10 Nov 2017
Market Commentary: November 2017
Stock markets have continued to make steady progress over the six month period under review, with many, notably in the US, making several new all-time highs.
Given the fact that the period contained a surprise general election in the UK (and an even more surprising result), the escalation of tensions on the Korean Peninsula and the threat of tighter monetary policy in several regions, investors can be very happy with the progress.
The UK’s headline domestic index, the FTSE 100 Index, which rose 3.8%, rather underplays what a bountiful period this was for global equity investors, especially those with dollar portfolios. The FTSE World Index (measured in dollars) notched up a 7.6% capital gain for the six months to the end of September. Currency volatility has had a visible influence on returns. The weaker dollar has flattered returns for US-based investors, while those based in the UK have seen their non-sterling assets fighting the headwind of a recovering pound.
Equities can be said to have “climbed a wall of worry”, to use a well-worn stock market aphorism. There was much to worry about, with a lot of it in the geopolitical arena, not least Continental European elections, but worst fears were not met, leaving markets to benefit from a continuing recovery in the global economy. Indeed, 2017 promises to be the first year of synchronised global growth since 2010, and this time it is driven by real demand rather than a recovery in inventories. Global GDP growth forecasts have edged up since the start of the year, predominantly driven by Continental Europe and emerging economies. Company profits are rising nicely, with double-digit growth forecast for this year, and something close to that in 2018.
‘Bonds had their best period during August, when Kim Jong-un’s nuclear threat was at its peak. It is almost incredible that markets have remained so sanguine in the face of such an existential threat.’
The overriding theme of our investment outlook has for some time now been “regime change”, and this refers to developments in both politics and monetary policy. To take the first of those, it has mostly been encapsulated in populist movements. These have their roots in rising inequality, which itself has various origins. These range from robotics and globalisation, which have both depressed wages, to the effects of low interest rates and quantitative easing (QE), which have forced assets, particularly houses, out of the price range of many potential buyers. The financial crisis might have been the catalyst for a lot of this unrest, but the seeds had already been sown. The effects have been seen, most notably, in the result of the Brexit referendum and Donald Trump’s victory in last year’s US presidential election, but there have also been scares in Europe, with right wing parties gaining legions of new supporters, notably in France and Germany. Most recently the unrest has been seen in Spain, with Catalonia’s quest for independence. This last example is different in nature, in that it involves a rich region wanting to end its subsidy of poorer regions, but it still threatens disruption.
The outcome of populism’s rise is not helpful for investors. Anti-globalisation puts roadblocks in the way of global trade, and barriers to immigration lead to local shortages of labour. Both of these are potentially inflationary, and higher inflation would tend to lead to higher interest rates. Furthermore, populist politicians favour the redistribution of wealth, and so punitive taxes on capital gains and unearned income become more probable. Trump himself is the populist exception who proves the rule, and somehow wishes to please the rich and the poor! None of his budget plans come close to balancing.
‘The outcome of populism’s rise is not helpful for investors. Anti-globalisation puts roadblocks in the way of global trade, and barriers to immigration lead to local shortages of labour.’
The other big regime change is in the realm of monetary policy. The US Federal Reserve (Fed) was the first central bank to raise interest rates in this cycle, and has so far raised in four quarter-percent increments. That still only leaves them in a 1% – 1.25% target range, but they are projected to rise by around another 1% over the next year. The Fed has now taken the next step, which is to start gradually reducing the size of its balance sheet, which has ballooned to $4.5 trillion thanks to asset purchases under its QE programme. The Bank of England has also started to be more aggressive, finally delivering the first interest rate rise for ten years on the 2nd November. The European Central Bank has also reduced the rate of its QE from €60 billion to €30bn per month, but extended the programme to September 2018, while still suggesting that policy could yet be eased again if required. All of this represents a potential headwind for financial assets. It is indisputable that QE has helped to raise the price of assets, although impossible to calculate exactly by how much. However, it is considered highly probable that the removal of this liquidity support will remove some of the valuation props for both bond and equity markets. That is not to say that a financial crisis or bear market is imminent, especially if continued economic growth makes for decent earnings growth, but it does create uncertainty. We remain in the experimental laboratory of monetary policy – and we are the lab rats, not the scientists.
Another regime change to mention is the shift of global economic power towards Asia, and with that comes increased political power. China’s People’s Party Congress in late October cemented the position of President Xi, and he highlighted thestrength of China’s position on the world stage today. There was limited discussion of new policies, but these will be unveiled in the months ahead. Further domestic reforms and military ambitions, particularly in the South China Sea, will be of great interest. How China handles its increasingly important status in the world will have a great bearing on the global outlook. Its growth also offers immense potential for investors.
Politics continued to dominate the UK agenda. The Conservative Party’s loss of its parliamentary majority was a major surprise, and it also undermined Brexit negotiations with the EU27, which have made limited progress over the summer. The sterling tailwind of 2016 has turned into something of a headwind. The pound has benefitted from hawkish comments from the Governor of the Bank of England, and this has accelerated the timetable for interest rate rises. Indeed the base rate was raised by 0.25% to 0.5% on 2nd November– the first rise since 2007. This should not have too much impact on domestic growth. Meanwhile the equity market is supported by one of the more generous dividend yields available.
