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October market review

Trade pacts, rate rises and the global economy

Andrew Milligan photo

Trade remains a major talking point. There was good news as President Trump signed a revised trade pact with South Korea, and a new deal with Canada and Mexico. The bad news was the worsening trade tensions with China, which has accused the US of bullying. Andrew Milligan, Head of Global Strategy at Aberdeen Standard Investments, considers the ongoing situation surrounding trade and the US, while also taking a closer look at rate rises and inflation, emerging markets, and whether a recession is on the horizon.

 

Trade negotiations affect investor sentiment

The US has now reached trade agreements with South Korea, Canada and Mexico, and discussions are also under way with Japan.

At first sight this seems to be good news, but the sting in the tail is that the US looks to be putting China even more firmly in its sights. There are stronger signs that the concerns of the US political
establishment are moving away from trade towards intellectual property rights, the battle for the next generation of technological supremacy, and even military and political control of the Pacific
region.

How far these trends go is very uncertain, but the US mid-term elections in November will be important – showing how much room for manoeuvre the White House has in terms of foreign policy.

 

Inflation pressures emerging in the major economies

Inflation is beginning to show signs of pressure in some countries. This is leading central banks either to raise interest rates, as in the case of the US, or to warn of the approaching need to do so, as in the case of Europe.

One piece of good news is that financial markets are forward looking and have already priced in the majority of rate increases expected in the US in 2018 and 2019. So there would need to be a major inflation surprise to shock the markets.

Another piece of good news is that technology, such as price comparison websites or new means of delivering goods and services via the internet, is restraining inflation in developed and emerging
economies. The net result is only a slow upward trend in wages and therefore inflation.

The outlook for the US stock market remains positive

At Aberdeen Standard Investments, we believe the US equity market can move higher in 2018 and 2019, which is why our funds remain overweight in US stocks. The reasons are clear. First of all, the economy is growing robustly as it benefits from the Trump administration’s tax cuts. Secondly, the US stock market has a large number of high street name technology companies that provide
essential goods and services globally.

In the second quarter of 2018, we saw profits growth of 24% compared with the same period in 2017. Yes, this is likely to slow into 2019, but it’s probably 2020 before we’re more concerned about
the strain and stress on company cash flows.

Of course, there are risks from tariffs and trade, from higher US interest rates, and from regulation and government interference. But for the time being, we like US stocks.

Emerging markets may offer better value than the US

Valuations matter for investors who can take a longer term approach. Most academic research suggests that valuations are more important over 5-, 10-, even 20-year timescales.

In the near term, investors will be much more concerned about US monetary policy, tariffs and trade, but especially the outlook for the US dollar. In the past 12-18 months, there’s been a much closer relationship between the ups and downs of the US dollar, and emerging market bonds and equities.

However, for the longer term investor, it could be worth thinking about starting to take profits in the US and buy into emerging market assets. At today’s valuations, there have been few examples in the post-war period when decisions based on these valuation divergences didn’t lead to a better outcome.

 

Recession looks improbable

With the US economic expansion now the second longest on record, I’m frequently asked if we’re near the end of the cycle and if a recession is on the horizon.

Yes, the US economic cycle is indeed long-lived, but that doesn’t mean it need end quickly. The usual causes of a downturn or recession are a mixture of internal or external imbalances. This could
include too much debt or a large trade deficit, which are then triggered by some shock such as much higher interest rates, or an oil price surge or trade collapse.

The momentum of the global economy may be slowing, but from a high level the pace of growth looks to be solid in 2018 and 2019. 2020 is more uncertain. But traditionally the US economy performs well in the year before a US presidential election, so perhaps 2021 is a greater risk.

All in all, we’re examining leading indicators carefully. So far they suggest slower growth but the likelihood of a recession is on the low side.

 

A year-end Santa rally is unlikely

We need to ask ourselves – what circumstances could lead to a year-end rally? The answers would include signs of stronger economic growth outside the US, signs from the Federal Reserve that it will be cautious in 2019 and, of course, reconciliation between the US and its major trading partners, especially China.

For now, it must be said that it’s not looking too likely. Days when the markets focus on economic growth and company profits are the days they rise. But when politics and geopolitics hit the headlines, markets come under pressure – and there’s likely to be a lot of politics in the news over the coming months.

 

The information in this blog or any response to comments should not be regarded as financial advice. Please remember that the value of your investment can go down as well as up and may be worth less than you paid in. The information is based on our understanding in October 2018.

 

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