Tactical Asset Allocator: US sets pace but risks hard to weigh

The US economy is growing, but slowing jobs growth, higher oil prices and interest rate hikes suggest near-term risk ahead.

Stock markets can be perverse. Having been braced for the fallout from the US administration’s decision to exit the Iran nuclear deal and impose severe sanctions, the S&P 500 index has surprised everyone by surging ahead. In fact, while the market plummeted during president Trump’s speech announcing the move, it finished the session higher.

There seems to be genuine lack of consensus about how to read international situations, or even how to view some basic economic data. Employment ratios are high, consumer spending is relatively buoyant and demand for commodities is strong – which are all positive because these conditions support the argument that the economy is growing.

However, if you look at the medium-term trajectories, interest rates are rising, jobs growth is slowing and oil prices have spiked to a three year high – and each of these factors could deliver more immediate pain than the circumstances in February that rattled the markets.

One big difference between now and February is the level of confidence about corporate earnings. Goldman Sachs has calculated that even accounting for elevated expectations at the start of the earnings season, 55 per cent of S&P 500 companies managed to beat earnings expectations this year. On this basis, the US market is no longer expensive, trading at around 17 times projected 2018 earnings, which is more or less the historical average. Moreover, in periods of low inflation, price/earnings multiples tend to be higher.

As well as earnings announcements that have surprised on the upside, a number of political speedbumps have recently been dismantled. For example, Trump has pulled back from his earlier threats to the drug industry, such as tougher pricing negotiations and a duty for Medicare Part D healthcare plans to share the discounts they receive from pharma companies with patients.

Big pharma’s relief

As president, rather than campaigner, he is no longer pushing for the federal government to negotiate prices directly with drug manufacturers, as happens in other developed countries. There has been no discussion of allowing imports of cheap drugs from other countries, nor of radically redesigning the patent system, which could be a quick way of bringing prices down. The pharma industry’s relief is reflected in the portfolio’s iShares US Pharmaceuticals ETF, which has risen since our valuation update on Friday.

This need to focus on the US is now a way of investment life, so it’s different from a few years ago – but Wall Street increasingly sets the tempo for global large-cap stock stories, partly because the world’s largest companies are getting more powerful, and also because their fortunes are now at the mercy of a single loose cannon in the White House.

While developed markets tend to echo the US, emerging market equities, bonds and currencies have suffered since the US dollar strengthened a month ago. Rising oil prices have hit heavy importers such as South Africa, Turkey and Poland. Russia is a particularly difficult market, prone to political sell-off and still in pugilistic mode over the Skripals’ poisoning in Salisbury.

However, tension across Asia had been tempered by the announcement of the meeting between Trump and Kim Jong Un in Singapore on 12 June, the first meeting between a North Korean leader and a sitting US president. Moreover, lower than expected inflation in the US is a positive for Asian equities; and higher oil prices have bolstered the attraction of some countries such as Mexico, so it may be worth watching currencies such as the Mexican peso for signs of changing sentiment.

Nearer home, the strength of European markets has confounded expectations this year. For example, US hedge fund Bridgewater Associates has admitted it placed $22 billion of short bets against the Euro Stoxx 50, which have since gone sour.

Of these markets, the UK still looks cheap compared with the rest of the world, with average price/ earnings multiples of 14, as prices have been driven down by Brexit tensions. The challenge in increasing a portfolio’s weightings to the UK is that a global stock index like the FTSE 100 depends on a myriad of factors, with more than two thirds of its constituents’ profits coming from outside the UK. The FTSE 250 is much more focused on the UK, and is better diversified over different industrial sectors, which is why Lyxor ETF FTSE 250 is our core UK position in the portfolio.

Overall, however, current stock markets are very difficult to read. There are lots of imponderables to take in, such as the extent to which corporate buybacks are countering fund outflows. The Vix index of expected market volatility isn’t particularly helpful either. It’s unreasonably low at 12.6, well short of its longterm average of around 20, let alone the 50 it reached in February. One chain of events we can be sure of, however, is that interest rates will rise in the medium term. This could boost gold prices, particularly in view of potential crises in the Middle East.

Gold speculators have also been reducing their positioning, but that could reverse if the Fed signals a more relaxed attitude to inflation, particularly now the important $1,300 barrier has been breached. We are therefore topping up our holding in the iShares Physical Gold ETC

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