The FTSE All-Share index produced a negative return (-6.1%) over the three months to the end of November, as Brexit uncertainty rose still further and concerns that global economic activity might be slipping faster than expected gained ground. Both Sterling (which slipped during the period) and the UK stock market remain highly out of favour with international investors given this uncertainty. Elsewhere, equity markets (in aggregate) produced better returns for investors based in the United Kingdom (FTSE World ex UK (£) index, -3.8%).
The strongest regional equity index was the United States’ S&P500 index which fell -2.6% in Sterling terms. Returns were helped by a stronger US Dollar versus Sterling as well as signalling by the Federal Reserve toward the end of the period that interest rate policy was more flexible than generally believed.
European equities (FTSEurofirst 300 £ index, -6.1%) performed poorly due to rising political tensions in France and Italy, as well as increased concerns that the capitalisation of some specific banks in the Eurozone might be inadequate.
Debt investors fretted that the fall in the oil price might spill over into increased default rates.
Gilts produced a negative return during the period (FTSE Gilts All Stocks Index, -1.8%). Both Investment grade debt (ICE BofAML Sterling Corp, -2.4%) and ‘riskier’ high yield debt (BAML £ High Yield index, -2.4%) underperformed Gilts. Debt investors fretted that the fall in the oil price might spill over into increased default rates.
During the 3-month period, the Brent crude price fell by 24%, finishing November at $58.7 per barrel. Saudi Arabia had been encouraged to increase oil production in the expectation that US sanctions on Iranian oil sales would result in the abrupt curtailment of supply from that country. In the end, the United States introduced waivers which resulted in Iranian crude continuing to be sold to specific partners. This has led to a temporary oversupply in the market.
Gold rallied 1.8% to $1223/oz as investors sought a safe haven from equity market volatility. In Sterling terms, the gold price rose by 3.4% as the Dollar strengthened against Sterling over the period.
Equity market returns have been poor over the past three months. Numerous suggestions have been put forward to account for the change in market psychology.
The two most commonly cited reasons for the sell-off are that recent Federal Reserve messaging suggests that interest rates in the United States will rise by considerably more than previously expected and that the IMF has downgraded its forecast for global economic growth.
It is true that the Chairman of the Federal Reserve said that current interest rates in the United States were a long way from neutral and they may take interest rates above the neutral rate if they thought fit. However, this is entirely in keeping with previous messaging released by the Federal Reserve in March and so shouldn’t be a surprise.
The IMF cut their global growth forecast from 3.9%pa for 2018 and 2019 to 3.7% and cited trade wars as a key reason for the downgrade. The IMF has a risible record of economic forecasting and so it would seem strange for investors to take too much notice of what the IMF has to say.
This means that we have to look elsewhere for reasons for the change in perception concerning the outlook.
We believe that the most relevant issue is that third quarter trading updates from economically sensitive companies have been mixed with those that are exposed to the global car market and semi-conductor sectors, in particular, reporting a difficult quarter. This has led some to suggest that we may be close to a peak in earnings for this cycle. We believe this is wide of the mark and expect earnings growth to persist albeit at a considerably slower rate than the exceptional growth reported during the third quarter of 2018 where US companies, in aggregate, reported earnings growth of around 25% year on year.
Allied with unease about the outlook for earnings is the fact that interest rates have risen in the United States, to such an extent that it is now possible to buy Government debt with a yield of nearly 3% per annum maturing in three years’ time. This compares with a yield of circa 2% for the S&P500 equity index. This means that US based investors, who are uncomfortable with the increased volatility of the stock market and would like to book some of the gains they have made over the past ten years, have a ‘risk free’ investment which will provide a return that is likely to match (or beat) inflation over the next three years. This has resulted in profit taking and has spilled over into other equity markets.
There are good grounds to be optimistic about the outlook for equity markets.
We take a different view and believe there are good grounds to be optimistic about the outlook for equity markets, notwithstanding the increase in volatility, which is likely to persist.
First of all, other traditional indicators of a reduction in risk appetite have not moved much. Whilst the cost of debt financing for higher risk companies has risen, the spread between Treasuries and high yield corporate debt remains narrow relative to history. This seems fair to us, as we do not believe that the corporate debt default rate is about to rise materially from current levels. Furthermore, there is little sign of a loss in confidence concerning lending between banks.
It is true that US housing market activity is subdued due to rising mortgage costs, however it is, arguably, a good thing that the current US expansion is not reliant on a US housing boom. In aggregate, however, US economic data releases are tracking in line with expectations and, importantly, inflation expectations remain well anchored, which suggests interest rates in the United States are unlikely to have to rise by more than currently forecast by the Federal Reserve.
Globally, service sector confidence surveys continue to be robust.
Globally, service sector confidence surveys continue to be robust. Manufacturing confidence surveys are strong in the US and Japan. In Europe, they remain positive but have come off the boil somewhat (probably as a result of the auto sector issues). Manufacturing confidence is least strong (i.e. neutral) in China as a result of the trade tariffs and a slowing domestic economy. The Chinese authorities are now beginning to use both fiscal and monetary policy to stimulate economic activity and the results of this should soon be evident.
Despite the rhetoric, we expect a trade deal between China and the United States to be forthcoming. Such an outcome would be a materially positive catalyst to share prices.
The oil price had hit a new high at the start of the October, and this may well have triggered a reassessment of the impact of rising energy costs on some companies’ operating margins. Since then however, the oil price retrenched sharply as the United States imposed oil sanctions on Iran which were less draconian than initially expected. OPEC and Russia have responded and it is now expected that OPEC will announce oil production cuts in early December, thus stabilising the oil price.
Much has been made of the strengthening US Dollar and it is true that some emerging market currencies have fallen sharply against the US Dollar, but on a ‘trade weighted’ basis, the US dollar has not strengthened materially.
In the US, manufacturing companies are reporting that significant numbers of their customers believe that they are running with too little inventory following a period of stronger than expected demand. This suggests that customers will need to replenish stock levels and the positive impact of this on manufacturing company sales and margins is being underestimated by investors.
We believe that the observed strong growth in capital expenditure by companies will persist.
We believe that the observed strong growth in capital expenditure by companies will persist and that this will drive productivity gains, earnings growth and help ensure that underlying inflation remains ‘well-behaved’. Banks in the United States (and elsewhere) continue to make it easier for corporates to borrow and this underpins our confidence concerning the persistence of the economic upswing.
The recent equity market falls leave valuations at attractive levels. The FTSE All-Share index is now trading on a forecast 2019 dividend yield of around 4.6%. We currently view this pullback in equity markets as more of a buying opportunity than something more sinister.
Sources: Bloomberg, Bloomberg Indices, Deutsche Bank, FTSE, Federal Reserve, IMF, ISM, Morningstar, MSCI, S&P.
Cornelian Investment Team