Markets tested the conviction of investors this week as economic data continued to sour, contributing to a plethora of negative data released since the start of the year. After a positive week in markets on very little economic data last week, markets turned negative on Monday following rising pessimism concerning US and China trade tensions, low Chinese growth figures for 2018, and revised global growth estimates from the IMF. It is clear that risks to the global economy are significant, with the World Economic Forum’s annual meeting in Davos this week providing a stage for key leaders and economists to express their concerns about the outstanding risks to growth in 2019.
Significant risks to the global economy in 2019
It is now widely accepted that 2019 will be characterised by weaker global growth, which is likely to result in subdued market returns over the year. This week, the IMF released its World Economic Outlook report, downgrading its expectations for global growth in 2019 by 20bps from 3.7% to 3.5%. The downgrade came as evidence of slower global growth strengthened, with particular weakness now seen in German and Turkish economies. The revision is the IMF’s second downgrade for 2019 global growth so far, and is being regarded as a lagged reaction to recent economic data. As it stands, with weaker economic growth and high levels of political uncertainty, there are a number of outstanding risks facing financial markets in 2019. The key risks are:
o Credit concerns
o Brexit negotiations
o Lower corporate earnings
o Slowing growth in China
o Slowing growth in the US
o Eurozone recession
Against a backdrop of rising rates and slowing global growth, credit risk is increasing, with significant risks in the corporate credit channel which could either trigger or amplify a global economic slowdown. Recent data suggests that pockets of risk and over-indebtedness are appearing in the global economy, with rapid household debt growth in China warranting concern. At the corporate level, credit risks are highest in China, Hong Kong, France, Chile and Canada, with declining credit quality increasing corporate risks in the US, Europe and Turkey. In the US, the share of investment grade credit rated BBB has risen to nearly 50% from 38% in 2011 and is currently higher than in 2007. One fifth of this BBB credit is rated at the lowest band, BBB-, so is at risk of downgrade into non-investment grade or ‘junk’ status. A large and rapid expansion of junk credit runs the risk of disrupting credit markets as most investors cannot hold junk debt. In the Eurozone, the situation is worse, with the share of investment grade credit rising from 20% in 2011 to around 50%. Globally, the BBB share in investment grade credit has doubled from 24% in 2007 to 48% now. Credit markets are likely to be extremely vulnerable to developments in the global economic backdrop.
Uncertainty over the overall Brexit outcome remains as Theresa May struggles to find a deal which would be approved by parliament. With 65 days remaining until the scheduled Brexit date on 29th March, the parliamentary debate continues, with no clear consensus emerging within parliament. While the Prime Minister looks towards the EU for further concessions over the controversial Irish border backstop, MPs are putting forward amendments to her deal which will be voted on in Tuesday’s parliamentary session. Among the amendments are plans to stop a no-deal Brexit and to extend the deadline for leaving the EU. Earlier in the week, Labour leader Jeremy Corbyn tabled an amendment that could open the door to a second Brexit referendum. As it stands, unless a consensus emerges for a deal or an extension of the deadline, the UK will crash out of the EU with no deal on 29th March, with the fallout likely to result in recession in the UK, causing global growth to deteriorate further. All eyes are on next week’s parliamentary vote.
Lower Corporate earnings
Weaker global growth and trade uncertainties are beginning to feed into corporate earnings figures, resulting in a series of earnings forecast reversions and negative earnings surprises for Q4 2018. According to Factset data, over the last three months, analysts made the largest cuts to S&P 500 EPS estimates in four years for the first half of 2019. The 4.5% decline in the H1 2019 EPS median estimate represents the largest decrease in earnings expectations since H1 2015. The largest EPS revisions came from Energy, Technology and Materials sectors, all of which have the highest international revenue exposures in the index. For Q1 2019, 6 S&P 500 companies have issued negative EPS guidance and none have issued positive EPS guidance. Lower corporate earnings are likely to trigger a sell off in equity markets in H1 2019.
Slowing growth in China
China announced on Monday that its economy grew by 6.6% in 2018, its weakest annual growth since 1990. China’s economic growth slowed further than expected in Q4, with data signalling a broad-based slowdown which indicates a more marked deceleration than the headline GDP figure suggests. Chinese growth is expected to remain under pressure in 2019 as the economy faces issues on both domestic and external fronts. On a domestic level, the economy faces reduced domestic demand due to weak sentiment and cooling real estate activity amid downward pressure on PPI (a measure of inflation) and industrial profits. Externally, less robust global demand will continue to depress export momentum, and the US-China trade conflict will continue to cloud the outlook.
According to the IMF’s latest report, the slowdown of China is of particular concern for global growth, with pressure from tightening financial regulations and US tariffs potentially resulting in “abrupt, wide reaching sell offs in financial and commodity markets that place its trading partners, commodity exporters, and other emerging markets under pressure”. It is clear that the Chinese economy is slowing, however the resolution of US-China trade tensions will be key to limiting the negative impact on the global economy.
