After such fantastic returns from equities and bonds in 2019 and a 10-year bull market, it makes sense to ask: should we take those chips off the table, de-risk and bank the profits?
The manufacturing sector has been in recession, but there are now signs of a turn. Chart 1 shows that the manufacturing Purchasing Managers’ Index (PMI) has picked up only a little and from a low base. Despite the recent setback associated with trade tensions, new orders relative to inventory suggest that this recovery will gather pace. Manufacturing is tiny relative to services when it comes to GDP in developed markets, but importantly for financial markets, when it comes to corporate earnings and equities the reverse is true: manufacturing is much more important.
Chart 1: Manufacturing recovery underway
Source: BMO Global Asset Management/ J.P. Morgan as at 13-Jan-20
This turnaround is being led by semiconductors. Last spring this sector was seeing a contraction of around 15% year on year, but the market has begun to turn as the 5G roll-out gets going and by this spring we are likely to be seeing growth rates of 20% or more. A big turnaround.
Moreover, the dramatic pivot by the Fed along with subdued inflation has led to a big improvement in the US housing market with more to come. And when housing is strong, the rest of the economy tends to be strong too.
The other commodity behind the recent manufacturing recession is cars. I’ve written about this before – it’s a clear case of environmental, social and governance (ESG) issues impacting at the macro level – and it’s a major problem in Europe with the scandal of VW and emissions. However, recently we have seen something of a stabilisation. And that’s true of European growth in general, partly helped by a pick-up in construction following the easing by the European Central Bank.
Chart 2: European growth forecasts stabilise
Source: Bloomberg and BMO Global Asset Management as at 06-Jan-20
This chart shows successive vintages of consensus economic forecasts for GDP growth in the year to Q4 2019. It therefore reflects actual data and economists’ estimates.
The big story here is the continuing change in the structure of the Chinese economy. Agriculture as a share of GDP is basically irrelevant. Industry (mining, manufacturing, construction and utilities) as a share of GDP is now declining and the service sector is booming. There’s a sub-plot too: China imported $300bn of semiconductors last year. That’s more than they spent on oil. They currently produce only small numbers of technically obsolete chips, and they want to change that. As they build up their production capability there’ll be massive orders for
companies outside China, including semiconductor and software design company ARM here in the UK, as well as many US companies unless Trump imposes export controls. In fact, the main beneficiaries are likely to be Taiwan and Korea.
Chart 4: EM Asia Exports to US
Source: BMO Global Asset Management as at April 2019
Chart 4 shows that while Chinese exports to the US have fallen as a result of the trade war, other Asian countries have filled much of the gap (EMAX – emerging market Asia ex China). And Mexico too. The markets breathed a huge sigh of relief when the ‘Phase 1’ trade deal was agreed. For now, all is well but we do not believe that China can comply with its terms. Yes, they will import more soya beans and pork but a genuine $200 billion increase in imports from the US is a target that will probably be missed. As the presidential election race hots up, trade tensions will revive.
The UK’s Withdrawal Agreement with the EU is all done bar the shouting, but the new cliff edge is the end of this year. Boris Johnson could request an extension in July and many Europeans would welcome that and the money that goes with it; but Boris has ruled it out. We think he’ll keep his promise on this one. There is no practical reason why a basic free trade agreement cannot be negotiated this year. The EU were already planning to offer one in the event of a no-deal Brexit. We would then leave the Customs Union and be free to negotiate our own tariffs with other countries. All very well, but because we would no longer be charging the EU’s common external tariff there is a risk that we could be a Trojan Horse undermining EU tariffs. To prevent this, British exporters will have to prove percentage UK rules of origin. What these percentages would be and such technical issues as bi-lateral and diagonal cumulation would have to be agreed on literally thousands of items. This would be a massive undertaking. But it is doable. Not least because we have a huge trade deficit in goods with the EU. Negotiations on services will be subject to much greater protectionist measures, not least because we have a large trade surplus in services with the EU. But whatever deal we strike, UK firms will be in a weaker position competing in Europe. For example, we will be granted equivalence in financial services by the EU commission but they can withdraw this with just three months’ notice. In many areas of services there will be no cliff edge at the end of this year.
