After a poor May markets recovered in June, with global equities returning 6% in Sterling terms. Whilst the world economy remains in a “soft patch”, there has been a marked shift in central bank guidance within the developed world, with the US Federal Reserve confirming at its June monetary policy meeting that it is prepared to cut short-term interest rates to support the US economy. It was only seven months ago that the Fed seemed set on a path to raise interest rates even further so the 1%+ rate cuts anticipated by the market over the next 18 months is a huge turnaround in expectations of the future interest rate landscape.
Why is this important for equity markets? Well, the more expensive bonds become the cheaper equities appear in comparison. This is reflected in the very generous global equity market earnings yield over global investment grade bond yields and a near record yield differential between FTSE 100 equity index and ten-year UK government bonds. Elsewhere, lower sovereign bond yields have the effect of lowering the so-called discount rate that applies to future equity earnings and boost equity valuations via raising the earnings multiple the market is prepared to pay.
With economic growth sluggish, corporate earnings growth decelerating markedly and further central bank policy ease in sight it does feel a little like 2014-16. During this period, equities posted reasonable returns, but caution on the economic cycle and declining bond yields made investors increasingly favour defensive equities (for a relatively generous and sustainable dividend yield) and growth stocks (for more consistent earnings growth) at the expense of the value style, which is generally more exposed to the economic cycle.
Another positive development for markets was some rapprochement on trade between the US and China at the G20 meeting in Osaka. Whilst details of what was discussed are sketchy, the US and China are now engaged in trade talks and the threat of 25% tariffs on an additional $300bn of US imports from China is currently off the table. Elsewhere, there remains some ambiguity around the ability of US companies to engage in trading activities with Chinese tech giant Huawei, but we get a sense that the US authorities are going to attach some strict conditionality around lifting import restrictions. Taken in the round, whilst there has been some welcome relief in markets reflecting better mood music on trade, there is still a long way to go before we can sure that trade tensions are easing in a material and sustainable way.
So where do we go from here? The first half of 2019 has been characterised by arguably the strongest and most broad-based asset price reflation seen since 2009. Most asset classes have returned in just six months somewhat more than their long-term annual average. So, against the background of sluggish economic and corporate earnings growth and higher starting valuations, it is reasonable to expect more moderate returns in the months ahead. We would also highlight some tension between the markets expecting a US-China trade deal and at the same time discounting at least four 25bps rate cuts from the Fed. If we are reading the Fed correctly it seems to us that much of prospect for rate cuts is linked to the downside risk to growth that an ongoing stalemate on trade is likely to cause. In short a trade deal and 1%+ rate cuts may be too optimistic.
In conclusion, notwithstanding some near term vulnerability in equity markets we still maintain a long-term preference for equities over bonds on relative valuation and our expectation that central bank policy can help end the current economic cycle.
