If the market rally of January through April this year was all about the Fed (US Federal Reserve) pivot and the expectation that we are clearly going to get a US-China agreement on trade, then we had better prepare for disappointment.
That trade deal is a long way off, if it comes at all. The messaging suggests that the issues are difficult and the two sides are digging in for a long battle for supremacy.
Meanwhile, economic data is deteriorating – this includes PMIs (Purchasing Managers’ Index), industrial production and the housing market – everything apart from consumer confidence. The US consumer is doing ok so far.
The bond market sees signs of slowdown and risk. The move in the 10-year Treasury is significant – with the yield at a 20-month low at the time of writing – and German bund yields have gone negative again. And yet the Fed is making noise that everything is fine and there’s no rush to ease interest rates. In the coming weeks, with bond yields where they are, I believe equities really have got to fall. It is almost necessary for equities to fall in order for the Fed to begin to worry and to make some kind of policy response. If equities are weaker, President Trump, who appears to be a keen follower of the stock market, will begin to lean on the Fed to help.
It could be a difficult few weeks or months for the markets. To my mind, there’s potential for an up to 10% correction in equities, similar to what happened in Q4 last year, and nothing more sinister than that because the underlying economy is not doing that badly. It is softer, as I said, but there is no sign of recession.
I’m confident that the Fed will step in, allowing the equity market to look across the valley and beyond some modest company earnings in the second half of the year – provided that things pick up in 2020.
We’ve come this far without mentioning Brexit. There will be a brief recess in August. That leaves September and October for the new government’s negotiations with the EU, ahead of the 31 October deadline for leaving. Clearly, that is a pretty tight timetable. It’s likely to mean the government will ask for an extension past October and that the Brexit “handbrake,’’ which has constrained economic 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 total returns in large cap stocks where a combination of dividend, special dividend and buyback result in solid double-digit total returns.
We continue to find no shortage of stocks with significant potential upside on a three-year view. When the Brexit handbrake is removed, we believe these stocks could see material reratings.