22 October 2019 – One of Europe’s biggest hedge funds predicts big changes in market leadership; earnings season gathers speed with a handful of tech giants in focus; Brexit continues to dominate the domestic headlines; China growth slows to 6% and Mario Draghi bows out of the ECB.
The world’s stock markets have been rising for 11 years since the financial crisis. Indeed, the S&P 500 rose above 3,000 again yesterday to within 0.6% of its July all-time high. So too have bond prices as extraordinary monetary policy has seen yields fall to historically unprecedented levels.
Investors have been worrying whether a change of direction is imminent for what seems like years now but sticking with it has been the profitable trade.
Well one of Europe’s most influential hedge funds reckons big changes may be afoot. Lansdowne Partners, which manages $15bn in assets, is predicting a shift in the underlying trends that have dominated markets for so long, according to an interesting piece in the FT this week.
Perhaps the most important bet the fund is reported to be taking is against the bond market where prices have reached what it describes as ‘idiotic levels’. There are a couple of risks with government bonds today. The first is that $17trn of them now offer a negative yield so investors are essentially paying for the privilege of lending their money to a government. That looks unsustainable on anything other than the greater fool theory that negative yields can get even more negative, and prices therefore even higher, before they revert to the mean.
The second risk is that governments can always issue more bonds, which typically results in rising yields and so falling prices. This is one of the big new themes in investment today, the idea that, with monetary policy running out of road, the pressure will rise on governments to step into the breach to stimulate economies. The increasingly populist nature of many governments around the world makes this more likely, it is argued, as spending is cranked up to please voters.
One natural consequence of heavy government spending could be a return of inflation, which has largely been absent from financial markets for many years. If inflation does return this could also have a significant impact on markets. Inflation is typically very bad news for bonds and other fixed income investments because the purchasing power of that income erodes over time as prices rise. But it is also bad for shares if it rises above even quite a low level.
Investments that have the ability to raise their income, such as commercial property and high yield stocks could do better than fixed income in a modestly inflationary environment. Gold, too, is seen as a safe haven as prices rise, especially if the dollar falls at the same time.
A second controversial bet is on technology stocks reversing their stellar gains of recent years as valuations reach levels not seen since the dot.com bubble of the late 1990s. The wisdom of this change of tack may become evident sooner rather than later as a string of high-profile tech stocks are due to report over the next couple of weeks, including Amazon and Microsoft.
A third, perhaps even more contrarian position, is on UK stocks. If political risks abate then it is arguable that the UK stock market is one of the world’s cheapest. Lansdowne argues that British companies are much better managed than they were 10 or 15 years ago and have stronger balance sheets. Put Brexit behind us and they just might bounce. We are already seeing domestic stocks outperform the more international FTSE 100 on good Brexit news.
The immediate outlook for stock markets will probably be decided by the trajectory of company earnings as the third quarter results season gets underway. Having digested a mixed bag of bank
results last week, attention shifts over the next two weeks to tech stocks, which also look like being mixed.
Overall, the expectation remains that earnings will fall in the third quarter, by around 4% or so on the basis of analysts’ forecasts. That would build on two quarters of marginal declines in earnings in the first half of the year. However, with companies usually beating expectations that have already been massaged lower in the run up to results day, there remains an outside chance that earnings could edge into positive territory in the July-September quarter.
Closer to home, attention is naturally focused on the ongoing Brexit saga, which is showing a few signs of finally heading towards a resolution, albeit there is still plenty that can go wrong, especially over the next few crucial days.
Last week saw some key developments, including success for Prime Minister Boris Johnson in securing a withdrawal agreement with the EU in Brussels before the now traditional return to earth with a bump as the Government’s plans to get MPs to rubber stamp the deal on Saturday were scuppered.
A last-minute amendment by backbencher Oliver Letwin was designed to ensure that Britain does not accidentally crash out of the EU simply because implementing the legislation required to leave takes too long and over-runs the October 31st deadline. The amendment was passed by 322 votes to 306 and Boris Johnson was obliged to write to the EU requesting a further extension to the process, although typically he did this by writing two letters. One requested the extension which he didn’t sign while a second one said why he didn’t want an extension - this he pointedly did sign.
With the amendment voted through, the vote on the substance of the withdrawal agreement was postponed until today. Mr Johnson will try to drive through the agreement and necessary legislation this week but securing the votes of the 320 MPs he needs remains uncertain. With perhaps a million people marching on the Houses of Parliament on Saturday to demand a second referendum, the deep-seated splits in Britain are no closer to being resolved.
So what is in prospect now? A vote on the deal could still go ahead and, with a combination of long sittings and the Lords coming in at the weekend, hitting the Halloween deadline for Brexit is just about possible. Alternatively, the opposition parties could still force through amendments requiring a confirmatory referendum or more likely insisting on Britain staying in the customs union. Whatever happens, we could head towards a general election before year end to try to break the impasse.
Despite the uncertainty, sterling has rallied as the most feared prospect, a no-deal crash-out, has receded. The range of outcomes for the pound remains wide, however, with traders talking about a rise to $1.35 or higher with a favourable deal, or back down towards $1.20 if things go badly. Currently the pound is close to $1.30.
The main economic news this week has been the announcement that China’s gross domestic product in the third quarter fell to a slightly lower than forecast 6%. This was the lowest figure for 30 years confirming that the days of double digit growth are long gone as the Chinese economy matures and the impact of Donald Trump’s trade war bites.
Not everyone is unduly concerned about China’s slowing growth. It can be argued that the country actually needs slower but more sustainable growth if it is to stop wasting money on uneconomic stimulus measures. In the long run it is actually a good thing and probably not Beijing’s biggest concern at the moment as it continues to deal with protests in Hong Kong and a nationwide swine
fever outbreak that threatens to fire up inflation in a country where pork is the biggest source of protein.
On the trade war, the news is actually improving. Donald Trump tells us talks are going well and at least a phase one agreement may now be signed in November. The potential uplift in the global economy if trade tensions ease is one reason why investors are starting to turn their attention to so-called value stocks which do well in a recovery as opposed to the defensive shares which have been favoured during the long-slow aftermath of the financial crisis.
Looking ahead to Thursday, the big event on the policy agenda will be Mario Draghi’s final meeting as head of the European Central Bank before he hands over the reins to former IMF chief Christine Lagarde.
The past eight years have been a difficult time to lead one of the world’s most important central banks. Looking back, there is general agreement that Mr Draghi’s was the right hand on the tiller during the dark days of the Eurozone sovereign debt crisis when he famously promised to do ‘whatever it takes’ to protect the single currency. He moved swiftly to neutralise the unwise interest rates hikes of his predecessor Jean-Claude Trichet and he was subsequently successful in reducing unemployment in the region.
The reaction to his more recent dovishness has been less unanimous. There are open divisions within the ECB over his approach with last month’s stimulus package triggering a backlash from more hawkish colleagues. Jens Weidmann, the head of the German Bundesbank, for example has said that the ECB should stick to a narrow focus on inflation. Investors, however, have generally welcomed Mr Draghi’s dovish stance and they will be looking for him this week to restate the bank’s commitment to its stimulus programme.