Overview

Incipient trade wars; a mini-eurozone crisis; disappointing economic data in several regions; another interest rate rise from the Federal Reserve; the European Central Bank’s (ECB) confirmation of the end of Quantitative Easing (QE); a shakeout in Emerging Markets (EM); and still minimal progress in Brexit negotiations: this litany of factors sounds like the recipe for a potential market setback. And yet, with the MSCI All-Countries World Equity Index delivering a 0.68% total return in the three months to the end of June, outsiders might conclude that City traders have been doing little more than filing their nails and watching cricket and football on television. We should quickly lay such scurrilous thoughts to rest. All of these factors have required careful analysis, which in aggregate has led investors to hold their nerve in the absence of firmly negative conclusions.

Monetary tightening is something that has been high on our list of influences for some time, and at least we think we have some visibility on its speed. It certainly has less capacity to shock markets now. Given the apparently synchronised global growth that seemed well set at the start of the year, the disappointing data from Europe and, more recently, China, has been unhelpful, but at least is neither a bolt from the blue nor necessarily the harbinger of recession. Temporary seasonal factors seem to have played a part in Europe’s slowdown, and China’s government and central bank have been deliberately taking some of the steam out of a potentially overheating economy. Indeed, they are already starting to deploy the safety nets in case it slows down too fast.

All of which leaves protectionism as the big uncertain variable. Logic and the application of Game Theory suggest that all parties have so much to lose in terms of global trade and easy access to foreign goods at a reasonable price that the initial skirmishes should not lead to outright trade wars. That could well be why investors have initially remained so relaxed in the face of the threat. After all, bringing such analysis to bear on the situation in North Korea – another Trump-inspired scare – bore fruit in the form of a surprising rapprochement. Also, so far at least, the sums involved are small, amounting to just 2% of global imports and 0.5% of global Gross Domestic Product. However, there is no sign of a climbdown by any side, and although China was seen as the main target of Trump’s policy, India, Canada and the EU have all been dragged into the scrap. The optimistic view is that Trump is playing a short-term political game which involves rallying his supporters with bold gestures ahead of the mid-term elections in November, after which he will move on to some new obsession. More worryingly, and knowing how he seems to react to such things, the fact that his standing in popularity polls has increased might only embolden his attitude. Given such uncertainty and the lack of a meaningful market sell-off to offer bargains, we find it difficult to take a strong view either way at the moment.

In Europe, at least, a compromise of sorts was reached with respect to the formation of a new coalition government in Italy, but not before the disruption caused when the President vetoed the appointment of a staunch eurosceptic Finance Minister (who was subsequently given the role of Minister of European Affairs!). 

A sharp sell-off for Italian government bonds sent a warning shot from markets that the intended policies of the new government would make the country’s debt position unsustainable within the confines of the single currency, potentially leading to a highly disruptive “Italexit”. Order has since been restored, but this is a smouldering ember that has the capacity to flare up again at any moment.

One cannot ignore Brexit, although, as with the trade war threat, it is very difficult to reach conclusions, not least as the government itself remains in some disarray on the subject. We have listened closely to the arguments of both sides in the campaign, some of which are well argued with supporting data and some of which are no more than pedagoguery. We remain of the opinion that the initial downside risk of a “no deal”, notably to the pound, but also to business sentiment generally, is greater than the upside relief in the event of some sort of deal being carved out, and have positioned ourselves accordingly.

Key Influences

Politicians and central bankers remain the primary influencers of market sentiment, which in many ways is frustrating for investors, because, in aggregate, and when left to their own devices, companies are doing well, at least when measured by the simplest metric of earnings growth. Global earnings are forecast to rise by close to 20% this year, helped by stronger commodity prices and the US tax cuts in particular. As is usual, some companies are doing better than others, and different markets are experiencing different drivers. In the US it is very much the Technology sector, which accounts for around a quarter of the market’s capitalisation, which is leading the way; in the UK, especially since the acquisition of ARM by Softbank of Japan, Technology barely registers, and it is the Resource sectors that have done much of the heavy lifting. Indeed, in a year when there has been very little to choose between various asset classes, the oil price sticks out like a sore thumb on performance charts, having gained almost 20%. The UK’s large Mining companies have also benefitted from the recovery in metals prices as well as their own conservatism in terms of investment, such that they are now generating enormous amounts of cash that is being distributed to shareholders rather than sunk into big new holes in the ground.

