Key points
- The US-China trade tensions intensified during August. US tariffs will be applied to all Chinese imports by Christmas at an average rate of 22% (from 14% currently). In response, China imposed tariffs of 5-25% on US$185bn of US imports and suspended purchases of US agricultural products.
- Global manufacturing data continued to come in weaker in Europe and China. US followed this theme in early September with an ISM Manufacturing print which was well below expectations.
- Despite the slowdown in manufacturing, US earnings season delivered three times as many earnings beats as misses. Guidance was less upbeat. Domestic earnings season also delivered more beats than misses though, like the US market, earnings forecasts have, in aggregate, been downgraded.
- The Reserve Bank of New Zealand (RBNZ) cut interest rates by 0.50%. A cut of 0.25% was widely expected.
Key developments
Lead economic indicators continued to weaken and uncertainty around trade negotiations dragged on during September. It was against this uncertain backdrop that global equity markets fell 2.0% (in local currency). New Zealand equities held up comparatively well, down -0.9%, with higher yielding companies faring best after the RBNZ’s surprised 50bp cut to interest rates. Australia suffered the brunt of falling commodity prices, down 2.4% (in AUD).
Global data has generally disappointed relative to expectations recently, particularly in Europe and China. Chinese July activity and credit data suggested renewed weakness with industrial production growth the lowest in 17 years. The US also showed signs of weakness with an unexpected contraction in the ISM Manufacturing PMI which was released in early September.
Despite the weakness in US manufacturing sector the US consumer, the key driver of US GDP, still looks in relatively good shape with ongoing jobs growth and low interest rates leading to buoyant confidence surveys. US companies have also shown little sign of slowing with earnings season widely being regarded as a success. Of the 495 companies that reported earnings, 375 (76%) delivered positive earnings surprises. However, guidance was less upbeat, painting a less rosy picture of the road ahead.
The New Zealand and Australian August company profit reporting season for the June period saw more earnings beats than misses against consensus expectations. Post result earnings revisions have seen more consensus earnings downgrades than upgrades and there were more negative than positive outlook statements from companies than we have seen in recent years. Company caution generally reflected global economic uncertainty and trade negotiations. At an underlying company level, actual operating activity remained sound.
What to watch
Looking forward, there are three key themes we are focussing on:
Recession Risks: We have seen odds of a US recession increase in recent months. One of our independent global research partners, Strategas, recently increased their 2020 US recession probability to 30%. US recessions have led to global recessions in the past. While, for now, the strength in the US consumer is offsetting weakness in manufacturing, we will be keeping an eye on forward looking surveys.
The disconnect between the Fed and the market: The US Federal Reserve (the “Fed”) described its July rate cut as a “mid-cycle adjustment” and communication since then has not deviated from this message. In Fed Chair Powell’s speech at the Jackson Hole Economic Symposium, he described the US economy as “strong” yet US interest rate markets imply more than 100bp of Fed Funds rate cuts over the next year taking the policy rate to c.1.00%. If and how these views converge is likely to be a source of volatility.
Brexit: Few of us could have anticipated what lay ahead when the decision for Britain to leave the European Union was made in 2016. Two Prime Ministers later, uncertainty still reigns with newly anointed Prime Minister Boris Johnson’s plan on getting Britain out of the European Union by October 31st looking more frail by the day. In a recent poll, 76% of Britons think the UK is doing a bad job of negotiating Brexit. One would hazard a guess that this will rise further given recent events.
Source: Bloomberg, YouGov
Market outlook and positioning
During August, we saw the US 10-year government bond briefly trade at a yield below the 2-year bond. This “inversion” preceded the past five US recessions, adding to market fears of a recession. While we are keeping a close eye on economic data in the US, a recession is far from our base case looking forward.
Within fixed interest markets, for much of 2019 we had taken the view that New Zealand bonds were expensive, that the economy would hold up and that the Reserve Bank would not need to cut rates as aggressively as the market was pricing in. The failure of trade talks and ensuing deterioration in confidence throughout the global manufacturing sector, plus the Reserve Bank’s willingness to cut rates aggressively has led us to change our view. The downward momentum in global growth now looks difficult to reverse and, until it does so, we see the downward pressure on bond yields continuing despite the unattractive valuation levels we have reached. We have also taken some profit on inflation-indexed bonds and other valuation-based positions that have performed well.
Within our equity portfolios there is little doubt slower activity will constrain near term profit growth, particularly for more cyclical businesses. Company outlook commentary has turned cautionary. Cyclical companies exposed to slowing demand with weak pricing power and fixed cost structures provided the most cautious outlook comments around their profit results. Meanwhile, investor appetite remains unabated for income yielding stocks, which have risen to new share price highs as bond-proxy companies delivered profit results that support near term dividend payments. In our view, companies that can continue to expand their revenue base and grow earnings through slower cyclical economic growth periods offer investors the potential to benefit from the biggest driver of equity market returns - long term compound growth. We believe investing in compound growth companies offers an attractive investment option in a diversified portfolio.
In multi-asset portfolios, we have built up an overweight allocation to Australasian equities. While we are wary of valuations in this sector, we believe these equities look relatively attractive against the backdrop of lower and lower interest rates. At the same time, we trimmed our position within global equity markets. While global equities are cheaper using headline valuation metrics, given the heightened global macroeconomic risks, we view it as sensible to take a more cautious approach within global share markets at this time.
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