Bill McQuaker: Is it crunch time for asset owners?

By Bill McQuaker

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Oct 24, 2018

There are signs trouble may be on the horizon around the world

The leading story of 2018 is continuing to develop as we move closer to the end of the year. This story is the strong outperformance of the US economy and its equity markets, while the rest of the world lags behind.

But like the late stages of a football match where one side has a lead, events often accelerate late in the game, and investors are rightly beginning to get nervous about the sustainability of US dominance.

But before delving into the possible outcomes, it is worth discussing where we are situated at present, and what is really driving US outperformance and the structure of asset prices globally.

First and foremost, the US economy has performed better than other countries, with GDP growth accelerating for eight consecutive quarters up to the second quarter of this year, reaching an annual rate of more than 4 per cent. The US Federal Reserve has been slowly raising interest rates, inflation is – for the most part – subdued, and the US dollar has continued its march upwards. All of these factors have helped US equity markets to strongly outperform, with technology stocks leading the way.

But while these are all positive developments for the US, these same conditions have been a drag on the performance of the rest of the world, particularly for nations that have big current account deficits and high levels of US dollar debt.

Emerging markets most often display these conditions, with Argentina and Turkey being prime examples, and not accidentally, they are at the forefront of the negative headlines of late.

While their idiosyncrasies might make them more vulnerable than some of their emerging market counterparts, and transmission mechanisms to developed markets from vulnerable emerging markets are somewhat limited, this speaks to the broader theme of the US tightening driving conditions in every corner of the world.

But why is it crunch time now? While the positive side of the story in the US is clearly outlined above, there are growing signs that trouble may be on the horizon, and the factors driving the US outperformance may be fading. The expansionary monetary policy we have become accustomed to is being unwound, and with the Fed continuing with rate hikes, this is resulting in higher funding costs domestically as well as globally.

In addition, the positive momentum created by president Trump’s tax cuts may be close to peaking. At the same time, America is waking up to the fact that the tax cuts must be financed, and this may require higher rates than those now on offer.

The OECD’s recent leading indicator report is pointing to a slowdown in growth, and at some point, rising wages, a higher oil price, and increased funding costs are likely to weigh on corporate profitability. The US may be less sensitive than others to global headwinds, but it is not immune.

The other driving force of the global economy is of course China, which has slowed significantly since 2009.

Although this slowdown has been punctuated by periods of monetary and fiscal stimulus which have proved important for financial markets, the evidence is not convincing that this structural downward trend in growth is over.

Even with slower growth, China remains hugely important for the global economy, and while tepid money supply, reduced infrastructure spending, and slowing consumer demand all suggest renewed stimulus is around the corner, good levels of corporate profitability, a still strong housing market and high PPI do not.

It may therefore be premature to expect meaningful stimulus at this stage, and the evidence is not sufficiently compelling that the China put option is coming into play.

So where does this leave us at this late stage in the game? We are in a time when the outlook is not crystal clear, but we could be close to the tipping point. It has been a long time since markets have faced both slowing growth and tightening policy – conditions that could fall into place if the US falters.

Still, positive signals out of China on renewed stimulus and a slowdown in the pace of US monetary tightening could provide a release of the pressure building up globally, and lead to a resurgence of risk-on sentiment.

But for now, the risks look to be building and we are inclined to stick with a cautious stance. The US could still see the game out and emerge as the clear-cut winner of 2018. But it might not.

Bill McQuaker is portfolio manager of Fidelity Multi Asset Open funds

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