One of the key features of both of these large UK sectors is that virtually none of their operating assets are based in the UK. At least half of the earnings of most major developed markets are generated in another currency – in the UK’s case it is about three-quarters – meaning that foreign exchange movements can have a profound effect on performance when measured in the local currency. Thus when sterling rises, the FTSE 100 tends to underperform, but the index does better when the pound is weak. This can sometimes give the comforting illusion that all is well in the UK when international investors are selling the pound because they are worried about, for example, the state of our politics or the size of our trade deficit. In the real world the decline in the pound is more readily visible in either higher imported goods prices in the UK or painfully more expensive holidays overseas. This increases the attraction of a more internationally diversified portfolio: it smooths out some of the currency volatility, but also, crucially, gives access to a much broader and deeper range of attractive companies in which to invest. 

The themes of populism and central bank monetary tightening have featured in this section of the review for some time now, but there is no sign of their influence waning. If anything, recent political developments reinforce the populist and protectionist trends. These would include Donald Trump’s imposition of trade tariffs and the ground-breaking coalition of anti-establishment parties in Italy, for example. Similarly, the Federal Reserve Bank in the US appears to be on a relentless path of monetary tightening, both raising interest rates and reducing its stock of assets purchased under QE, while the ECB has firmly signalled the termination of its asset purchases by the end of 2018. If international trade is becoming more costly and liquidity less free, then investors face the loss of two very strong tailwinds that have driven asset prices higher. While this does not necessarily spell the disaster that some of the gloomier commentators predict, it certainly makes the investment outlook more challenging than it has been for some years.

UK

The FTSE 100 ended the second quarter of 2018 as one of the better performing markets, especially when viewed in local currency, recording a gain of 8.2% over those three months. There were three key reasons for this. First, a combination of political and economic fears had persuaded many overseas investors to abandon the UK at almost any cost in the first quarter, so there was an element of recovery from a heavily oversold position. Second, the enduring power of a weaker pound to boost the earnings of the large proportion of overseas earners in the index again played its part, notably in the case of dollar earners, as the US currency continued to appreciate. Finally, thanks to the recovering oil price, the oil majors, BP and Royal Dutch Shell, alone contributed 40% of the index’s gains.

US

It’s impossible to keep the US market down for long at the moment, although below the headlines there has been a sharp divergence in performance. Technology giants continue to lead the market higher, with the top handful of companies contributing more than 100% of the index’s slim gains so far this year. Technology is viewed to be relatively immune to trade war fears, and investors continue to be attracted by the promise of endless growth. While we note that valuations are nowhere near as stretched as they were in 2000, and that most of these big companies now make substantial profits, the headlong charge into index funds and Exchange Traded Funds does suggest a lack of discernment, and so we are not minded to chase this trend higher.

Europe

European markets have run into a perfect storm: local political upsets (Italy’s election, followed by Mrs Merkel’s problems); the lagged dampening of exports from last year’s strong euro; (hopefully temporary) seasonal factors, such as snow and flu; and the region finds itself at the sharp end of trade war fears, with German automotive exporters fully in Donald Trump’s sights. So in some ways being essentially unchanged over the quarter is a positive achievement. We still believe that Europe’s domestic recovery is sustainable, and, should that turn out to be the case, there is plenty of value left in certain sectors, notably in Financials.

