New article from Tatton Investment Management: Markets Looking Ahead

21 January 2019

The New Year's stock market recovery rally we wrote about last week has continued, to the surprise of many who are observing unprecedented political shambles on either side of the Atlantic. The UK appeared to be descending into political chaos, with a disorderly Brexit seemingly only 10 weeks away. Meanwhile, the US economy suffers from the longest government shutdown on record. So how can it possibly be that investors are willing to return to risk asset markets?

The answer is probably that liquidity easing and an actual reduction in perceived political uncertainty has made risk assets look cheaper than justified.

Just before Christmas, stock market valuation levels priced in a material decline in corporate earnings which only normally happen during a recession. The stock market reaction to the slowing economic growth outlook will have been exacerbated by the liquidity squeeze we wrote so much about in December.

That shortness of liquidity initially eased at the beginning of January, as hedge funds had finished liquidating their portfolios to satisfy year-end redemption requests and the Fed signalled that it may well pause its recent series of interest rate rises in response to falling economic growth. This week, the third culprit for the global liquidity drain of Q4 2018, China, also sprang to action: The PBoC, their central bank, injected a surprisingly large volume of additional liquidity into their financial system. The step up in fiscal easing initiatives, in the form of rail infrastructure investment that the government announced in parallel, helped to rekindle market expectations that China would not allow its economy to take as big a hit from the structural reform pains as it had done in 2018.

President Trump's continued government shut-down show-down against the new Democratic House of Representatives over the funding for his Mexican border wall, on the other hand, is beginning to have a negative impact on the near term economic outlook for the US. Here, interestingly, capital markets appeared to be minded looking through this impasse as short-term noise rather than interpreting it as a potential cause for longer term economic derailment. Beyond this, a number of factors have significantly lowered the anticipated risk of US recession in 2019: continued strong domestic consumer demand, various rumours that the US-China trade negotiations are taking a constructive turn and a positive start to the corporate earnings season.

Markets also took the House of Commons' emphatic rejection of the government's Brexit plans surprisingly well. Any expectation that £-Sterling would suffer was quickly disappointed, as the currency actually rose not insubstantially against the US$ and the €-Euro in the aftermath. This positive market reaction to what seemed like a historical disaster for the UK's political class is aligned with our view that the rejection is leading towards either another procrastination in Brexit proceedings or at least a softer version of what has been voted down. 'Dr Currency Market', and in its wake the stock market, certainly signalled that the probability of a disorderly EU departure is now perceived as much smaller, despite some noises from politicians to the contrary.

So far so good then. But is the new-found market positivity going to last?

We see recession expectations waning, which justifies the market recovery thus far. But we do not expect a significant further easing of liquidity conditions. This is because the US central bank, the Federal Reserve, will continue with its liquidity reduction program under QT, while the European Central Bank (ECB) has stopped providing further liquidity under QE and the Chinese have the capital control means to prevent most of their central bank's liquidity provision from leaking out of China. This means that we must reasonably expect that any swing of the ongoing news flow to the negative or the positive compared to where we are now to cause larger than perhaps expected swings in the stock markets as well. The significant one day moves up or down as we have seen so far over the course of January are therefore likely to be the norm for a while, at least until financial sector liquidity sources replace the receding central bank liquidity.

This Friday's near 2% upsurge in stock markets on news that China may have offered the US to reduce its trade surplus towards 0 by boosting imports from the US over the coming 6 years was a good example for this two-way volatility.

To summarise then, we are pleased to see some rationality returning to stock market valuations as China is stepping up efforts to support its wider economy that is under the strain of the painful but necessary structural reforms and US trade repression. The slowing of the US economy is now finally recognised by capital markets, which has not only brought US stock markets 'down to earth' again, but also significantly reduced the risk of a disorderly bond market unwind. This should in turn prevent any further strengthening of the US$. In the past, a stable or falling US$ has been beneficial to the global economy which should get a further boost from China's domestic stimulus measures. Encouragingly, the relative US weakness also seems to spur the Trump administration into action to progress their trade negotiations with China.

All this taken together makes us optimistic that markets in 2019 will be a better reflection of economic progress and decent corporate earnings growth than 2018, when fears and liquidity issues prevented a positive year end result. However, as central banks continue on their path of monetary policy normalisation through QT, liquidity will not return to previous surplus levels. It will now once again depend more strongly on the private financial sector's willingness and ability to turn over the existing monetary aggregates effectively. This limits the absolute upside of risk assets and increases market volatility but should still be supportive of sustainable economic and corporate earnings growth to underpin higher stock market valuations.
One last word on the UK after the tumultuous week in parliament. The currency and stock markets may have reacted positively, but that does not mean that indecision and continued uncertainty about the UK's future among its EU trading partners has suddenly turned into a positive for the economy. All that has happened is that - as we had laid out here in the past - capital markets had priced in a harder and more imminent Brexit than now looks likely. If the political stalemate results in a 'kicking the can down the road' Brexit approach of continued uncertainty of trading conditions, then this will also continue the performance drag of underinvestment the past two years' uncertainty has had on the UK economy.

Not an immediate disaster but leading to economic performance of the UK that is increasingly below its potential. It will be interesting to see which political class on either side of the Atlantic realises first that their political incompetence is not just an embarrassment but has real economic consequences. As odd as this may sound, but I would not be surprised if Donald Trump solved the US conflict with China before the UK finally finds a viable way forward for its relationship with the EU.