Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Does the US midterm election change anything for equities?
Peter Garnry
Chief Investment Strategist
The US midterm election is done and polls where shockingly and finally right in their anticipation of the election outcome. Democrats grabbed the majority in the House while the Republicans defended their majority in the Senate. Overall, the election is somewhat neutral for equities as the US Congress is split, although we are seeing strong European equity markets today, likely tied to the idea that a split Congress will deliver a sweetener in an upcoming trade deal.
A split Congress will end Trump’s momentum but not stop his foreign policy on trade. The most important takeaway from the election is that the Democrats have aligned with the Republicans on the China issue (so no big change here) and the Democrats would like to spend money on infrastructure (like the Republicans) while probably not daring to touch the recent tax reform.
This leads to two things: The US-China conflict will persist and have an impact on markets. Secondly, the US budget deficit will continue to accelerate into 2019. The post midterm election political landscape might also bring gridlock and another fight over the debt ceiling and potential subpoenas of Trump’s tax records which could be a nasty distraction for investors towards the 2020 general election.
What matters to markets
Zooming out from today’s apparent higher equities and lower interest rates, the world is still facing three critical risks: 1) the Fed and US debt, 2) US-China relationship, and 3) Italy’s confrontation with EU.
With equities on firmer ground the Fed will feel confident to deliver another rate hike in December. The neutral rate is still far ahead of us if the Fed chairman is to be believed. This means an additional three rate hikes next year, sending the Fed Funds Rate above 3% This pushes up the funding costs for the US Treasury at a time when the deficit will widen further due to the tax reform.
But already now the cost of servicing the US Treasury debt is surging to $548bn in October, which corresponds to around 2.7% of nominal GDP and 16.5% of the current budget. With several trillions of Treasuries rolling over the next two years this servicing cost will go up – maybe double? The recent peak in servicing cost was in the early 1980s with the interest cost around 4% of nominal GDP. At one point this will spook the market and the fundamental issue is that the USD is the global reserve currency. The world is literally running on USD and unfortunately the world has borrowed too much of it after the great financial crisis.
The US-China relationship will continue to be in dire straits as the two countries have incompatible world views and agendas. We believe tariffs will increase globally as a function of greater nationalism/populism putting upwards pressure on prices as supply chains will be disrupted. Look at the car industry if want to verify the impact. The direct result is a margin squeeze which will be bad for corporate profit growth. Since the 1980s globalisation has expanded and tariffs have plunged. Our big theme is that the pendulum is swinging back a bit with de-globalisation as a theme. It’s the only natural action for the system to function as the two world powers have diverging interests. As we have been saying all year: stay away from industrials, the car industry, and semiconductors as these global supply chains will be disrupted in the US-China conflict.
Italy is an existential risk to the EU project. It’s simply too big to fail. As a result the EU is likely to strike a deal with Italy but not until the market has disciplined Italy to climb down from its pedestal. That means markets will get fresh injections of volatility as news will evolve on Italy until we get a deal. While Italy is a key risk it is also a potential outrageous trade idea. In a Goldilocks scenario Italian equities could be 30% higher within the next nine months. All it takes is: 1) Brexit deal, 2) China succeeds in stimulating its economy, 3) potential soft deal between the US and China, 4) The ECB chooses a slightly more dovish path through 2019, 5) Italy strikes a deal with the EU and 6) the global economy stays robust.
Our equity views
As communicated in our Q4 Outlook and recent presentations, we are negative (underweight) US equities due to valuations and positive (overweight) Europe and China. Our dynamic asset allocation model Stronghold has reduced equity exposure to around 35% which is conservative. Any equity exposure should be defensive or tilted towards minimum volatility factor. Be prepared for a volatile 2019 where the US debt/deficit issue will potentially spook markets and the Fed is overshooting on rates.
Italy is an existential risk to the EU project. It’s simply too big to fail. As a result the EU is likely to strike a deal with Italy but not until the market has disciplined Italy to climb down from its pedestal. That means markets will get fresh injections of volatility as news will evolve on Italy until we get a deal. While Italy is a key risk it is also a potential outrageous trade idea. In a Goldilocks scenario Italian equities could be 30% higher within the next nine months. All it takes is: 1) Brexit deal, 2) China succeeds in stimulating its economy, 3) potential soft deal between the US and China, 4) The ECB chooses a slightly more dovish path through 2019, 5) Italy strikes a deal with the EU and 6) the global economy stays robust.
Our equity views
As communicated in our Q4 Outlook and recent presentations, we are negative (underweight) US equities due to valuations and positive (overweight) Europe and China. Our dynamic asset allocation model Stronghold has reduced equity exposure to around 35% which is conservative. Any equity exposure should be defensive or tilted towards minimum volatility factor. Be prepared for a volatile 2019 where the US debt/deficit issue will potentially spook markets and the Fed is overshooting on rates.
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