Capital markets have yet to enter into an early festive spirit.
The first week of December made for a bad start in risk assets.
As we have written before, expectations of future US-China trade relations are vital to market sentiment – and we've seen a blow in that regard.
President Trump has indicated a trade deal between the world’s two largest economies might have to wait until after the presidential election in November 2020.
Markets, on the other hand, had effectively priced in a deal in the next few weeks or months.
That disappointment will sting, given the current economic backdrop.
We have sensed that markets appear to be ‘frontrunning’ the economy by pricing in a more imminent recovery from the global economic slowdown than the data currently suggests.
Equity valuations have risen close to where they were during the heady days of late 2017.
Sure enough, stockmarkets around the globe fell 2 to 3 per cent at the beginning of last week – testament to the fact that investors are feeling a little nervous about their optimism.
Cash buffers and the 'Santa rally'
The year-end can make for a rather odd time in capital markets.
Tighter liquidity conditions and the ‘Santa rally’ phenomenon tend to drive returns more than underlying fundamentals.
In particular, investment managers who may have missed out on the rally during the rest of the year often feel the need to join in.
At the opposite end of the scale are investors, often institutional, who either have a requirement to hold specific cash levels at year-end, or are inclined to ‘bank’ the year’s returns by crystalizing the gains.
There are reasons for taking both positions, as it has indeed been a good year.
Investors with globally diversified investment portfolios should have seen double-digit returns in 2019 – barring those with the lowest risk profile.
Beyond the Trump-induced market wobble, one of the more interesting recent trends has been the strength of £-sterling, despite (or perhaps because of) the upcoming election.
For the last three and half years, currency valuation has been the primary method through which investors express their expectations on Brexit.
The likelihood of a harder Brexit has forced sterling lower, while the prospects of a softer Brexit have driven it higher.
But on the face of it, the current sterling rally has to do with the increased (implied) likelihood of a Conservative majority, despite Boris Johnson being the hardest Brexiteer of all major party candidates.
The theory is that with a sizable majority, Boris Johnson will be able to pursue a more pragmatic (softer) Brexit than some on the fringes of his party would prefer.
There is perhaps some truth to this.
But we believe a better explanation is the growing risk appetite among global investors.
With investor risk appetite firmly returning, high-yielding assets are now in high demand, and UK credit and equity fits that bill.
Since the 2016 Brexit referendum, British assets gradually became seriously undervalued compared to their global peers, so the general brightening of markets’ global economic outlook has benefited them more than others.
Perversely, the largest capital flows into British assets seem to be coming from European investors, with sterling’s rally against the euro outpacing its US-dollar gains.
However, Brexit is still the spanner in the works for any potential sustained rally of UK risk assets.
The binary outcomes of this week’s election (large Tory majority versus a hung parliament) is more positive on that front.
The other likely outcomes (a small majority or minority Tory government) are less so, as in these scenarios Conservative Brexieers have more power.
Given that we'll know much more about this very soon, we'll refrain from delving into it too much.
What we do expect is that even if we get a surprise result of a hung parliament, any market volatility should be brief, as it was after the 2016 referendum.
The inevitable compromises that would result from that would likely dawn on investors as a positive, at least as far as a pragmatic Brexit is concerned.
Global trade and Trump's trade wars
Taking a more global view, there is still a lot that could upset nervous markets.
President Trump is preoccupied with both impeachment proceedings and with getting re-elected. This is a negative for the global trade picture.
So too is the news that Chinese tech giant Huawei could be shut out of western payment systems.
The US Congress is also following up its Hong Kong Human Rights and Democracy Act with an Uyghur Act against China’s human rights abuses in Xinjiang.
These are obviously important issues, but they dampen any prospect of a trade deal between the US and China, which is investors’ biggest concern.
But the muted market reaction to Trump’s 'couldn’t care less' trade deal attitude is revealing.
Positive economic data needs to come through sooner or later to support the ongoing risk sentiment, and there have been tentative signs that it will.
The market expectation that 2020 will see a return of higher growth rates across the global economy is increasingly supported by the data.
This will provide support for risk asset valuations, but will be bad news for safe haven investments like government bonds.
Lower levels of fear, together with a return of inflation pressures and growth prospects, make their meagre yields more painful to accept.
Global trade has indeed been hurt by Trump’s trade wars.
But the near-term resolution which markets were looking for may not even be needed now.
If the sentiment-driven rally in risk assets morphs into a data-driven rally, we can have more confidence that it is sustainable.
We take heart in some improvements in the autos sector, which has previously been the laggard this year.
Current data indicates a running down of manufacturing inventories in Europe and Asia, suggesting a rebound in demand. This is in an early and fragile state, but is positive nonetheless.
The Christmas shopping season will be vital in showing markets whether their faith is justified.
Seasonal effects make economic performance hard to judge around this time, but markets will be expecting an uplift, not a ‘Scrooge Christmas’.
We will have to wait and see. In the meantime, the next couple of weeks could be choppy for markets.