What a year it has been and what a difference a year makes! This time last year, equity markets were in free fall. As of today however, the S&P 500 Index is up +24% year-do-date, and the rally that started in Q1 2009 goes on and on. On the back of three interest rate cuts by the US Federal Reserve (Fed) starting in July this year, easing geopolitical risks, easing trade war risks, and the levelling off of the global manufacturing slowdown - the world's stock markets have enjoyed a stellar year. With all the major central banks of the world once again printing money simultaneously, for the first time since 2008, there are good reasons to believe that rally will be sustained into next year. Given the Fed has moved back from pressing for higher interest rates, the US Dollar may have some downside risk in the very short term. However, I do not see that risk elevated.
Next week, the UK will see a rerun of the 2017 general election, albeit with one crucial change - The Conservatives are under the “new management” of Prime Minister Boris Johnson. Two years on and the election seems to be offering voters the same choice as it offered in 2017 – a Tory party asking voters for a mandate to deliver Brexit, and a Labour leader who is doubling down on his “redistributive” policies. My prediction is…
One potato, two potato…
It’s beginning to look a lot like Christmas, as festive illuminations are aglow again all over London’s streets and ice rinks spring up all over town. Families up and down the length and breadth of the country are drawing up a list for Christmas dinner. Whatever your choice may be for Christmas roast, there’s one thing that’s always on the menu – Roast potatoes. Crispy, piping-hot potatoes devoured with the main meal, with leftovers fried up on Boxing Day as bubble and squeak.
For the early part of this year, I often found myself singing the “One potato, two potato, three potato four, five potato six potato seven potato more” to my three-year-old. Beside it being a Christmas tradition and a perfect counting song for children, the humble potato has made a rather extraordinary contribution to the world, particularly to Europe. Hunger was widespread in 16th, 17th and 18th Century Europe. The Continent simply could not reliably feed itself. The cultivation of the potato changed all that. Compared with grains, tubers are inherently more productive and can grow in almost any climate. In terms of calories, it doubled Europe’s food supply.
The potato was first cultivated in 8,000 BC by the Incas in Peru and brought to Europe in the latter part of the 16th Century by the Spanish who came across the tuber when they conquered the new world – Mexico and Peru. Sir Walter Raleigh introduced the potato to English shores in the late 16th Century. When it was first introduced in Europe, people refused to eat the plant thinking it was poisonous. A largely Catholic population was supported in its dissension of the potato by the Orthodox Church, which argued that potatoes were suspect, because they were not mentioned in the Bible. Potatoes did not become a staple until the food shortages associated with the Revolutionary Wars in the mid and latter part of the 18th Century.
When the European diet expanded to include potatoes, not only were farmers able to produce more food, they now had protection against the catastrophe of a grain crop failure. The higher birth rates and lower mortality rates led to a tremendous population explosion in Europe, the US and the British Empire. The high yields of the potato allowed even the poorest farmers to produce more healthy food than they needed, with scarcely any investment or hard labour. Even children could plant, harvest and cook potatoes - which of course required no threshing, curing or grinding.
The humble spud was therefore the fuel that built Europe and powered the Industrial Revolution, which relied on the supply of plenty and well-fed labour force to work the machines. The potato became the fuel for the Industrial Revolution.
Charles Mann in his book “1493: Uncovering the New World Columbus Created” writes that before the potato (and corn), and intensive fertilization, European living standards were roughly equivalent to those in Cameroon and Bangladesh today. On average, European peasants ate less per day than hunting-and-gathering societies in Africa or the Amazon.
Historian William H. McNeill has argued, that the potato led to empire: “By feeding rapidly growing populations, [it] permitted a handful of European nations to assert dominion over most of the world between 1750 and 1950.” The potato, in other words, fuelled the rise of the West.
British Economist, Adam Smith sang its praises in "The Wealth of Nations," writing that "the food produced by a ﬁeld of potatoes is ... much superior to what is produced by a ﬁeld of wheat ... No food can afford a more decisive proof of its nourishing quality, or of its being peculiarly suitable to the health of the human constitution."
So, this Christmas as you eat your meal, do toast the contribution of the humble spud to Europe and to humanity!
