Powell, Trump and Xi
We see three significant issues for the next few months:
- Whether the Fed tightens for the fourth time this year at the December Federal Open Market Committee (FOMC) meeting, and how hawkish it sounds
- How aggressively President Trump pursues his trade war agenda
- The amount that China stimulates its economy
A December Fed funds rate hike is looking likely with increased pressure on wages. More important will be the message that investors take from the FOMC statement. Markets are pricing in additional tightening with two more interest rate increases in 2018 and a further three or four hikes in 2019. This would take the federal funds rate to 3.3%. A shift to a more aggressive outlook would put upward pressure on the U.S. dollar and Treasury yields. It also would add to the stresses in emerging markets. We think the risks are shifting towards a slightly more aggressive Fed than the market is pricing.
President Trump has implemented a further $200 billion in tariffs against China at a 10% rate. He has threatened to increase this to a 25% rate and further threatened tariffs on an additional $267 billion, which would cover the entirety of China’s exports to the U.S. He also has threatened tariffs against Europe’s automobile industry, although these seem less likely to be implemented. We see an escalation in trade wars as a threat to emerging markets and global trade.
Meanwhile, President Xi Jinping is focused on deleveraging and structural reform in China, but he also needs to implement policy stimulus to counteract the impact of U.S. tariffs. Some stimulus has already happened, most notably the 9% depreciation in the renminbi since April. More stimulus is coming in a mix of fiscal spending and credit easing. It is unlikely, however, to be close to the substantial easing that took place in 2009 and 2015. We believe it is more likely to resemble “stepping off the brake” than “pushing on the accelerator”.
There is also the risk that oil prices could head higher as global supply is restricted by the renewed U.S. sanctions against Iran, the economic collapse in Venezuela and the growing risks of a civil war in Iraq.
Emerging markets look oversold as the third quarter ends, though still offer reasonable value, but we believe the risks of an escalated trade war and a stronger U.S. dollar (USD) on the back of a more hawkish Fed argue for caution for now.
We also like the idea of leaning into Eurozone equity exposure after its recent underperformance. Italian risk looks to be dissipating, corporate earnings remain robust and the industry consensus has become too pessimistic about the economic outlook. Trade-war risk, however, tempers our enthusiasm.
The S&P500® has been the best performing regional equity market this year. Corporate earnings growth has exceeded S&P 500 analysts’ expectations and, according to International Monetary Fund (IMF) estimates, fiscal stimulus is adding 0.7% to Gross Domestic Product (GDP) growth this year and should add 0.8% in 2019. The cycle is a small tailwind for U.S. equities, but even so, they are very expensive. The Shiller cyclically adjusted P/E reached 33 times its 10-year average as of mid-September, which is its highest level ever outside of 1929 and the late 1990s.
U.S Investors Intelligence Survey: Bulls minus Bears
Source: Datastream, last observation September 11, 2018, smoothed with a Henderson trend filter (which is designed to eliminate irregular variations that are of very short frequency).
Indexes are unmanaged and cannot be invested indirectly. Performance quoted represents past performance and should not be viewed as a guarantee of future results.
Momentum favors U.S. equities, but some of our contrarian overbought indicators are beginning to trigger. The Investors Intelligence survey of market newsletters has moved into strongly bullish territory. It’s not as overexuberant as it was in January, but is at levels that have previously been associated with a heightened risk of a correction.
U.S caution flag: longer-term risks are building
This year has shown once again that valuation is a poor tool for market timing. The S&P500 is the most expensive regional equity market by a wide margin, and one indicator that argues for some caution is the amount of bullishness built into longer-term earnings expectations. Industry analysts expect long-term earnings growth of 16% per annum. This was only exceeded at the peak of the tech bubble in 1990.
S&P 500 analysts are the most bullish on earnings since the tech bubble ended in 2000
Source: Datastream/lnstitutional Brokers' Estimate System (IBES) as of Sept. 1, 2018.
We believe the hurdle for earnings to surprise on the upside is now very high. The impact of corporate tax cuts on earnings will soon disappear, and both borrowing costs and wages have headed higher. A slowdown in earnings growth will take away one of the main supports for U.S. outperformance relative to other markets.
Conclusion: bull market isn’t over but caution warranted
The next few months look particularly uncertain, with a lot riding on the decisions of Fed Chair Jay Powell, Donald Trump and China’s President Xi Jinping. For the near term, we like the defensive qualities of U.S. government bonds and the Japanese yen.
The yen has three advantages to support our outlook. It’s 20% undervalued relative to purchasing power parity, is getting cycle support at the margin as the Bank of Japan becomes less dovish, and has solid sentiment support from sizeable net short positions. The added benefit is that the yen performs well as a safe haven, so it gets a tick as a defensive diversifier on portfolio construction grounds.
Ten-year U.S. Treasury yields near 3% offer reasonable value amid the current uncertainty. Over the medium term, however, the cycle forces of inflation pressures and central bank tightening will put global government bond markets under pressure.
We’re neutral global equities for now, with a small preference for non-U.S. markets. The pessimism on Eurozone equities looks overdone. We’re waiting for more clarity on trade talks, the Fed and China stimulus before leaning into oversold emerging markets.