Rollercoaster of expectation changes

13 April 2017

For most, the Easter holidays mark the drawing to a close of the year's first quarter. Although I have already, over the past 2 weeks, reflected on what 2017 brought us thus far, it was only over the last few days that things really sprung out. We started the year expecting the biggest political upheaval in decades, but also, economically and in investment terms, a continuation of the strong recovery momentum that had started in Q2 of 2016.

Three months on, it looks more the other way around!

As we move from winter to spring, we see more and more evidence that Donald Trump's tweets and interview statements should indeed not be taken at face value, as he is more than willing to change his views quicker than other people change their shirts. Over the past days, we have learned that Mr Putin is actually not to be trusted, that the US will continue its role as global police man after all, that he regards the Chinese no longer as currency manipulators (as long as they help him contain the North Korea threat), that he actually prefers low interest rates over higher rates (for savers?) and that US Central Bank chair Janet Yellen is - quote: 'not toast'. No wonder Mr Putin complained that he no longer knew where the US administration stands.

It appears to me that since the year began, we have moved from expecting destructive incompetence to experiencing randomly constructive incompetence in the field of foreign policy and a '˜going nowhere' with his domestic change agenda when faced with the realities of a checks-and-balances-based legislative. Make no mistake, the impression of lack of plan, strategy, capable resource and consistency is still very worrisome. But, there is also the distinct impression that the comprehensive, fact-based briefings the new president is now subjected to are beginning to have an effect and are returning US policy somewhat back to the past norm.

For the US economy, capital markets and the US$, the direction of travel has also gone the other way. While, in January, there were expectations that the US$ would continue to rise on the back of US economic growth rates returning to the 4-5% pre-Financial Crisis levels and stock markets rallied in anticipation, since then markets and the US economy have lost much of their momentum, and have entered more of a holding pattern, awaiting new direction.

As I mentioned last week, the quarterly round of corporate results announcements (Q1 earnings season) that has just commenced may prove crucial in this respect. With the macro economic data side being somewhat ambiguous at the moment, hard corporate earnings numbers and outlook statements will help to create a clearer picture about the state of the economy. As we discuss in a dedicated article this week, we are fairly optimistic that earnings growth will have been strong. But whether it is strong enough to not disappoint the high expectations from the beginning of the year, and the stock market valuations this generated, is a different matter.

We are hopeful that the substantial improvement in business sentiment over the past 12 months will counterbalance the slight flagging of consumer demand, resulting in still healthy earnings growth. This may be sufficient to underpin current stock market valuation levels in the US and provide further upside dynamic for the lower valued European and Asian markets. This has also the potential to change recent exchange rate parities, as we are discussing in a further article this week. If Europe and Asia overtake the US in growth terms, then there is in our view a high probability that the US$ will continue to decline from the high it reached at the end of last year.

Unfortunately, there is also a pessimistic scenario for the shorter term, where markets are disappointed by the US results and enter a correction which then spreads around the globe - as we experienced before. However, since this would most likely be merely a correction from elevated US valuation levels, rather than a prolonged bear market because of declining economic prospects, we would expect a fairly swift recovery. Such a recovery would then be likely to provide the catalyst for a change in market leadership. The US markets would be unlikely to recover quickly back to their previous highs, while the European and Asian markets would have the potential to go further.

So, either through currency movements or market gyrations, we expect the capital market leadership to pass on from the currently very optimistically priced US stock market.

Where does that leave our home market, the UK? Well, as so often, most likely somewhere in the middle. UK consumer demand has, similarly to the US, slowed, but business sentiment is improving. The latter is most likely to do with the economic acceleration in the Eurozone, with UK businesses currently enjoying the paradoxical, yet enviable position of still being part of this biggest free trade zone in the world, while operating with pricing advantage of a currency that has already substantially devalued in anticipation of leaving the EU in 2 years.

The chart at the top shows roughly the returns corridor UK investors in risk profiled portfolios similar to the ones Tatton manages would have experienced over the first quarter. The fact that the lines don't cross informs us that it has been a benign investment period with decent returns. Easter 2017 we find us at a crossroads - if previous expectations have to be scaled back, then these lines could get a whole lot more volatile. But equally, if companies can positively surprise, then there is potential for gradual upwards movement to continue, even if the regional market leadership is still likely to change.

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