Equity Research; Feb 2019

Key recent developments more positive for 2019

A few factors have calmed nerves delivering a strong start to 2019:-

a) A drop in US Treasury yields along the yield curve

19th January 2019

14th February 2019

Source: www.bloomberg.com

The ongoing drop across the US yield curve indicates short-term expectations of the path of US interest rates in 2019 have become subdued. The Federal Reserve has stressed it will remain “patient” and data dependent which investors have interpreted as pausing on its previous guidance of two rate hikes over 2019. The central bank appears to be taking a more cautious view of the US economic expansion given the GDP slowdown ex USA.

This is a change from December 2018 when investors rightly concluded that the hike to Federal funds and “autopilot” balance sheet reduction amounted to the central bank applying brakes to the economy. For now the pressure on the brakes appears to be off.

b) “Quantitative tightening” (“QT”) ($50bn of asset sales per month) has the potential to increase yields. For now worries about QT have abated, but this is a moving part for 2019.

c) The other positive is the buzz around the now resumed Sino-US trade talks and indications that both sides want to conclude a trade deal quickly.

d) Investors are convinced the ECB will not move on interest rates during 2019 as evidence mounts of slow EU conditions, principally in the larger economies of Italy, France and Germany.

US imbalances will be an issue in 2019

Some commentators, including former Fed Chair (1987-2006) Alan Greenspan have warned that the US budget deficit is spiraling out of control and cuts to “entitlement programs” are essential to correct US structural imbalance.

We now have a picture of just how much red ink the US is generating.

• The US budget deficit totaled US$318.9bn in Q1 2019 alone. This was a staggering 41.8% rise from Q1 2018.
• The US national debt surpassed $22trn for the first time this week. Since 1991 the US national debt is up c. $20trn with no apparent force standing in the way of further debt accumulation. Both the US Congress and Trump Administration, far from looking to stem the red ink, are considering more spending initiatives.

The debt load and structural imbalances is a key recurring challenge that could prompt a loss of confidence in US assets and higher rates.

Key conclusions for 2019

• Whilst predictions are as likely to be wrong than right! We think valuations and expectations have started 2019 low (UK-350 P/E of 12x). We think positive UK100 returns are likely c. 12% to 7,500.
• Global bond yield curves likely to continue to flatten, we expect no rate increases from the US Fed, the ECB or the Bank of England over 2019. We do expect continued QT from the US Federal Reserve and further withdrawal of stimulus by the ECB. This could result in positive fixed income returns of 5%-10% in the 10-30 year maturities.
• We think there is an equal probability of a “hard Brexit” (UK departing from the EU without a deal/ transition agreement) and a “soft Brexit” (UK departing EU with a deal or remaining in the customs union or customs partnership). UK equities have moved to price in a soft Brexit in a similar way to the pricing in of a “Remain” result in June 2016! A soft Brexit needs to be delivered in our view, and if it is not recent gains may be vulnerable.
• Having survived a tough 2018 in good form, our expectation is for strong returns from US technology stocks in 2019.
• After limping out a tough 2018 with weak volumes and pricing increasingly under pressure, we expect UK property to have a tough 2019. This is principally due to high transaction taxes, a lack of overseas investor demand and weak affordability. London is likely to be the epicentre of UK property angst with some new schemes already in trouble.
• Oil/ oil services we are bearish on the grounds that the US will continue to pressure OPEC (Organization of Petroleum Exporting Countries) to keep prices low which threatens OPEC management.
• We are positive on paper and packaging suppliers into FMCG (fast moving consumer goods) sectors as online volumes are rising alongside increasing consumer environmental awareness.
• Investors want more exposure to developing technologies, artificial intelligence, robotics and data/ algorithm based businesses.
• Banks face the positive impact of digitization, recent restructuring gains and the end of payment protection insurance (29th August 2019) having started 2019 on very low ratings.