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Anthony Willis: Volatility ahead for US after midterms

Political noise from Washington is likely to increase in volume

A recent visit to the US to meet fund managers, strategists and analysts left us reassured that, for now, the US economy is in decent shape. But we were not convinced market momentum would be sustained.

The S&P reached a record high during our visit, but recent weeks have proved to be considerably more volatile, despite an earnings season that was generally positive.

We have seen corporate earnings season come to the rescue when markets have struggled in the past but this time, despite the majority of companies beating expectations, the mood appears to have been “glass half-empty”.

Why style differentiation matters in US equity investing

With earnings having been so robust, the narrative now appears to be that we are past peak earnings growth for this cycle, with firms facing headwinds from rising wages, higher input costs and pressures from tariffs, on top of a backdrop of higher interest rates.

The economic data in the US remains strong, albeit boosted by a significant increase in government debt to fund tax cuts, with more to come as the nation seeks to increase infrastructure spending in 2019.

There was a consensus that the boost from the tax cuts and positive second-round effects will more than offset the impact of the trade war and lengthen this economic cycle further. We also noted that quantitative easing and low rates have had a long-term impact on US corporates, with 36 per cent of companies in the Russell 2000 failing to make any profit last year.

But firms fail to go out of business, meaning the economic “winners” cannot succeed because the “losers” continue to operate.

Was October volatility a trick or treat?

The most memorable quote came from a fund manager talking about higher interest rates: “When the Federal Reserve hits the brakes, someone always goes through the windshield.” The Fed has only just taken its foot off the gas – and interest rates are only just positive in real terms – so there could be more interesting and volatile times ahead.

PMI manufacturing data shows that the US economy has for the moment “decoupled” from other major economies, with the momentum from the second half of 2017 sustained. PMI data elsewhere has eased significantly, as seen in the chart below.

The midterm elections saw the Democrats take control of the House of Representatives for the first time since 2010. A situation of “gridlock” in Congress is a regular occurrence in US politics. It is normally a decent backdrop for markets, but as policy change becomes less likely, this time it does mean that the tax cuts which have stimulated the economy this year may not be followed up with further significant policy measures.

President Trump called for collaboration with the Democrats in the aftermath of the election, seeing scope for common ground on issues such as infrastructure, trade and drug pricing. However, given the current polarisation of US politics, it remains unclear how much the Democrats will be willing to work with the president.

They are likely to use their majority to initiate investigations into Trump’s tax affairs and Russian “meddling” in the 2016 election.

EU faces significant political choices

The political noise from Washington is likely to increase in volume; this will continue to prove a distraction but could impact sentiment from time to time, not least if the president seeks to ramp up the trade war with China.

With the midterm elections behind us, history suggests this should be a more positive period for US equities. US indices are already in reasonable shape.

Nevertheless, we do expect further bouts of volatility ahead. This is appropriate at this stage of the cycle, as financial conditions begin to tighten and the Fed continues to shift from the monetary largesse of the past nine years to a monetary policy more in line with rising inflation and tight labour markets.

Anthony Willis is an investment manager in the multi-manager team at BMO Global Asset Management


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