06 Oct 2017
Market Commentary: October 2017
An old stock market aphorism suggests that investors should “Sell in May, go away, and don’t come back till St Leger’s Day.”
This year’s Saint Leger Stakes, the last classic horse race of the season, was held on Saturday 16th September. The FTSE 100 Index ended April at 7,204 points, and closed on Friday 15th September at 7,215 points, and so the collection of dividends is pretty much all that an index-tracker will have achieved, at least leading to a cash and inflation-beating total return of 2%. 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, perhaps we should be grateful for small mercies.
However, the UK’s headline domestic index 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 6% capital gain for the six months to the end of September. UK-based investors saw that reduced to just 0.9% owing to the weakness of the dollar, which fell more than 6% against the pound. The strongest major currency was the Euro, which, in turn, rose almost 4% against sterling, driven by a strengthening economy and the threat of tighter monetary policy.
‘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.’
To use another stock market aphorism, equities “climbed a wall of worry”. 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.
Bond investors had a rockier ride, with government bond yields rising sharply towards the end of the period as investors anticipated tighter monetary conditions ahead in the UK, the US and Europe. In many ways this was a positive development, as central bank governors now feel sufficiently confident in the recovery to take their foot off the accelerator, and even to dab the brakes in the case of the US. 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, but the rational conclusion has been reached that neither side has anything to gain from all-out hostilities, and, therefore, that the concept of Mutually Assured Destruction, which stayed the hands of both the US and the Soviet Union during the Cold War, will once again prevail.
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 voting (illegally) 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. Of course, 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.
‘We remain in the experimental laboratory of monetary policy – and we are the lab rats, not the scientists.’
The other big regime change is in the realm of monetary policy. The US Federal Reserve 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 next step for the Fed 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 make more aggressive noises about the possibility of raising the base rate in November, while the European Central Bank is also considering reducing the rate of its QE from the current €60 billion per month. 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. It will be informative to see what comes out of China’s People’s Party Congress in late October in terms of the plans for the next five years. 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 seem to 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 an interest rate rise – the first since 2007 – so that November is now seen as when a ¼% hike will be announced, although 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, and the expectations surrounding policy initiatives from the White House are so low that any progress with, for example, tax reforms, would constitute a positive surprise. No doubt 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.
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 eurozone 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. 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. An imminent snap election should result in a continued mandate for Premier Shinzo Abe, but we have seen enough shocks in other countries not to take this for granted.
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 promises, 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. 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 buffetted 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 offer higher yields, and remain more attractive as long as global growth trends continue. We continue to seek out opportunities in these asset classes, although neither can currently be considered bargains.
UK gilts have delivered a total return of -1.73% over the last six months and -3.56% over the last year. Index-Linked Gilts returned -3.27% and -4.36% over the same respective periods. Emerging Market sovereign bonds produced a total return of -2.03% in sterling over the half year to September (+0.53% over 12m). Global High Yield bonds delivered -0.64% (+5.81% over 12m).
‘Several potential upsets have been avoided, but there always seems to be a long trail of potential banana skins ahead.’
Markets appear to be balanced between two conflicting forces. Positively, the global economy is in a synchronised growth phase that we have not witnessed since 2010. More negatively, central banks are considering the withdrawal of the extreme monetary stimulus that has been in place for most of the post-financial crisis era. A central bank “policy mistake” now ranks very high on our list of possible risk factors for investors. Much of the liquidity created by central banks in recent years has not been required in the real economy owing to lacklustre growth and the ability of companies to operate more efficiently. Much of the excess liquidity has found its way into financial markets and property. It is only logical that if there is less liquidity in the system, particularly if companies’ demand for capital increases as growth recovers, then financial assets will find less support. This by no means constitutes a recipe for another financial crisis – indeed, we believe that the structure of the financial system is far more robust now than in 2008 – but it will make gains harder to come by.
Perhaps the biggest threat to investors (and, indeed, the whole global population) is the possibility of some sort of war breaking out which involves North Korea. Whether it or the United States is the aggressor, the potential loss of life does not bear thinking about, even before we get around to trying to assess the economic implications. With Japan and South Korea in the firing line, and weapons that can, apparently, reach the west coast of America, Kim Jong-un presents a worryingly credible threat. However, he must also know that his own country would be obliterated if he shot first. 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.
More optimistically, if none of these threats come to pass, the outlook for riskier assets remains reasonably positive as global growth continues and sovereign bonds offer little in the way of competition for asset allocation. The underlying outlook suggests that company earnings can continue to grow, and, if combined with dividends, holds out the promise of positive returns for equity investors, even if not on the scale of past returns.