Market Commentary: March 2018
03 Jun 2020
2018 began much as 2017 ended, with good gains for investors willing to accept a modicum of risk. Once again, however, there was little sense of euphoria.
This happy equilibrium was shattered at the beginning of February by one piece of US economic data. Annual wage growth jumped from 2.5% to 2.9%, igniting inflation fears and setting off a chain of events that culminated in a 10% correction for many equity markets around the world. The jump in wages was interpreted as a precursor to higher inflation, which would be driven by companies raising prices to preserve their margins, which in turn would spur even higher wage demands. The potential for higher inflation would force the Federal Reserve to raise interest rates, thus dampening economic activity. Bondholders demanded higher yields to compensate for the risk of higher inflation, raising the cost of capital for companies and putting downward pressure on the valuation of equities.
In other circumstances, the potential for higher corporate profits and dividends might have outweighed the negative effects of higher bond yields, but the return of volatility after a long period of calm created an environment of near panic. Certain funds that relied on volatility remaining low to generate profits suddenly lost almost all of their value within a couple of days and two high profile exchange-traded notes were liquidated, but not before there had been a rush to buy volatility in an attempt to mitigate losses. Other funds that base their asset allocation between bonds and equities on the current level of volatility found themselves having to sell higher risk assets such as equities. Hedge funds that base their strategy on momentum also had to sell equities, which had been performing strongly in recent months. All in all, it is estimated that there were forced sellers of several hundred million dollars’ worth of shares. Although in the grand scheme of things this is not a huge sum, the selling pressure at the margin was enormous – a lot more buyers than sellers – and the immediate demand for liquidity created extra pressure.
The good news is that this storm blew itself out in a few days, and there was minimal contagion into other asset classes. The relatively resilient performance of High Yield corporate bonds was a testament to the fact that investors remained upbeat about economic growth prospects. However, the inflation cat has now got at least one paw out of the bag, and the next developments in inflation trends along with central banks’ reaction to them are going to be crucial for the next leg of the market cycle.
‘The jump in wages was interpreted as a precursor to higher inflation, driven by companies raising prices to preserve margins, which in turn would spur even higher wage demands.’
On the political front, it would be premature to declare that the populist tide has turned, but it certainly has not delivered the destructive force that was feared. Last year voters in the Netherlands, France and Germany resoundingly rejected far-right parties in the final rounds of voting, although it must be recognised that France’s Front National and Germany’s Alternative für Deutschland did make serious gains in the polls. Indeed, in Germany this meant that Angela Merkel’s Christian Democrats were in no position to form a government, and, at the time of writing, coalition negotiations remain inconclusive. The next hurdle to overcome is an Italian election in March, and the outcome is currently uncertain. Still, we believe there is enough underlying economic momentum in Europe for the Continent to continue to recover in spite of its politicians. This is very much what has happened in the United States, where Donald Trump’s inability to push through much in the way of legislative change until very late in the year failed to hinder the economy.
In the UK, all policy is overshadowed by Brexit negotiations. There seems little doubt that investment in the UK has suffered from the uncertainty, and it is hard to see that situation reversing dramatically until the full terms of Brexit are decided. But all is not lost. The weaker pound, despite its recent rally, means that UK assets and products look cheap to overseas buyers, who themselves are operating in a brighter economic environment. It is always easier to weather a period of domestic stress when external conditions are more positive.
Monetary policy presents a greater challenge. The US, UK and Canada, amongst major developed economies, have already raised the local base rate of interest, with the US on track to deliver another three quarter-point rises in 2018, and possibly the same in 2019. That might appear alarming, but would potentially only take the Fed Funds rate back to “normal”, offering investors a safe positive real return. We continue to believe that central banks will continue to fine tune interest rates depending on the economic situation. There is no set path which leads into a brick wall. Future decisions will depend greatly on the behaviour of inflation, which has so far been notable by its absence. Eminent economists are unable to reach a consensus on the outlook. Crudely, there are two major camps: the “inflationists”, who believe that it is only a matter of time before tight labour markets lead to a traditional wage/price spiral; and the “deflationists”, who believe that technological and demographic trends will continue to dampen inflationary pressures. We have no strong opinion either way, but do believe that the greater short-term threat to markets would be provided by a sharp upward move in wages and/or consumer prices leading to a negative repricing of bonds and other asset classes that take their cue from bond yields. We will monitor the data very closely.
