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18 February 2019

Given the recent rally we have decided now is as good a time as any to follow our ‘sell the rally’ mantra and reduce our equity exposure. We downgrade our cyclical outlook for equity markets and for the first time in years we are now tactically cautious. Economic data and leading indicators point to weakening fundamentals. Let’s be clear, we do not forecast a recession, but simply think equity markets will struggle to stay at these elevated levels. Return on capital will contract, but as long as interest rates stay low there is no immediate pressure. We do expect continued growth disappointments and further multiple contraction. We favor regions where policymakers have wiggle room to provide some support. Hence we favor the US and EM.

A lesson in communication

Every new central banker gets tested in his first months in the job. Jerome Powell’s test was how to communicate with markets. Within the space of three months the narrative of the Fed changed from a solid path of rate hikes to a pause. What happened? Well, clearly there was no need to be so vigilant in October. As we discussed before leading indicators were slowing and inflation was not really a problem. Hiking interest rates in December and saying that quantitative tightening was on autopilot while the economic slowdown was clear for all to see led to a tightening of financial conditions and spooked markets. After a sell-off and a little bit of panic during illiquid December, the Fed was only right to change course. With economic activity still solid and a tight labor market, at a certain point markets will have to face reality about the extent of the dovishness.

“The economic slowdown is even more visible outside the US.”

Markets rally against economic slowdown

The economic slowdown is even more visible outside the US. Business confidence has weakened significantly in the eurozone and in emerging market economies. Industrial production plunged by 3.9% YoY in December, while retail sales eked out a modest 0.6% YoY gain. In China there is only scant evidence that stimulus measures are forcefully changing the direction of the economy, while were the region in general must cope with the slowdown in global trade. Markets have rallied, partly on the Fed’s U-turn, but also due to diminishing risks of an escalation in the trade war between the US an China and the probable avoidance of another government shutdown in the US. Meanwhile, corporate earnings growth has slowed, analysts are revising down earnings forecasts and CEOs are generally cautious in their company outlooks. Downgrading the cyclical score on equities is not a decision we take lightly, but with the economic and earnings cycle weakening and markets rallying in a late-cycle environment, we have become more cautious. Hence now is a good time to lighten up on equity risk.

Wiggle wiggle

With growth slowing we prefer to have our risk exposure in markets and economies where there is wiggle room for policy. That means that despite the cheap valuation on its equity markets this does not include Europe. The ECB has only just announced an end to QE. It is possible they also make a U-turn but not probable, and certainly not in the Dukes-of-Hazard style of the Fed. Fundamentally, slower growth is no positive for EM, but slowing inflation and stable currencies provide its central banks with ample ammo to cut rates. Hence we prefer to hold our equity exposure in EM or the US.

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

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