Moving on to the markets
What a year it has been and what difference a year makes! This time last year, equity markets were in free fall with the S&P 500 (SPX) Index falling over -15% in December alone and finishing the year down -6% (see table below)
As of today the SPX is up +24% (YTD, year-do-date) and the rally that started in Q1 2009 goes on and on. On the back of three rate cuts by the US Federal Reserve (Fed) starting in July this year, easing geopolitical risks, easing trade war risks, and the levelling off of the global manufacturing slowdown - the world's stock markets have enjoyed a stellar year. With all the major central banks of the world again printing money simultaneously, for the first time since 2008 and with fiscal policy easing at the same time, there are good reasons to believe that the rally will be sustained into next year.
Benchmark Equity Index Performance (Year-to-Date)
UK elections: inducing voters with their own money
Next week, the UK we will see a rerun of the 2017 general election, albeit with one crucial change - The Conservatives are under the “new management” of Prime Minister Boris Johnson. Two years on and the election seems to be offering the voters the same choice as it offered in 2017 – a Tory party asking voters for a mandate to deliver Brexit, and a Labour leader who is doubling down on his “redistributive” policies promising to renationalise rail, mail, water and gas supply, outlaw private schools, make university education free, offer free broadband to everyone, increase wages of public sector workers, offer free dental checks, have an open immigration system, scrap trident – UK’s nuclear deterrent, take one-third off rail fares and so on and so forth…. The freebies are coming thick and fast, as if a “Closing down” sale had just been announced.
Strangely, the Conservatives did not lose the 2017 election – they won 330 seats to Labour’s 232 seats- yet they have spent the last two years trying to understand what happened. On the other hand, Labour did lose the last election, yet they have acted as if they won and are convinced that it worked for them and have doubled down on “redistributive policies” and un-costed government spending. For every £1 of day-to-day extra spending pledged by the Conservatives in their manifesto, Labour is promising an extra £28, or as I like to call it – inducing UK voters with their own money.
Despite the “free-spending” promises, Jeremy Corbyn’s Labour party trails Prime Minister Boris Johnson’s Conservatives in the polls by around 12 points and Labour’s chance of winning the election outright is as “close to zero as one can safely say,” according to Sir John Curtice, UK’s leading polling guru. But Labour doesn’t need to win to get into office. If the Conservatives fail to get a majority, Labour leader Jeremy Corbyn could still lead a group of smaller parties into power. Come December 12, we will find out if the UK is in for more nationalisation – labour’s announced goal, or privatisation and deregulation – the goal of the Conservatives.
My prediction is that the Conservatives will win a majority of 25-40 seats (with risk to the upside). The new government of PM Johnson will be a radical free-market government that will lower taxes, cut stamp duty on houses, deregulate where required, address the concern of income-inequality and repose the faith in that most important thing – innovation and private enterprise.
Markets and the Economy
As mentioned before, the SPX is up nearly +25% YTD and is headed for its biggest gain since 2013. So what should we expect for next year?
2020 is Presidential election year in the US. Therefore, all eyes will be focused on what happens in the Democratic primary. Senator Elizabeth Warren had the markets and Wall Street worried with her – no fracking and healthcare for all – plan. However, her recent dramatic decline in the polls has been cheered both by healthcare stocks and the market in general. Warren’s probability of winning the Democratic nomination is now down to just 16.5% (see chart below). This is a whopping 36.4% point drop from the high. The only comparable decline is the 32.2%-point fall see for Senator Kamala Harris who, this week, decided to withdraw from the race. That leaves former Vice President Joseph Biden as clear favourite, at least for now. Biden will be seen as a continuity candidate and one that markets will like. Exceptionally low unemployment and no sign of recession will keep President Donald Trump's chances of getting re-elected high. So, in my view, there is little by way of election risk. The US is running the largest peacetime deficit and given the Fed's back to rate-cutting and Trump keen to do a deal with China, the risk to US equities is to the upside.
I expect the SPX to finish next year at 3420 i.e. +10% higher from today’s level, with returns driven by a combination of more stock buybacks, a modest increase in corporate earnings growth as consumer sentiments remain buoyed and cyclical shares performing well.
The only risk to this bullish prediction is the possibility of a far-left Democrat winning the White House. In which case you will be advised to hold on tight to your wallet.
Democratic Primary (% chance of winning)
Source: Bespoke Group
In the September month Market Viewpoints, I wrote:
"Whatever the reason, it seems Trump is willing to make a deal. It is very likely he may wind up delaying the October 1 tariff as well as delaying the December 15 one. Both actions will be bullish for risk assets. No further escalation in the trade spat should be seen as a short term deal. The S&P 500 (SPX) Index could easily attempt a jump to 3100 or higher in October …it is amply clear by now, that Trump will put getting re-elected over everything else and China is not keen to continue sparring either”.
