The Fed taketh and the Fed giveth
After the worst December performance by US equity markets in many decades, the first month of 2019 saw the best January performance of the Standard & Poor’s 500 since 1987.
And again, the market movement was all due to comments from US Federal Reserve (Fed) chair Jerome Powell.
After spooking the market in early October last year with his hawkish views of increasing interest rates, Powell reversed course in early January by commenting that the Fed was willing to be “patient” and that to keep the US economy on track, noting that there was “no pre-set path for policy.”
By the end of January, Powell confirmed this stance with the first meeting of the Federal Open Market Committee, keeping US interest rates on hold and confirming the outlook was now data dependent, with global risks having increased to the downside.
The market responded positively to the perception that the much publicised “Fed put” (that interest rates will potentially decrease) is now back in play.
While a constructive start to 2019 counters the destructive last quarter of 2018, economic risks remain.
Financial conditions are expected to remain supportive of markets for the foreseeable future.
This includes low interest rates and supportive levels of liquidity provided by Central Banks.
The reason Central Banks will continue to underpin the financial system is that the cyclical part of the global economy (the part of the economy most affected by demand for goods and services) is slowing.
China continues to transition its economy from fixed asset investment and exports to consumption, services and sustainable energy.
This change in direction is impacting on the demand for global commodities and industrial resources.
At the same time, China’s aging workforce and highly indebted households are slowing demand for consumer items such as cars.
China’s drive to substitute globally manufactured products for those made locally is also impacting on the import demand for electronics and technology.
This trade contagion is hurting manufacturers in Japan, South Korea, Taiwan and Germany.
The manufacturing downturn is also spreading throughout the wider Euro area and other parts of Asia.
This is why we believe financial conditions will remain accommodating (interest rates will remain low) throughout most, if not all, of 2019.
Reasons to remain invested
While cyclical challenges have emerged in the global economy and impetus is lacking on the trade front, there remain some positives that will support investment activity, particularly for the generally defensive, higher-yielding nature of New Zealand equities:
Labour markets around the world remain strong with capacity constraints related to skills shortages.
Inflationary pressures have moderated as global energy prices have stabilised. This is providing comfort to Central Bank policies of maintaining accommodative monetary conditions (low interest rates).
Equity valuations in many sectors have corrected to below long-term averages. Assuming economic growth doesn’t collapse and earnings hold up, many equity markets are now regarded as fair-value.
The two powerhouse global economies (the United States and China) are being supported by a renewed dovish stance by the Fed (less concern about inflation) and financial stimulus from policy makers in China.
We prefer income over cyclical growth in 2019
If our concerns about China slowing more than expected are correct, any weakness in financial markets during 2019 will be due to economic rather than just financial market reasons.
China’s emergence as an economic powerhouse resulted in huge demand for raw materials and industrial commodities, boosting global trade. Cyclical sectors and producers of commodities were major beneficiaries.
As China transitions and attempts to rein-in its debt, its growth drivers will change. This will have a major impact on global manufacturing and trade.
With stable financial conditions expected this year (low inflation and low interest rates), we don’t expect a major credit event to disrupt markets. Labour markets should remain relatively firm, which will ensure consumption ticks over.
But tightening credit conditions as financial institutions increase their capital strength, and slower or weaker growth in house prices, will result in defensive income-generating investments outperforming cyclical growth investments this year.
This column is general in nature and is not personalised investment advice. This column has been prepared in good faith based on information obtained from sources believed to be reliable and accurate. Disclosure Statements for Forsyth Barr Authorised Financial Advisers are available on request and free of charge.