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Market Insights – 6th of May 2019

Each week, a team of experts shares its market views with you.

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Essentials

President Trump changed his tone on trade negotiations with China and threatened to raise tariffs – but it’s too early to tell whether this is just a negotiating tactic. However, both countries are in a stronger position in this last phase of the trade talks, thanks to the stimulus programme in China and the pause in rate hikes in the USA.

In the USA, job creation largely outstripped economists’ expectations, with 263,000 new positions created in April. Unemployment fell again to reach 3.6% – its lowest level since 1969. Additional good news came from the latest wage figures, which showed a modest 3.2% uptick, meaning the impact on inflation will also be muted.

In the UK, some of the uncertainty surrounding Brexit has faded, helping to strengthen the pound. This most likely reflects the EU’s agreement to extend the deadline until October, as well as the prospect of constructive discussions between Prime Minister Theresa May and the head of the Labour opposition party in order to prevent a no-deal Brexit.

Temporary, but relatively

 Last week’s Federal Reserve meeting turned out to be much ado about nothing. The central bank decided to keep its federal funds target range unchanged at 2.25%–2.50%. After once again stepping up the pressure on Fed Chairman Jerome Powell over the past few weeks, President Trump can take some comfort in the fact that the central bank lowered its interest rate on excess reserves slightly, from 2.40% to 2.35%. So both sides have saved face. But the battle to maintain the Fed’s independence has only just begun.

In his post-meeting statement, Mr. Powell was apparently addressing the White House’s criticisms of the low inflation figures in the USA when he said that the recent slide in consumer prices is probably only temporary. But that overlooks the fact that the USA – like the rest of the world – is caught in a long period of disinflation that began nearly 40 years ago.

At the time, “monetarism” economists like Milton Friedman said that inflation was purely a monetary phenomenon and could be regulated by altering the money supply. And by adopting this theory, authorities were able to end the widespread hyperinflation triggered by the first oil-price shock. However, today inflation is still at rock bottom after over a decade of ultra-loose monetary policies from central banks, which – behind all new monetary policy acronyms – are basically printing money. And the printing press will probably keep running because, however little Mr. Powell may like it, major structural changes are under way that will maintain the disinflationary pressure: globalisation, e-commerce, automation, robotics and the digitalisation of huge swathes of the economy.

These trends will keep the lid on production costs and retail prices for goods and services around the world for some time to come. In addition, productivity is once again increasing thanks to investments companies have made in their production facilities. In the first quarter, US productivity grew 3.6% and unit labour costs shrunk as the economy nears full employment. Soon President Trump will find that the “temporary” dip in inflation has lasted too long – and will certainly bring that to Mr. Powell’s attention. But the most important thing for equity investors is that interest rates have stopped rising.

No US earnings recession in the first quarter

 

Nearly 80% of S&P 500 companies have reported their Q1 2019 earnings so far, and we can already rule out an earnings recession, which had been feared by the most pessimistic investors. Although US corporate earnings will probably come in 2% higher year on year, this is much lower than the 20%+ growth rates seen in 2018. Not only has the boost from the tax reform faded, but higher hourly wages are squeezing companies’ profit margins. Business levels nevertheless remain high ,with revenues growing at a solid 4.6% in the first quarter. The best-performing sectors were health care and communication services, which reported top-line growth of 17% and 10%, respectively.

These good surprises reflect the overly bleak outlook that investors and analysts had adopted at the start of the year, when analysts slashed their Q1 earnings growth forecasts. This made it easy for companies to beat expectations, with some 75% coming in ahead of consensus estimates. But investors will become increasingly demanding as the year progresses: the bar is still fairly low for Q2, but expectations for the second half are too optimistic in our view and pave the way for disappointment.

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