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Market worries about trade should pass

Weekly Investment View – 04 March 2018

The bell-weather S&P500 closed 2.04% lower over the week in choppy trade, driven firstly by new Fed Chair Jerome Powell’s first semi-annual testimony to Congress being interpreted hawkishly, followed by President Trump saying he intended to impose a 25% tariff on steel and 10% on aluminium - the latter being prematurely read as the beginning of a trade war by commentators. US equities closed off the lows, however, as both technology and defensive stocks rallied. European equities closed 3.70% lower on the STOXX Europe 600 index, given that export earnings are important to this asset class. Japan’s TOPIX closed 2.96% lower, although it could have been rather worse given the further strength seen in the yen. The MSCI Asia-Pacific (ex-Japan) index fell 2.12%; within this grouping, Chinese equities as measured by the Shanghai Shenzhen CSI 300 index closed down a moderate 1.34% over the week.

“We still expect the economic cycle to be elongated - despite some US protectionism”
Global bonds, as represented by the Bloomberg Barclays Global-Aggregate Total Return (hedged) USD index, edged 0.17% higher, with a growing number of market participants really itching to call the end of the decades-long bull market in bonds - although without the data fully supporting this: for instance last week the US Commerce Department’s PCE ‘core’ inflation measure for January (the one the Fed favours) came in at an unchanged 1.5% year-on-year.
Last week we suggested it was not yet time for the US 10-year Treasury yield to blast upwards through 3% as the majority appeared to expect, choosing instead to suggest a long trade in bonds on a tactical basis, looking for a yield of perhaps sub-2.70% as a target to take profits. A two-day close above 3% would be the stop-loss. Indeed in a Bloomberg interview last week former US Treasury Secretary, Larry Summers, talked in terms of US inflation not being about to take off, and with ‘deep forces’ in place to reduce real rates. While we don’t agree with his secular stagnation thesis (we are quite bullish on world growth), we would underline what he (like others) referred to as the ‘Amazon effect’, which along with demographic factors should keep inflation subdued. Incidentally, Professor Summers said that Jay Powell is a “real professional”. Returning to the numbers, the US 10-year Treasury yield closed very slightly lower on the week (at 2.8643%), while the more policy-sensitive 2-year yield closed only slightly firmer (at 2.2418%). Accordingly the 2-to-10 year curve remains above 60 basis points, with the 2-year yield 0.6225% below the 10-year (as and when short rates trade above longer rates, this has been a good predictor of recessions in the past - so we are still some way off seeing such a signal). As far as we can tell - and we will return to tariffs and trade wars later - the ‘Goldilocks’ investment environment (whereby growth is good and inflation is relatively low) remains in place, and we don’t expect a US recession for at least a few more years in what will likely be an extraordinarily long economic cycle.

“Sterling continues to suffer as Brexit gets tougher – and tougher”
In foreign exchange markets, at one stage last week in the wake of Mr. Powell’s rate-supportive message to Congress the dollar rallied to just above 90.6 on its index – and for a few hours with the 91 level in sight there was a palpable sense that rate differentials were set to return as the dominant short-term determinant of the dollar vs. the other major currencies.
However negative ‘Trumpian’ factors then impacted the dollar with the news about Trump’s tariffs and the tweet containing “trade wars are good, and easy to win”. In deciding to impose the tariffs the president went against the advice of Gary Cohn, director of the National Economic Council, one of Trump’s two most important economic advisors. Mr. Cohn is reportedly considering his position as a result, according to Bloomberg. The FAB Asset Allocation Committee meets later this week, and will further consider the evidence regarding the outlook for the US dollar. Over the week the major reserve currency closed slightly firmer on its index (at 89.935), and admittedly below the 91 lower level suggested in our recent ‘Outlook 2018’. So a reappraisal of the dollar’s outlook is due. The yen was once again strong last week, with the dollar/yen pair tracking down to 105.75, 1.07% lower over the period, the Bank of Japan having indicated the possibility of a less-loose/tighter stance in monetary policy next year. Sterling was still lying low (at $1.3802), 1.21% lower over the week, impacted by on-balance difficult Brexit sentiment following an important related speech by British Prime Minister, Theresa May. This time she was sounding tougher than recently, and began to disclose more by way of what her government actually wants out of Brexit. Mrs. May outlined a desire for a ‘trading partnership’ with the EU, although European Commission officials likened this to the ‘Canadian’ model, rather than anything more accommodating. Lastly, in commodities, Brent crude closed 4.37% lower in mixed trade (at $64.37/barrel), and gold remained relatively friendless, $6 lower over the week (at $1,322.75/oz).