US equity markets have continued to make a string of new highs. The economy has recovered well from its now traditional first quarter softness. Expectations surrounding policy initiatives from the White House were so low that any progress would constitute a positive surprise. Some constructive movement on tax reform was therefore positively received by investors. The weakness of the dollar has provided a boost to multinational companies. The Federal Reserve’s plans to raise interest rates and reduce its balance sheet constitute the greatest risk, although we believe that the central bank will continue to err on the side of caution under the new chair, Jay Powell.
Europe has been the poster child for recovery this year, although investors with portfolios denominated in euros might struggle to see the good news, thanks to the strength of the euro. A series of elections failed to produce the threatened negative outcome, while all the repair work following the euro zone crisis in 2011 began to bear fruit. Admittedly some countries are doing better than others, with Germany and Spain of the larger countries heading the growth tables, but even Italy is showing signs of life, and France has the potential to benefit enormously from planned reforms by the new president, Emmanuel Macron. The storm in Catalonia appears to have been weathered, at least for the present. We continue to give Europe the benefit of any doubts that might arise.
Japan’s economy has finally shown some signs of life, which has as much to do with exporters gaining from the recovery in global trade as any domestic growth. The demographic headwind remains strong as the ageing population continues to shrink, and this has little prospect of reversing. However, Japanese companies continue to dominate value screens, and improvements to corporate governance increase the rewards for shareholders. A snap election resulted in a larger majority for Premier Shinzo Abe, so policies will remain committed towards reflation.
Emerging markets have led the pack in terms of regional performance this year. Admittedly they started 2017 at something of a low point, facing the twin threat of a strong dollar and a protectionist US President. The dollar has weakened in the face of quiescent inflation, and Mr Trump has not followed through on his threats, leading to strong recovery. This has been further bolstered by a bounce in the levels of global trade, and China’s economy, in particular, has been supported by the government in the run up to the Party Congress, an event that confirmed the “first amongst equals” status of President Xi. We continue to see premium growth and investment return prospects for emerging economies owing to the stronger underlying social and demographic trends than are evident in the developed world.
Bond markets have been buffeted by opposing forces during the last six months. On the one hand, global inflation has been subdued, with only the UK of major economies seeing greater upward pressure on consumer price indices thanks to the post-referendum weakness in sterling. This lack of inflation, which central bank chiefs remain unable fully to explain, has kept bond yields subdued. On the other hand the same central bankers have been threatening to tighten monetary policy in response to the recovery in global growth. They are also concerned that a persistent near-zero interest rate environment might encourage speculative activity in financial markets, leading to bubbles which could ultimately pop with dire consequences. The tendency towards higher interest rates and the reining in of QE forces yields higher.
Towards the end of the period under review it was definitely the latter forces that prevailed, with 10-year bond yields in the UK, US and Germany trading towards the top of their ranges. Indeed, with yields at such low levels, sovereign bond investors are struggling to generate a positive total return this year. It remains an area where we see limited prospects for returns, and government bonds are held primarily for their safety-first credentials in the event of economic or geopolitical shocks.
High yield corporate bonds and emerging market sovereign bonds continue to offer higher yields, but the former asset class is beginning to look a little stretched on valuation grounds.
UK Gilts have delivered a total return of -1.69% over the last six months and +0.63% over the last year. Index-Linked Gilts returned -4.72% and -2.98% over the same respective periods. Emerging Market sovereign bonds produced a total return of -0.7% in sterling over the half year to October (-2.72% over 12m). Global High Yield bonds delivered +2.15% (+1.38% over 12m).
‘The most serious risk in terms of possible negative outcomes is the tension between the US and North Korea. Nuclear war is a possibility so chilling that it seems almost unthinkable.’
Risk asset markets continue to make grudging progress, treading the fine line between accelerating growth on the one hand and tightening monetary policy on the other. Several potential upsets have been avoided, but there always seems to be a long trail of potential banana skins ahead. If these are avoided, then markets will follow the current trend higher, but outright bullishness is tempered by full valuations. A central bank “policy mistake” now ranks very high on our list of possible risk factors for investors.
The most serious risk in terms of possible negative outcomes is the tension between the US and North Korea. Nuclear war is a possibility so chilling that it seems almost unthinkable. From a balanced portfolio investor’s point of view, it is almost impossible to hedge. It either happens or it doesn’t. The future is either pretty much as it is now or catastrophic. This suggests a binary “in or out” decision for market participants. To a great degree we have to assume that the concept of Mutually Assured Destruction will keep all the players honest, much as it did during the Cold War.
Our longer term projections for returns remain positive, although investors must be aware that generating half decent real returns (and especially income) from the current starting point requires exposure to riskier assets. One of our roles is to guide clients towards a suitable risk profile dependent upon current and future circumstances and requirements.