The MSCI UK All Cap NR index returned 2.5% during the three months to the end of May, underperforming the MSCI World (£) index which returned 4.4% for the UK based investor (as Sterling fell against most major currencies).
In local currency terms, the MSCI World ex UK NR index returned -0.8%. Initially, investor confidence recovered as the US Federal Reserve indicated that its policy of monetary policy tightening would be adjusted to reflect the slower growth outlook, the oil price rose (in response to OPEC oil production cuts) and company trading updates reassured. However, towards the end of the period, concerns that global growth was continuing to slow gathered pace and risk assets were sold.
In Sterling terms, the strongest major regional equity indices were the United States (MSCI USA NR index, +4.6%) and Europe (MSCI Europe ex UK NR index, +4.5%). This was mainly driven by Sterling weakness. Asia ex Japan performed relatively badly. In Sterling terms, the MSCI Asia ex Japan NR index returned +0.1%, as concerns regarding the US/China trade dispute reverberated around the region.
Gilts performed strongly on the back of several indicators that suggested that global growth was slowing faster than expected.
Alongside many developed market government bonds, Gilts performed strongly (MSCI iBoxx GBP Gilts TR index, +4.6%) on the back of several indicators that suggested that global growth was slowing faster than expected. Both Investment grade debt (ICE BofAML Sterling Corp, +3.5%) and ‘riskier’ high yield debt (BAML £ High Yield index, +2.5%) underperformed Gilts.
The Brent crude oil price ended May at $64.5/barrel, a decrease of 2.3% since the end of February. The oil price rallied as evidence emerged that OPEC was following through on promises to cut production in order to bring the market back to balance. However, towards the end of the period the oil price fell sharply as concerns increased that US oil production growth, combined with weaker global economic growth, could undermine OPEC attempts to stabilise the oil price.
The gold price fell 0.6% to $1306/oz during the period under review. This performance followed strong gains during the final quarter of 2018 when investors’ aversion to risk increased substantially. Due to Sterling weakness, the gold price rose 4.4% to £1033.8/oz for UK based investors (during the three months to the end of May).
The strong rebound in risk assets (most notably equities and higher risk company debt) to the end of April was as a result of various factors, the most important of which were: The US Federal Reserve indicated that it would take its foot off the pedal for monetary policy tightening (interest rate increases and quantitative tightening) thus ameliorating fears that they would, through their actions, drive the US economy into recession. Secondly, the oil price rebounded as evidence materialised that OPEC, Russia and Canada were cutting oil production swiftly in response to the glut in supply. This reduced fears of bankruptcies in the US onshore oil sector which, if they had materialised, could have derailed the credit cycle as banks may have become more wary about lending to corporates, in general. Finally, company trading updates have, generally, reassured investors concerning the outlook for 2019.
However, since then indicators of global macro-economic activity have continued to be weaker than expected. This is particularly true of the manufacturing sector, where it is evident that demand has been relatively lacklustre of late. Furthermore, wholesale inventories have risen relative to sales. In order for these inventories to clear, either end demand has to pick up or manufacturers will need to reduce manufacturing production rates (which negatively impacts earnings).
In addition, the US/China trade talks have broken down and the positions of both sides are seemingly becoming more entrenched.
In addition, the US/China trade talks have broken down and the positions of both sides are seemingly becoming more entrenched. This may mean that a resolution of the areas of disagreement will be delayed and the application of higher tariffs enacted, which would disrupt supply chains still further. This, alongside new trade tensions elsewhere (most recently Mexico and India) all increase the possibility that investors lose confidence.
In order for risk assets to produce positive returns during the remainder of 2019, investors will need to begin to believe that the US consumer will start to spend and that Chinese economic growth will stabilise, following a period when it has slowed fairly rapidly.
We continue to hold a positive view on both outcomes.
The US unemployment rate is low and falling, real wages are growing at a healthy clip, consumers have been saving a significant proportion of their take home pay (relative to history) and those who are on the housing ladder have built up significant amounts of equity in their homes. We believe that residential housing market activity in the United States may be one of the positive surprises of the year, following years of disappointment, helped, in part, by the fall in mortgages interest rates.
The authorities in China have been actively countering the slowdown in their economy by cutting interest rates and taxes and introducing measures to promote bank lending.
The authorities in China have been actively countering the slowdown in their economy by cutting interest rates and taxes and introducing measures to promote bank lending. They have announced a myriad of targeted policy initiatives designed to stimulate the economy and it would appear that the squeeze on the shadow banking sector is also coming to an end. We believe that these actions will be sufficient to stabilise Chinese economic growth, notwithstanding a successful conclusion to the US/China trade negotiations.
We, therefore, remain constructive on the medium term outlook for risk assets for the reasons given, however tail risks have certainly increased and several alarm bells are beginning to ring. The most important of which is that the yields on developed market government bonds have fallen appreciably over the period. The extent of the falls is a concern as it suggests investors (as a whole) believe that global economic growth going forward will be materially below consensus forecasts. As a result, we have derisked portfolios somewhat by reducing the overall allocation to equities (both UK and overseas) and adding a position in gold to increase diversification.
Cornelian Investment Team