President Trump did delay the tariff that was to come into effect on October 1 and December 15 and as a result the SPX vaulted to 3,100 mid-November. My views on the US-China trade war have not changed and I still see them doing "a deal" as it is in the mutual interest of both countries. The deal, of course, will not be the end of the matter and the US will continue to fight to preserve its lead in the world in technology and commerce, which is under attack by China. I, however, remain positive on the prospect for US equities. My view then as now is based on – the US consumer is in a healthy state, a recession is not on the horizon, the trade war is not getting worse and even the Eurozone is finally joining in the repair work. I continue to believe that equities offer a better return than bonds (particularly in Europe), a point I also highlighted during my interview on CNBC last week.
It was good to see that in the third quarter of this year, US GDP grew by +2.1% (up from the estimate of +1.9%). It's another confirmation that while the recovery is long in the tooth, it hasn't run out of the road by any estimate. Consumer spending drove economic momentum in Q3 and it's likely to continue.
There are three key reasons to believe that US consumers are well placed to keep spending more and therefore the broader consumer discretionary sector looks a good bet:
The job market remains healthy despite weak manufacturing activity and soft capital spending by firms. Consumer confidence readings remain perky, implying that workers are not worried about their job prospects
Since July, the Fed has lowered short rates by -0.75%. As a result, consumers can expect to soon benefit from cheaper loan finance, which tends to follow short rates with a lag of about 60 days. This should give a spur to big-ticket purchases.
Weak energy prices have dialed down inflation and forward-looking expectations of it and this also increases consumer spending power as well as confidence. With oil prices stuck at around US$55 a barrel, US inflation expectations should stay anchored.
So, to summarise,
The US: The Fed is doing Quantitative Easing (QE) again, housing and consumption are booming and yield curves have moved out of inversion
Europe: With a no-deal Brexit off the table, Europe is set for a modest recovery fuelled by European Central Bank (ECB) largess and perhaps some fiscal loosening
China: We inch close to a “phase one” US-China trade deal and a mini rate cut cycle has already begun
Emerging Markets (EM): Low energy prices are a big boost and improving US-China trade relationship will rub off on EMs as a whole.
A co-ordinated monetary and fiscal easing in all big economic blocs means a broad rally is sustainable into Q1 2020 before the election cycle in the US takes over the news flow. Over last two years only US equity returns have been impressive: –
S&P 500 (SPX) Index +16%,
Eurostoxx 50 (SX5E) +4.8%,
MSCI Emerging Markets (MXEF) -10%
Japan (NKY) +1.5%.
Therefore, non-US equities have a lot of catching up to do.
Given the Fed has moved back from pressing for higher interest rates, the US Dollar may have some downside risk in the very short term. However, I do not see that risk elevated.
One big impact of this swing back towards an easier monetary policy is that bond yield curves, after spending much of 2019 inverted, - have now un-inverted and steepened (long rates higher than short rates). Both the US Treasury yield curve and the German Bund yield curve have steepened. This steepening reflects a brightening of economic sentiment and has directly boosted bank stocks and indirectly supported other cyclical stocks that benefit from economic recovery or improving economic sentiments. This is set to continue into 2020.
In continuing positive signs, the New York Fed’s recession probability model (discussed in September’s newsletter) which reached 38% recently continued its downward trend and is now at 29% in its latest monthly update. Keep in mind; this model looks at the 3-month / 10-year yield spread. With this spread now in positive territory, the NY Fed’s recession indicator has likely peaked and a recession has been averted for at least two quarters, if not more.
Democratic Primary (% chance of winning)
In the US, I prefer to be long Financials (XLF), Consumer Discretionary (XLP), Healthcare (XLV) and Industrials (XLI) stocks with an overweight position in Consumer Discretionary and Healthcare as the two sectors play catch up for the year. Individual stocks in the Technology (XLK), Communication Services (XLC) and Materials (XLB) sectors also offer good upside. For specific stock recommendations, please do not hesitate to get in touch.
“On that note, I wish you and your family all the best for this holiday season as well as a very Happy New Year. And if you celebrate Christmas – have a lovely Christmas and enjoy the potatoes!”