This article first appeared in Personal Wealth, The Edge Malaysia Weekly on July 29, 2019 - August 4, 2019

The bull market in the US is set to continue due to strong economic fundamentals and a looser monetary policy environment, according to Kenneth J Taubes, executive vice-president and chief investment officer at Amundi Pioneer Asset Management.

Diminished expectations of a rise in US interest rates this year has helped to reduce equity market volatility in recent months. Taubes points out that on average, stocks listed on the various exchanges are trading at an average of 18 times earnings.

“Given the current inflation environment and margins, the price-earnings ratios are right where they ought to be. They are not overpriced. One could even argue that they are a little under where they could be,” he says.

“If the inflation rate were 3% to 4%, 18 times earnings would be very expensive. But with inflation at less than 2%, 18 times is not very expensive.

“The market is not monolithic. There are different sectors and different types of companies. When you look at the equity market, growth companies in general have way outperformed value stocks.

“Value stocks are typically the most sensitive part of the market because with slower growth their earnings are low. These are companies in industries such as chemicals, manufacturing and financials.”

Stock markets in the US have hit record highs in recent weeks, with the Dow Jones Industrial Average breaking above 27,000 points and the S&P 500 crossing the 3,000-point mark. The outperformance of the indices is said to be in anticipation of an interest rate cut by the US Federal Reserve at the end of this month.

The Fed’s decision to hold off its quantitative tightening (QT) is also expected to lift the pressure on emerging markets (EMs) as interest rate hikes add stress to their currencies. “To an extent, the Fed has stopped and [is expected to] even cut interest rates a little. This will help central banks in EMs to also cut their interest rates. A turn in the cycle will be good for the region and may actually strengthen some of the EM currencies,” says Taubes.

The main catalyst for a reversal of slowing global growth is the end of the trade tiff between the US and China. Once the two economic giants come to an agreement, investors will be able to anticipate better growth, says Taubes.

“A lot of countries trade with the US. So, the fact that the US economy continues to chug along is a good thing, especially with China slowing,” he adds.

Despite the fact that there is no end in sight in terms of a conclusive trade agreement, it is in the interests of both countries to resolve the standoff, says Taubes. “US President Donald Trump was elected on his ability to negotiate trade agreements and improve the economy. He is supposed to be a great negotiator and his campaign promise was to fix these trade issues.

“If he is going into the next election in 2020 with a mess in a trade that is causing a slowdown in the US economy, he will not get re-elected. Hence, he cannot afford to leave this mess. Eventually, he will want to cut a deal.

“The US economy is like a gigantic ocean liner. If this is still a mess next spring, which is a year from now, Trump will not be able to turn the economy around in two or three months. He needs to get the agreement or the certainty in place before the end of this year so there is enough time for businesses to digest it. Only then will the deal have a timely economic impact.”

China President Xi Jinping also needs to cut a deal as the tariff conflict between the world’s two largest economies is exacerbating the Chinese economic situation, says Taubes. “Despite the fact that Xi has a certain amount of leeway and power, he is still not politically insensitive to what is going on in the country. He needs strong growth to maintain stability in the country. So, he is motivated to get a deal done too.

“The Chinese negotiators would be in error to wait for the next US president, if Trump is not re-elected, to negotiate the agreement because this is the one issue the Republicans and Democrats agree on. They are aligned in their view that the Chinese are taking advantage of the US system. In fact, the Democrats are more hostile towards free trade than the Republicans.”

Taubes says the Democratic candidates are bound to learn from Trump’s previous campaign. “He won because of votes from heavily industrialised and unionised states such as Pennsylvania, Wisconsin and Michigan. These people used to vote for Democrats, but they did not vote for Hillary Clinton because they could relate to Trump’s message.

“I think the market is anticipating that the trade agreement will get done. The US market would not be trading near its all-time highs if it thought the deal would not get done.”

