celebrate small victories and in the immortal words of Colonel John Hannibal Smith from The A Team, “I love it when a plan comes together”.

A pause for breath

After such a strong recovery across world equity markets it is reasonable to expect a pause for breath and I would not be surprised to see some consolidation of the gains at current levels. Many market participants, particularly in the hedge fund community, were caught out by the rally and are probably now considering their options. Having furiously covered short positions, the appreciation of the markets may be a tempting opportunity for them to be reinstated as a fair number of macroeconomic uncertainties remain. Therefore, it is logical to expect that the pace of gains will slow from here but we would use any reasonable pullback as an opportunity to invest.

The reasons for staying on track principally revolve around the changes in policy by both the Federal Reserve (Fed) and the authorities in China, (the Chinese Communist Party and Peoples’ Bank of China) that support our three tenets of investing – namely monetary policy, fiscal policy and valuations. Our focus is on the change in each based on empirical evidence, rather than the absolute level, and all three currently support our positive bias.

Monetary policy

In the US the monetary policy backdrop has improved markedly this year with market expectations for further interest rate increases in 2019 now virtually zero and a rate cut forecast for 2020. This is in response to the broad slowdown in the global economy and reflects a very different outlook to the three rate increases that were forecast prior to the December Fed meeting.

The equity market response to this easier monetary stance has been decisively positive and expectations are now that the Fed may reduce the pace of balance sheet reduction (quantitative tightening or QT) soon. However, while we would agree that the Fed is very likely to moderate the total assets they plan to cut, a growing minority of investors are now predicting that the Fed will stop QT imminently. We believe this optimism is premature and it is one of the reasons we would not look to chase the recent equity move too eagerly.

The second positive monetary policy driver is centred on credit growth in China, for which I make no apologies for highlighting again. Beijing has introduced policy shifts over the past six months that reflect a need to rejuvenate the economy and end the drive to crimp the growth of consumer credit. These policy shifts take time to work but our credit growth model has now turned up for the first time since the end of 2017 and we expect economic activity to recover as a result.

Earnings and valuations

With the monetary policy shift providing an improved backdrop and fiscal policy expected to be broadly positive this year, earnings and valuations will become more crucial drivers of the direction of equity markets.

From a valuation perspective, the recent recovery has already achieved a significant proportion of the upside we expected from multiple expansion this year, leaving earnings growth and dividends to do most of the heavy lifting from here. For 2019, earnings growth is expected to be around 8% and the dividend yield of the MSCI World is approximately 2.7%, suggesting a total return of around 11%. However, since earnings estimates are usually revised down, it would be prudent to reduce the earnings growth element, particularly with the global economy still struggling with the hangover from the tighter liquidity condition of last year.

Therefore, with no assumption for further multiple expansion, a conservative estimate for earnings growth and adding the dividend yield implies a total net return of 8% from current levels. The caveat is that we still live in a volatile political environment and the outcome of trade talks between the US and China is a particularly important uncertainty that remains.

The international arena

In the international arena, we are more confident about Asia Pacific and Latin America this year and more wary of Europe. Europe is faced with the uncertainty of Brexit, a structurally weak financial system and now the potential for its own trade issues with the US. President Trump is currently considering the recommendations of a special report regarding European tariffs on US cars and his response may be unsettling for markets. Combined with a hard Brexit, an imposition of US tariffs on European autos would drive Europe firmly into recession and raise stark stability issues for the Eurozone that politicians will be keen to avoid. How this trade issue plays out could be quite influential in regard to the ongoing Brexit negotiations and the direction of equities in the Eurozone.

Our favoured equity markets remain the UK and Emerging Markets, with the UK looking particularly attractive from a valuation and dividend yield perspective. The valuation discount is there to compensate investors in the long term for taking risk but in the short term, the risks for the UK economy are obvious and our more constructive stance is a more controversial call.

Equity price/earnings ratios

The UK housing market

In addition to Brexit, a growing concern we have with regard to the UK is the deterioration of the housing market. In a recent survey by LonRes, 63% of London-based estate agents said they had seen declines of more than10% in prices as sales volumes have ground to a halt. In prime central London, prices were down 6% in the fourth quarter of 2018 and the prime ‘fringe’ districts fell by 7% over the year as a whole.

The collapse in volumes is of particular concern, with the number of transactions in properties between £1-2 million down 25%, while those between £2-5 million were down 12% for the year. For now, there is solace in the fact that select regional markets are more buoyant, and the Nationwide Index managed an overall price increase of 2.5% on average in 2018. However, it is unlikely that the regions will remain immune from a trickle-down effect if the London market continues to deteriorate.

For most people, a house is their principal asset and changes in value have the potential to influence consumer sentiment and consumption. The total value of UK housing is approximately £7.2 trillion and a 1% drop in value is equivalent to 3.4% of UK GDP. To put that in perspective, the economic impact of leaving the European Union under WTO rules is estimated to be around 4% over 10 years or 0.4% of GDP per year.

While the wealth effect of a change in property value on consumption is not easy to quantify, it is perceived by economists to be influential and the sheer size of numbers means that a correlation does not have to be very high to have a material effect on the economy. Therefore, although this may prove to be principally a London-centric problem, housing price stability is becoming more of a concern for us. Stamp Duty is listed as an influential factor behind the slowdown and perhaps a review is overdue if the Chancellor is looking for a positive way to respond to the economic impact of Brexit.

House prices lead UK GDP

The Independent Group

The emergence of The Independent Group in UK politics is an altogether new revelation, adding confusion for investors who are already pretty confused and it is likely to discourage them further. We will review our positive stance on UK equities as the situation develops but, in the circumstances, it seems more likely that realising the apparent value in the UK equity market will not be a quick win and will require patience and resolve.

While the UK is grabbing headlines, it only represents 3.3% of global GDP and is not alone when it comes to challenges to growth.  After such a strong rebound from the December lows in global equity markets, it is important to remember that the road ahead is far from clear. At the time of writing, the trade dispute between the US and China remains unsettled, Brexit continues to be an event risk and the Federal Reserve is taking the risk of an inflation shock with an easy monetary policy and an economy at full employment. Our bias toward equities remains positive but we expect more volatility and it will pay to be patient, opportunistic and flexible in asset allocation.

For more information or if you have any questions, please get in touch by calling 020 7189 2400 or emailing contact@tilney.co.uk.