Rolling 6-month agreements with shorter notice periods are likely and these will extend far beyond the end of the official transition period. This will also apply to trade in goods where the complex issues on rules of origin will be tweaked over many years. Much depends on the spirit of cooperation between the UK and the EU27. For now, it’s all friendly and constructive, but that is unlikely to last when the negotiations on the nitty gritty of the deals starts. Fish (which accounts for just 0.12% of UK GDP) could well prove to be a source of acrimony.
… fisheries agreement that builds on “existing reciprocal access and quota shares” is a matter of priority.
President Macron, 25 November 2018.
All the blustering about Brexit has distracted attention from the fundamentals in the UK. And they are not good. Wage inflation is rising and with the minimum wage set to rise by a record amount in April, pressures will grow. Rising wages are of course a good thing but productivity is growing by less than 1%, so 4% wage growth means costs rising at 3% per year. That’s not consistent with a 2% inflation target. Something has to give – could it be sterling? It was the world’s strongest currency in Q4, but our huge and sustained current account deficit is an important headwind, which could turn into a gale in ‘risk-off’ market conditions.
Chart 5: High-LTV mortgage rates have fallen hard
Source: BMO Global Asset Management and Bank of England, as at 9-Jan-2020. LTV – value of the loan as a % of the value of the property
It’s not all bad news though. UK mortgage rates have fallen in the last five years, despite a net increase in Bank of England base rates. This reflects an important change in the mortgage market. This is most notable in high loan-to-value mortgage lending which has seen the spread fall almost to zero. This has little to do with Brexit – it began well before the Referendum, but the housing market has stabilised as a result. Prices look set to accelerate this spring. As I have stated many times, there is nothing positive for the UK economy from Brexit. But equally, it won’t be a disaster. We will remain a highly educated nation with a skilled and flexible labour market and outstanding institutions even if some of them have taken a bit of a knock of late.
The political side is another matter – the impact on the UK could well be profound. Opinion polls show a majority of Scots are in favour of independence and a majority of citizens in Northern Ireland now favour unification with the south. I actually think Irish Unification is more likely than Scottish Independence but either could make Boris Johnson the last Prime Minister of the United Kingdom.
And what about the Budget on 11 March? A major medium-term increase in spending is planned, focused on infrastructure and the regions. It’s not a quick fix – for Boris it’s a 10-year project.
So, what does all this mean for financial markets? At a fundamental level, equities are all about earnings, and earnings are all about the economy. Chart 6 shows a model for S&P 500 earnings estimates based on the manufacturing and services indices…and manufacturing is over twice as important as services. And if I’m right about the manufacturing recovery and decent growth in the US, this model suggests that S&P earnings will recover nicely during the course of this year.
Chart 6: US Earnings
Source: BMO Global Asset Management/ Eikon as at 06-Jan-20
Whatever happens to future earnings, they must be discounted to present value to provide a guide to fundamental value. The yield on 10-year US Treasury Inflation-Protected Securities, a good measure of this discount rate, declined almost to zero in the last year. This explains much of last year’s bull market and, with inflation so well-behaved in most countries, looks set to remain a major support for risk assets in 2020.
Chart 7: Yield on 10 year US inflation protected security
Source: BMO Global Asset Management and Bloomberg as at 02-Jan-20
All in all, this looks set to be a good year for the world economy and risk assets. However, as a paid-up member of the “dismal science”, I would sound one cautionary note. Wage inflation has been slowly but steadily rising in the US. Unlike the UK, productivity has been picking up a little in the US and wage costs have been well behaved as a result. Should wages recover, either corporate profits would be squeezed or inflation would go up, putting the Fed under pressure to raise interest rates. There are several big “ifs” in this scenario and I do not expect it to be relevant in the first half of this year. But if it were to materialise it could well be a decisive factor in the presidential election.
So, the world economy is recovering. It’s no boom but fears of a near-term recession are misplaced and inflation is not too high nor too low. This is an excellent backdrop for risk assets, although things could change as the year draws to a close. So, perhaps don’t take those chips off the table just yet.