Apart from Independence Day and the 50th anniversary of the moon landing, the US had another good reason to celebrate in July. The month also marked the 11th year of economic expansion and set a new record for the longest business cycle from data going back to 1854. Given the length of the current expansion, there are doubts that it can continue. However, it is worth noting that the expansion has been quite tepid; the current average annualised real GDP growth of 2.3% since 2009 is the lowest rate out of all the post-second world war recoveries. For investors, the slower pace of expansion should be seen as a positive, since it probably means that there is less likelihood of accumulated economic imbalances (e.g. rapid credit growth) to undermine the business cycle, a point we highlighted in our April Investment Outlook. Moreover, a paper released by the Federal Reserve Bank of Cleveland* in February makes the point that there is no evidence that long expansions are necessarily followed by deeper recessions.
The bottom line is that so long as the US economy is growing, corporate sales can continue to increase to provide fundamental earnings support for US (and global) equities – see the chart on the top of the next page. On top of company earnings, shareholder returns have also been boosted by nearly $5trn in equity buy-backs since the bull market started in March 2009. US equity valuations look justifiable provided global growth continues to expand, as we expect.
Bond markets are a risk for equities
Global government bond yields continue to fall, with US, UK and German 10-year yields trading at or near record lows. Fixed interest rates have been dragged down by a slowdown in the global economy, which has prompted dovish messages from the US, UK and European central banks. In addition, the nomination of Christine Lagarde as the next president of the ECB also helped to lower yields. As a continuity candidate, Ms. Lagarde has strongly backed ECB President Draghi’s “whatever it takes” pledge in 2012 to use unconventional monetary policy (i.e. quantitative easing) to support the euro and has recently called on central banks to adjust policies in response to concerns about global growth. We see three key risks from bonds that could spill over to equities.
First, it would be a US inflationary surprise that forces the Fed to become more hawkish on interest rates. Bond markets would likely correct and this could undermine the rally seen in equities, which have been driven this year by an expansion in valuations despite weaker earnings. For the moment, we see that risk as contained. Market inflation expectations, as derived by inflation linked securities, continue to trend down.
Second, in a desperate search for higher returns, investors have been willing to take on more risk than they perhaps realise. For instance, even though Italy has a huge public debt pile and the current Eurosceptic administration has a fractious relationship with Brussels, the Italian government was still able to issue a 50-year bond that was six times oversubscribed at a yield of 2.9%, almost a full percentage point down on late 2018. Should the Italian political relationship with the EU deteriorate, it could lead to a contagion sell-off in riskier forms of debt, including junk bonds.
And third, considering that the prices of fixed income and equities have been tightly correlated, so that both asset classes have risen this year, a sharp unwinding of extremely overbought bond positions could have a detrimental impact on equities.
Provided global growth stabilises, as we expect, this will provide a favourable backdrop for company earnings and some protection for risks in the bond market. On balance, we still remain constructive on equities over bonds as an asset class.
Rising probability of a snap UK general elections
When parliament comes back from recess in early September, Boris Johnson, the new Prime Minister, will have an incentive to show a determination to leave the EU, even if it means doing so under a no deal Brexit. First, in a scenario where Brexit has been delivered, a YouGov opinion poll showed that the Tories could win a majority in the House if a snap election is called. And second, Jeremy’s Corbyn’s recent email to party members implies that Labour is now a second referendum and remain party, a move that could draw votes away from the EU friendly Liberal Democrats in a first past the post voting system and improve the chances of the Tories to get re-elected. The threat of a no deal Brexit could mean that the government faces a confidence vote in the autumn, with some ardent remainer Tories actually voting against the government. Considering that the government has a small working majority in the House of Commons, the probability of a snap election is high, and this risk is likely to weigh down on sterling and sterling-denominated financial assets.