The FTSE All-Share index produced a negative return (-1.3%) during the three-month period to the end of January, outperforming the FTSE World ex UK index which returned -1.6% (in Sterling terms). Early on in the period, investor confidence was undermined by the sharp fall in the oil price, evidence that the Eurozone and Chinese economies were growing at a slower rate than expected and concerns that US policymakers’ attempts to ‘normalise’ monetary policy (by increasing interest rates and reversing quantitative tightening) could inadvertently tip the economy into recession. However, equities performed strongly in January following OPEC production cuts (which supported the oil price) and more benign messaging from the Federal Reserve, concerning the pace of interest rate rises and quantitative tightening.
Over the period, Sterling strengthened against most major currencies as it became clearer that there was not a majority in the House of Commons for a hard, cliff edge Brexit on the 29th March. This pared back the modest gains seen in international equities for UK based investors. In local currency terms, the FTSE World ex UK index returned +0.4%.
The strongest major regional equity index was Emerging Markets (MSCI Emerging Markets (£) index, +5.3%), in anticipation of a weaker US Dollar and potential Chinese economic stimulus. Japanese equities performed least well during the period (MSCI Japan (£) index, -3.5%) as the Japanese central bank expressed concerns over the outlook for the economy.
Gilts were well supported during the period thanks to their status as a ‘safe haven’ asset. Gilts were well supported during the period (FTSE Gilts All Stocks Index, +2.1%) thanks to their status as a ‘safe haven’ asset. Both Investment grade debt (ICE BofAML Sterling Corp, +1.4%) and ‘riskier’ high yield debt (BAML £ High Yield index, -1.4%) underperformed Gilts.
The Brent crude oil price ended the period at $61.9/barrel, down 18% from the price at the beginning of the period. 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. OPEC responded in December, announcing a cut in production in order to support the oil price.
Gold rose 8.8% to $1321/oz as investors sought a safe haven from equity market volatility. In Sterling terms, the gold price rose by 5.7% as Sterling strengthened against the US Dollar over the period.
The underlying cause of the market falls observed in the latter part of 2018 was a reassessment of risk brought about by rising interest rates and/or the drawing to an end of quantitative easing in western economies.
As a result of strong US economic growth, the Federal Reserve has been at the forefront of trying to ‘normalise’ monetary policy by both increasing interest rates and reversing quantitative easing.
However, investors have become concerned that the central bank may tighten monetary policy by more than the US economy can bare, thus tipping it into recession. This issue has become more pressing as the impact of the Trump fiscal stimulus package (tax cuts and increased federal spending) in the United States will soon start to fade and economic growth in other parts of the globe is decelerating.
Furthermore, the sharp fall in the oil price threatened to upend the US corporate credit cycle, where banks which have lent to US onshore oil companies start to experience increased levels of debt default and, therefore, decide to be more careful lending to other segments of the economy.
There is political instability in many European nations.
Beyond interest rates and economic growth, political uncertainty remains elevated. The risk of an escalation in the trade war between the United States and (principally) China continues. Furthermore, there is political instability in many European nations including, of course, the United Kingdom where the Brexit denouement will shortly be upon us.
Given the heightened level of doubt, investors reduced their exposure to risk assets towards the end of the year. Despite these concerns, we believe it is too early to call time on the economic upcycle and remain constructive regarding the outlook for equities and corporate bonds.
Markets bounced strongly in January. There were four major reasons for the more constructive tone to markets.
Firstly, recent clarifications by the chair of the Federal Reserve concerning the US central bank’s thinking and flexibility suggest that policymakers will not turn a deaf ear to developments in the economy and, if needed, a more supportive monetary policy could be enacted in order to extend the cycle. Importantly, inflation expectations in the US are likely to remain well anchored and this means that the Federal Reserve has room to ease the rate of monetary policy tightening or, indeed, reverse it, as required.
The oil price recovered some lost ground in January following an agreement by OPEC, Russia and Canada to co-ordinate oil production cuts.
Secondly, the oil price recovered some lost ground in January following an agreement by OPEC, Russia and Canada to co-ordinate oil production cuts. This action should be enough to stabilise the oil price and reduce the risk of higher debt defaults and a turn in the corporate credit cycle.
Thirdly, Chinese authorities have been easing monetary policy and have also announced a variety of fiscal measures designed to boost the economy and these should soon start to have a positive impact on activity. In addition, the probability of a trade deal being agreed between China and the United States appeared to have increased during January.
Finally, fourth quarter trading updates from companies have been dull but reassuring and this has been enough to assuage concerns that the global economy may be slowing considerably faster than previously anticipated. US economic growth is currently strong, the labour market is tight and wage inflation is accelerating. Confidence concerning the domestic economy is high and we expect this to continue to percolate through the economy resulting in a more resilient economic upcycle than investors currently anticipate.
Brexit remains front of mind given the timetable.
Brexit remains front of mind given the timetable. The situation is clearly very fluid, the route to a resolution is difficult to discern and the range of outcomes remains high. Nonetheless, there is no majority in the House of Commons for a hard Brexit, which should mean that Theresa May’s Brexit plan or something softer than that is enacted, if agreement can be reached. If not and the cliff edge is reached without significant concessions from the EU, then it also follows that the Government will ask the EU for more time to consider next steps (such as a referendum) and if this is not received then Parliament will probably vote to revoke the Article 50 withdrawal process in order to achieve the same result (ie. more time to consider next steps). This ability to revoke the withdrawal process unilaterally is, perhaps, the ultimate backstop given neither of the major parties want to be responsible for a cliff edge, hard Brexit outcome. We, therefore, continue to believe that there is only a low chance that the UK will undergo a cliff edge, hard Brexit on the 29th March this year.
International investors have deserted UK assets finding the political uncertainty deeply unpalatable. Even if the Brexit outcome (via a referendum) is a two year ‘managed hard Brexit’, as political uncertainty subsides, as it surely will, we expect investors to return as the value now seen in the UK equity market is compelling. This view assumes that the Conservatives and DUP will do all in their power to avoid an early general election, however this is clearly not a given.
Cornelian Investment Team