Shorten investment horizon, prepare to shift, strategist says
JONATHAN RATNER
The global growth strategy is paying off for investors, as both Europe and emerging markets remain attractive destinations when compared to a relatively expensive U.S. equity market.
But fresh doubts are surfacing when it comes to three drivers of U.S. underperformance in risk markets and the currency: Growth momentum, monetary policy, and fiscal policy.
In terms of growth, after a year of meeting expectations, the U.S. has now joined both the Euro area and emerging markets (EM) with upside surprises. That’s helped cyclicals outperform, bond yields rise, credit spreads tighten, and oil rally.
“Markets are making a lot more sense,” said Jan Loeys, global strategist at J.P. Morgan, noting that stocks are moving more in sync with the growth trade, as equity markets rally to new highs.
Second and third quarter U.S. growth has been better than many anticipated, and while EM continues to be upgraded, the Euro area is drifting back toward projections.
When it comes to monetary policy, the U.S. Federal Reserve and economists have steadily been projecting three to five 25 basis point rate hikes by the end of 2018. Yet rate markets were pricing in no hikes just two weeks ago, and even now are only pricing in one.
“This was partly because the FOMC’s dots of previous year have been steadily above what it actually ended up doing,” Loeys said, adding that inflation’s downside surprise for five consecutive months also played a role.
But with core CPI for August coming in above consensus, the strategist believes the negative momentum for inflation is “probably broken,” even if significant upside isn’t here just yet.
Perhaps the most significant driver of U.S. equity markets since the election of U.S. Presdient Donald Trump — expectations for fiscal reform and tax cuts — has justifiably been met with skepticism of late. Yet the return of what Loey’s calls a “can-do attitude” in Washington could not only drive U.S. stocks higher, but also put some momentum behind the U.S. dollar.
Hope has emerged that a bipartisan agreement can be reached on the status of illegal immigrants who entered the U.S. as minors, while the White House and congressional Republican leaders are promising the release of tax plan details by Sept.25.
Wide-ranging tax reform will be very difficult to achieve, and the odds of significant changes being passed remains low, but they nonetheless look a little more likely.
So if these three drivers all turn more bullish in favour of U.S. growth and interest rates, Loeys expects the U.S. dollar weakness will be the first place to see a reversal. That would see the greenback strengthen vs. the euro and Japanese yen, but also perhaps EM currencies.
“U.S. equities would gain strongly from higher growth and fiscal reform, even as the stronger dollar would take part of this away,” the strategist said, adding that tax reform should boost S&P 500 earnings by US$10, raise index levels, and make domestic companies, particularly small caps, outperform.
Stronger growth, higher inflation, fiscal stimulus and faster rate hikes will likely shorten the economic upswing, not lengthen it, since the U.S. economy and labour markets are already operating above capacity. While this brings forward the timeline for an inevitable recession, Loeys is confident that these factors will “inject adrenaline” into U.S. risk markets.
His advice for investors? Shorten your investment horizon, and be prepared to shift positioning when new warnings signs emerge.