Equities: Momentum Continues
Summary: We ended the year with a bullish bias on equities (not the real economy) based on the recession of risks on the geopolitical front and huge amounts of liquidity being thrown at the market by central banks. Equities have continued to march higher and overnight the S&P 500 closed at another record high.
But what to expect after a year of 30% returns - expensive markets and stretched valuations! Momentum is strong and presents further upside for risk assets throughout Q1 2020.
Further into the year, the key test will then be whether reality is in line with market expectations. Will green shoots actually translate into a return to trend growth, and will the narrative of receding geopolitical risks be maintained. We are sceptical on both fronts.
The prior year’s gains have been driven almost exclusively by multiple expansion, and a recovery in earnings is already priced. This leaves the market frothy and somewhat vulnerable to shocks and there are plenty of catalysts for potential drawdown, geopolitical, economic, policy or otherwise. But for long term investors, these headwinds should not deter. With liquidity being pumped and low yields forcing risk seeking behaviour, dip buyers are there on the sidelines ready to step in as valuations correct which lends an underlying support to global markets. Monetary policymakers have already exhibited their willingness to intervene with added stimulus measures in an attempt to extend the cycle, so, for as long as investors feel like central banks have their back and policy rates remain low there will be upside for equities.
Monetary policy remains a powerful determinant of asset prices, and as we progress through the year, continued central bank liquidity injections will lend underlying support to equity markets. Record low interest rates also tempt investors up the risk spectrum and feed into valuation models, justifying higher multiples, and fuelling asset price inflation. A dynamic set to continue throughout the year ahead. Obviously the inability of such policies to produce a self-sustaining revival in growth, without stoking record wealth inequality, social unrest, and global political risk is a problem for another day.
In other news, this week the long awaited Phase 1 trade deal is set to be signed, although no one has seen the text yet! A lot of the positivity has already been priced and so we question how much further markets can rally on trade optimism, its seemingly endless. At any rate attention has shifted to primary drivers being earnings and central banks accommodation anyway. The risks really lie on the downside if the deal is perhaps more watered down than expected, or there is room for China to backtrack on promises easily. Something they have a long history in doing. Considering how difficult it was to get to this phase one deal, nobody should expect a phase two deal any time soon – if ever. Even Trump himself acknowledges phase 2 is unlikely to come before elections. Which means tariffs are likely to remain at current levels, bar the small rollback included in this phase 1 deal.
Will talks breakdown again? The election will be won on a strong economy and Trump sees the stock market as a real time indicator of that, but being tough on China also appeals to not only Trumps base but a bipartisan audience so it’s going to be a balancing act. The risk of tariff hikes in election year is reduced, but China have a reputation of failing to deliver on prior promises which is why enforcement was such a big issue during these negotiations. If China do not comply with the agreement set to be signed Wednesday, Trump has free reign to impose additional tariffs. There are some ambitious purchase commitments included in the deal, so there is plenty of scope for failing to meet them.
The deal by no means, means the stand-off is over. A lot of the more deep rooted issues have been left for phase 2 negotiations and whatever deal is signed between the 2 sides there is an ongoing bifurcation as it relates to technology well under way. Many Chinese companies remain blacklisted by the US Commerce department, and these efforts will be ongoing regardless of the present truce. Meanwhile Beijing are removing foreign computer equipment and software from government offices and public institutions and continue to increase self-reliance. On the technology battleground, you can’t get more specific sign of disengagement than this.
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