Macro

Music is wonderful in that it’s often recycled and reused to create new songs that can give old songs a new lease of life. It’s also a painful reminder of getting older, as I recognize more music not for being the latest chart topper, but for the much older song usually heavily sampled in making it. Such is the case with the latest pop hit to draw heavily on the now 30 year old Soul II Soul classic Back to Life.

Similarly, markets are moving back to life and back toward the cycle as the last quarter of the year rolls on. Bond yields and equities are rising and investors starting to worry less about tail risks to the market and economic outlook, nearly all of which are political. What’s behind this foot tapping lift in market spirits?

Alleviated political risk. The phase one agreement between the U.S. and China was welcomed by markets, even as it lacked detail on many of the real sticking points in the negotiations. There is an increasing chance that the agreement will be formally signed in the middle of next month at the APEC meeting in Chile. While the agreement may be light on substance, a phase 1 deal suggests that phase 2 will follow and that in the meantime there will be at least a hiatus in the escalation of tariffs between the two nations.

Then there is Brexit. UK Prime Minister Boris Johnson has managed to do something his predecessor couldn’t and get the UK 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 even if not meeting inflation targets are at least keep 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 has been 38 cumulative rate cuts across the globe. More will come.

The market is widely expecting the U.S. 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% probability of a 25 basis point rate cut.

Even with the expectation of further rate cuts, bond markets are sending a slightly better signal and that perhaps a recession shouldn’t be the base case. Back in late August, the U.S. yield curve briefly inverted as the spread in yields between the 10 year and 2 year government bonds became negative. This in the past has been a signal that a recession was coming. But since then the spread has started to widen again as the yield on 10 year bonds has risen by more than the yield on 2 year bonds.

A word of caution.

The catchy hook often sampled from Soul II Souls song is ‘back to life, back to reality’ and the reality is that while some of the biggest downside risks facing the global economy and markets have receded, the slowing global growth momentum has not. The epicentre of the slowing is the weakness in corporate investment, but has reverberated around the globe and is having a clear impact on earnings.

The earnings season in the U.S. is still in its early days. While a series of higher profile earnings beats have buoyed equities, the overall trend in earnings is down. Combining the reported earnings so far with analyst expectations for the rest gives overall earnings per share growth of -2.8% year-over-year for this quarter. While this negative earnings growth number could become positive over the course of the reporting season, it’s not likely to be very strong and expectations for the coming year are being revised down.

There is a renewed sentiment towards riskier assets as we entered into the final quarter of the year. The moderating of political risk has the potential to keep markets elevated heading into year end. But while sentiment can change with the latest news, we should recognise, and focus, on the underlying trends when approaching this market. Those trends are of slowing global growth and a greatly reduce environment for corporate earnings growth which should moderate our expectations for market returns.

The lyrics may change but the music stays the same.



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