The MSCI UK All Cap NR index returned 2.3% during the three months to the end of July, underperforming the MSCI World ex UK (£) index which returned 7.7% for the UK based investor (as Sterling fell against most major currencies). In local currency terms, the MSCI World ex UK NR index returned 0.9%.
Confidence was dented in May as concerns that global growth was continuing to slow resurfaced, however, hopes rose that the G20 meeting at the end of June would produce co-ordinated policy responses to counteract the global slowdown and this helped drive asset prices higher in June and July.
In local currency terms, the region produced a negative return as concerns regarding the US/China trade dispute reverberated.
In Sterling terms, the strongest major regional equity index was the USA (MSCI USA NR index, +8.2%). This outperformance was entirely driven by Sterling weakness. Asia ex Japan equities performed relatively poorly in Sterling terms (MSCI Asia ex Japan NR Index, +2.0%). In local currency terms, the region produced a negative return (MSCI Asia ex Japan NR index, -4.3%) as concerns regarding the US/China trade dispute reverberated.
Alongside many developed market government bonds, Gilts performed strongly (MSCI iBoxx GBP Gilts TR index, +5.3%) due to numerous indicators that suggested that global growth was slowing faster than expected and expectations that central banks around the world would cut interest rates. Both Investment grade debt (ICE BofAML Sterling Corp, +4.7%) and ‘riskier’ high yield debt (BAML £ High Yield index, +1.8%) underperformed Gilts.
The Brent crude oil price ended July at $65.2/barrel, a decrease of 10.5% since the end of April. The oil price fell as concerns increased that the weaker global economic growth environment could undermine OPEC attempts to stabilise the oil price going forward.
The gold price rose 10.2% to $1414/oz during the period as the consensus began to assume that interest rates would be on a downward trajectory going forward and this would reduce the opportunity cost of holding gold. Sterling weakness ensured the gold price rose by more for UK based investors (+17.6% to £1158/oz).
There has been a palpable loss in momentum in the global economy as end demand has been less forthcoming than expected and inventories have increased to levels which are uncomfortable. This has not gone unnoticed by government bond investors, but investors in riskier assets appear to be ignoring the evidence on the hope that policy makers will step in and come to the rescue once again.
Central banks around the world are becoming more vocal concerning their willingness and readiness to ease monetary policy.
In this they are probably right. Central banks around the world are becoming more vocal concerning their willingness and readiness to ease monetary policy and the Federal Reserve has cut interest rates for the first time since the financial crisis.
Mario Draghi, the ECB’s President recently announced that he was prepared to move interest rates deeper into negative territory and print more money if inflation and economic growth do not pick up shortly. The timing of his announcement was curious as he seemed to be binding his successor’s hands to an easing course (Draghi leaves his post at the end of October). However, he was reacting to a sudden and sharp drop in inflation expectations in the Eurozone. If not arrested, this could result in a prolonged period of deflation and slack economic growth, in the knowledge that, dependent upon country, politicians within the Eurozone are either unwilling or unable to boost fiscal spending.
From our perspective, it is disappointing that the levers that Draghi has reached for are the same levers which he has used before to help prop up asset prices, but did not deliver a sustained improvement in Eurozone economic activity. As we have already seen, this course of action increases inequality and promotes political populism. Cutting interest rates to even more negative levels and re-introducing quantitative easing will result in more of the same, that is: more private sector debt; more investment in riskier assets (as yield is chased); and the misallocation of capital (which is distorted by a negative ‘risk free’ rate of return). Another term for this is financial repression. If enacted, this will mean that achieving a self-sustaining level of economic growth, that helps the region escape an environment of low growth and low inflation, will become even more difficult.
In anticipation of significant monetary policy easing going forward, investors have bid up the price of debt, such that the value of debt now trading on a negative yield (if held to maturity) has never been higher (source: Bloomberg Barclays). Furthermore, investors have also priced in four interest rate cuts by the Federal Reserve in the United States over the next twelve months.
Equity and credit prices have responded as policy makers would have hoped.
Equity and credit prices have responded as policy makers would have hoped. The strong performance of the US stock market during the first half of the year has been driven almost entirely by multiple expansion as investors price in a projected lower cost of financing, rather than an anticipation that global economic growth will rebound. Indeed, earnings have been revised down consistently as the year has progressed.
Only in China are we guaranteed meaningful fiscal stimulus alongside interest rate cuts, which may be enough to stabilise the economy’s growth rate.
The questions that now have to be answered are (a) whether the impact of this next raft of ‘co-ordinated’ stimuli from the US, the Eurozone and China has already been largely priced in and (b) whether the effect of the policy easing will have a less strong impact on the underlying economy than expected. We think the answers to both questions are probably yes, particularly if President Trump follows through with his threat to increase tariffs on Chinese imports.
Nonetheless, investors are likely to focus on the initiation of a globally co-ordinated easing of monetary policy over the summer (which should support asset prices), particularly as the average investor is fairly defensively positioned and may be pushed into adding more risk as another bout of financial repression takes hold.
Despite the cuts to earnings forecasts that analysts have made to date, forecast earnings growth for 2020 over 2019 continues to look overambitious.
Nonetheless, numerous economically sensitive companies have reported relatively disappointing trading performances year to date and are relying on a strong second half to deliver results in line with previous management guidance. This will be difficult to achieve. Despite the cuts to earnings forecasts that analysts have made to date, forecast earnings growth for 2020 over 2019 continues to look overambitious and this may become a material issue towards the end of 2019. As a result, we’ve started to take advantage of high asset prices to take some equity risk off the table, having participated in the strong equity market returns year to date.
The Brexit issue has moved into its next reincarnation as the new Prime Minister takes the government’s helm. With promises to cut taxes and increase spending as well as ramping up the possibility of a no deal Brexit, it is difficult to see international investors returning to buy UK assets in the near term, particularly as the probability of another general election is rising. Therefore, the risk to UK based investors’ global multi-asset portfolio values that Sterling strength would engender seems relatively limited in the near term.
Cornelian Investment Team