We all know the New Year and New Year’s resolutions don’t really count for much. After all we are the same people on the 1st January as we were on December 31st and we will carry the same baggage and issues into 2019 as we had in 2018. So it is with the global economy and stock markets. We all know the causes of the current malaise – US/China trade wars, quantitative tightening (QT*), rising interest rates and dollar strength in the US, a falling oil price, Brexit woes and the Italian budget crisis. I fully expect these issues will carry through into 2019 but are there any prospects for change?
At this time of the year fund managers, chief investment officers and other professional commentators are all putting out their opinions on the state of markets and what investors can expect in 2019. An interesting article from Artemis Fund Managers considered the history of stock market crashes and bear markets going back to the 1929 Wall Street crash and identified the portents of doom that indicated that all was not well. For example the 2008 global financial crises was in the context of high levels of personal debt, lax banking regulation, over-valued bank stocks and rapid growth in money supply.
High valuations appear as a common theme in most crashes whilst other factors included companies with minimal cash earnings as in the technology crash in the early noughties and leverage, investors borrowing to buy stocks in the run up to the Wall Street crash.
Whilst Artemis consider valuations to be reasonable today, debt is a clear concern. They note that total US debt is much higher today than it was in 2008 although this is mostly government debt and reasonably serviceable with low interest rates. In contrast Artemis consider corporate America to have strong balance sheets and few households have high levels of debt. Whilst I concluded Artemis see no definitive signs of a crash coming they are certainly wary, noting that trade disputes have previously led to crashes and fast paced electronic trading platforms have potential for damage.
Franklin Templeton observed a confluence of negative forces coming together in the last quarter of 2018. They think the cause of any global recession will be trade tariffs and Federal Reserve policy error. The Federal Reserve is the US central bank and the policy error would be raising interest rates too fast especially in the light of a slowing economy from US/China trade wars. Franklin Templeton are more optimistic that the Fed will ease back on tightening than they are on trade wars abating, as they reckon US policy is geopolitical i.e. it is as much about curbing China’s global influence as it is about trade deficits.
Another interesting point Franklin Templeton make is that all the negatives are priced in and if there are no further shocks at the very least stock prices should stabilise. They also consider the UK equity market to be cheap with a forward P/E ratio** of 12x at the time of writing on the 7th December and a dividend yield close to 5%. The market is now trading at a discount to its intrinsic value as opposed to a premium. That said I don’t expect unloved UK stocks to rally until the outcome of Brexit is clearer.
Meanwhile in early October the International Monetary Fund (IMF) cut their 2019 forecasts for global economic growth to 3.7% from 3.9% previously. In late November the Organization for Economic Cooperation and Development (OECD) downgraded its forecast for growth in worldwide gross domestic product (GDP) to 3.5%. If these figures prove to be true they don’t seem too bad to me. Clearly there will be wide disparity in different economies. Brexit is bound to have an effect in the UK as will the consumption tax hike from 8% to 10% in Japan scheduled for October 2019. In this respect we need to bear in mind that smaller companies are more geared to the domestic economy and will be more sensitive to local issues. In contrast around 70% of the earnings from FTSE 100 companies are from abroad. Not only are they less affected by poor domestic demand a weak pound boosts the value of those earnings when they are repatriated back to the UK. If Sterling falls yes we will import inflation but it is not an unmitigated disaster as some suggest. Similarly is a falling oil price good or bad? It is good and bad, it is great for net importers of oil like India and Japan and it keeps petrol costs down in the UK. However it is bad for oil exporters notably emerging markets.
So what do I conclude? The long bull market, the flat yield curve (another historic harbinger of doom. This was discussed in August http://montgo.co.uk/crystal-balls-yield-curves-old-folk/ ), unwinding of QE, rising interest rates, a stronger dollar and trade wars suggest a bumpy ride in 2019 with the potential for recession. However in the long term share prices are driven by fundamentals for example cash flows, earnings growth and competitive advantage, and I don’t think the fundamentals look too bad. A culture of shareholder value is developing, notably in Japan and whilst US tech giants have taken a hit recently but they hold enormous amounts of cash which can sustain growth and dividends. Moreover tech companies are dynamic and innovative and I expect them to adapt to challenges for example Apple’s disappointing iPhone sales. Finally Chancellor Philip Hammond would bite your hand off for 3.5% GDP growth in the UK. Global economic growth at that level should support earnings.
In conclusion I can’t help thinking sentiment is worse than the fundamentals would suggest, although there is disparity from economy to economy and sector to sector. No-one would seriously suggest for example that the UK retail sector is in great shape. That said sentiment is a strong driver of markets and trumps fundamentals in sell-offs. I guess I am not too pessimistic. It could get worse with a further crash and recession but if markets have fully priced in the bad news there could be a rebound if things turn out better than expected.
In general my advice to clients is likely to be stay invested, deploy cash on the dips, buy and hold, use monthly investment to reduce risk, maintain portfolio diversity in terms of asset allocation and invest with high quality active fund managers. I expect the withdrawal of QE and QT will result in disparity of stock returns and in this scenario stock picking strategies should outperform passive investment.
*Quantitative tightening (QT) is the unwinding of the bond buying programme (QE) of central banks. It is currently happening in the US. It decreases the size of the government’s balance sheet and the money supply. The Fed is doing this by allowing up to $50 billion of bonds to mature each month without replacing them. Please note QT is not the same as tapering of QE. This is a gradual reduction in asset purchases by central banks. Eventually QT should follow. The European Central Bank has started tapering with an aim of ending it by the end of this year.
**The P/E is the ratio of the price of a stock or market to earnings per share. The P/E is a widely used measure of valuations, the higher the ratio the higher the value. A P/E of 15 means an investor would require 15 years of earnings at the current level to recoup the price of buying the stock or market at the current price. Various earnings are used to calculate P/E ratios. As historic earnings are not necessarily indicative of future returns projected future earnings are sometimes used.
The content of this blog is intended for general commentary only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.
May I take this opportunity to wish you a very happy Christmas and New Year.