Slowing growth in the US
Concerns over slowing US growth due to trade tensions with China, Fed tightening and fading fiscal stimulus have resulted in higher volatility in markets in recent months, with slower growth beginning to feed into markets. Despite evidence of slowing growth, the IMF still sees the US as one of the world’s strongest economies, however with momentum fading as fiscal stimulus wears off, it projects 2.5% growth in 2019 and 1.8% growth in 2020, which presents a stark contrast to the Trump administration’s forecasts of over 3% for the foreseeable future.
Alongside external issues impacting growth, the US is currently on day 33 of a government shutdown as a result of a stalemate between President Trump and democrats over funding of a controversial boarder wall. The shutdown is expected to reduce Q1 GDP by 0.2% as government agencies grind to a halt until an agreement is made. Should the government shutdown continue, the US could face a downgrade of its sovereign credit rating which would likely trigger a sell off in financial markets. US debt levels are increasing, increasing the country’s interest burden over the next decade. According to credit rating agency Fitch, if the political stalemate continues and the debt ceiling becomes problematic due to difficulties passing budgets, a rating downgrade is likely.
Normalisation of the Fed balance sheet is expected to continue in 2019. While liquidity is unlikely to be a systemic concern, increased regulatory requirements for banks and increased treasury bill issuance in the context of rising budget deficits are likely to result in elevated short-term rates, which could potentially result in inversion of the 10-2 year Treasury yield spread.
Possible Recession in the Europe
Following the material loss of growth momentum in the Eurozone in 2018, downside risks persist for the Eurozone. The increasing risk of a ‘no-deal’ Brexit, a slowing global economy and the threat of car tariffs, all carry the potential to spark a deterioration in sentiment and activity. Following a series of more negative economic data, markets are expecting a more cautious message from the ECB at its meeting tomorrow after Draghi highlighted existing weakness in the Eurozone economies. Germany’s growth is at its lowest point since 2013, Italian growth has stalled, and France and Spain are seeing abrupt slowdowns. Given current economic conditions within the bloc, the ECB must tread carefully to avoid Europe’s slowdown becoming a recession.
It is clear that significant risks to the global economy persist in 2019, with a high level of uncertainty over political and trade issues remaining in near term. For these reasons, we retain our defensive positioning and encourage investors to view intra-week market movements in the context of the global economic risks and our overall defensive strategy. Over the week, markets are up slightly, as complacent investors ignore risks and favour higher risk strategies in the pursuit of higher returns.
It is key to highlight that our defensive strategy was not implemented on the expectation that markets would immediately decline, but rather because we do not see any merit in putting our clients’ capital and accumulated portfolio returns at risk by trying to eke out further gains given the excessive risks present in equity markets. The key economic data has become increasingly negative in recent weeks, and as a result, we expect a drop back in equity valuations when the data feeds through to markets.
Key Dates this week
24th January- ECB Monetary Policy decision
29th January- Parliamentary vote on Brexit amendments
30th-31st January – US-China trade talks in Washington
For anyone who wants further data to substantiate the position please review the attached Global Economic News Document.
Model Portfolios & Indices
Following the defensive repositioning of portfolios in December, our OBI portfolios have a low equity allocation, with exposure predominantly coming from the FTSE 100 and S&P 500 shorts as well as the Odey Long/Short European fund. For this reason, the equity exposure within portfolios is inversely correlated to markets ahead of the expected decline this quarter. Markets were up over the week on speculation and momentum in the absence of positive economic data, leading to underperformance of the portfolios in comparison to the benchmark.
Markets fluctuate, and we must not allow ourselves to be caught up in short-term sentiment when the economic data remains unchanged. Bear markets continue to move up and down in intraday movements, but trend down and bull markets do the same but trend upwards. It is clear that we are currently in a bear market, and it takes time for the data to feed through structurally, therefore what is happening remains in line with our expectations.
In the meantime, as we wait for the data to feed through into markets, we are expecting volatile market conditions, however it is key to bear in mind that the scenario will take time to play out. If we view intra week market movements in the context of longer-term market trends and stay content in the knowledge that portfolios are protected from the excessive risks in markets.
The impact of the defensive repositioning
The chart below shows portfolios following the defensive rebalances in December. At the lowest point, clients were 4% down and now they are flat, so the strategy is proving itself when markets decline. With the expectation that the recent rally will fizzle out and negative earning data will feed through into markets, we remain confident in this positioning. In the short term, we have avoided the drop and excess volatility.
The data above will not directly correlate to the indices as there is always a delay in pricing because the US markets close significantly later than the European markets and the Asian markets. The data set above reflects the last close and much of the days movements will not yet be reflected in the portfolios due to pricing delays. You cannot therefore directly correlate indices to the portfolios. The value of investments may fluctuate in price or value and you may get back less than the amount originally invested. Past performance is not a guarantee of future performance. Performance figures quoted include the fund manager charges but exclude other fees such as adviser, custodian, switch and/or discretionary investment management fees. Unless otherwise instructed and accrued, income is reinvested into the portfolio.
This Day in History
On this day in 1571, Queen Elizabeth I opened the Royal Exchange, London, as a bankers’ meeting house. It was founded by the financier Sir Thomas Gresham.
Have a great week,