Our second-quarter outlook

The Tilney Group’s Chief Investment Officer Chris Godding gives his outlook for the second quarter of 2018.

Centre Chris Godding
27 March 2018

After bursting out of the blocks in January, global equities have had a very tough time in the first quarter of the year. The catalyst for the initial fall was higher than expected wage inflation data out of the US. Developed market Central banks have been running accommodative monetary policies in order to restore sustainable inflation and the hot topic for investors in 2018 is whether they will now need to tighten the screws to avoid overheating. The negative market reaction to the wage data illustrated coiled investor sensitivities to higher inflation, the prospect of monetary tightening and also the overly optimistic investor sentiment at the start of the year.

Major developed market core inflation

Source: Bloomberg

Bond markets and interest rate expectations

Bond markets also had a difficult time in the first quarter, with rate expectations rising across the board in developed markets. In the US, traders were also unsettled by projections for the fiscal budget in 2017 to 2020. A US$1.3 trillion extension to the budget in 2018, that substantially boosts military and domestic spending but denies immigrant ‘Dreamers’, has led to materially higher Treasury bill issuance and has driven 3-month money (LIBOR) in the United States up from 1.4% at the end of last October to above 2.2% in March.

This rise in the interest rate on short-term liquidity for the global reserve currency has the potential to temper global growth, but is offset to some extent by a US dollar that is weakening under the burden of widening trade and budget deficits.

Investors need global growth to be robust if monetary policy is tightening, and although fiscal spending is good for US growth, the secondary effect of higher US dollar funding costs could become a headwind for the rest of the world. The negative impact of short-term US Treasury supply will fade as the Treasury Department extends the term of borrowing, but it has clearly added to investor nervousness.

US budget balance (% GDP)

Source: Bloomberg

Global equity expectations

Our base case assumption for global equities is that earnings growth will ultimately drive their appreciation in the face of modestly higher interest rates. Global growth is strong, fiscal and monetary policies are accommodative and inflation is below target.

However, a negative surprise on inflation or a continuation of the increase in US dollar funding costs mentioned above is likely to shift this negative correlation of bonds and equities to positive. This means that equities will fall while bond yields rise, reflecting an unwelcome tightening of liquidity.

On the earnings front, we fully expect first-quarter results to confirm high expectations and perhaps be the catalyst to turn markets out of their malaise. Earnings expectations have already been revised up by nearly 4% from the start of the year and the consensus expectation is that earnings will advance nearly 20% in the US’s S&P 500 index, 14% in the emerging markets, 8% in Europe (including the UK), 5% in Japan and by 14% globally this year.

While expectations cannot be cashed, these bottom-up company forecasts reiterate the strength of the global growth picture and support a positive stance on equities. Slowing momentum in China means that it is unlikely that current headline growth will be sustained but on the flip side, the impressive pace of improvement in Europe and the US continues to be supportive.

What next for the UK?

The UK is expected to be a notable laggard on the economic front in 2018, but UK equity earnings are holding up well.  The global nature of UK companies minimises the Brexit risks for the FTSE 100, but the fact that Unilever decided to move its headquarters to the Netherlands has not helped to calm longer-term concerns regarding capital investment.

The UK equity market is unloved by international investors at the moment. It is the highest consensus underweight for money managers and the strength of the pound against the US dollar has not helped improve this sentiment.

Political risk is particularly difficult to price but a combination of negative investor positioning, strong global growth and a relatively attractive valuation suggest now is probably not the right time to throw in the towel on UK equities.

MSCI equity indices

Source: Bloomberg

The recent UK wage and inflation data was welcome good news for the economy and we would become actively more positive on the UK if we saw some improvement in the index price momentum.

Money flows

According to a recent Bank of America Merrill Lynch fund manager survey, Europe and Japan are currently the most favoured markets – and money flows support this view.

Equity fund flows – last 12 months (% year on year)

Source: JP Morgan

The contrarian would look at US and UK markets based on this data and be cheered by the negative competitive impact of the strength of the euro and yen. Contrary to the rest of the world, earnings revisions in Europe this year have done nothing, despite the fact that the Eurozone’s economic momentum appears to be improving rapidly.

A 14% year on year appreciation of the euro versus the US dollar is perhaps beginning to undermine earnings momentum, and European equities are a likely source of funding for us as we consider raising exposure to the UK.

Trump’s trade tariffs

This year equities have also been unsettled by the initiation of trade tariffs by the Trump Administration. The main target is China and the US$75 billion trade deficit in February is testimony to a deteriorating condition.

China has the largest bilateral trade surplus with the US at 1.9% of GDP, but exports to the US make up more than 5% of GDP for Thailand, Malaysia, Taiwan, Canada and Mexico. China has definitely crossed the line on a number of competitive behaviour issues but trade tariffs are unambiguously bad for world growth. The net impact will depend on the reaction to this provocation.

The optimistic and somewhat cynical interpretation is that it is an opportunistic and political decision, intended to raise jingoistic support for the Republicans ahead of the mid-term elections. If this is the case, then the substance is likely to be thin and will have a limited long-term effect.

On the other hand, if it is a trade war of substance the estimated impact on global GDP would be in the region of 0.5%, with no relative benefit to the USA. It will be inflationary and disruptive but may be a gamble that Trump is willing to take to restore the industrial heartland of the USA.

Exports to US (% of GDP)

Source: JP Morgan

It is difficult to reverse “globalisation” and much of the structural damage to the US manufacturing base has been done. Trying to return to past glories at this stage is like putting toothpaste back in the tube, given that China has now firmly established its dominant position and the global supply chains have been set.

China’s priorities

The priority for the Chinese Communist Party is the domestic economy and sustainable growth rather than further mercantilism, now that the transition from an agrarian to an industrial economy is well established.

China’s ‘adoption’ of foreign intellectual property has also been legendary and something I initially became aware of as a technology analyst in the 90’s when Huawei was shipping its leading-edge servers with Cisco instruction manuals.

However, more intellectual property is now home grown and the US should be concerned about the impressive pace of innovation in China rather than trying to regain market share at the low end of the value chain. Equities will struggle to make ground while uncertainty remains on trade, but hopefully the President will realise it’s a zero sum game and focus on something more rewarding.

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