Moving into the second half of the year we remain cautiously optimistic, our view unchanged since our previous quarterly review when we made the same comment. Both equities and bonds have risen this year mainly because central banks made a surprising move towards easier policies, clearly a different stance to that of late 2018 when markets were expecting higher interest rates. A positive for markets going forward would be to see policy makers continue along this path and judging by recent comments from the ECB, quantative easing is back on the table. Markets appear to be pricing in these positive outcomes so the negative would be if central banks and policy makers fail to deliver.
The other macro focus remains the trade dispute between the U.S. and China. Negotiations between the two countries had a major set-back in April when the U.S. increased tariffs on $200 billion in Chinese imports and China retaliated. In May equity markets fell as negotiations broke down and the U.S. announced new tarriffs on Mexican goods (these were not implemented). There was more optimism in the June though, as investors anticipated the meeting between the US and Chinese leaders in Japan at the end of the mnth. The hope was for an agreement to resume talks and thankfully this was delivered. Let’s hope that self-interest on both sides will ultimately win the day, but until real progress is seen, markets could remain volatile and subject to emotional responses with every negative tweet from President Trump.
In April talks between the U.K. government and the Labour party reached an impasse and broke down completely in May. Theresa May was not able to get the backing she needed for her deal with the EU and announced she would resign on June 7th. The Brexit Party took more than 30% of the vote in the European elections; the Conservatives came in fifth with their worst ever result in a national election and voters flocked to the Liberal Democrats and the Green party. The Brexit Party win was interpreted by the market as increasing the likelihood that the U.K. will either leave the EU without a deal or have a general election, and the Pound fell. The final two candidates in the Tory leadership race have been setting out their plans for Brexit. Jeremy Hunt is prepared to leave without a deal, but not if there was the “prospect of a better deal” on the table. He sees October 31st as a “fake deadline” that could trigger a general election. Boris Johnson takes a harder line and believes the survival of the Conservative Party depends on delivering Brexit. As Johnson is the favourite in the race, markets are currently pricing in the greater chance of a no-deal exit which explains why the Pound has continued to fall lower. From a technical perspective we have had a negative view of the Pound for months and currently e maintain that view.
We continue to remain under-weight UK equities but there has been improvement in our monthly UK Market Chart where our Breadth indicator turned neutral from negative in June and our Price Momentum indicator improved. On a regional basis we favour the U.S. equity market. Seventy four percent of S&P 500 companies beat their first quarter earnings expectations which is a good sign for the economy and leading indicators do not indicate an imminent recession in the U.S. Our monthly U.S. Market Chart improved as well, again our Breadth Indicator turned neutral from negative and our Momentum Indicator (although it ticked lower) remains positive. The U.S. S&P 500 index is currently close to its highs, unlike many other regional indices, underlining its relative strength. Our Relative Strength analysis also indicates that Europe as a region, and Emerging Markets have been improving. We have avoided investing directly into Japan as it remains weak in this analysis.
Bond markets continued their strong run in the second quarter. US Treasury yields fell earlier in the year following announcements from the US Fed, which resulted in a new expectation that the Fed will lower rates before the end of the year. Bonds rallied and continued to do so in response to the increase in trade tensions and equity weakness in May. Most Bond sectors remained strong through June, particularly Global Bonds, helped by Sterling weakness. In a technical sense Bonds are overbought but we don’t see any weakness yet. This can be explained for several reasons. Markets are pricing in a strong chance that the main Central Banks are likely to cut interest rates, the Fed has signaled as much and Europe has indicated that it would restart monetary stimulus should there be a need to support economies. Inflation has remained under control and with fears of escalating trade wars, bonds have been bought as a safe-haven protection.
The fall in investment markets through May was accompanied by a plunge in bullish sentiment to an extreme level. As explained previously, in a counter-intuitive way, when market sentiment responds in this way this is usually bullish. However, the rally in June hasn’t done as much as one would expect to dispel negativity. Many measures are indicating that a surprising level of investor fear is still present and again, in a counter-intuitive way, this is also usually bullish. Further evidence in recent data, that market sentiment is not over-stretched, can be found in the latest global fund manager survey which shows that global managers are holding an extremely high level of cash and their equity holdings are very underweight relative to their average equity allocations over the last few years. This again illustrates there is more money on the sidelines waiting to be allocated to equities should risk abate.
Despite the on-going risk of escalating trade wars and a slowdown in global growth, equity markets rallied in June and leading indicators are not signaling a high risk of imminent recession in major markets. Falling bond yields indicate a change in expectations with investors now anticipating that the US Fed will cut interest rates. Sentiment indicators suggest a high level of investor fear is still present and there seems to be a surprising level of cash on the sidelines which, as we explain below, could help support higher prices. The weakness in the Pound against most major currencies continued in June with the uncertainty over who will lead the Tory Party and in turn the government’s negotiations with Europe over Brexit.
Despite all the political and economic concerns, markets are holding up really well. Whilst we remain underweight the UK, due to the uncertainty over Brexit, the strongest regional market remains the U.S. where the macro outlook seems to be consistent with a slowdown rather than a recession. On the positive side, it is possible that both equities and bonds could receive a further boost from continuing supportive policies from the central banks and could be helped further should there be a resolution to the trade dispute between the U.S. and China. Our research indicates that investment fund managers maintain a highly defensive position with a high allocation to cash and if this money is put to work it should support higher equity prices.
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