Japan

For many, investing in Japan represents the ultimate triumph of hope over experience. Just as the economy looks like it is getting back on its feet and when there are signs that inflation might be gaining traction, either domestic politicians enact some inappropriate policy or more global influences conspire to knock it back again. All the time Japan is dragging the heavy anchor of a shrinking, ageing population. And yet its stock market remains home to more value plays that any other major equity market, and good stock pickers can take advantage of the fact that analyst coverage of many less well-known companies is pitifully thin. We continue to back our favoured managers in Japan who have developed strong track records.

Emerging Markets

Developed equity markets tend to rise when their currencies fall, thanks to a positive translation effect. The opposite is true for emerging markets, because investors fear that they will not be able to service, repay or refinance foreign currency liabilities. Seeing as the vast majority of these are denominated in US dollars, and dollar-based investors were not too long ago falling over themselves to find a half-decent return anywhere else in the world, the most recent recovery of the dollar has been particularly damaging to emerging markets. A self-imposed period of relative austerity is China is also unhelpful. However, we still see greater prospects for long-term growth in EM, and believe that their aggregate financial position is less stretched than it was in the late 1990’s, thus lowering the probability of a full-on crisis developing.

Fixed Income

Bond markets have remained resilient in the face of the threat of higher interest rates in the US and the end of the ECB’s QE programme. For example, the yield on the 10-year Gilt ended March at 1.35% and was 1.28% at the end of June. The US 10-year Treasury yield rose from 2.74% to 2.86% over the same period, but failed to hold over a 3% yield for more than a few days in May. Given that the US is much deeper into its economic cycle and has also been boosted by President Trump’s tax cuts and spending plans, that is a decent outcome. Remember that the equity market sell-off at the start of 2018 was triggered by a sharp rise in the US bond yield in response to surprisingly high wage growth. That worry has since subsided, but there are abundant signs of a squeeze in the US jobs market, not least the fact that there are now more job openings than there are people looking for work. We remain concerned that cyclical inflationary pressures continue to build, and that this will encourage the Federal Reserve to keep tightening policy until the economy starts to decelerate. One can see that the market has a similar view, with the yield spread between 2-year Treasuries and 10-year Treasuries now as low as 0.32%, down from a high of 2.65% at the end of 2013. Historically when that spread goes negative the probability of a recession rises sharply, so this will remain a closely watched indicator for the health of the US economy.

UK Gilts have delivered a total return of 0.4% over the last three months and 1.93% over the last year. Index-Linked Gilts returned -0.63% and -1.23% over the same respective periods. Emerging Market sovereign bonds produced a total return of 2.55% in sterling over the quarter to end June (-3.8% over 12m). Global High Yield bonds delivered 4.27% (-0.32% over 12m).

Conclusion and Outlook

Equity markets appear to have reached some sort of impasse in the short term. Strong corporate performance is being offset by negative policy developments. Valuations are still not cheap enough to tempt new cash into the market, but there is still a lack of sufficiently attractive alternative investments to persuade investors to head for the exits. Much the same is true for bonds, with earlier concerns about greater inflationary pressures giving way to worries about the possible negative influence of protectionism and escalating trade wars. This has been the narrative for the last few years, it seems: investors, not unreasonably given the scars of financial crisis, find things to worry about, and then chase assets higher once the worst outcome does not come to pass. We might well find that the same happens if Mr Trump relents on his tariffs… there again, he might not, and further downside beckons.

In such an environment, and in the absence of exceptionally cheap markets, we find ourselves tempted to do very little. We continue to invest in companies that have the ability to generate strong returns on capital, relatively safe in the knowledge that these returns will compound in the long-term to provide strong investment performance. But there are no short-term guarantees. Similarly we can accumulate income from certain segments of the Fixed Income markets, but we find the prospects for capital gains limited. There are periods during the cycles of markets when “wait and see” is the best advice, and we appear to be in such a period now. We are also concerned that within the next couple of years there is a rising probability of a more marked global slowdown, driven by the US interest rate cycle. Bearing that in mind we continue to recommend a marginally cautious stance overall.