“Expect continuity at the Fed – and possibly more frequent ‘dot plots’”
Unsurprisingly, there was intense focus last week on Jerome (‘Jay’) Powell’s testimony as he presented the Federal Reserve’s semi-annual Monetary Policy Report to the US Congress.
As he said in his prepared text, he is “committed to clearly explaining what we are doing and why we are doing it”. Above all, we can expect continuity and professionalism from this Republican appointee. With tongue slightly in cheek we wondered if we would see the famous ‘the risks are roughly balanced’ quote in Mr Powell’s prepared text - and yes, there it was: “The Committee (FOMC) views the near-term risks to the economic outlook as roughly balanced but will continue to monitor inflation developments closely”. Moving on, he noted that real GDP rose at an annual rate of about 3% in the second half of 2017, one percentage point faster than in the first half of the year, and that “growth in business investment stepped up sharply last year, which should support higher productivity growth in time”, adding that, “Against a backdrop of solid growth and a strong labor market, inflation has been low and stable”, “…the economic outlook remains strong”, and that “solid economic growth among our trading partners should lead to further gains in US exports”. Moreover, he noted that “…fiscal policy is becoming more stimulative. In this environment, we anticipate that inflation on a 12-month basis will move up this year and stabilize around the FOMC's 2% objective over the medium term. Wages should increase at a faster pace as well”. Turning to monetary policy, “While many factors shape the economic outlook, some of the headwinds the US economy faced in previous years have turned into tailwinds: In particular, fiscal policy has become more stimulative and foreign demand for US exports is on a firmer trajectory”, adding that, “…further gradual increases in the federal funds rate will best promote attainment of (both of) our objectives”. We have not yet watched the full 3 hour + recording, but suffice to say the markets read the proceedings hawkishly, with another Fed official saying that four hikes this year (rather than the previously signposted three) could still be construed as ‘gradual’. As Larry Summers said, three hikes this year is “already baked-in”, adding that he saw “no imminent emergency”. After last week, technically it looks as though four hikes are ‘baked-in’, with market participants seemingly thinking the hiking cycle should slow down into 2019. We remain optimistic for risk assets this year, given the good growth we still expect and as outlined in Outlook 2018, and despite envisaged rate normalization.

“Italy’s election result is particularly difficult to forecast – and that’s just the beginning!”
Italy is going to the polls as we write, and as we outlined in last week’s report the situation looks unnaturally complex, even compared to history.
To re-cap, the main parties are as follows (in no particular order): Forza Italia (centre-right alliance, led by four-time Prime Minister, Silvio Berlusconi); the Democratic Party (‘PD’, centre-left, led by former PM, Matteo Renzi); the League party (far-right, formerly known as the Northern League, led by the enigmatic Matteo Salvini); and the ‘5 Star Movement’ (M5S). Immigration and high youth unemployment/the economy have been the central issues during campaigning, with the atmosphere described as tense and divisive. Political populism is alive and well in Italy given the fervor behind the issues, with the saving grace of their system and parties being that extremism linked to any single party is highly likely to be watered-down in a coalition. Strictly speaking, opinion polls have been banned during the two weeks leading up to the vote, so there is little (if any) guidance from them, and bearing in mind that perhaps one third of voters were undecided a week or so ago. Overnight we will see the exit polls - but then new phases of horse-trading between various parties could have already kicked-off. As far as we can tell, a ‘Grand Coalition’ led by Forza Italia and PD was looking to be one of the most likely (and sensible) outcomes, with polls having suggested that Mr. Berlusconi's centre-right alliance would be the largest bloc in a hung parliament (he can’t hold public office until next year because of a tax fraud conviction, and has backed European Parliament President, Antonio Tajani, to lead the country in his absence). The Five Star Movement was expected to be the single largest party; they oppose austerity policies, and want to leave the euro (as does the League). The League has pledged to rid Italy of so-called illegal immigrants. So the results of the initial voting are in reality just the beginning. If it comes down to personalities popular with the electorate, Berlusconi, Renzi and Salvini are all in the frame. We will watch what happens with great interest. Certainly any shock result in favour of the League or M5S would hit the euro in the short-term, yet many in the markets would regard that (depending also on what happens in the German coalition talks this weekend) as a buying opportunity.

