quity market bulls received a great deal of encouraging news over the past month. UK Prime Minister Boris Johnson defied critics and analyst expectations by reaching a Brexit deal with the European Union (EU). He further defied expectations by getting his Brexit deal through a deeply divided UK parliament.
The exact terms for Brexit will have to be settled in a December 12th election, but Johnson’s proposed Brexit deal means that all three major UK political parties are endorsing some form of “soft” Brexit or no Brexit at all. We believe the risk that Europe will endure a disruptive and economically damaging “no deal” Brexit has been virtually eliminated. At the same time, the ability of EU business leaders to plan and invest has been enhanced now that the specter of a hard Brexit no longer hangs over their decisions.
Better than expected news on Brexit was accompanied by stronger than expected US economic data. Third quarter US GDP growth slipped to 1.9% but robust consumer spending prevented slumping business investment from pulling growth down even further.
The October unemployment report was also reassuring regarding US growth. Good job gains in October and upward revisions to August and September data suggest labor markets have remained stable despite a slowing economy and big drops in business spending. Employment data is a lagging indicator, but we believe the stronger than expected employment report substantially reduces the odds of an eminent pull back in consumer spending.
A third piece of unexpected good news for financial markets came with the Federal Reserve’s October policy pronouncement. The Fed lowered short rates in October as expected to a range of 1.50% to 1.75%.
However, Fed watchers had worried that after this rate reduction the Fed would be trapped between two unpleasant alternatives. The Fed could signal further rate cuts and risk undermining confidence in the economy, or indicate an end to rate cuts and reignite fears of an overly hawkish Fed.
Instead, Fed Chairman Powell skillfully sidestepped this forward guidance trap. Powell indicated an end to rate cuts but accompanied that bad news with an unexpected commitment that no rate hikes will occur until inflation moves significantly higher. Powell’s deft communication strategy reassured investors about the economy without stoking fears of higher rates.
All this unexpectedly good news must be balanced by our belief that President Trump’s proposed “Phase 1” trade deal with China disappointed even our modest expectations. Based on the Trump administration’s summary of the deal terms, China is offering fewer trade concessions in this agreement than they offered unilaterally back in April of 2018 before any tariffs were imposed. The most important and contentious issues (intellectual property theft, industry subsidies, etc.) have been deferred to future “Phase 2” negotiations.
Despite having done very well in Phase 1 negotiations, China has yet to announce agreement to even the modest concessions touted by President Trump. China’s Commerce Ministry also announced that mutual tariff rollbacks were a part of the Phase 1 agreement, an assertion that President Trump strenuously denies.
Chinese negotiators are apparently trying to sweeten an already sweet deal by pushing the US to remove a substantial amount of tariffs in Phase 1, a concession that might reduce President Trump’s negotiating leverage in the more contentious Phase 2 discussions. China’s tough negotiating stance may reflect their assessment that President Trump needs to show progress on his trade war in the run up to the 2020 elections. However, such hardball tactics run the risk of the Phase 1 deal falling apart.
As we expected, US equity markets celebrated the Phase 1 deal announcement by breaking out to all-time highs. Markets were able to push higher despite the deal’s modest terms and uncertainty over whether an agreement has actually been reached. Investors appear confident that President Trump needs a trade deal and will ultimately sign some sort of Phase 1 agreement with China, and that a trade truce is a far better outcome for equity investors than an escalating trade war.
The potential for substantial tariff relief also creates the possibility for increased consumer spending as prices on imported goods fall. However, both sides are disputing the terms of the Phase 1 agreement and the most important issues such as intellectual property theft remain unresolved. We are concerned that investors may be overestimating the impact this agreement will have on economic growth and business investment.
Any disappointment over the US/China deal was likely more than offset by the stunning breakthrough in Brexit negotiations, good news on the economy and reassurance about future Fed policy.
Prime Minister Johnson’s Brexit breakthrough was an especially important upside surprise to our cautious market outlook. We underestimated Johnson’s creativity and negotiating skills, and our assumed best case scenario was another Brexit delay and continued uncertainty over whether Europe would endure a hard Brexit debacle. For the past three years, European companies have been hit with Brexit uncertainty and a slowing Chinese economy (a top European export market). Prospects for stability in both European trade relations and the Chinese economy could prompt renewed business investment in these economies.
The Brexit breakthrough is an unexpected upside surprise to our outlook, and we are investing approximately half of our cash position in currency hedged European equities as a result.
We are retaining half of our cash and our overweight in treasury bonds due to uncertainty over whether a Phase 1 US/China deal will be enacted, and our skepticism that the terms of any Phase 1 agreement will resolve long term concerns over the US/China relationship.
The third quarter earnings season could mark the beginning of a period of outperformance by European equities. US equities largely behaved as expected to earnings releases – companies that beat expectations went up and those that missed went down. By contrast, European equities that missed Q3 earnings expectations went up and companies that beat expectations went up even more.
Aggressive buying of companies that disappoint on earnings suggests a substantial improvement in investor sentiment toward European earnings growth prospects. After underperforming under the weight of Brexit and Chinese growth concerns, we believe that European equities are undervalued and may finally be getting the necessary catalysts to outperform.
We are hedging the euro on our European equity positions because Christine Lagarde, the new President of the European Central Bank (ECB), is likely to start her term by adding to the stimulus package just implemented by her predecessor. Renewed stimulus efforts by the ECB contrasts with the rate stability offered by the Fed and could put downward pressure on the euro.
US interest rates have risen sharply in response to the positive economic developments, but we intend to retain our overweight position in longer maturity treasury bonds. Although we believe that President Trump wants and needs a trade deal with China, China appears to be driving a very hard bargain. Our unpredictable President could respond by walking away from the negotiations.
Treasury bonds provide a good hedge against such an outcome. The Fed has promised no rate increases until inflation rises persistently from current levels, which we believe should limit the short-term downside risks of our treasury bond hedge.
Over the long run, the US budget deficit is at $1 trillion despite low unemployment. Interest rate declines could be the only policy tool available to fight the next economic slowdown. The recent good economic news may have pushed the risk of such a slowdown further into the future, but we remain confident that the long term trend for US rates is down.
