Q2 Market Commentary: Navigating dark times the right way

In one scene in Harry Potter and the Goblet of Fire, Albus Dumbledore, the famed headmaster of Hogwarts School of Witchcraft and Wizardry, said: “Dark times lie ahead of us and there will be a time when we must choose between what is easy and what is right.”

The dark times could be a possible slow-down in the global economy. Unpredictable politicians and ongoing concerns on a trade war make things look worse. Jerome Powell, chairman of the Federal Reserve in the US, is concerned enough to indicate that US interest rates need to be cut in order to avoid a recession. In just over 3 months, the probability of a rate cut in the next Federal Reserve meeting has gone from 0% to 100%.

The expectations of dark times also exist in the rest of the world. Europe has signalled that they are ending “quantitative tightening” and need to consider stimulus again. In the UK, economists are trying to assess the economic impact of a possible no-deal Brexit. China is also trying all types of measures to make sure its economy does not have a hard landing.

Alas, central bankers seem to have forgotten what Professor Dumbledore said after mentioning dark times. We must choose between what is easy and what is right. Central bankers may think cutting rates is the right thing to do. The thinking being that low interest rates allow for lower borrowing costs on things like mortgages and business loans, and thus easier economic conditions. Rather, it looks like an easy solution that only kicks the can further down the road.

Over the last decade, asset valuations have gone up as investors look for yield when interest rates remain low globally. Witness the growing flows into exchange traded funds and high share prices of large companies in major indices. An easing of interest rates will keep this trend going.

We think the worry of a recession is overblown. True, there are uncertainties, especially in the UK. But things are probably not as bad as economists think. Economic data, especially those “leading indicators” that have good predicting power on economic growth, are pointing to a slow down, but not a recessionwhere economies contract. Rather, we are entering into the last phase of the economic cycle.

In this environment, where financial markets are expecting interest rate cuts, stock and bond prices will likely remain strong, although the pace of appreciation may slow down. But if economic growth, and hence company earnings, turns out to be fine, which frequently happens in a late stage of an economic cycle, the rate cut expectations will likely be reversed sharply again. This can cause a correction (but not a crash) in the market, similar to what we saw at the end of 2018. For this reason, it is time to shift away from large companies that dominate indices to defensive strategies that invest in companies whose share prices look undervalued.

For UK investors, it is time to remain diversified. Investors should not avoid the UK completely. But they should allocate to investments in the US and Asia as well, especially  those investors who are looking for long term capital growth. Meanwhile, fixed income looks overvalued, especially since there is a risk that this easy way of cutting rates is going to sow the seeds for inflation in later years.

Investors should take the right way, not the easy way, in the current environment. That means remaining diversified, not being over-pessimistic on the economy, but being prepared that the authorities can make policy mistakes by going defensive.

Written by James Chu
Head of Investment Strategy & Structured Investments