The MSCI UK All Cap NR index returned 3.7% during the three months to the end of December, outperforming the MSCI World ex UK (£) NR index which returned 0.9% in Sterling terms. The relatively poor performance of international markets was driven by the strength of Sterling against most major currencies (MSCI World ex UK NR index returned +7.8% in local currencies).
Additional monetary policy easing allied with the announcement of a ‘phase one’ trade agreement between the USA and clarity on the Brexit issue following the UK’s general election, helped equity markets perform strongly during the period in local currency terms.
In Sterling terms, the strongest major regional equity index was Emerging Markets (MSCI EM NR £ index, +4.0%), as the trade deal improved sentiment to the region following a period of underperformance.
Gilts produced a negative return (iShares Core UK Gilts ETF, -3.9%) as investors grew more confident that the decline in global growth was stabilising. Both Investment grade debt (iShares Core £ Corporate Bond ETF, -0.4%) and ‘riskier’ high yield debt (iShares Global High Yield GBP Hedged ETF, +2.2%) outperformed Gilts.
The oil price rose as the view that global economic activity was stabilising gained ground and OPEC+ announced further supply restraint.
The Brent crude oil price ended December at $66.0/barrel, an increase of 8.6% since the end of September. The oil price rose as the view that global economic activity was stabilising gained ground and OPEC+ announced further supply restraint.
The gold price rose 3.0% to $1517/oz during the final quarter of 2019. Sterling strength, however, meant that the value of gold held by UK based investors fell by 4.5% (to £1,144/oz).
Following a poor year in 2018, risk assets (such as equities and corporate credit) have performed strongly in 2019. The major contributor to this positive change in investor sentiment was the adjustment in stance by the Federal Reserve. In 2018, the central bank’s chairman made it clear that 2019 would herald a period of small but sustained interest rate rises. As economic growth slowed and risk asset prices fell in value, the Federal Reserve capitulated and in fact delivered three interest rate cuts during the year. This, alongside the restart of quantitative easing in Europe, reduced the yield on government bonds materially and pushed investors into higher yielding ‘riskier’ assets. These central bank policies made it clear to investors that policymakers continue to believe that actively supporting asset prices remains a valid transmission mechanism for the delivery of sustained economic growth. Our belief that this is a perversion of the economic and investment cycle remains irrelevant for now.
At the tail end of the 2019, the US announced that a ‘phase one’ trade deal with the Chinese authorities had been agreed. Details are scant, but enough appears to have been agreed to postpone the insoluble strategic decisions that need to be taken until after the Presidential election in early November 2020. Furthermore, the recent progress to ratify the USMCA (United States, Mexico and Canada) free trade agreement helps diminish risk from this area as well. Both developments have rightly been taken well by investors.
The breaking of the UK domestic Brexit impasse and the avoidance of a socialist UK government via a decisive election victory for the pro-Brexit Conservative party has also been supportive to asset prices.
With declining global economic growth, the risk of a lower oil price (which has in the past caused the US credit cycle to turn negative) was reduced by the proactive cutting of oil production by the OPEC+ group as well as heightened tensions in the gulf.
Investors sense that the profit warnings, so prevalent in economically sensitive stocks during 2019, may be replaced by positive trading updates in 2020.In recent months government bond yields have started to rise as the belief has gained ground that the global economic slowdown is coming to an end. Whilst lower government bond yields supported risk asset prices earlier in 2019, it is interesting to note that share prices have continued to appreciate despite this turn in government bond yields in the latter part of the year. The basis for this decoupling is that investors sense that the profit warnings, so prevalent in economically sensitive stocks during 2019, may be replaced by positive trading updates in 2020.
The reasons why investors are more positive about economic growth going forward are several fold:
The belief is building that the Chinese have introduced enough stimulus to stabilise their economic growth rate which has been slipping for some time. This view is supported by the strong performance of mid-sized mainland China property developers (listed on the Hong Kong stock exchange) which have in general, performed strongly in anticipation of better times ahead.
In developed economies labour markets, whilst strong, appear to have become less tight which suggests that inflationary risks remain fairly muted despite real wage growth moving ahead at a healthy rate. In addition, the US consumer remains in remarkably good shape (good real wage growth, relatively low indebtedness and rising house prices) and they certainly have the wherewithal to prolong the economic upcycle given few signs of consumer overexuberance creeping into the domestic economy.
Furthermore, at the margin, countries such as China, Japan, France and the UK are beginning to increase fiscal spending and this should help underpin economic growth going forward and is helping sentiment.
US equity valuations are high relative to history and decent earnings growth needs to return to justify current market multiples.Reasons for caution are being overlooked. US equity valuations are high relative to history and decent earnings growth needs to return to justify current market multiples. However, corporates continue to hold too much inventory (for trade war and Brexit related contingency reasons, for example) and this will need to be worked down which means a positive turn in the earnings cycle may be a little further away than people hope and so could result in some near-term market indigestion.
Moreover, if global economic growth does start to accelerate, concerns about inflation are likely to resurface resulting in a steeper yield curve (productivity boosting technology capital expenditure notwithstanding), which may undermine valuations.
The positive outlook is also tempered by the high levels of global indebtedness (both at the government and corporate levels) which means that resilience to an exogenous shock is fragile. The recent ramp up in tension between the USA and Iran is clearly worrying in this context, given the potential for oil supply disruption which might produce a material rise in the oil price (and derail the global economy).
The premium that investors pay for government bonds relative to riskier corporate debt is currently very low relative to history (despite government bond prices being high) which suggests that corporate debt is currently expensive and therefore caution is needed. Corporate bonds are particularly vulnerable to any whiff of either (a) a return of inflation or (b) a further deterioration in macro-economic outlook.
One of the few justifications for holding government debt currently is that it will act as an insurance policy against an unexpected slump in global growth as quantitative easing would be fully deployed again and this would support government bond prices.
The consensus is forming that 2020 will see enough global growth return to drive earnings upgrades but not increase inflation expectations.Providing there are no exogenous shocks, returns during the first half of the year could be strong, as investors move into equities as the goldilocks narrative gains ground and investors allocate to equities in the fear of missing out. After all, the consensus is forming that 2020 will see enough global growth return (due to fiscal and monetary stimulus) to drive earnings upgrades but not increase inflation expectations. In such a scenario, European and Emerging market equities could do well as the asset classes play catch up concerning the global/Chinese reflation trade.
This ‘not too hot/not too cold’ pathway is narrow with risks on either side. Given the high valuations in debt and equity markets and the narrowness of the pathway, it is less clear that such market performance could be sustained through to the end of the year. Of the major asset classes, equities are probably best placed to generate positive returns given their relatively attractive dividend yield and a probable return to earnings growth.
Whilst UK equities are likely to continue to perform well in the near term on the back of the global reflation trade and the acknowledgement of a pro-business government with a large majority in the House of Commons, the complexities of negotiating a favourable trade agreement with the EU are likely to become more apparent as the year progresses.
Cornelian Investment Team
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