Stockwatch: Threats and opportunities in 2019

2019 will be jam-packed with major threats to the global economy and share prices, but there will be New Year trading opportunities, too, argues companies analyst Edmond Jackson.

It's easy to see Brexit as dictating all, but the global financial plate tectonics have long rumbled and smouldered risks. We felt the first eruptions over a year ago as tougher credit ground noisily against over-priced US equities, then trade conflict broke out openly between the US and China.  

Much of the UK stockmarket's fall has correlated with US stocks: from August to early October the FTSE 100 was down only 2% then fell a further 11% in sympathy with US indices.  The S&P 500 index extended its drop to 20% then rebounded 5% on 26 December on news of the strongest US retail sales in six years.

US corporate earnings may have peaked

The underlying trend has appeared to moderate: consensus for Q4 2018 profits from S&P 500 companies has been trimmed 2.5% which, according to Bloomberg, is the most of any quarter since early 2017.  Investors have also been used to regular upward revisions during the Trump presidency.  The crux is whether a "reversion to mean" rate of underlying growth is underway, or trade conflict and tighter credit are stalling a decade-long upturn. 

Fourth-quarter profits are still expected to grow around 14% like-for-like, which is twice the average of the past five years; and the US market's fall has taken its 12-month forward price/earnings (PE) below 15 times – helping explain a sudden outbreak of buyers.  

But mind a Goldman Sachs study which shows a 30-year record of analysts cutting forecasts by an average 8% around cyclical peaks, i.e. they had been over-optimistic. There is also the effect of President Trump's tax cuts waning after their boost to profits in 2018, compared say with the 1990s when US productivity was three times greater.

Plunging financial shares/measures: a portent?

As I noted in my recent 2018 Stockwatch review, smaller UK financial stocks are down in the order of 50% from September peaks, despite no adverse change in updates.  They range from asset managers to IFA pensions advice; yet H&T Group (HAT) the AIM-listed pawnbroking and gold trading stock, is down 35% despite normally being regarded as benefiting from harder consumer times and an upturn in gold prices.  Lower footfall on the high street also raises fears for its personal loans side (lest demand contracts and delinquencies rise) which may explain the drop, but it highlights UK small caps under the cosh.  Eyes will therefore be on trading updates, as to whether this is a portent, or overdone.

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US financial shares have seen their biggest fall since 1931 as interest rates rise, seemingly perverse for lenders but likely a response to higher risks: e.g. the extent of rise in yields on US investment grade debt has historically meant a recession in 3-6 months' time.

Moreover, $176 billion worth of corporate bonds have fallen from 'A' grade to 'BBB', the biggest drop since late 2015 when low oil prices sparked casualties among commodity related firms; and risk spreads among high-yield bonds are also up.

Monetary economists emphasise cash activity and, according to Janus Henderson's analyst, the 'M1' measure of cash in circulation is at its worst level since mid-2008 for the 14-largest developed and developing economies; quite how relevant this remains in the modern era of electronic cash is unclear.  I recall negative indicators like this, touted at end-2011 also in early 2015 when a deflationary bear market was predicted. 

Those occasions prove buying opportunities in equities but mind how this time around, central banks have broadly shifted from monetary stimulus to tightening mode. The US Federal Reserve is in a dilemma as it tries to normalise interest rates both to create scope for future cuts and check incipient inflation from President Trump's tax cuts. 

Trump and some monetary economists criticise the Fed for raising rates at a sensitive time but, if it does not uphold policy, investors could fret "the Fed knows something dire" or is a push-over.

Where should investors hide?

Smaller listed UK asset managers (I mentioned in my 2018 review) are notable also for diversifying into bond funds, supposedly to help clients (and themselves) spread risk.  The orthodoxy is bond and equity values being inversely related over the long run, hence portfolios should own both asset classes.  Yet an inverse relation also between bond yields and prices has meant that as yields have recently crept up with interest rates, this has typically weighed on prices.

Precious metals are also mooted to offset risks in equities, e.g. gold prices fell 13% mid-year as equities generally peaked, then rose about 8.5% as equities were hit since autumn, silver similarly so.  Choices are mining shares or exchange traded funds (ETFs) or physical purchase such as krugerrands. Yet, in the teeth of crises past – 1987, 2000 and 2008 – I recall pretty much everything getting hit and gold has lately seen down-days with equities. 

"Investing" in gold is very much a bet on sentiment, its market price way above what's justified by fundamentals, and will turn down the moment "risk-on" returns to equities. Some investors will thus prefer to be cash-ready despite ongoing low interest rates.

Perceived safe-haven currencies – especially the US dollar, also Swiss Franc and Japanese Yen – are likely to gain support if financial tremors persist during 2019.  If you're disinclined towards foreign exchange and overseas investing, then consider US dollar-earning companies listed in London, which benefited as a class after the 2016 referendum on EU membership.

Indications that the economic cycle is turning

House prices are down in Australia and Canada; a host of countries including Germany and Japan now cite reduced GDP growth or indeed falling GDP; business growth in the eurozone is cited at a four-year low; and China missed both industrial output and retail sales expectations for last November, with retail growing the slowest in over 15 years.  

Hopes are for China to unveil major new stimulus measures that will also rescue global GDP – potentially able to give stockmarkets a boost – although I recall one study showing how the "dollar effectiveness of extra debt on GDP" has reached diminishing returns – at around 40 cents in the developed world including China.  

Oil prices have also resumed their fall since last September, despite a fillip in response to OPEC and other producers recently agreeing quotas.  Fears involve not only strong US supply but also fears that weaker global growth is reducing demand.

Brexit: a near-term hinge for UK investors

Whatever its real dangers or opportunities, Brexit is seen as a colossal act of self-harm by the international financial community, so, anything likely to slow or muddle the process, like Mrs May's EU withdrawal agreement, is cheered. British business similarly prefers a softer Brexit, if it really has to happen, than leaving with no deal.  Thus, if sentiment shifts among MPs, actually to vote the deal through, then sterling and UK risk assets will re-rate. 

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In recent months I have thought Mrs May would lose a first parliamentary vote but could potentially win a second. I wouldn't necessarily ditch this rationale – say if there are two votes in the New Year, enough MPs rebel against 'no deal' and Conservatives realise their chances of re-election will plunge if Brexit chaos ensues. 

Early 2019 could thus herald a relief rally, the crux being whether enough euro-sceptic MPs decide to moderate their opposition to Mrs May's deal. However, accepting it will not rescue UK equities for 2019; the US and Chinese economies are the key.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.