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Bill McQuaker: Global picture continues to get murkier

US outlook appears slightly pessimistic as fears over trade wars resurface

We are now well into the second quarter of this year and the profound risk-on move that looked so well established has been stopped in its tracks by renewed trade tensions. Risk assets have benefited over the year to date from market optimism, resulting from the US Federal Reserve’s “pause” and trade tensions easing considerably until recent weeks.

While the resurgence of the trade war story has unsettled markets and hit sentiment, year-to-date performance is still good, with the US equity market up nearly 15 per cent, down just 3 per cent from its recent all-time high.

We expected markets to rally at the start of the year but had become a bit uncomfortable with how far prices had moved when “green shoots” seemed few and far between. A bit of price weakness is therefore welcome, in our view.

The dominance of policy has been a key driver of the global backdrop so far this year. China’s stimulus is a far cry from that witnessed in previous slowdowns, but it is expected to show up in the data as we enter the second half of the year.

Europe’s own monetary intervention hasn’t meaningfully changed the picture but, as damage control, it seems to have at least temporarily assuaged the markets.

Meanwhile, the Federal Reserve’s policy normalisation in 2018 was short-lived, with equity markets signalling that all was not well before rebounding once again on news of the pause.

While this words-based policy intervention has certainly corresponded to strong market performance thus far, there are concerning signs on the horizon.

The gap between strong markets and weak economic data can’t carry on in perpetuity, but the question is will convergence come from improved growth or a fall in market performance?

There have been tentative signs of stabilisation in global growth, but the outlook for the US economy is significantly less optimistic, and recent signs are pointing to the possibility that it may “catch down” to the rest of the world. This would ultimately hurt the corporate sector and, in turn, markets.

Turning to the higher-frequency data releases, the most recent Institute for Supply Management Non-Manufacturing PMI was disappointing, showing the worst expansion in the service sector since July 2017.

In the corporate world, after 90 per cent of Q1 earnings have been reported, analyst forecasts of a 3.9 per cent decline have been soundly beaten. Yet this is of less importance than it may appear on the surface.

Expectations are typically set low so they can be exceeded and, this quarter, expectations were hammered between December and February. No wonder a decent proportion of companies beat them.

Concerningly, positive earnings surprises have been rewarded less than normal (0.7 per cent versus a five-year average of 1 per cent), while downside surprises have had a significantly more negative impact on share prices (-3.5 per cent versus a five-year average of -2.5 per cent).

Also worrying for the US corporate sector are the recent results of the quarterly CFO Magazine Global Business Outlook, produced by Duke University. It has 38 per cent of chief financial officers predicting a recession by the first quarter of 2020 and 84 per cent anticipating a recession by Q1 2021.

The most important takeaway from this result is the potential impact on levels of discretionary corporate spending, such as advertising and business travel, as well as capital expenditure. If CFOs are anticipating a recession, they are more likely to protect their firms’ balance sheets and cashflow from a possible downturn, and with the rapid growth of BBB-rated corporate bonds, highly levered companies are particularly vulnerable.

This complicated backdrop, combined with trade tensions surfacing again, does not bode well for accurately discerning the direction of travel from here. There are huge fundamental sticking points on each side of the trade dispute, and there is a real risk in being high-conviction in either a settlement or major escalation.

We suspect there may be a little more weakness in asset prices, as earlier optimism about policy and trade is washed out of markets.

It may be that most of the returns to be had in 2019 have already happened, but with the US president, the Federal Reserve and Chinese policymakers all keen to avoid a major slowdown, we are wary about becoming too negative.

Bill McQuaker is portfolio manager at Fidelity Multi Asset Open funds


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