“At the bottom line Trump’s steel and aluminium tariffs will hit Canada – not China”
President Trump has announced (using a 1962 law relating to grounds of security) his intention next week to sign into law tariffs of 25% on imported steel, and 10% on aluminium - and in so doing has provoked yells of ‘trade war’ throughout the ranks of analysts and the media.
Trump also said he would impose reciprocal tariffs, matching those in place against the US where necessary. An EU representative quoted in the FT said they would challenge Trump’s tariffs at the WTO, or could impose its own tariffs. However, let’s not jump to conclusions too soon, essentially as this is a game that in truth very few other countries want to play - as no one wins. We will certainly follow any possible retaliatory measures carefully, although we don’t actually expect much to happen - Trump’s protectionist whims are really targeted at Canada and Mexico (re: NAFTA) in this instance, with collateral damage being done to South Korea and Japan. China has been exporting less steel to the US, with the FT quoting Credit Suisse numbers to the effect that only 0.2% of China’s steel production goes to the US. Furthermore, the Lex column recorded that steel only represents 2% of US imports. In reality, China has been rationalizing its industrial sectors, including reducing its steel and aluminium production to achieve greater efficiency and to control pollution from those industries. In ‘Outlook 2018’ we said that the emerging economies would be doing more and more trade between themselves, with the Asia-Pacific region being in the vanguard of this; indeed the Trans Pacific Partnership (which President Trump recently took the US out of) looks as though it will do very well without them.

“Commentators will tell you about the trailing P/E of 21.7x for the S&P – not the 14.1x for 2019”
INVESTMENT SUMMARY: Our optimistic view of risk assets, essentially global equities, hasn’t changed - the world is growing nicely, as per the articles in our FAB Global Investment Outlook 2018, and this is supportive for equities, especially when inflation is staying under control.
For some months we (like others) have found especially US equities to be trading unnaturally (i.e. in such an ultra-steady path upwards), and we welcome what we believe are healthier markets - which by definition have more ‘rough and tumble’ about them. A constant ‘buy the dip’ mentality limiting falls to about 1% could not continue, and doesn’t represent the real world. At the same time a VIX (Chicago Board Options Exchange S&P500 Volatility) index that looks to be settling into a 15-20 range index (down from just above 50 intra-day a month or so ago) makes us very comfortable about adding to equity positions. Late last week we saw higher defensive sector participation (e.g. healthcare, staples and telecoms), and at the same time as technology stocks rallied, so investors may be beginning to rebalance their portfolios. Few commentators are bothering to write that the S&P500 consensus P/E ratio for the current year is only 15.6x, based on earnings expected to grow at 10.3%, or that the P/E for 2019 is now a very moderate 14.1x, based on earnings expected to grow at 10.7%. Lastly, Asia-Pacific (ex-Japan) equities remain our largest overweight position – and in that connection we are very pleased to see that China’s President Xi should now be in power beyond 2023; his reforms are exactly the kind that should in the next year or so justify a rather higher P/E ratio than today’s 11.7x for 2019.

For any inquiries related to this article, please contact Alain Marckus or Clint Dove.

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Weekly Investment View – 25 February 2018

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