Be prepared for storms this summer
Financial markets have prominent bull and bear factors at the moment. There was a tremendous rally in equities in the first part of the year, following the Federal Reserve’s more dovish stance, as well as the expectation that the US and China would agree a trade deal, and even that – somehow – Brexit would be settled.
Sadly, the prospect of a trade agreement has fallen away. While Mexico appears to have dodged president Trump’s latest tariff threats, the issues with China seem to be more intractable. Presidents Xi and Trump are potentially due to meet at the G20 at the end of the month, so there may be potential for a breakthrough, yet the messaging suggests the two sides are digging in for a long battle. Meanwhile, the economic data is weakening. The June US non-farm payroll figures showed sharply weaker-than-expected jobs growth.
This year’s purchasing managers’ index, industrial production and the housing market – everything apart from consumer confidence – have been weaker. The US consumer is doing OK.
The bond market has been reflecting concern about a slowdown and taking a considerably more bearish stance than the equities market. The move in the 10-year treasury has been significant, touching a 20-month low recently, and German bund yields have gone negative. The dollar, meanwhile, has stayed strong. This has created difficulties for many emerging market economies, which hold dollar-denominated debt that has become more expensive as their local currencies have weakened.
And yet the Fed doesn’t appear to be in a rush to come to the rescue of the markets by easing interest rates.
Chairman Jerome Powell has said the Fed will act as appropriate to sustain the economic expansion. The market is expecting as many as three rate cuts this year, and there may be a disconnect between expectation and reality. Rates will come down, but how quickly? With bond yields where they are, equities have really got to fall. It is almost necessary for equities to stumble in order for the Fed to make some kind of policy response.
If equities are weaker, Trump, who appears to be a keen follower of the stockmarket, will begin to lean on the Fed to help. In the course of the summer months, we may get a few market storms. I believe we could see something like a correction of up to 10 per cent in equities, similar to what happened in Q4 last year; nothing more sinister than that because the underlying economy is not doing too badly. It is softer, as I have said, but there is no sign of a recession.
It may be a weakness in financial markets that leads the Fed to make a move. This will allow the equities market to enjoy the policy response and look forward to something like a soft landing, and resumption of growth into 2020.
We may see some modest company earnings in the second half of the year but investors can tolerate this, provided things pick up next year.
The outlook for Brexit remains unclear. We won’t know who will be the new Tory leader until July.
In my view, they will have to survive a no-confidence vote, and that will be followed by a brief recess in August. This leaves September and October for the new government’s negotiations with the European Union, ahead of the 31 October deadline for leaving. Clearly, that is pretty tight. It’s likely to mean the government will ask for an extension past October and the Brexit “handbrake”, which has constrained growth, will remain a while longer.
UK stocks have been heavily sold off by global and domestic investors. Equities are cheap versus their long-run average valuations. Nevertheless, companies are still pushing out solid levels of earnings growth; low- to mid-single digits in some cases, high-single digits in others.
There are many examples of large-cap stocks where a combination of dividend, special dividend and buy-back results in solid double-digit total returns. We continue to see no shortage of UK stocks with significant potential upside on a three-year view.
When the handbrake is removed and when markets settle, I believe these stocks could see material re-ratings. A summer lull may prove to be just the time to buy.
Richard Buxton is head of UK equities at Merian Global Investors