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After languishing earlier this year, UK equities are now trading close to record highs. We believe the key catalyst for the recovery in the UK FTSE All Share index was a fall in popularity for the Labour party. The Tories now lead Labour by around 3% points in the latest opinion polls, implying a lower risk of a potentially market unfriendly, left-wing Jeremy Corbyn government. This follows disappointing English local elections for the Labour party in early May. Arguably, Labour’s declining popularity can be traced back to Jeremy Corbyn’s seemingly sympathetic stance towards Russia, following an apparent nerve agent attack in Salisbury, accusations of antisemitism in the leadership of the party and its anti-war stance on Syria. Indeed, much of the personal criticism against Jeremy Corbyn came from more moderate centrist Labour MPs, indicating there is just as much infighting within the Labour party as there is in the Tory party.
Despite some of the political clouds clearing, we are reluctant to believe the risks to UK financial markets from a Corbyn government have disappeared. First, the local election turnout was low at 35% and may not reflect how the electorate would vote in a general election. Second, expectations for Labour gains were inflated before the poll, and it was easier for the Labour party to disappoint. Third, the Tories do not appear to have a narrative beyond austerity and seem to be struggling to show a clear strategy over the future UK-EU trading relationship. Fourth, popular support for the Tories could slip, as PM May faces several political hurdles over the next couple of months that could ultimately lead to a hard Brexit and lower growth — see our May Investment Outlook.
The first quarter proved to be an impressive reporting season for US companies. With virtually all S&P 500 companies having reported, company earnings per share (EPS) rose around 25% from a year ago. Some financial highlights include EPS rising by double-digits in four out of the last five quarters, the biggest upside earnings surprise since 2010 and the fastest revenue expansion growth since 2011. Furthermore, the annualised run-rate for share buybacks is running at close to $950bn for this year, up from $513bn in 2017. The combination of healthy earnings growth and share buybacks should limit market downside risk.
Nevertheless, with the US 10-year Treasury bond yield now trading around 3%, its highest level for seven years (and providing some uplift for the US dollar), there is a risk financial conditions could tighten sufficiently to depress equity prices. True, higher rates are a risk for markets, but considering the inflationary backdrop is fairly benign, the Fed is unlikely to tighten monetary policy aggressively to stifle economic growth and/ or raise concerns over debt defaults. For instance, even after 2½ years of rate increases, the real Fed Funds rate (the central bank’s policy short term rate less inflation) is currently just -0.6%. Historically, a negative real Fed Funds interest rate is considered to be a stimulus for the economy and compares to positive rates of 2% before the start of the last two recessions in 2001 and 2008, respectively.
Moreover, higher interest rates do not appear to have increased US debt default stress. Household debt payments (interest and principal payments) account for just 10.2% of take-home pay, about a percentage point below the long-term average. Balance sheets are also much healthier, with financial liabilities taking up around 14% of assets, the lowest ratio for 18 years. One concern is the rising delinquency rate on credit card debt. However, considering credit card debt is around a tenth of the size of the mortgage market in 2007, or 6% of disposable income, it seems unlikely to crash the economy.
On the US corporate side, there is growing market concern over record levels of debt. However, to understand the full extent of corporate indebtedness, it makes sense to exclude outstanding liquid assets, such as cash and bank deposits, from overall liabilities. On this basis, US corporate net credit market debt stands at 33% of GDP, below previous cycle peaks of 35% to 36%. This suggests corporate balance sheets are in relatively healthy condition. In terms of the ability of firms to pay down debt, corporate bond markets show no signs of stress — see the second chart in the Market Highlights page opposite.
Though higher US rates are a drag on demand, steady job creation and the boost to incomes from tax cuts should enable the US economy to generate relatively stable output growth. Not only will that provide the fundamental backdrop to lift company earnings, but it should also boost market confidence, which has been somewhat fragile this year following the sell-off in early February.