Market Commentary: November 2017
10 Nov 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.
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 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.
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.’
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.