We are now well into the second quarter of 2019, and the strong risk-on trajectory that appeared so well established has been abruptly halted by renewed trade tensions. So far this year, equity markets have benefited from investor optimism following the US Federal Reserve’s ‘pause’ and positive noises coming from China-US trade talks. Both influences seem to have run their course, at least for now.
There are major fundamental sticking points on each side of the trade dispute between the US and China. Having strong convictions in either a meaningful resolution or major escalation is risky. But while the resurgence of the ‘trade wars’ story has worried markets, performance this year is still relatively strong. The US equity market has risen almost 11 per cent in 2019 after falling just under 6 per cent from its recent all-time peak. At the tail end of 2018, we did expect markets to rally after a period of overselling. More recently, we had become wary of upwards price momentum when economic ‘green shoots’ seemed thin on the ground, so a bit of price weakness is a welcome development.
Policy action is driving sentiment
One of the key drivers of global sentiment this year has been the dominance of policy. While the most recent policy support in China falls short of the ‘big bang’ stimulus implemented in response to previous slowdowns in 2008 and 2015, we do expect more positive data to arrive in the second half of the year. In Europe headwinds are still apparent. The ECB policy response of delaying rate hikes and beginning a new round of targeted long-term refinancing operations (TLTROs) has at least temporarily reassured markets, but we believe this to be more ‘damage control’ than major stimulus.
In the US, the Fed’s foray into policy normalisation eventually upset markets, forcing them to return to data dependency and hit the ‘pause’ button on the tightening cycle. While this ‘words-based policy intervention’ has certainly corresponded to strong market performance thus far, there are some concerning signs on the horizon.
The disparity between strong markets and weak economic data
The disparity between strong markets and weak fundamental data can’t continue forever, and the question is on what side will convergence come from? Will a market correction narrow the gap, or will economic data improve? While there have been tentative signs of global growth stabilising, the outlook for the US economy is less promising. We are still a tad cautious.
The corporate sector remains a key area to watch. Despite the majority of US firms soundly beating lowered earnings forecasts, positive surprises have been rewarded less than usual (0.7 per cent compared to a five-year average of 1.0 per cent). Meanwhile, downside surprises have hurt share prices more than in the past (-3.5 per cent compared to a five-year average of -2.5 per cent). Among shorter-term indicators, the most recent ISM Non-Manufacturing PMI is also concerning, indicating the weakest monthly expansion in the service sector since July 2017. We are also watching corporate capex and discretionary spending levels, as well as the health of leveraged loans and the rapidly growing BBB-rated corporate bond space.
Against this complicated backdrop and as trade tensions surface in earnest once again, we do not believe it is sensible to put more risk on the table. We suspect that there may be further weakness facing markets as optimism on trade and policy falters. But with the Fed, President Trump, and Chinese policy makers all seemingly intent on avoiding a major slowdown, we are wary about getting too negative.