William Davies
Global Head of Equities
For the past 10 years, I have been positive about the prospects for equities.
But at the end of May, I downgraded my view to neutral as the trade war between the US and China escalated. The rhetoric between the two superpowers was becoming more hard-line, and I foresaw the risks for equities rising. It appeared to me that the Chinese had decided to take a firmer line in negotiations, reducing the chances of a deal.
After being positive for such a long time, I did not change my view lightly. In my opinion, an impasse in trade talks would lead to the ratcheting up of tariffs and slower economic growth. In the months that followed, however, equities rallied. In the short term at least, I appeared to be wrong.
But President Trump’s announcement of an additional round of tariffs in early August heightens my caution. Frustrated by increasingly fruitless negotiations with China, he has significantly raised the stakes in a trade war that has been dragging on for more than a year. At some stage the uncertainty is likely to knock consumer spending, leading to lower global growth, although maybe not a full-blown recession.
In 2018 and early 2019, I believed the two sides were likely to reach an agreement. Logically, it is in both countries’ interests. President Trump needs a stronger economy ahead of the 2020 election. President Xi Jinping needs the strong economic growth that traditionally begets stability in China, lifting people out of poverty and providing jobs for the young.
More recently, however, all the signs are that an impasse is likely which would cause a marked deterioration in the economic outlook. The result for companies would be a reduction in future cash flows and earnings forecasts, creating a headwind for equity valuations.
Keeping on track
Think of the global economy as a train travelling down a set of narrow railway tracks. Central banks are the drivers steering a delicate course between, on the one hand, much stronger growth driven by low interest rates and quantitative easing (QE), and, on the other, a deteriorating economic environment, and low inflation, maybe even deflation. For the past 10 years, we have travelled these tracks, worried at different times about the “fire” of excessive growth, or the “ice” of low growth. Now, central bankers fear ice most of all.
That explains 2019’s biggest turnaround in financial markets: the U-turn in expectations for US interest rates. At the end of 2018, the US Fed funds target rate was 2.25% to 2.50%, with the expectation that it would rise further. In contrast, at the end of July the Federal Reserve announced a 0.25% cut to rates. The rate is now expected to fall towards just above 1.00% by the US presidential election in November 2020.
At the same time, US 10-year treasury bond yields have fallen from 3% a year ago to about 2%. That is a significant cut in the cost of money across the yield curve. Furthermore, the cost of money is falling across the globe, with the European Central Bank even reviving the possibility of further QE.
Equity markets have responded with euphoria to the reversal in rate expectations, although there was some disappointment following the July
cut when the Federal Reserve described it as a “mid-cycle adjustment to policy” rather than the beginning of a more aggressive cycle of monetary easing. Investors were incredibly nervous at the end of 2018, as markets fell about 20% from their September 2018 highs to their lows on Christmas Day. After Christmas, however, markets started to rally and, at the time of writing, they are close to their previous highs.
The key question is this. Will the falling cost of money succeed in supporting economic growth? If it does so, future cashflows will remain stable or even grow. A reduction in the cost of money also decreases the discount rate, which bolsters the current value of those future cash flows.
But I remain concerned that heightened trade tensions will undermine growth and cash flows. For now, the jury is out. Consumption has held up well, especially in the US, as employment has held steady. On the other hand, investment spending and purchasing manufacturers’ indices (PMIs) have declined in recent months. It is as if there is a two-tier economy: consumption is holding up, and manufacturing is deteriorating.
In my view, the weak PMIs result from uncertainty over the future terms of trade or tariffs. Until the US-China trade talks reach a conclusion, it’s hard for manufacturers selling into the US to decide whether to have a manufacturing base in China, Thailand or, indeed, the US. The obvious response is to delay any investments in production. And that could well be what is behind the lower PMIs.
If PMIs and investment remain low for long enough, the inevitable result is lower employment, which triggers falls in consumption. However, that has not happened yet. Will growth expectations decline to the degree that they trump low interest rates? If so, then equity valuations look vulnerable at today’s high levels. But if interest rate reductions successfully support growth, then equities could still rise.
Will globalisation falter?
So much hinges on the trade talks. It is difficult to predict the respective strategies of President Trump and President Xi Jinping. They are both strong leaders. But if strong leaders negotiate directly with each other, rather than through multilateral forums, they seem less likely to countenance the compromises needed to reach agreement, so challenging the resolution of their trade differences and even the continued progress of globalisation.
To put the US/China trade dispute into context, throughout my 34-year investment career, globalisation has benefited commerce and equity markets. It has made production more efficient, suppressed inflation as factories have been built in the most competitive places, and encouraged trade between countries. Trade wars could reverse globalisation. The UK indicates the dangers.
One of the biggest difficulties in leaving the European Union without a deal is the potential disruption to supply chains. The loser is likely to be manufacturing in the UK, as the car manufacturer PSA pointed out in late July, saying it would close its UK plant if Brexit rendered it unprofitable.
Returning to the analogy of central bankers following a narrow set of train tracks, it is becoming more difficult for them to stay on the central path. A failure by two strong leaders to strike a compromise over tariffs threatens to reduce global growth, and even stand in the way of globalisation. As risks rise, so too should the equity risk premium. That is why, even with the prospect of lower rates, I remain cautious about equity prices.
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