Andrew Milligan, Head of Global Strategy at Aberdeen Standard Investments, considers what the US Federal Reserve’s U-turn on interest rates means for the dollar and emerging markets, and whether a recession lies ahead.
Headlines suggest President Trump and Chinese leader Xi Jinping could put an end to the US-China trade war this month. Meanwhile sterling has strengthened against the euro, the US Federal Reserve has made a U-turn on interest rates and parts of Europe are teetering on the edge of recession.
Andrew Milligan, Head of Global Strategy at Aberdeen Standard Investments, reflects on how these factors are affecting global markets. He also considers what’s next for emerging markets and how the deteriorating quality of corporate debt could have an impact on investors.
Equity and credit markets are definitely reacting positively to signals from both Beijing and Washington about an approaching trade deal. There’s even some optimism that the deal could move beyond ordinary trade matters and start to focus on some of the other major concerns of the US government, such as intellectual property protection and technology transfers.
On days when economic data has been poor but trade reports have been upbeat, we’ve seen investors focus on political over business news. However, there are two other key issues investors need to think about.
Firstly, it seems very likely that China will increase its purchases of goods made in the US, such as aircraft, cars and soya beans. That means it will probably reduce its imports from other countries, so some emerging markets could find life more difficult.
Secondly, even if President Trump reaches an agreement with China, he may quickly turn his attention to Europe where he sees another large trade deficit. The risk here is not only that Washington launches a new campaign, but also that Brussels responds forcefully with a series of countermeasures aimed at voters in key US states.
The news could get worse before it gets better as we find ourselves in a political rather than an economic cycle.
At the time of writing (6 March 2019), sterling is about 5% higher against the euro than at the end of 2018. There are usually several reasons why two currencies move against each other, but in this case one reason is certainly Brexit. As parliamentary negotiations have edged forwards and the risk of a disorderly outcome has reduced, investors have adjusted their positions and sterling has moved higher.
The second cause is the expectations for interest rate moves in 2019 and 2020. Both the EU and UK economies are quite weak at the moment and parts of the manufacturing sector are getting close to a recession. Nevertheless, as the UK has slightly higher inflation, markets are pricing in the possibility that the Bank of England will raise interest rates a few times by the middle of 2020. Meanwhile, the prospects for the European Central Bank raising interest rates are being pushed further and further back.
The EU also faces some difficult parliamentary elections in May, where the populist vote could be high. In addition, when there are concerns in the world economy, the dollar is generally seen as more attractive than the euro. As such, at Aberdeen Standard Investments, we’re relatively neutral on sterling at the moment, but we prefer the dollar to the euro.
When the US Federal Reserve (the Fed) first indicated that interest rate rises were on hold, the dollar did fall, although it recovered once investors began to realise how weak activity was in other parts of the world too.
When it comes to the US dollar, there are other drivers of course. These include: cross-border capital flows, the state of current account deficits, political risk in the US and other countries, and where the currency stands in relation to long-term valuations. At Aberdeen Standard Investments, we take all of these into account in our currency analysis and, on balance, we think that the dollar won’t move much higher unless there’s a major inflation shock in the US causing the Fed to respond. Otherwise, we expect the dollar to stay at fair value, until higher levels of optimism lead US investors to start buying cheaper overseas assets again.
Emerging market assets have performed well in the past few months, both equity and debt. Despite emerging market economies being rather downbeat from last summer onwards, there’s still been some small but steady buying of emerging market assets. Of course past performance isn’t a reliable guide to future returns.
Clearly some investors were able to look through the gloomy headlines and search for value in their investing. As and when there was positive news on both US interest rates and US-China trade talks, value started to be released. For example, we’ve seen solid increases across much of Asia and very strong rises in China-related stocks.
At Aberdeen Standard Investments, we’ve been overweight in emerging market equities in our portfolios, although more recently we’ve taken some profits and moved them into a broader selection of global equities. As and when the monetary and fiscal stimulus around the world brings this period of slow growth to an end, we expect a wide range of companies to benefit.
This is an issue which we’ve been monitoring carefully. A lot of investors have been buying high-yield bonds, or using leverage to achieve the higher returns they want. Following a series of research reports and our latest asset allocation meeting, we discussed concerns around how either a sharp increase in borrowing costs or a sharp decline in company profits could hit debt-servicing capabilities.
This helps explain why we decided to increase our positions in higher quality investment-grade debt rather than high-yield bonds.
In a world of low interest rates (outside the US), there’s certainly every incentive to look for income from other assets apart from cash. However, an important concept is ‘sustainable yield’. It’s key to ensure that free cash-flow yields can be sustained, whether for equity, credit or real estate. This is achieved through a mixture of good management, good business models and solid balance sheets. In many situations, quality is still worth paying for.
Monetary policy normalisation and geopolitical risks are clear headwinds for 2019, and financial markets have already priced in the fact that we’re very close to recession in parts of Europe. The issue for investors is whether or not we’ll see weaker growth in the other two major blocs: China/Asia and North America.
Much of Europe faces a manufacturing sector recession, partly due to the slowdown in global trade and partly because of a series of one-off shocks to key sectors such as automobiles. With policymakers unable to do much in Europe, it will take an external force to stimulate a recovery.
On the other hand, prospects for consumers in China and the US look reasonable this year, and if a trade agreement is reached and stimulus measures in China are effective then we expect manufacturing in these countries to stage some recovery.
Our Research Institute models show that the risk of recession in the next 12-24 months has risen but it still remains low by historical standards. We’d need to see a major policy error or external shock to bring one about.
The information in this blog or any response to comments should not be regarded as financial advice. Please remember that the value of your client’s investment can go down as well as up and may be worth less than you paid in. Information is based on Aberdeen Standard Investment’s understanding in March 2019.