11 Sep 2017
Market Commentary: September 2017
Every day we seem to wake up to more bad news.
The latest upheavals in the White House; inconclusive Brexit negotiations; populist outcry in any number of countries; and missile tests in North Korea, to name but a few regular headline-makers. And yet the last six months has been another period of prosperity for investors, with equity markets making several new all-time highs and volatility remaining low apart from a couple of short spikes – a classic case of what is described in financial circles as “climbing a wall of worry.”
Investors have been worried about a lot of things for a long time. The Financial Crisis and the Eurozone Crisis are firmly imprinted on everyone’s minds, and it is human nature to fear a repeat performance. Political outcomes, not least the UK’s EU referendum result and the election of Donald Trump as President of the United States, reduced much conventional wisdom to rubble. The rise of populism in Europe threatened the integrity of the whole European project. But here lay the opportunity. When the worst outcomes fail to materialise, investors heave a sigh of relief and concentrate on the underlying health of economies and companies, and in this respect everything looks much rosier, at least on a global level.
One key feature of the global economy at the moment is that it is growing almost everywhere. Not at its pre-financial crisis pace, to be sure, but at what appears to be a sustainable level above 3%. Economists, on average, have raised their growth forecasts since the start of the year, with Europe a key component of those upgrades, a welcome development after years of unfulfilled promise. China also continues to defy the sceptics, with growth of 6.9% in both the first and second quarters. If there were disappointments, they were in the US, which had its now seemingly regular weak start to the year (which in itself raises questions about the reliability of the data), and the UK, where Brexit uncertainty and an inflationary squeeze on real incomes appear to be having an increasingly depressing effect on investment and consumption, although there are some signs of light in terms of exports.
‘One key feature of the global economy at the moment is that it is growing almost everywhere.’
Politics continues to dominate the headlines. Here in the UK, March’s triggering of Article 50, which fired the starting gun on the process of the UK leaving the European Union, was quickly followed by the calling of an entirely unexpected general election. That had an equally unexpected result, not least for Prime Minister May, who had gambled on securing a landslide majority. In the event she is left nursing a fragile minority government with the support of Northern Ireland’s Democratic Unionist Party. She has a weak mandate, to say the least, and somehow has to respond to the message sent by the electorate that it appears to favour a “softer” form of Brexit and an end to years of austerity. Challenging and uncertain times lie ahead.
The news was better in the Netherlands and France, where extreme right wing candidates were defeated in national polls. The elevation of Emmanuel Macron to the presidency of France is nothing short of phenomenal, in light of his relative inexperience and the fact that his party was just a year old. Given that Germany’s Chancellor Angela Merkel appears destined to retain her position in September’s election, reports of Europe’s demise appear to have been premature, although we still have an election in Italy to contend with before May 2018.
The phrase that we have been using this year to characterise our thoughts on the investment landscape is “regime change”. This applies to two areas in particular, namely politics and monetary policy. On the political front, it has become evident that large segments of the population of developed market economies have become disillusioned with how life has evolved in the aftermath of the financial crisis and in the face of increased globalisation and the progress of automating technology. They might not know what the answer is but there has been a call for change, thus the vote for Brexit, the arrival of Donald Trump in the White House and the election of M Macron. This creates both opportunity and uncertainty, and it has been difficult for investors to balance the two sides. Indeed, we have already seen markets price in all the possible benefits of Trump’s stimulus plans before pricing most of them out again as he struggled to pass any legislation in Congress.
Although the Brexit process is a mere sideshow in a global context, it remains headline news at home and will do for some time to come. It is having a relatively limited effect on either domestic equity or bond markets now, which tend to move more in line with global trends, but its influence is felt more in the foreign exchange markets. The pound was, in fact, relatively steady on a trade-weighted basis until the end of July, as strength against the dollar was cancelled out by weakness against the euro. However, the euro has been much stronger of late, reflecting the possibility of tighter monetary policy on the Continent, sending the pound back towards its post-referendum lows. The pound would now appear to be good value based on measures such as Purchasing Power Parity, but much depends on the UK’s future terms of trade and these remain uncertain.
‘Given the generally positive direction of the European economy, we are inclined to see the glass as more than half full.’
France’s outlook looks more appealing, with new president Emmanuel Macron effectively being mandated to proceed with long overdue reforms to the economy, not least in terms of employment practices. There are two caveats. First is the fact the turnout in the final round of the election was very low; second is the enduring power of the French unions, which are notorious for recommending disruptive strike action. However, given the generally positive direction of the European economy, we are inclined to see the glass as more than half full.
The subject that continues to exercise the minds of investors currently is the future path of interest rates. There has been a surprisingly public debate between several members of the Federal Reserve, as well as the Bank of England’s Monetary Policy Committee, about whether interest rates should be rising, suggesting a high level of disagreement amongst the “experts”. Everyone is on edge, not least because we have been used to record low interest rates for so long, and nobody is quite sure how much even small increases in rates will affect both the real economy and financial assets.