No sign of US recession

Taubes says the US economy has remained stable so far, even though talk of an impending recession has cast a cloud on economic expansion. “Personally, I do not anticipate a recession in the US this year. The worst we could expect is a slowdown. The Fed’s QT is still a bit of a drag.”

Contrary to the popular notion that the slowdown is due to the ongoing trade talks, Taubes believes that the reverse quantitative easing (QE) is partly the reason for the slower growth as the measure has reduced the amount of liquidity in the US. “I suspect that it is the lag effects of the tighter monetary policy as well. The Fed has been shrinking its balance sheet for some time now. It is still happening, although at a diminished rate. [It has indicated] that it will stop at the end of the year,” he says.

“The Fed created so much excess liquidity through its QE over the years that there is quite a build-up of excess reserves in the banking system. Technically, there is a large stock of excess liquidity unused in the real economy.

“The economy has been living off it for some time, but I think it is beginning to dry up a bit. At some point, the Fed will need to rethink its policy and that is why it said it would stop the QT. Nevertheless, the QT has not had the tightening effect that the market may have expected because there was so much surplus liquidity in the banking system over the last few years, allowing the banks to draw on it.”

Taubes points out that the spread of US high-yield corporate bonds is still rather narrow despite being susceptible to economic conditions. “The fact that the high-yield spread is still very close together regardless of the Fed’s tightening suggest that credit conditions are not that tight. The actual yields or interest rates that companies have to pay to finance themselves have not gone up — it has gone down,” he says.

The recent inversion of the yield curve, which used to foreshadow a recession in the past, is not enough to promise a recession, says Taubes. “First, there are parts of the yield curve that have not completely inverted. In fact, the curve has steepened a little over the last few weeks, maybe in anticipation of the Fed’s monetary policy easing measures.

“Generally, when the Fed [policy] is really tight, you will see that part of the curve goes flat as well — it is not inverted. Now, we have positive 50 basis points (bps) as a slope. I think the yield curve is telling us that things are slowing, but there is no recession yet.”

Credit spreads — which is the difference in yields between a US Treasury bond and another debt security of the same maturity but different credit quality — is a good leading indicator, says Taubes. “Historically, credit spreads widen a fair amount — at least 6 to 12 months — ahead of a recession. We are nowhere near those kinds of spreads. It has not happened.”

Rising energy prices and interest rates are the other causal effects of a recession. However, global crude oil prices have taken a dip since the beginning of the year while US interest rates have declined more than 100bps since last year.

“Companies are not only paying less for interest but consumers can now buy a house and get mortgage financing at 100bps cheaper. If you look at coincidence surveys of mortgage applications, they have begun to go up quite a bit for housing turnover and housing refinancing. That is also a positive economic leading indicator [as housing has a large multiplier effect],” says Taubes.

“The consumer continues to be in very strong shape as well because income is rising — not just wages — at over 3%. Inflation has come down, not gone up. Often, a sharp rise in inflation precedes a recession.

“Some of the surveys are suggesting slower economic growth. These are not so much the hard data, but surveys like the Purchasing Managers’ Index. I guess durable goods orders have been weak, but the consumer segments are still in a pretty good shape.”

The US manufacturing sector grew at its weakest level last month since 2016, according to a survey conducted by the Institute for Supply Management. But Taubes believes that the weak manufacturing data is due to an inventory build-up in the first quarter of this year.

“Companies are probably cutting back on production to work off the inventory and consumption is better this quarter than in the first quarter. I think the real slowdown is related to uncertainty surrounding the trade war because if you are in management and you are planning to build a plant here [in the US] and invest in equipment, you need to know with some certainty what will happen — what your cost is going to be, what the best location is and so on,” he says.

“One other positive development in the US that is not getting a lot of coverage is that the domestic productivity trend has improved. Productivity has been weak for many years. I think it bottomed out at about 0.7% year on year (y-o-y) in 2018, but is now up to nearly 2% y-o-y. That is a very positive development.”

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