Equity markets hit all-time highs in the first four months of the year only to sell off in May once trade tensions reignited. But since US Federal Reserve Chairman Jay Powell announced in early June that the Fed stood ready to “act as appropriate to sustain the expansion”, markets have again rallied to record highs - with investors preferring to focus on the direction of monetary policy over lingering trade tensions.
The Fed’s dovish progression has clearly influenced asset prices, but we have yet to see it feed through into the economic data, where there are increasingly worrying signs, particularly in the United States.
Corporate confidence as a bellwether
We believe that equity markets may be too complacent on the direction of 2019 earnings, and corporate confidence is trending downwards. This is too important to ignore. If the aggregate stance among corporates on the economy’s direction of travel is to ‘wait and see’ before deploying cash, this could combine with poor sentiment on trade tensions to bring a more meaningful slowdown to the US than what the consensus expects. Even if economic recession is avoided, earnings could be downgraded significantly. For an economic bellwether, it’s important to keep a close eye on the corporate sector, and some clarity may come during the next earnings season.
How to position for the uncertainty
With real rates declining, the US dollar softening, and uncertainty over the direction of risk assets, we have added back some gold after taking profits in the first quarter. But we are not yet embracing a return to full defensiveness. Despite some troubling signs, it would be too cavalier to be heavily bearish on equities, especially as the world’s leading central banks appear intent on doing what they can to keep the show on the road.
Our views are nuanced, however, and we have taken some profits in US homebuilders and global property equities, while adding short positions in technology. Driving these short positions is global weakness in semiconductors, an important component in electronic devices and a leading signal for the global economy.
Central banks in the driver’s seat
With central banks in the driver’s seat we aren’t ruling anything out. But we can’t ignore that these policies usually work…until they don’t. While a pre-emptive strike from the Fed in the form of a rate cut is typically a positive for risk assets, the effect can be short lived.
When the Fed cut rates proactively in early 2001 in response to weak data at the end of 2000, markets were initially buoyed, before falling significantly as the economy entered a mild economic recession. A further ten rate cuts were required throughout the year to end the eight-month decline in growth.
Investors would be remiss to selectively ignore history in favour of painting a rosier picture, and need to be prepared for even the most powerful of policy tools eventually reaching their limit.