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Market Commentary

Sterling strengthened against most major currencies as traders began to price in an imminent interest rate rise.

The S&P500 index returned 4.0% in Sterling terms as investors welcomed company updates which, in aggregate, continued to be positive and investors began to price in an increased probability of corporate tax reform being enacted in the United States.

Stronger regional equity market performers (in Sterling terms) included Japan (MSCI Japan (£) index, +5.8%) and Asia ex Japan (MSCI AC Asia ex Japan (£) index, +5.2%). Sentiment towards Japanese equities improved following a resounding victory by the Liberal Democratic party led by Prime Minister Abe in the snap general election, which reinforced Abe’s economic policy mandate. The Chinese economy continues to defy expectations of a material slowdown and recent moves by the authorities to stimulate bank lending should enable growth to continue at a rate which will help support global economic growth.

Gilts produced a small negative return (FTSE Gilts All Stocks index, -0.5%). The Bank of England continues to talk up the prospect of an interest rate increase and this resulted in a sharp sell-off in the 10 year gilt price late in the period, following a period of relative strength.

The generally supportive environment for equities was reflected in the fixed income markets, where UK high yield corporate debt (BAML £ HY index, +1.6%) and UK investment grade debt (BAML £ Corporate Securities index, -0.0%) outperformed Gilts.

The Brent crude oil price rallied 16.6% to $61.4 per barrel as a decision by OPEC and non-OPEC Russia to prolong a cut in production alongside better inventory data improved sentiment.  

The gold price produced a broadly flat return during the period rising 0.2% to $1271/oz. Early on in the period, the gold price benefited from the weaker US Dollar and the increased geopolitical risk on the Korean peninsula, but the US Dollar started to strengthen mid-way through the period and the tension concerning the Korean peninsula didn’t ratchet up any further and so the gold price fell back.

Market Outlook

It is always instructive to quiz manufacturing company management teams about how their order books have developed following the summer holiday period to obtain a real time gauge of global industrial activity. The message we have 'taken home' from these discussions is that demand is pretty good. The usual summer lull has been less deep than normal, distribution channels are short of inventory and end demand across most regions and sectors is not disappointing. 

The two biggest surprises have been that demand in Europe has returned and seems likely to be sustained and that the Chinese economy would appear to have managed to avoid (for now, at least) the anticipated hangover following the extraordinary stimulus enacted at the beginning of last year.

Whilst the great majority of the companies we have spoken to report in Sterling and therefore have had a significant 'assist' from the collapse in the currency, the underlying message is one of generally good global demand. This message is reassuring and points to further positive earnings surprises to come.

This improved confidence may enable company boards to authorise long awaited increases in capital expenditure which would help improve productivity and also increase overall demand still further. Suggested changes to the US corporate tax regime look to encourage investment by companies and, if enacted, would support this dynamic.

The more robust demand picture has led to increases in industrial commodity prices (such as aluminium, copper, iron ore and oil), and so throughout the value chain from raw materials to end products, costs are beginning to rise.

The picture painted encapsulates neatly the dilemma that fund managers are facing, namely that healthy economic demand is leading to earnings upgrades but that this is also tightening demand and supply balances, such that price rises are likely to become more prevalent across a variety of sectors. As evidence of this mounts, it is likely to galvanise central banks into action and interest rates could be increased more assertively than currently envisioned.

To our minds, earnings upgrades are likely to dominate the narrative going into the new year, but central banks are becoming emboldened enough to start signalling an intent, across most advanced economies, to withdraw some of the exceptional monetary stimulus which has been in place since the great financial crisis. This is exemplified by a recent speech from Janet Yellen where she said it was important for the Federal Reserve to be ‘wary of moving too gradually'. 

The reversal of quantitative easing, whereby central banks start to shrink their balance sheets, alongside interest rate rises could mean the period of excessively cheap financing is on its way out. If this is the case, it could push some weaker over-indebted companies into bankruptcy. The recent filing for bankruptcy protection by Toys ‘R’ Us in the United States may well be a forewarning of what is ahead. The consequence of this would be an earlier turn in the credit cycle as banks become more wary to whom they lend. Furthermore, this dynamic has the potential to derail the stellar increase of asset prices since the dark days of 2009.

One of the more striking memes circulating in the markets today is the idea that inflation in advanced economies is dead and buried and will not return in a material way. We would go further and suggest that today this has become a core belief of most fund managers. Now whilst they could be right in the longer term, any structural downshift can be masked for a time by cyclical factors. The current group think has, in our view, become too one sided and many investors may be surprised how fast inflation returns to the global economy over the next year or so. After all, Chinese producer price inflation is running at 6%, world food price inflation is running at 4% and wage inflation in the US is being masked to some extent by an increase in participation in the labour force by females and the young. As an aside, we continue to hear anecdotal evidence of significant wage pressures in the US. Recently, Target Corporation (the US discount retailer) announced a double digit percentage wage rise for its entry level employees for the second year in a row.

If we are right on this and medium term inflation expectations start to rise, investors could be underestimating the potential scale of interest rate rises that are ahead of us. We, therefore, continue to avoid longer dated government debt which we believe could sell off sharply in such an environment. 

Given the improved demand position we are more comfortable with our equity positioning than we have been for some time, although it should be noted that we are long overdue a pullback in equity markets.

Within our UK equity portfolios we believe our relatively high exposure to stocks that are more sensitive to global economic activity should perform well and those areas which have performed well in the recent past such as consumer staples companies, where we have little exposure, should start to struggle. 

Sentiment towards UK equities is currently low as international investors try to make sense of Brexit, the damaged Government, weak Pound and consequent surge in imported inflation that is resulting in real wages declining. UK consumer confidence has been falling alongside the pace of growth in retail spending as indebted consumers are now finding it more difficult to source new debt, let alone service existing debt. Perhaps perversely, this probably provides an opportunity for the brave investor as any Brexit deal which includes a lengthy transition period will be taken well from a currency perspective and would help stem imported inflation and the pressures on real wages.

We believe the US Dollar is oversold and that it is likely to rally as the Federal Reserve continues to increase interest rates. This will dampen sentiment towards emerging market equities, which have produced good returns year to date. The acceleration in global economic activity will benefit the Japanese stock market disproportionately as economically sensitive exporters are well represented on the listed market and corporate governance reform is really beginning to take hold in Japan. The coincidence of these two forces is auspicious and we anticipate Japanese equities, which have been overlooked for too long, will do well.

In summary, we think the near term outlook for earnings growth (and, by extension, equity markets) has certainly improved and we take comfort from this. However, the medium term consequences of the better demand picture could yet be quite negative for equity and debt prices as (i) company margins may come under pressure due to increasing raw material and labour costs, (ii) the interest rate assumptions used by analysts to value the current worth of future cash flows may rise (thereby reducing asset values), (iii) weaker companies may struggle to refinance their debt as interest rates rise and (iv) the consumer will have to contend with an environment of higher interest rates. However, these late cycle risks will not become evident for a while yet and so we believe investors will take heart and may well push stock markets higher in the interim.

The Cornelian Investment Team
November 2017

Risk Warning

Issued and approved by Cornelian Asset Managers Limited (CAML). You should remember that the value of investments and the income derived therefrom may fall as well as rise and you may not get back the amount that you invest. Past performance is not a guide to future returns. This material is directed only at persons in the UK and is not an offer or invitation to buy or sell securities. Opinions expressed represent the views of CAML at the time of preparation. They are subject to change and should not be interpreted as investment advice. CAML and connected companies, clients, directors, employees and other associates, may have a position in any security, or related financial instrument, issued by a company or organisation mentioned in this document.

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