US markets ended Friday’s trade on a more upbeat note boosted by trade optimism following President Trump’s iterations that a Phase 1 deal was “very close”. There seems to be no limit to stocks rising on repeated stale claims that a deal is imminent. Also helping risk trade firmer, the Markit US Manufacturing PMI rose for the 3rd straight month to a 7 month high maintaining reflationary optimism.
On the flipside EZ PMIs were mixed and Germany’s services PMI hit a fresh cycle low, highlighting the ongoing potential for the manufacturing slump to bleed into the larger services sector. Even if we see some stabilisation in manufacturing now, the protracted slump in manufacturing raises the question of how long services, and hence the consumer can remain immune to slow down. As we have said before, this is key as the services sector represents the bulk of employment and hence the knock-on effect to the real economy is far greater. If the manufacturing sector continues to lead services lower and weaker corporate earnings/capex spurs layoffs the level of consumer spending required to continue to shrug off the decline in manufacturing will be difficult to maintain.
Also, over the weekend, helping spur further gains in risk assets today was news from China on one of the sticking points in the trade spat; intellectual property theft. Officials stated China would move to raise penalties on violations of intellectual property rights. Not a game changer, but a positive notion nonetheless. Generally, tighter rules surrounding IP protection aligns with China’s own self-interests as it fits their own ambition of becoming a technology leader. So, this is in keeping with our long-held notion that the 2 sides remain far apart on fundamental issues but there is enough low hanging fruit to put together a watered down partial deal. Also positive at the margin in corroborating the Hong Bill that passed US congress was a record turnout of pro-democracy voters in Hong Kong. The landslide win for pro-democracy candidates should help US trade negotiators persuade Beijing that if Trump signs the bill, supposedly making its way to his desk, this shouldn’t derail the partial deal negotiations and Hong Kong should be a separate issue to the interim deal.
Uncertainties have subsided over the past couple of months with thawing trade tensions, a record number of central banks around the globe easing and no-deal Brexit risk being re-priced. With this moderation of risk, sentiment has clearly recovered and equity indices as we flagged in September, have managed to break higher. Equity markets may see continued upside if the narrative of “receding risks” prevails (as it has for the past month) slowly grinding higher on trade hope and multiple expansion, not economic realities. Lower interest rates also feed into share price valuations. Whereby a lower discount rate increases the present value of future cash flows, justifying higher valuations as interest rates fall, even when economic and earnings growth may be weak thus fuelling multiple expansion. However, we maintain that it is difficult to see equities breaking significantly higher over the next 6 months without a clear bottoming in global growth, weaker USD and the risk of recession taken off the table. With the Fed now on pause and the aggregate liquidity injection from central banks’ balance sheet growth over the next 12 months currently sitting at around a third of previous peak balance sheet growth, further accommodative actions are likely provisional on more pain in economic data and financial markets, so not yet a continuing upside catalyst for risk markets given the gains to date. Based on our overarching view that we remain in the downside of the economic cycle, the longer it takes for the Fed to capitulate and deliver on further easing, the more precarious engendering a re-acceleration in economic growth becomes relative to where we are in corporate profit and employment cycles.Growth is still buffeted by both cyclical and geopolitical headwinds, despite nascent signs of stabilisation. Improving sentiment has largely been propelled by “less bad news”, but incoming data shows the synchronised global slowdown has persisted into Q4 and leading indicators are still deteriorating. OECD leading indicators remain weak across the globe highlighting that the recent stabilisation across manufacturing PMIs could be a false flag and it is too early to sound the all clear. When we cut through the headlines, it is clear the global economy continues to slow although the downdraft may be stabilising, so now is the time to be avidly data dependant. Whilst also remembering, the problem is not just trade, meaning any détente will not be enough to prompt a reacceleration in economic growth given where we are in the labour market and profit cycles. A trade deal will not save these late cycle dynamics from materialising. On this basis a continued defensive tilt is warranted along with building optionality into portfolios to protect YTD gains, and potentially profit on downside if we don’t see a continued stabilisation in growth.