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Market sentiment: Global stock markets fell slightly in May in sterling and euro terms, but made solid returns when expressed in U.S dollars. The more economically sensitive U.K, continental European and Japanese stock markets outperformed the tech-heavy U.S market. Thereby hangs a tale, or perhaps three tales, as outlined below. The outlook for the coming months is for stock and credit markets to be supported by rising profits and continuing cheap borrowing costs. Core government bond markets appear calm.
Three themes to watch. The three tales alluded to above, that we saw in May, are themes that appear likely to persist into the summer.
First, U.S stock market underperformance. In recent months we have seen a preference by investors for ‘old economy’ industries as vaccine rollouts stimulate strong global growth, and which are cash generative. This favours industrials, energy stocks and financials. Meanwhile, the opportunity cost to investors of holding long-term growth sectors such as tech has risen as the ‘old economy’ sectors see rapid improvements in their profitability. Energy stocks are further benefiting from this week’s agreement by the OPEC Plus group (ie, OPEC and Russia), to limit the increase in the supply of oil as demand accelerates. This sector preference will continue to favour U.K, continental European and Japanese stock markets over the coming months at the expense of the more tech-heavy U.K stock market.
Second, dollar weakness. There is skittishness amongst some investors about holding the dollar, given the fear of ever-expanding budget deficits under the Biden administration. Furthermore, as the global economy recovers from Covid-19 -albeit stutteringly- investors want to sell the ultimate safe-haven currency, to buy riskier ones. Add to this the Fed’s determination not to raise interest rates (or even to taper its $120bn a month bond purchase program) until the last possible moment, and the dollar appears vulnerable. However, talk of it fading as a key reserve currency are overblown. The dollar maintains many relative advantages over the euro, yen and renminbi. The most notable is the deep liquidity of the Treasury market, which is how many investors hold their dollar bets.
Put them together, and we are surely looking at a summer of relative underperformance for U.S financial assets for investors based in sterling, euro, yen or Swiss francs. Meanwhile, dollar-based investors might see strong returns from overseas markets, as the combination of the ‘right’ sector balance on European and Japanese stock markets, combined with dollar weakness, flatters their returns when expressed in dollars.
The third theme is inflation. For all the bouts of volatility on global stock markets in May, as U.S and European inflation rates leapt upwards (from low levels), investors appear now to have reached the same conclusion of bond investors did in April. Which is that central bankers -notably Jay Powell at the Fed, and Christine Lagarde at the ECB- are right when they characterise the current spike in inflation as a ‘temporary phenomena’, resulting from short-term bottlenecks in supplies, and which will subside next hear. But we should not assume that these fears won’t return over the coming months, particularly if labour markets in the developed world turn out to be tighter than expected and wage inflation becomes widespread (and not limited to certain ‘recovery’ sectors).
What is holding the Fed back? The Fed’s nightmare is finding itself tightening monetary policy (ie, raising interest rates and/or tapering its bond purchase program), just as the U.S economy is in ‘peak growth’ and likely to cool down of its own accord early next year. Central bankers do not want to repeat the errors they made in 2010 and 2011, when they tightened monetary policy as the global economy recovered from the financial crisis, only to find that austerity-driven fiscal policies around the world were already reducing demand. The result was a decade of low global growth. It is clearly willing to stomach mid-single-digit rates of inflation over the coming months, rather than find it has made an unforced error (after all, the bond market is not signalling concern of long-term inflation).
The Fed is pencilling in 6% plus GDP growth for the U.S economy this year, approximately 4% for next, and around 2% for 2023, based on current assumptions of U.S fiscal policy and the business cycle, and assuming no change to current monetary policy. The 2% for 2023 is already below its long-term target GDP growth rate of 3%. Jay Powell appears willing to let the dollar take the burden of any investor fear of inflation or an oversupply of Treasuries.
Brexit, Australia and sterling: The prospect of a strong economic rebound in the second half of the year, together with the Bank of England recently appearing to finally rule out negative interest rates, has supported sterling. But FX traders are now focused on trade policy – something of a novelty for those who trade sterling, given that Brussels has governed the U.K’s trade relations since 1973.
Despite the efforts of PM Boris Johnson, the Australian trade deal remains unsigned. The U.K government continues its internal debate as to whether it wants post-Brexit Britain’ to be a leader in free trade policy, as one wing of Conservative party demands, or, as the more nativistic wing demands, to use Brexit to safeguard the country from change. Sheep and cattle farmers are most at risk from a tariff and quota-free trade deal with Australia. They, like the country’s fishermen and the Unionist community in Northern Ireland, were once keen supporters of Brexit.
Sterling is likely to be sensitive to the outcome of the trade talks with Australia. If a deal is done on the principle of no tariffs and no quotas, it will boost the pound as investors buy into the U.K’s commitment to free trade. If talks fail, the pound will fall. As a government minister recently observed, if the U.K can’t do a trade deal with Australia, a country with which it has strong ties, it bodes ill for attempting trade deals with the likes of Brazil and India.
Remain diversified. As always, investors should be as diversified as possible in order to maximise returns relative to risk (ie, volatility). This means geographical, sector and asset class diversification.