The other big monetary threat comes from the reduction and ultimate reversal of Quantitative Easing. The Federal Reserve is already shrinking its balance sheet, and the European Central Bank will halve its monthly purchases from €60bn to €30bn in January 2018, potentially reducing that to zero later in the year. Even the Bank of Japan, with its apparently bottomless well of liquidity, has been reducing its purchases of bonds as yields have stabilised. The central banks of the UK and Switzerland are currently on hold. It is widely projected that the aggregate size of these five central banks’ balance sheets will begin to shrink around the turn of 2019. Why is that important? While it is impossible to calculate the full impact, it is beyond question that financial assets have been buoyed by central bank liquidity since 2009. If that liquidity provision is not increased, or even reversed, then it is not unreasonable to expect financial assets to struggle to make progress. That does not mean a crisis is imminent, or even a bear market, which would probably require a recession to unfold in at least one of the major economies, but it certainly presents a meaningful looming risk for investors.
‘There is enough underlying economic momentum in Europe for the Continent to continue to recover in spite of its politicians. This is very much what has happened in the United States.’
Inflation expectations are not the only influence on bond yields. Supply and demand is also an issue. Yields have been suppressed by almost a decade of Quantitative Easing, a factor that is forecast to end (in aggregate) by early 2019. Many governments, notably the US, also seem less committed to austerity. This might be good for demand in the economy, but also raises the threat of too much growth and an increased supply of government debt.
The risk/reward ratio for sovereign bonds still looks unattractive, given that a small shift upwards in yields can wipe out a year’s income very quickly. They are held mainly to insure against unexpected economic or geopolitical shocks. Index-linked bonds are currently preferred for their protection against the risk of higher inflation. The higher yields on emerging market sovereign bonds and high yield credit offer a modicum of protection against falling capital values.
UK Gilts have delivered a total return of -2.41% over the last six months and -1.22% over the last year. Index-Linked Gilts returned -3.2% and –1.81% over the same respective periods. Emerging Market sovereign bonds produced a total return of -8.0% in sterling over the half year to February (-6.79% over 12m). Global High Yield bonds delivered -5.21% (-3.74% over 12m).
Conclusion and outlook
The upward grind of risk asset prices had been relentless and yet rarely trusted. There was certainly not the sort of euphoria normally associated with market peaks. Investors consistently found things to worry about – Trump, North Korea, various elections – but none of them have derailed the economic recovery, and, ultimately, it is the profits growth of companies that drives returns. In the end, it was the threat of too much growth rather than too little that was the catalyst for a market correction. We feared that a heavy-handed central bank might eventually slay the bull market, and that was certainly investors’ fear in February. However, given past performance (which, of course, is not necessarily a guide to the future!), we maintain the opinion that central bankers are more worried by the threat of too little growth than too much and will be slow to choke off demand.
We were not at all surprised by the recent correction, although the timing was always going to be difficult to pin down. Thinking constructively, it is positive that some of the froth has been blown off the top of the market. It is also good that a decent portion of the “short volatility” positions have been reduced, thus mitigating further risks. That is not to say we have been give an “all clear”, but it is always healthier when market risks have been recognised. Even though we do recognise that this economic and market cycle is long in the tooth, it still has some legs, although equity gains from here are likely to be harder won and subject to greater volatility. It is still hard to make a strong case for owning conventional government bonds, other than as insurance against some sort of unanticipated crisis. One thing became clear in the recent turmoil: in this particular set of circumstances (rising inflation and bond yields), there were very few places to hide other than cash.