Early wobbles in the risk mood - China returns next week

Friday, 8th February 2019 14:33 - by Shant

Early wobbles in the risk mood - China returns next week

It is fair to say that after the sharp losses seen in the major stock markets at the end of last year, we have somewhat reverted back to type, notwithstanding the predictable effect of a dovish Federal Reserve which has now suggested they are ready to pause the quantitative tightening process and resume full reinvestments.  This is all well and good as a short term fix, helping to re-establish some of the norms - effectively, that of cheap liquidity inflating valuations as a purely mathematical function.  

Late yesterday, however, we heard the US president confirm that he will indeed not be meeting China's premier Xi for discussions on trade before the 01 March deadline on tariffs, so this naturally led to some profit taking as the Wall Street indices - again rather predictably - reacted to short term news.  The fact that this raises the prospect that tariffs will go ahead, and that an escalation of protectionist measures will destabilise sentiment on the global economy which is already at a low point in the current market psyche.  With China off this week celebrating the Lunar New Year holidays, we can perhaps expect volatility to pick up on their return next week.  

For now however, we have to consider the level of the recovery and just how far this is reflected in terms of valuation (based on the capital cost of money) and forward earnings.  A key feature of the argument against the meteoric rise in equity prices is the level of forward-looking optimism in sales and volume demand.  While this has been mixed in more recent times, there is a layered system on which the slowdown process gradually has an effect.  As we saw from the miss on from Caterpillar last week, along with warnings of reduced demand from China, on a wholesale level (for want of a better word), the signs that the first wave of economic weakness is starting to hit the Chinese economy.  As a bellwether for infrastructure spending, Caterpillar's outlook on China should be a major alarm bell which is at present, being ignored.  

Apple has been the more high profile name to be affected by the slowdown in China, but this is the early part of the trickle-down effect, while other companies such as automotive parts suppliers such as Delphi have also been feeling the heat given the constraints and slow deterioration in production.  Deere and Co and Honeywell International Inc are other big names who are suffering from the early stage process.  

Add in the effects of trade tensions, and the market is also underplaying the potential multiplier effect this can have on global growth which can only have a negative impact on valuations based on the above assumption that forward pricing has been overstated by some way.

Against this, certain consumer names have reported ongoing positive results, and this is a natural effect of the wealth process which has proliferated in China as a result of decades of economic growth.  Remember, China still enjoys a growth rate of 6.0% which based on recent projections, is the envy of some of the developed economies in the west.  Consumer names are still enjoying the benefits of a late cycle demand, which will at some point begin to top out.  Alibaba beat estimates on earnings, but also warned of the effects of economic deceleration in China.  

This is not a time to consider the latest upturn on Wall Street as the start of a fresh wave higher.  Far from it. Once again, looking across some of the other asset classes, we can see that if there was genuine optimism going forward, safe havens like Gold would be taking a back seat.  In the foreign exchange markets, funding currencies in the carry trade are also looking better supported given the traditional correlations with stocks.  These are clear signs of scepticism - not to be ignored.  

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.