Eye on America as global liquidity dries up

US economic growth should hold up even as quantitative tightening continues to take its toll in emerging markets, Europe grapples with ongoing structural issues and the UK is hamstrung by Brexit, according to Talib Sheikh, manager of the Jupiter Flexible Income Fund. “In these tricky conditions, flexibility and having options are key to managing risk, he added.

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The US economy is booming. Unemployment is at 44-year lows, inflation is relatively muted and economic growth in the second quarter of this year was at its strongest in nearly four years. Donald Trump’s pro-growth policies, including $1.5tn in tax cuts seem to be having their effect. It’s an embarrassment of riches and investors like what they see, buying up US assets at the expense of other markets, allowing the US economy to power ahead against its rivals.

No man is an island: the US just might be

Yet the question remains whether the US can continue on this trajectory when all around it the economies of both developing and developed nations are struggling with lacklustre growth at best or in the worst case, recession and even financial collapse. Financial markets have given their answer and so far it is a resounding ‘yes’. The S&P 500 Index continues to flirt with all-time highs, suggesting the US should be able to insulate itself against the world’s woes. Some sceptics like to point to the flattening of the US Treasury curve as a signal that US economic growth may be running out of steam; their focus is generally on the difference in the rate of interest being paid on two-year and 10-year Treasury bonds, but we would argue the yield curve between three-month bills and two-year Treasuries and three-month bills and five-year Treasuries is more indicative of the current health of the economy.

These are benchmarks that give us a view on the net interest margins banks are making and by extension, they suggest growth is in fact likely to accelerate over the next two to three years.

High yield bonds: what’s not to like

Given this favourable climate, the US high yield bond market holds a lot of appeal for us. It’s hard at the moment to make the case across most assets globally that there is a tremendous amount of value to be had given the high valuations we are seeing. In this context, US high yield bonds offering yields between 6-6.5% look relatively attractive. In any case, it is not valuation necessarily that hurts in high yield but more sentiment that the US could be moving into a recessionary phase leading to an uptick in default rates. As this is not our core scenario, we are not anticipating such an event.

As for US equities, the case has been made and continues to be made that they are now relatively expensive. It is important to bear in mind though that US companies have just gone through an impressive second quarter earnings season, with 25% year-on-year growth.

Yes, US indexes have moved higher, but not meaningfully so. In fact, since the euphoria of late January, US equity valuations have actually come off a little. They are cheaper to buy relative to the profits they are delivering. In this environment, we are likely to maintain a bias towards US equities.

The US Federal Reserve: draining global liquidity

Outside of the US, we need to exercise caution. As Warren Buffett famously said, “You only find out who is swimming naked when the tide goes out” and today that tide is going out across the global economy, revealing some deeply flawed economies such as Turkey and Argentina. Some may argue these are idiosyncratic events and their problems are specific to those countries, but we would say they point more to the consequence of the draining of the global economy’s excess liquidity sparked by the US Federal Reserve raising interest rates and starting quantitative tightening. With the US economy likely to remain buoyant in the near future, emerging markets may experience further pain as the US dollar continues to rise and the cost of repaying dollar-denominated debt rises with it.

Closer to home, Europe makes us nervous. We may have made significant progress since the darkest days of the euro zone crisis in 2011, but there are still many structural issues to be resolved. It also doesn’t help when the current Italian government is threatening to break one of the golden rules of the fiscal compact that returned stability to the euro zone post crisis. It has consistently warned Italy’s public deficit may breach the European Union ceiling of 3% of GDP so it can fund spending measures promised during the country’s general election. Politics could in effect derail the solid economic growth we have been seeing out of the European Union especially in the last year.

Our level of exposure to Europe will remain relatively modest for the time being, focusing on companies that offer a sustainable, repeatable dividend with the potential for growth, rather than buying into an explosive growth scenario, which we are more likely to see coming out of the US.

The UK: hamstrung

Politics is again the disruptor in the UK. Three years ago, we would never have said “trade politics” because it is never profitable as a strategy. Yet, in the UK, it has been a key driver of markets, most noticeably in relation to sterling’s performance against other currencies. While some investors have chosen to ignore the UK until the dust settles around Brexit, we are planning a relatively modest and neutral allocation to the market. After all, the falling pound has been a boon for over 70% of FTSE-100 companies revenues originate from outside the UK.

As we move into this late cycle phase of the global economy, quantitative tightening and the imbalance between US economic growth and the rest of the world will require us to remain nimble in our asset allocation in order to achieve the returns we seek at the level of risk with which we are comfortable.

Talib Sheikh October 2018

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