Variations on the balance theme

From our current vantage point halfway through 2019, we still see no valid reason to alter the basic view of financial markets we put forward at the close of the first quarter – despite the many dramatic political and geopolitical developments unfolding. The title of our March Note, “Augmented Reality” , referred to the reality of a slowdown in the world economy that was being mitigated by a shift in monetary policy towards out-and-out support for economic activity and financial markets, in contrast to the policies pursued in 2018. Since then, the trade-war saga (see our June Note, “Trump or mercantilism 3.0”) has done little other than to spice up an overall business climate whose consequences for equity markets remain fairly benign (see our April Note, “A return to greater balance”).

Equity indices performed moderately well in the second quarter: not a single major stock market, even in the US, has strayed more than 4% from its level at the end of March The renewed acceleration of the falling bond-yield trend has given wings to share prices, which had previously been hurt by mounting uncertainty. In this late-cycle period, it is important to maintain our disciplined market analysis so that we can continue to distinguish between noise and signal.

With the global economy on the wane, the US and China will be more inclined to be cautious about confrontation

As one could reasonably hope, the key takeaway from the talks between Donald Trump and Xi Jinping at the G20 summit in late June is that neither China nor the United States is particularly keen on throwing the world economy into a deep slump. This suggests that as both sides go on blowing hot and cold in the coming months – and the breeze this time in Osaka was rather mild – they will be influenced not only by their underlying strategic rivalry, but also by the US election timetable and a global economy on the wane. Both governments will therefore be inclined in the short run to be cautious about confrontation.

Wherever you look today, you see a lacklustre economic backdrop, with industrial production stuck in the doghouse – although the traditionally less cyclical service sector still seems resilient. China is a case in point. At 49.4, the June manufacturing PMI survey released just after the G20 event confirms the downward trend. Nor does Beijing appear to be in the mood for a new stimulus programme at this juncture. In the United States, the growth rate for private non-residential fixed investment has continued to fall, no doubt as a result of uncertainty over trade. Europe’s service sector indicators seem to be perking up a bit (for example, the Markit Services PMI for France rose from 51.6 to 53 in June), but the downtrend in manufacturing shows only tentative signs of levelling off, as in Germany, where the Markit Manufacturing PMI inched up from 44.3 in May to 45 in June. Oddly enough, however, this basically downbeat climate is good news for markets in the short term. Indeed, the outlook for low but relatively steady GDP growth temporarily limits the risk of trade-war escalation between China and the US and also ensures that central banks will hew to an accommodating stance, without lapsing into panic mode for the time being.

In the medium term, the need to resort to greater fiscal spending is increasingly acknowledged

It’s tricky business attaching relative weights to the various drivers of deceleration in the global economy: 1/ the slowdown deliberately engineered by Beijing in 2018; 2/the detrimental impact of the US-China trade war on capital spending; and 3/ the untimely monetary policy tightening carried out last year. Due to its unclear proportions, this cocktail invites a key question. Will the return to dovish monetary policies currently on the agenda of the leading central banks be enough to counteract all the causes of the economic slowdown, particularly if the pressure on the Chinese economy holds up?

This shouldn’t matter much in the short run, as the financial markets will probably feel comfortable with central bankers’ renewed interventionism in what looks for now like a settled economic and political climate.

But in the medium term, the issue will be crucial, because unconventional monetary policy is plainly on its last legs. Consider the eurozone. What benefits can we expect to derive from a new bond-buying programme or a cut in key interest rates, given that France is already borrowing at negative rates on maturities up to ten years and that the yield on Spain’s ten-year bonds is just 0.2%? So even with very high debt loads to contend with, there is growing recognition in Europe and the United States of the need to resort to greater fiscal spending – in coordination with support from central bankers. The sense that such political connivance will be unavoidable may help understand – or even justify – the appointment of central bank presidents possessing more of a legal background and demonstrated political savvy than expertise in the technicalities of monetary policy. And yet one has to wonder how this major shift will eventually impact bond and equity markets that have seen nothing other than financial repression and fiscal austerity for the past ten years.

The most sensible investment strategy at this stage of the business cycle still has the same three basic components. The first one is a core equity portfolio focused on carefully selected growth stocks, given that they now constitute a pricy market segment. The second component is sufficient agility to be able to capture the upside potential of the intermediate market movements that are inherent in such transitional phases – and that are amplified by public postures reflecting domestic political agendas. Occasional, but highly disciplined use of option contracts makes it easier to avoid getting wrongfooted by the resulting ebb and flow of hope and disappointment. The third and last component relates to fixed income, through positioning along the yield curve to exploit the greater clarity today on policy easing by central banks. A disciplined approach in this case involves staying away from irrational negative yields and focusing instead on government and corporate bonds from developed and emerging economies that adequately reward risk.

Source: Bloomberg, 03/07/2019