Central banks in supportive mode as political risks increase
Review & Outlook, mid-year 2019: Investors increasingly expect the Federal Reserve and other central banks to support growth by cutting rates.
Trade tariffs trigger renewed volatility
We have long been expecting to see higher volatility in markets and it has materialised over the past quarter. The trigger was the escalation in global trade tensions, with the US imposing tariffs on Chinese goods and threatening to do so on Mexican products.
Equity markets have recovered following a political agreement with Mexico that removes the immediate threat of tariffs. Even so, the uncertainty around global trade – and the potential to weigh on business and consumer spending – has not gone away.
We still expect positive global growth this year and next. However, the pace of expansion is likely to slow in 2020.
Schroders recently trimmed its expectations for global GDP growth in 2020 to 2.6%. That sounds reasonable for a mature economy, but it is less impressive given it includes the world’s largest and fastest growing economies.
In an environment of slowing growth, the risk of shocks – including unexpected tariffs, diplomatic conflicts and political unrest – becomes greater. Indeed, Schroder Investment Management’s chief economist recently described the global economy as a “wobbly bike”. It is moving forward, but could “be tipped over by the slightest bump in the road”.
Expectations of rate cuts
Equity markets have been remarkably resilient given indications that global growth has peaked and the rising political and economic risks; despite some volatility in May and June, major equity indices remain close to all-time highs, with valuations slightly above long-term
historical averages. This reflects the fact that investors increasingly expect the Federal Reserve to support US growth by cutting interest rates. The latest bond market pricing now suggests this might happen during the third quarter.
While equity markets might respond positively to indications of monetary stimulus, the fact remains that the Fed will not be cutting interest rates because of their confidence in the economic outlook.
Recent economic data out of the US has been mixed. While unemployment remains at historically low levels, the latest figures suggest hiring activity may be weakening. Other data paints a similarly mixed picture.
Retail sales were strong but inflation readings remain depressed. Normally when the jobs market is strong, inflation rises. This has not been happening in recent years. Possible explanations include the impact of technology and a rising share of employment in less productive sectors of the economy. However, the worry is that slowing inflation is a sign of underlying economic weakness. For now, we still expect to see inflation rise modestly from current levels in the second half of the year.
Eurozone and UK slowing, with no Brexit resolution in sight
Closer to home, the economic backdrop does little to inspire confidence. In the eurozone, continued weakness in the manufacturing sector continues to weigh on overall economic output. There are also clear signs of a decline in UK activity. Early indications of April’s GDP showed the weakest output levels since 2016.
There is little reason to expect much of a rebound until there is more clarity on Brexit. This is unlikely to come soon. The resignation of Theresa May opened the door to a wider range of Brexit outcomes and it will be some time until we know the new direction of travel. A government led by a hard-line Brexiteer could try to take the UK out of the EU without a deal. If successful, this would likely lead to a UK recession.
There is also the possibility that a prime minister with the support of the pro-Brexit wing of the Conservative Party finds a way to reinvigorate the Brexit process and boost UK consumer and business confidence.
We expect sterling and domestically exposed UK equities to remain under pressure until the outlook is clearer. However, we are mindful of the possibility that both could move significantly – in either direction – from current levels.
Despite the risks to the outlook, corporate profits continue to grow at a modest pace. While valuations are slightly higher than average, they are not excessive. As a result, we retain an exposure to equities that is in line with our long-term targets. We provide further detail on our asset allocation and portfolio construction below.
We believe it is prudent to remain prepared for higher levels of volatility. We do this by ensuring our portfolios are well-diversified, which helps to reduce risk. We also have a larger-than-usual allocation to cash in portfolios, which we could use to take advantage of attractive investment opportunities that may arise as a result of market turbulence.