7 December 2018
The news of a 90-day trade truce between presidents Trump and Xi’s was widely welcomed as the most that could be expected outcome of their much-anticipated dinner conversation at the fringes of the G20 summit last weekend in Argentina. Despite offering the prospect of a road-map to new trade terms and thereby the potential to defusing the biggest concern for any 2019 outlook, its good news fuel for stock markets only lasted for a one-day stock market rally, before equities were once more caught in selling downdraft.
UK investors would be excused from suspecting the continued UK stock market sell-off was Brexit related given the much-held expectation that parliament will reject the withdrawal deal on offer. No, it had all to do with continued trade concerns and a partially inverted yield curve. Trade war concerns quickly returned with a vengeance after the finance director of China’s largest IT company Huawei was arrested at the behest of the US in Vancouver. And with 5-year yields this week falling to lower levels than shorter term US bond yields, the predictive power of yield curve inversions is creating additional fear, given every US recession since WWII was preceded by a yield curve inversion.
We have written about this phenomenon here before and it is worth repeating that (a) the reverse is not also true, i.e. not every yield curve inversion has been followed by recession, (b) when inversions were followed by recessions, marked economic slowdown had preceded the inversion, (c) this is currently only a partial inversion in the middle of the yield curve and (d) the US central bank has already signalled that it will consider pausing further interest rises should the economy slow.
On the trade war side, it transpired over the week that the Huawei arrest was very likely unrelated to the restart of the trade negotiations and in any case the Chinese side appeared to have decided to not let this side show get in the way of their efforts to resolve the trade issues.
Against the backdrop of otherwise stable if uninspiring macro-economic news flow and data releases it would seem to me that the short-term, speculative investor fraternity was merely putting forward reasons to liquidate positions on which they had made gains on over the short string of positive trading days over the previous week until Monday.
What we are witnessing at the moment is an outsized market reaction to a mild economic slowdown which are exacerbated by the fear that central banks will raise interests regardless of economic conditions, despite having repeatedly stated that they would not. Longer term investors are usually well advised to endure but ignore such periods of heightened market volatility until underlying economic fundamentals once again persuade all market participants that there is upside potential.
The one issue we will be watching closely during this period is whether there is a risk that the above relationship is turned on its head which is the one effect were capital market overreaction can create a negative feedback loop. This is where risk aversion leads to such a rise in corporate borrowing through the bond markets that it leads to a rise in corporate defaults which eventually undermines the economy as a whole.
The last time this threat was looming was during the market downturn of Q1 2016, when credit spreads widened so substantially that default level indeed rose significantly. Back then the Fed’s pausing of monetary tightening led to a fall in general yield levels and the US$ which together with economic stimulus measures by China’s government and lower oil and resource prices converged to a global stimulus which culminated in the 2016/2017 growth spurt and the stock market rally.
This time around all of the aforementioned stimulus elements are once again present although less pronounced. At the same time, however, there is nowhere nearly the same level of economic slowing we witnessed over 2014/2015. Against this backdrop, equity valuations that have fallen to levels where dividend yields are now above their historical averages should entice long term investors back into the markets, even if the stimulus effect is less pronounced this time around.
One last word – on Brexit: Not much to add over what we wrote last week, except to say that it may be premature to write off Theresa May’s Brexit deal or her government, even in the case that it does get rejected by parliament in the first reading next week. I sense that the UK’s electorate is by now so tired of everything Brexit that MPs may then well only be left with the choice between Theresa’s Brexit or no Brexit at all. Either outcome would be welcomed by UK business and stock markets.