Into the roaring 20s?
Together with today’s decisive UK Election result and better prospects for a trade deal between the US and China, it’s a risk-on end to the year. It’s hard to believe that the global economy continues to expand and risky assets keep on outperforming as we enter the new decade. Interest rates are going nowhere, political risks are being diffused and underlying fundamentals are surprisingly robust. There will, no doubt, be plenty of things to test markets and investor sentiment in the months ahead, but for now, stay invested.
The reaction to the UK general election result has been as expected. A sizeable and workable Conservative majority has been met with a stronger pound, higher gilt yields, tighter credit spreads and a very impressive rise in UK equities. Uncertainty about the near-term outlook has diminished and that could pave the way for a more positive medium-term economic outlook for the UK. This is how markets have opened and I suspect that UK equities will perform well, as we have discussed in recent weeks. The focus will now be on getting the Withdrawal Agreement through parliament and then what the policy priorities will be in the coming months, with a budget in February very much being in focussed.
Next, a deal on trade
More interesting and important for business is what the longer-term trading relationship with the European Union will look like. A significant disruption to the UK economy could still come from a failure to achieve a trade deal. One would hope that the UK government can come to a mutually beneficial deal with the EU. At home, the arch-Brexiteers have potentially seen their tactical influence over government decisions weakened and a more centrist Johnson could be very positive for the medium-term outlook.
Rates on hold
We look at the UK with a little more optimism today but with the proviso that things could still go wrong on the Brexit front. There is the potential for some improvement in business and consumer spending and some fiscal stimulus. Right now that seems an argument for the Bank of England to keep interest rates unchanged for some time, in line with our expectations about policy in the US and in Europe. The message from the Fed right now is that it would require inflation to be persistently higher for the central bank to raise interest rates. Although the consumer price inflation rate did tick higher in November (2.1% versus 1.8%), core inflation is showing no signs of accelerating and, even if it did, the Fed would appear to be minded to tolerate this for some time. In Europe, Christine Lagarde has stated that the policy review will be front and centre of ECB attention next year, with the inference being that rates policy will remain unchanged as the ECB tries to prevent Euro Area inflation falling any further. This is all good news for risky assets. Monetary policy is super-supportive and would only not be if there was a material acceleration in global growth and inflation.
Equities doing what they should
Back to the UK. Sterling is higher and given it has appreciated by 12% against the dollar since the summer it is hard at this stage to see it going considerably higher, although $1.40 can’t be ruled out. Gilts are likely to see a further steepening of the yield curve with 10-year gilt yields probably heading back to 1% as the market slowly digests increased issuance over the next couple of years, as well as a better economy. Credit spreads should tighten by another 20-30 basis points, thus continuing to outperform the sovereign curve. On the equity side, apart from a big improvement in sentiment and some valuation advantages relative to other stock indices, the UK needs to see some improvement in margins to really sustain a period of strong performance. The strength of the rally in the aftermath of the election suggests that these are important drivers, as well as the prospect of improved fundamentals, given that the FTSE100 has done well even with a stronger pound. While not reading too much into the initial moves, stocks that have outperformed on the day have tended to be domestically focussed, which again suggests investors are upping their expectations for the UK economy.
Welcome to the 20s
The risk-on tone of markets should persist into the new year (and new decade), not least because it seems, at the time of writing, that the US is not going to add more tariffs on Chinese goods. Progress on a trade deal with China in a US election year has still to be the default expectation. Unless news proves this to the contrary there should be more positive sentiment about the outlook. In the US, equities have outperformed bonds for a long time now and I suspect that this continues given that the Federal Reserve is on hold. Previous periods of equity market outperformance came to an end with monetary tightening but, for now at least, it looks as though the Fed backed off enough, and in enough time, to prevent that outperformance going into reverse. Against that backdrop, the higher beta markets should perform well in the near-term – emerging markets bonds, equities and currencies, Japanese equities, triple-B and high yield rated bonds. These have been wining asset classes for the last three years and should continue to be. The derailment of risk now would have to come from some reversal of the US stance, a geo-political event or a significant rise in interest rate expectations on the back of a renewed acceleration of the cycle. Oh yes, there is the question of valuation as well. Everything is expensive but with central banks provided zero cost money, the buy on dips approach will continue to prevail. The 20s could get off to a roaring start.
I’m off for a year-end holiday in the sun. I fully expect Manchester United to be in the top-four by the time the year turns with 2-3 highly rated potential buys in the making in January. Perhaps I’m getting a little carried away with both markets and football. Anyway, a very happy holiday period to you all!
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