A more challenging backdrop for markets and decelerating global earnings growth have contributed to a drop-off in support for global equities, according to GAM Investments’ Larry Hatheway, who believes investors should proceed with caution.
This year started strongly as markets appeared to shake off many of last year’s macroeconomic and geopolitical headwinds.
Hopes over a US-China trade deal, a softening of the Federal Reserve’s policy stance and the receding threat of a ‘no deal’ Brexit made for a much more positive market backdrop and greater optimism for global growth.
As the below chart shows, the MSCI World index was up by 9.94 per cent – in sterling terms – during the first quarter of the year as the S&P 500 soared by 10.91 per cent.
Performance of indices during Q1
Source: FE Analytics
GAM group chief economist Hatheway said that the main cause of better performance during the early part of 2019 had been the removal of political and policy uncertainty, which caused last year’s slowdown in global growth momentum.
However, Hatheway said GAM’s asset allocation committee had decided by mid-Q1 that the equity market recovery was unlikely to continue even if conditions remained benign.
Having earlier noted that decelerating earnings growth and rising multiples would likely stall the market’s advance or even lead to a pullback, Hatheway said the catalyst arrived in the form of a breakdown in trade negotiations between the US and China on 6 May.
US president Donald Trump signalled that he would be raising tariffs on $600bn worth of Chinese goods from 10 per cent to 25 per cent, sparking a sell-off in markets.
This he said unnerved investors concerned of a “tit-for-tat escalation of tariffs between the two countries”.
“The timing could not have been worse, coming as it did at the end of a supportive US first quarter earnings season and during a lull in key macroeconomic data,” said Hatheway. “Moreover, investors have been too quick to count on the US Federal Reserve and other central banks for relief.”
The renewal of trade hostilities between the US and China – which responded to the US decision by levying tariffs of 25 per cent on $60bn worth of US goods – had a greatly unsettling effect on markets.
As the below chart shows, over the past month the S&P 500 index has fallen by 6.68 per cent in US dollar terms, while the MSCI China has sunk by 13.52 per cent.
Performance of indices over 1mth
Source: FE Analytics
While the return of protectionism – in the form of renewed hostilities between the US and China – “casts anew a shadow over the global growth outlook”, there are a number of other factors that are also causing greater challenges for investors.
The return of the US-China trade dispute and protectionism has also been accompanied by other market-impacting factors with renewed uncertainty in the UK over Brexit, doubts over the central bank policy and fears that Chinese growth could slow substantially.
While the Fed halted its drive towards policy normalisation, it remains to be seen whether the central bank will step in to offer further support for markets.
Hatheway said it will likely take a larger erosion of asset prices, confidence and growth for central banks to consider further easing this year.
The GAM chief economist said rising trade tensions had arrived as earnings growth – as represented by S&P 500 constituents – slowed to 1 per cent
As such, the strategist said an earnings recession was a key risk to markets over the next two quarters and noted that appetite for equity risk has evaporated.
As such, the GAM asset allocation committee has concluded that support for global equities is waning, adding that a “defensive stance remains warranted and it is premature to re-engage in risk assets”.
“Owing to the absent news of a credible trade deal between the US and China, the asset allocation committee feels caution remains appropriate,” said Hatheway.
Within strategies that aim to minimise drawdown or those with target return, the firm has aimed to neutralise equity directional risk. Its preferred factors are quality and minimum volatility, while value and cyclicals remain underweight.
“Where we hold equities, we prefer allocations to companies, sectors and styles most likely to deliver resilient earnings,” said the economist. “We have a preference for companies with high and stable profit margins versus those with low and variable margins.”
Within the fixed income space, GAM has a preference for shorter duration specialty credit – such as mortgage-backed securities and insurance-linked bonds – which are weakly correlated to bond and equity market direction.