Leading the charge is the Federal Reserve, which has already raised interest rates four times in quarter point increments, with apparently limited effects on growth. Markets have learned to live with the threat of higher rates as long as the economy justifies them. Of greater concern, perhaps, is the Fed’s plan to start reducing the size of its balance sheet, the reversal of Quantitative Easing (QE). QE has played a big part in sustaining the performance of financial assets, although it is impossible to quantify the extent. Once that liquidity is withdrawn, equity markets, in particular, will have to rely much more on the actual growth of earnings to sustain and extend their gains. With the European Central Bank now also contemplating a reduction (but not reversal) of its own monetary stimulus, financial markets face headwinds that they have not encountered for several years.
For the third time in as many years, Britain’s electorate has confounded the expectations of opinion pollsters, although little damage was inflicted upon financial assets. With around three-quarters of revenues generated overseas, the companies of the FTSE 100 remain beholden to influences well beyond these shores. The market remains well supported by one of the highest dividend yields available in major markets, but there is some concern about the concentration of dividends amongst a few very large companies and their ability to increase, or even maintain, payouts from here.
US equities remain close to all-time highs, with the bulk of this year’s gains coming from growth stocks, particularly the “FAANG” companies: Facebook, Apple, Amazon, Netflix, Google (now called Alphabet). It is slightly worrying when investment decisions are driven by acronyms, and some have begun to question the sustainability of such strong performance. However, a 2000-style technology crash is less probable, as these are all dominant, revenue generating leaders in their respective industries. Even so, leadership from elsewhere would be welcomed, and for that we might have to wait for evidence that the President’ stimulus plans are back on track.
European equities had failed to live up to their potential for several years, held back by structural and political concerns as well as a dysfunctional banking sector. Finally, there are signs of health, and investors have been increasingly attracted to the value and recovery potential on offer. The failure of populist candidates to win elections in the Netherlands and France helped to bolster sentiment, but already Europe was the area with the biggest upgrades to growth forecasts this year. Challenges lie ahead in the form of possible central bank policy tightening (leading to a stronger euro) and an Italian election that is due by May 2018, but these are surmountable obstacles.
Japan’s economy stubbornly refuses to find second gear, but at least hasn’t slipped back into neutral, thanks to apparently endless monetary stimulus from the Bank of Japan. There is a modicum of growth, but this will always be under pressure from the country’s demographic deficit, an ageing and shrinking population. The better news is that Japanese companies, used to years of flat demand, have stockpiled cash, but are now more motivated to return it to shareholders thanks to improved corporate governance codes of practice.
Emerging markets have performed well this year, bouncing strongly as fears of unfriendly US policies faded. China’s latest growth spurt has been of benefit, as has the weakness of the US dollar, a currency in which many EM companies have large liabilities. Fears of another Asian Crisis remain unmet, and we continue to believe that the majority of EM countries are in much better shape now than they were in 1998. In the long term it remains something of an article of faith to us that EM countries, in aggregate, will grow faster than Developed Market countries, thanks to superior demographic and social mobility trends, although these traits are not universal. This should help to deliver superior returns.
Global sovereign bond markets have already been through four distinctive phases in 2017. At the beginning of the year the talk was very much of reflation, thanks to Donald Trump’s promise to double US GDP growth to 4%. Inflation indices were also on the rise thanks to reaching the one year anniversary of early 2016’s commodity price trough. In this environment bond yields were trending higher. In fact, they peaked in January in the UK and in March in the US and Germany, and started to head lower again as it became clear that Mr Trump was struggling to turn promises into action and the US economy had its now apparently traditional weak first quarter.
Additionally OPEC’s best attempts to support the oil price failed in the face of increasing shale oil production in the US, and future inflation expectations remain highly correlated to oil price movements. This year’s initial yield trough was reached in June, after which upward pressure returned as central bankers in several countries pondered publicly the possibility of tightening policy. Most recently a string of benign inflation readings, combined with safe haven demand in light of tensions on the Korean Peninsula, have sent yields back to the lows for the year in the US and UK.
With so little income available from Developed Market government bonds, and at what could be a turning point after a multi-decade bull market, we continue to find this asset class unappealing. However, its “safety first” nature means that we continue to recommend some exposure as insurance against unexpected shocks. Better yields are available from corporate and Emerging Market sovereign bonds, and we continue to see opportunities in these areas even after good performance, especially as global growth recovers.
UK Gilts have delivered a total return of 0.95% over the last six months and -3.28% over the last year. Index-Linked Gilts returned 1.01% and -1.72% over the same respective periods. Emerging Market sovereign bonds produced a total return of 0.74% in sterling over the half year to May (+7.01% over 12m). Global High Yield bonds delivered 1.11% (+12.07% over 12m).
‘A central bank “policy mistake” now ranks very high on our list of possible risk factors for investors.’
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.