Six weeks after the sharp equity market correction that was set off by heightened appreciation of US inflation risks, a sequence of poor trading days on global equity markets late last week again erased 2018’s year-to-date gains and moved several key markets back into the red. For the full week, US shares lost 5.9%, Japanese shares dropped 4.9%, Eurozone equities fell 3.4% and Australian shares slid by 2.2%. New Zealand equities look set to fall today, but actually registered a small positive return (0.3%) for last week.
Having begun 2018 with the strongest January in twenty years for the S&P 500 Index, the rest of the first quarter has proved a minefield for investors. Optimists have focused on easing geopolitical tensions in Korea, high levels of demand across the developed world, and upcoming stimulatory policies such as tax cuts and public infrastructure projects. However, food for the pessimists has also been plentiful, with a range of (often self-inflicted) political problems drawing attention away from strong corporate profitability and still-low financing costs.
Disruptions have ranged from White House sackings, re-assignments and investigations, inconclusive Brexit negotiations, growing hostility approaching a stand-off between Russia and the United Kingdom, and the approaching strains of higher global interest rates, oil and other input prices. Added to the mix is now the risk of escalating trade hostilities between the US and some of its key manufactured goods suppliers, notably (but not only) China. Confrontational trade rhetoric and punitive proposals unnerve investors, particularly in the context of an assertive Chinese leader now entrenched as President without term limits, the re-election of Vladimir Putin in Russia (also, effectively without term limits,) an erratic US President who claims to admire both of the foregoing leaders’ scope of domestic authority, and a new US Federal Reserve Chairman who will be governing the world’s most influential central bank for at least the next four years.
The more realistic re-pricing of risks continues
The global economy remains in a state of synchronized growth between regions. This has, so far, supplied a positive backdrop to corporate earnings, a gently-accelerating inflation pathway and the initial stages of a global capital spending upsurge which should improve productivity and future growth. However, as the cycle ages (the bull equity market is now over nine years old) and valuations for many assets are extended, there are signs of increasing fragility in the financial market outlook. Until early February, very little risk premium has been available for those investors seeking yield from historically volatile and cyclical assets. We believe that the extreme market movements seen subsequently are early signals of adjustment to a more realistic evaluation of the potential dangers to the current expansion.
At the same time, most of the established indicators which flag a concluding bull market are not yet present. Underlying economic robustness is allowing the US Federal Reserve (the Fed) to continue moving interest rates gradually higher, while the interest rate spreads in the bond markets that signal intensified risks have only very recently turned upwards from low levels. Global excess liquidity growth has turned down recently, but remains positive.
An interesting feature of the sell-off late last week is that the price of Brent Crude Oil – a barometer of global economic vigour – rose sharply, even as trade war fears hit the equity markets. That supports our view that input price inflation (as well as poor economic management) do present asset price risks which thus far have been underestimated. In the course of the US market drop on Thursday and Friday, the energy and utilities sectors held up better than the technology and financial sectors. These ‘real economy’ industries are a comparatively small proportion of the S&P Index but give an example of pockets of relative value within an overall investment landscape where equities and bonds are still expensive and diversification is harder to find.
Oil prices have risen back to 2018 highs while equities correct last week
Mixed messages for Washington-watchers
Last week’s news from Washington was initially market-supportive, as new Federal Reserve Chair Jerome Powell generally impressed observers with his upbeat reading of current conditions and the likely future track of US policy adjustments – carefully treading the middle line between hawks and doves by signalling two more rate increases in 2018 and three subsequently during 2019. Powell underlined that the Fed has no plan to accelerate balance sheet reduction from the current schedule, which dampens the risk of a damaging spike in bond yields.
He also stated clearly that “we don’t do trade policy here at the Fed”, meaning that unless a US trade restriction will significantly affect the outlook for growth, employment and inflation, the central bank will not undertake offsetting measures. Nor will it comment on the economic validity or otherwise of the Administration’s policy thrusts. However, some Fed regional Governors did use the meeting to relay concerns from the business community about tariffs’ unintended negative effects.
