It’s been a pretty decent third quarter corporate earnings season, including guidance, particularly in the US. This chimes with a broad economic environment that is characterised by solid growth. For sure, there are some signs of slower economic growth further out but at this stage there’s no reason to believe it’s anything more than reduced overheating pressures, and few signs that it’s recessionary.
For example, many of the traditionally reliable warning signs of recession aren’t flashing red, or anywhere near red. High yield credit spreads in the US are close to historically narrow levels, showing little sign of stress, and are certainly nowhere near pre-recession levels. Meanwhile, whilst the yield curve has been flattening, it would be expected to do so in a Fed hiking cycle, and is still upwards sloping. Also, real rates are still negative. None of these are consistent with a looming US recession.
So, the data environment, both in terms of the micro and macro data, and in terms of the traditional indicators of recession, sketch out a fairly positive backdrop. However, as we found in February and October of this year, the market doesn’t need a recession to fall 10% or so. And, as we’ve stated before, markets can fall 20+% (bear market territory) without a recession.
Turning to the market itself, historically, the months following US mid-term elections tend to be pretty positive for the US equity market and November and December tend to be pretty positive months for equity markets generally. So, why are markets not embracing a year-end rally? Well, in time they might but that’s not the current mood music.
There seem to be two main reasons why investors are cautious. Firstly, as we have stated before, higher US rates and the exit from quantitative easing are leading to a tougher environment for financial markets, as investors start to focus on fundamentals again (note two sell-offs within nine months). Secondly, politics is taking an increasingly dominant role in driving financial markets. This is disruptive because political risk is very difficult for markets to price compared to, say, economic risk.
For example, scanning the globe for political drivers, Brexit is one of the key drivers of UK assets and, despite recent positive newsflow between the EU and the UK, for us it hasn’t improved visibility, it just means the noise has moved from Brussels to Westminster. Meanwhile, the election of a perceived market friendly president in Brazil has been driving Brazilian assets, while the president-elect in Mexico has pushed Mexican assets lower on a couple of non-market friendly actions. The discussions between the Italian coalition and the EU has been driving Italian assets, while Trump’s comments have played a material part in the dramatic fall in the price of oil (down over 25% since October peak) and more generally this year his trade policy towards China has dominated markets.
So, political risk now impacts a large part of global financial markets, being less limited to emerging markets, as was the case previously. We don’t see a good reason for this to change short term.
Whether we get a “Santa rally” seems too binary to try to answer. Instead, our approach has been to focus on what’s driving markets. So, more on fundamentals, for example, our bias is to companies that are less indebted and better value. We have also reduced exposure to political risk. For example, we have been reducing our exposure to global trade, such as cyclicals, and increasing exposure to areas like infrastructure and pharmaceuticals. We also continue to have a material amount of overseas currency hedged back to sterling, so that Brexit-related currency volatility doesn’t dominate fund performance.
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Source for information: Miton as at 14/11/2018 unless otherwise stated.
The views expressed are those of the fund manager at the time of writing and are subject to change without notice. They are not necessarily the views of Miton and do not constitute investment advice.
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