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  Asset Allocation update August

21 August 2019

Earnings are still expected to grow modestly and equity markets are still near record highs. Credit markets don’t signal an increase in defaults either. Which market is right is hard to tell as we see a similarly divided picture in economic data. Regardless, the developments of the past weeks have made us more cautious for now. We turned more negative on equities and have reduced our risk exposure.

Is this time different?
One of the most looked-at and reliable predictors of a recession is the inversion of the yield curve. Historically almost every recession was preluded by long (10-year) interest rates falling below short (2-year) rates. As interest rates fell to new lows over the past few weeks we saw this phenomenon occur for the first time since the global financial crisis. Unsurprisingly this triggered a lot of discussion among investors whether we are headed towards a new recession. Although a reliable indicator, there have been inversions before that were not followed by a recession. The most recent example was in 1998 when decisive action of central banks effectively supported the economy. Claiming ‘this time is different’ is a risky bet and we will not argue that this time it is. There are reasons for some optimism for a turnaround though.

“The quarterly earnings reports that came out over the past weeks were better than expected and helped to boost confidence companies are weathering the current downturn quite well.”

Earnings 

The quarterly earnings reports that came out over the past weeks were better than expected and helped to boost confidence companies are weathering the current downturn quite well. Most of the weakness we did see in earnings were in sectors exposed to global trade and manufacturing, which was no surprise given the weak number on trade and capex. On the other hand, the more domestic and consumer driven sectors help up surprisingly well. Despite the positive surprise, absolute growth was modest at best. US equities grew earnings per share by just 5%, in Europe growth was essentially flat. We see a similar picture in economic data. Global trade and manufacturing PMI’s continue to decline and are at recession levels, while consumer confidence and service PMI’s are solid and point at modest growth. Estimates for equities are also optimistic, after a few weak quarters the consensus is that we will return to modest growth.

The Fed and Trade war
Markets are expecting monetary policy to be aggressively eased going forward, much more than the current official guidance of the Fed and ECB. More interest rate cuts by central banks or even a return to quantitative easing would certainly help markets, the question is whether policy makers have enough room to maneuver. Cutting interest rate (further) into negative territory may do more harm than good to the economy and quantitative easing programs are not a popular option. At earlier market downturns in the past months dovish words from central bankers were enough to turn markets for the better, but we have doubts this trick will continue to be so effective. Especially since the market is already anticipating a big move. The words from President Trump were certainly not aimed at calming markets. Unexpectedly the trade tensions between the US and China flared up again as the US announced new tariffs to be imposed on Chinese products. The Chinese government responded by devaluating its currency beyond the symbolic level of seven Yuan per Dollar. Market sentiment worsened as this unfolded, and while trade negotiations continue it is likely tensions remain elevated going forward.

While there are still positive developments in markets and economy, mainly dovish central banks and better than expected earnings we see the support from these fading. The most recent earnings were not so bad as generally thought, but in absolute terms we saw growth slow to the lowest levels in years. Central banks turn more and more dovish, but the impact of new rounds of monetary stimulus is decreasing. With economic numbers still weakening and political turmoil rising again we become more bearish on equities and decrease our risk exposure. 

Disclaimer
Kempen Capital Management N.V. (KCM) is licensed as a manager of various investment funds and to provide investment services and is subject to supervision by the Netherlands Authority for the Financial Markets. This information may not be construed as an offer and provides insufficient basis for an investment decision.

The Asset Allocation  Desk

Joost van Leenders
Ivo Kuiper

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