Equities could have one last hurrah in 2019 before rising bond yields provide a sucker punch later on in the year, according to Richard Buxton, chief executive of Merian Global Investors.
As asset management firms try to digest their views, both short term and long term, ahead of the New Year, many have been warning of a 2019 recession, or the end of the decade long bull market.
Warnings Signs are There
Last week we saw the yield spread between the US three-year and US five-year treasuries inverted; meaning the shorter-dated three-year bond paid more, at 2.72% on Friday, than the longer-dated five-year paper at 2.7%.
It’s the first time in more than a decade this has happened, and is generally seen as a warning sign of an imminent recession.
Fixed income markets have been pricing in continued interest rate hikes from the US Federal Reserve for some time, meaning bond yields have risen. However, even in recent days and with a rate rise around the corner, Fed Chair Jerome Powell has suggested that may not necessarily hold true.
US economic growth, which has been a beacon of light in a tough environment for the rest of the world, has begun to slow. And as the sugar rush from President Donald Trump’s tax stimulus fades, Buxton reckons the differential between the US and elsewhere will continue to re-synchronise.
As interest rate sensitive areas of the US economy, such as autos sales and housing, pull back, he believes the Fed will be more cautious in its rate outlook. “I thought it would take until March for the data to get to the stage where they would begin to do that, but they’re doing it even before the December rate rise,” says Buxton.
“As the US slows from super-charged growth to nearer trend, and as the Fed stops nudging rates up, the dollar will soften a bit and that will help re-synchronise things relative to the rest of the world.”
As a result, bond markets will likely become “more sanguine about life” and the inversion could reverse. That could signal a better environment for risk assets, which should pick up on the back of more benign bond markets through the next 12 months.
The Last Market Dip You Want to Buy
However, adds the manager of the Morningstar Silver Rated Merian UK Alpha fund, “that could actually be the last hurrah” for equities; “the last dip you want to buy”.
That’s due to a much longer-term story that is developing. Clearly, while the Fed might stop raising rates mid-2019, they will be higher than they have been for the best part of the last decade. As a result, the cost of capital for both businesses and sovereigns to service their deb will rise. That is where the sucker punch will likely come.
“There’s going to be, on a much longer-term basis than just the next 12 months, an increased cost of capital for the big borrowers and China is turning into a big borrower and the US certainly is,” adds Buxton.
“It could be that the current relaxed nature of the bond market persists for some considerable time next year, it buoys risk assets, but then ultimately we could have a sucker punch with rising bond yields later on just because of rising costs of capital and demand from big borrowers.”
UK Equities a 'Phenomenal' Buying Opportunity
On the UK, Buxton continues to be constructive in the longer term. In fact, as Brexit headlines intensify the closer we get to the current March 2019 deadline without certainty, we could see some “phenomenal buying opportunities” in the equity market.
November’s Budget, he explains, was “a very significant turning point”, as the Government abandoned attempts to balance the books and announce it would re-commence a spending programme. “I think that is quite right, because having about a £20 billion deficit per annum on a £2 trillion economy is kind of a rounding error; why beat yourselves up on a rounding error?” Buxton concludes.
What’s more, the jobs market looks strong, private sector wage growth is healthy and an upward tick in public wages could begin soon. “All of that will be gently supportive of the UK economy, so I don’t think it’s too bad," he adds.
While the vote on Prime Minister Theresa May’s Brexit deal looks to have been put off for the time being, Buxton’s believes the deal, or some variant of it, will eventually be voted through Parliament.
“I’m still of the view that it’s in no-one’s interest for the UK to fall out on a no-deal. I think we will end up, at some point between now and February, with a deal that is voted through and therefore transitional arrangements,” he predicts.
This, he claims, should in turn create “some extraordinary buying opportunities within the UK”.
“If you believe that earnings can grow modestly next year then the UK market is now on 11 times next year’s earnings. Strip out financials and resources and that rises to about 13 times.
“That’s still below our 14 times 40-year average, so that’s pretty compelling value, and certainly in some of the domestically oriented areas there could be some phenomenal buying opportunities in the course of the coming months of volatility.”
