Following all that champagne at the end of a remarkable 2019, equity markets carried on partying into January. The immediate cause was the so-called Phase 1 US-China trade deal, but volatility was so low that it looked as though investors would be untroubled by anything coming their way. The new coronavirus outbreak is a stark reminder of the unpredictable and has raised fears of a slowdown in Chinese activity. US stock market volatility has climbed from 12% to 18% at the time of writing, and after an historic 31.6% progression last year plus a peak of another 3% so far in 2020, the MSCI US has fallen back to its 2019 close.
The Phase 1 agreement certainly favours the USA, but will it be respected? It is supposed to enforce intellectual property rights, end forced technology transfer, remove administrative barriers to farm exports, open financial markets, rule out currency market manipulation and will require China to import 0 billion-worth of goods over two years, of which billion in farm products. The problem is that there is no neutral dispute resolution mechanism and either side can walk away from the agreement at its own risk. This is why Donald Trump has made only the smallest gesture by cancelling recent tariff hikes.
While the legal part of Brexit is finally over this week, it marks only the start of more – and probably more difficult – negotiations. The British would like the free flow of goods to continue, but without tying themselves to the EU rulebook and at the same time opening up new trade agreements with mainly English-speaking countries elsewhere. Fishing rights are a serious bone of contention and the end-year deadline for a trade agreement is far too tight. In the meantime, the UK’s attractiveness as an investment platform with access to the Continent is bound to wane. European financial institutions are already migrating back to base and some industrial firms are doing the same. The big international risks this year will be Iran and the Middle East, with a serious risk of interruptions to oil supplies. The North Korean missile threat has not gone away, either.
America is providing a steady trickle of upbeat macroeconomic news to counteract a generally sluggish global picture. Its construction sector has gone from strength to strength on the back of low interest rates, consumer confidence is at its highs, employment remains buoyant and the services ISM index has rebounded. But the composite leading indicators index is down, indicating a slowdown in the future, and that echoes a drop in 2020 GDP growth forecasts from 2% to 1.8%. US inflation is showing no sign of acceleration and the Fed is on hold. It may even lower rates as a result of the coronavirus: the markets think so, as the curve has inverted out to 3 years and the 30 year is down to 2.12%. In contrast, the ECB has no scope left to lower rates and it may yet resort to helicopter money in 2020. Food prices have been rising faster than overall inflation over the past 15 years in China and India, and apart from kindling fears of a world crisis, renewed pressure now could cause inflation rates to spike in both countries. The implied consensus growth rate for world GDP this year is down to 2.62%, with many revisions stemming from Asia. French GDP is expected to increase 1.5% this year, above the European average.
S&P 500 profits will have been unchanged in 2019 and we expect an 8% gain this year. That estimate could fade if the coronavirus ends up hitting international activity. Our valuation model has raised our year-end objective for the S&P 500 from 2,897 to 3,051 points, and to 3,200 points using current long rates. The index multiple of 18.7x 2020 is still high. The theoretical objective for the MSCI EMU index 142 points, compared with last week’s close of 133 points, and a very generous 3.5% dividend yield can be added to that. We are maintaining our equities underweight relative to our benchmark (35% vs. 40%), and have no intention of being swept up in the prevailing panic as this is a long-term allocation. We have consistently argued in favour of keeping cash in dollars rather than at negative interest rates in euros; this strategy has proved its worth for a very long time, notwithstanding dollar appreciation and Fed easing.