The resignation of former Goldman Sachs head Gary Cohen from the National Economic Council on March 6th, triggered by his disagreement with the President over trade policy, indicated that the Trump Administration is prepared to risk loss of market credibility if political capital can be made from staking out a tough, unorthodox position. Even if last week’s announcement of a proposed 25% tariff on Chinese imports in the intellectual property-intensive aerospace, information and communication technology and machinery sectors worth around NZD70 billion is an opening gambit in a negotiation which may have been played up for electoral purposes, the new uncertainty has been enough to inject strong caution back into markets. Given the improvised nature of this Administration’s policy thrusts, the high staff turnover level and the fact that the Commerce Secretary Wilbur Ross (who supports domestic industry protection) has gained the upper hand in the Cabinet, fewer investors are prepared to trust that “Trump the Pragmatist” will in fact prevail over “Trump the Populist”.
All this has weakened the optimists’ view that Trump’s policies are pragmatic mercantilism at their core or that serious trade-war confrontationalism is more of a bluffing strategy than a central policy goal. Having achieved tax cuts, Trump wishes to prioritize infrastructure in 2018 and to use both public and private borrowing to make the upgrades possible. However, he also threatened on Friday that he would sign no more temporary funding measures to avoid Government shutdowns, and if this proves true it would necessitate sharper cuts to public spending in other areas. Such cuts are unlikely before the November mid-term Congressional elections, but if introduced subsequently they would slow the economy in 2019-2020, raising the probability of an end to the expansion amid rising inflationary pressures. Such an outcome (not our central expectation) would present a challenge to the more richly-valued asset markets.
Asset strategy implications
We have long highlighted the chief risk to medium-term returns would be a phase of sustained, simultaneous weakness in both bond and equity markets. Our portfolios have remained somewhat defensively positioned with this risk scenario in mind. We have been dedicated to an overweight cash strategy, despite the drag that this implies at times. We retain a neutral overall weighting to equities (both global and Australasian) because, despite an improving world economy the risk of disruption from a yield shock has become ever more worrying. There is also a heightened degree of sensitivity to political confrontation, as events of the last week have shown.
Notable along with the reversal of risk tolerance in the equity markets was the relatively limited gains in bonds. The willingness of investors to switch into debt securities at times of turmoil has clearly diminished this year, and cash has been preferred as the safe-haven asset to hold immediately following market shocks, while awaiting clarification and re-building confidence in the continuing case for growth assets.
We have a low allocation to fixed income securities, with underweights compared to our benchmarks for both international and New Zealand bonds. We have for similar reasons preserved a small bias against the New Zealand dollar in favour of foreign currencies, because the kiwi currency tends to suffer in periods of risk aversion and the yield advantage of investing in New Zealand debt instruments is shrinking as global yields track upwards.
Because the current ructions in markets come after a very strong run-up and are disconnected from underlying economic and corporate health, we still see the first quarter’s turbulence as a consolidation rather than an enduring market peak. The increased earnings prospects of global companies have reduced their degree of over-valuation recently, particularly with equities in many countries outside the US having declined further than the American indices.
As highlighted in our Quarterly Strategic Outlook, we expect 2018 to be a rougher ride in markets than 2016-2017 as some overdue adjustments in pricing and position crowding play out across the globe. We focus on the underlying economic and profitability strengths supporting our selected equity holdings, on the superior credit quality distinguishing our fixed interest portfolios, and on the fact that we have a higher-than-normal allocation to cash, as we see little real undervaluation around the world to take advantage of at present.
While this ‘dry powder’ approach of retaining a decent cash weighting may restrain our overall gains somewhat during ‘raging bull’ phases, it also positions our funds better to minimize capital losses on equities accruing during moments of anxiety. With fundamentals in the world economy now favouring gradual inflation and capacity pressure, we do not feel that fixed interest will function as the best diversifier if equities’ recovery path remains as jagged as February and March have been. This ‘cautiously optimistic’ strategic bias, while introducing elements of portfolio protection and diversification where viable, will be retained and can be adjusted easily to either a greater degree of defensiveness or to the acquisition of better-valued securities in the event of a deeper correction than the current re-pricing.
This blog post has been prepared to provide general information and does not constitute financial advice in accordance with the Financial Markets Conduct Act 2013. An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.