Markets lifted by US-China trade and Brexit breakthroughs but deep economic risks remain

Receding political risks look likely to keep market spirits up for the rest of 2019 but be warned: global growth continues to slow and corporate investment remains weak while the props for growth – reforms, tax cuts, fiscal spending – look shaky

Kerry Craig

Published: 11:00pm, 25 Oct 2019

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As we enter the last quarter of the year, investors are beginning to speculate on whether equity markets will enjoy a lift into the end of the year. Bond yields and equities are indeed rising, and investors are starting to worry less about the risks to the market and the economic outlook, nearly all of which are political. So, what is behind this lift in market spirits?

For a start, political risk has been alleviated. The phase-one trade deal between the US and China was welcomed by markets, even though it lacked detail on many of the real sticking points in negotiations. There is an increasing chance that the agreement will be formally signed in the middle of next month at the Asia-Pacific Economic Cooperation meeting in Chile.

While the deal may be light on substance, it does suggest that phase two will follow and that, in the meantime, there will at least be a hiatus in the escalation of tariffs between the two nations.

Then there is Brexit. British Prime Minister Boris Johnson has managed to do something his predecessor could not, and get Parliament to pass an action on the path towards Brexit. The outcome is still far from certain, but it adds to market sentiment that political will is converging rather than diverging.

Overall, Brexit has been a fascinating political soap opera that has created a big splash in financial headlines, but small ripples when it comes to the effect on global markets.

Underpinning this is the expectation that central banks will continue to play a supporting role in keeping growth ticking along and that, even if they are not meeting inflation targets, are at least keeping deflation forces at bay.

Based on the central banks monitored by the Bank of International Settlements, over the first nine months of this year, there have been 38 cumulative rate cuts across the globe. More will follow.

The market widely expects the US Federal Reserve to cut rates again at its October policy meeting. At the time of writing, the Fed Funds futures market was pricing a more than 90 per cent probability of a 25 basis point rate cut.

Even with the expectation of further rate cuts, bond markets are sending a slightly better signal that perhaps a recession should not be the base case.

Back in late August, the US yield curve briefly inverted as the spread between 10-year and two-year government bonds became negative. This, in the past, has signalled a coming recession. But the spread has since widened as the yield on 10-year bonds rose above the yield on two-year bonds.

However, a word of caution. The reality is that while some of the biggest risks facing the global economy and markets have receded, the danger posed by slowing global growth momentum remains. The epicentre of the slowing is the weakness in corporate investment, which has reverberated around the globe and is having a clear impact on earnings.

The US earnings season is still in its early days but while a series of higher-profile earnings have beaten expectations, buoying equities, the overall trend is downwards. Combining the reported earnings so far with analyst expectations for the rest gives an overall earnings per share growth of minus 2.8 per cent, year on year, for this quarter.

While this negative number could become positive over the course of the reporting season, it is unlikely to be very strong and expectations for the coming year are being revised downwards.

Why Europe should join the US, UK and China in quitting austerity

At the same time, economic reforms, tax cuts and more government spending are needed to support global growth. These kinds of changes require a shift in mindset and a great deal of political will, both of which can be challenging.

There is renewed sentiment for riskier assets as we enter the final quarter of the year. Reduced political risk has the potential to keep markets elevated.

But while sentiment can change quickly, we should recognise, and focus on, the underlying trends – of slowing global growth and a greatly reduced environment for corporate earnings growth. These should moderate our expectations for market returns.

Kerry Craig is a global market strategist at JP Morgan Asset Management

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