Goldilocks and the Trump Bear

Economic and Stock Market Commentary

The year began with strong performances from global share markets and economies, although in more recent weeks share prices have fallen back to the lower levels of a few months, even a year ago. The initial bout of market weakness in February was blamed on rising wage inflation and fears of rising interest rates, but this time round it is a reaction to President Trump’s announcement of a range of tariffs on imports from China.

The White House declared an intent to erect tariff barriers and other measures designed to punish China for unfair industrial policies and theft of intellectual policies. China announced some retaliation of its own and the effect was dramatic with stock markets fearing a full-blown trade war, a possibility that has been discussed, and dismissed, since Mr Trump was elected as President. But the tariff announcement was well telegraphed and left everything open for negotiation. Furthermore, the truth behind the steel tariffs is that they now apply to barely any major exporter of steel to the US and so a trade war can be easily avoided.

Although equity markets have taken a battering since the market melt-up at the turn of the year when US corporate tax cuts were in focus, this sharp uptick in volatility is to be expected. It is quite normal for markets to remain nervous for a month or two after such a sharp initial reversal and a move back to and below the initial lows is not surprising.
Pessimists are also talking up the prospect of an unwanted war in the Korean Peninsula, a banking collapse somewhere, a Chinese economic hard landing, a resurgence in inflation or aggressive interest rate rises that could bring the good times to an end. It is a worried bull market and investors are once again wondering if it is time to sell and/or reduce exposure to equities.

However, we at Clarion Wealth do not subscribe to these negative views. There is still plenty of cash on the sidelines waiting to be invested and Central banks are following policies which are supportive of economic growth, fearful that if they apply the brake too early the world will lurch back into recession and a deflationary spiral. It is also noteworthy that commodity markets haven’t reacted particularly badly to the tariffs spat and emerging market equities are outperforming in the sell-off, both signs that global growth remains on track.

With muted inflationary pressures keeping interest rates low and corporate profits growing the fundamentals and outlook remain positive. Stock markets thrive on this not too hot, not too cold “Goldilocks” backdrop; a phase of growth strong enough to boost corporate profitability and inflation low enough to keep monetary policy loose.

It is true that inflation in the UK has been rising but this is largely a function of sterling’s decline over the last two years. Looking more widely across the developed world, it is clear that despite years of unprecedented monetary policy stimulus, inflation is still undesirably low. This is because of the slowness of the economic recovery, itself a function of the need of governments, corporates and consumers to reduce debt. As a result, spare capacity has been eaten up at a much more modest pace than in previous cycles.

The decline in unemployment has not fed through to the type of wage gains which have characterised previous cycles. There is also a strong disinflationary influence from the rapid advance in technology and the rise in the “Amazon” type economy.

Against this backdrop, central banks are unlikely to be concerned that a steep rise in inflation is around the corner. In fact, looking at the US, the Federal Reserve is more worried about persistently below target inflation. The inflation outlook in Japan and the Eurozone is even more downbeat and as a consequence, highly accommodative monetary policy in these countries is likely for the foreseeable future.

If we look at the UK, the Bank of England has hinted that base rates are likely to rise in the months ahead, but the fragility of the economic growth outlook much reduces the prospects for a more extended cycle of monetary tightening that could unsettle financial markets. In the United States, the Federal Reserve has nudged up interest rates and has embarked on the lengthy process of reducing its balance sheet, but the removal of monetary policy accommodation is likely to be measured and modest.

Taken together, this backdrop does not seem to fit with the traditional view that after several years of economic expansion, central banks invariably take the monetary policy punchbowl from the party and precipitate the demise of the cycle.

With global interest rates and bond yields likely to remain at historically low levels for quite some time, investors are still going to look for higher potential sources of return. With the yield on stocks and shares still generous relative to the returns on bonds and cash, the economic backdrop still supports an optimistic view on equities particularly given the recent strong pickup in corporate earnings growth.

And yet, in the words of an old Bob Dylan song, “the times they are a changing!”. Fiscal headwinds are becoming tailwinds. Trade policy is becoming less free. Volatility is on the rise. For investors, perhaps the most important change is the rise, however small, in short term interest rates, which really started in September last year. For the first time in over a decade it is now possible to be paid for holding cash. All theoretical investment decisions now have a little bit of competition from the idea of doing nothing and getting paid for it. Who is likely to lose the most in this new scenario? Perhaps the high dividend and minimum volatility strategies that became so popular a couple of years ago. There was always something of a free lunch about an idea that an investor could just put money into some low volatility or high dividend ETF and get market like returns or even better. It stands to reason that many investors attracted to this will be the first to exit when there is a new low risk way to get paid. Investors should therefore be prepared for an increase in volatility but perhaps also, more importantly, a re-emergence of the popularity of the active Fund Manager and actively managed investment strategies.

In the investment world, it is sometimes said to “be greedy when others are fearful and be fearful when others are greedy”. It is the Clarion view that at the moment there is an equal balance between greed and fear which is good backdrop for financial markets to prosper. Despite recent scares from both the Inflation Bear and the Trump Bear, Goldilocks is alive and well and there is still plenty of life in this current economic cycle.