The FTSE All-Share index rallied strongly during the first quarter of the year (+9.4%), only narrowly underperforming the FTSE World ex UK (£) index which returned 9.6%. Investor confidence recovered as the US Federal Reserve indicated that its policy of tightening monetary conditions 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.
In local currency terms, the FTSE World ex UK index returned 12.4%, but this return was pared back for UK-based investors as Sterling strengthened against most major currencies during the period. Sentiment towards Sterling improved as it became clear that there was no majority in the House of Commons for a hard, cliff-edge Brexit.
In Sterling terms, the strongest major regional equity index was the United States (S&P500 index, +11.1%), where investors responded positively to the Federal Reserve’s messaging concerning easier monetary policy going forward. Japan produced the most disappointing performance over the three-month period (MSCI Japan (£) index, +4.3%) due to concerns that negative interest rates may compromise the outlook for the domestic bank sector and fears that the anticipated sales tax increase (scheduled for later this year) may undermine the economic recovery.
Gilts performed strongly. Most of the return was observed towards the tail end of the period (FTSE Gilts All Stocks Index, +3.4%) on the back of several indicators that suggested global growth was slowing faster than expected. Both Investment grade debt (ICE BofAML Sterling Corp, +5.0%) and ‘riskier’ high yield debt (BAML £ High Yield index, +4.7%) outperformed Gilts.
The Brent crude oil price ended March at $68.4/barrel, an increase of 31% since the end of 2018.
The Brent crude oil price ended March at $68.4/barrel, an increase of 31% since the end of 2018. 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.
The gold price was broadly flat during the period under review $1292/oz (+0.8%). This performance followed strong gains during the final quarter of 2018 as investors’ aversion to risk increased substantially. For the UK-based investor, the gold price fell 1.4% due to Sterling strength against the US Dollar.
The strong rebound in risk assets (most notably equities and higher risk company debt) during the first quarter of the year 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 monetary policy tighten pedal (higher interest rate rises 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 in January and February generally reassured investors concerning the outlook for 2019.
Share prices have rallied strongly, whilst indicators of global macro-economic activity have continued to come in weaker than expected.
However, we are now at a slightly uncomfortable juncture as share prices have rallied strongly, whilst indicators of global macro-economic activity have continued to come in 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). The increase in stocks could be as a result of pre-stocking ahead of the US/China trade negotiations denouement, which if they break down will see tariffs increase materially and supply chains disrupted, or it could be due to reduced global demand. If the former (and the trade talks are resolved satisfactorily) the issue will clear fairly swiftly. If not, then earnings downgrades will persist for some time to come and this could undermine investor confidence. It should be noted that the Brexit debacle has seen a similar inventory dynamic, however from a global perspective, a cliff-edge, hard Brexit is much less important.
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 hold a positive view on both outcomes.
Residential housing market activity in the United States may be one of the positive surprises of the year, following years of disappointment.
The yields on US government bonds have fallen sharply in recent weeks. This could be taken negatively as it might indicate a less robust economic environment going forward, however this view ignores an important feedback loop. Lower long term interest rates reduce US mortgage interest rates, thus boosting housing affordability and allowing existing mortgage holders to refinance at cheaper interest rates. Indeed, this economic upswing is notable due to the lack of any signs of a countrywide housing bubble, despite the consumer in the United States being in rude health. The 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.
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 changes designed to stimulate the economy and it would appear that their squeeze on the shadow banking sector is also coming to an end. We believe that these actions, alongside a successful resolution of the US/China trade negotiations will be sufficient to stabilise Chinese economic growth, however we do not believe that this is the consensus view and investor confidence, in general, should improve if evidence of this materialises.
There are already some positive indicators to support our view on China. Firstly, industrial commodities and steel prices have been rising despite the global economic cycle slowdown. We believe that this is an indicator that specialist investors believe in the Chinese recovery story. Secondly, the share prices of mid-tier Chinese property development companies listed on the Hong Kong stock exchange are performing strongly. Finally, the cost to insure against the risk of default on the debt of China’s biggest bank, ICBC, has fallen to cycle lows which suggests that investors believe that the outlook for capital generation at ICBC is good. For this to hold true, the risk of a systemically important rise in debt defaults (more broadly) in China has to be low. In order for this to come about, investors have to believe that the authorities will be successful in stabilising economic growth through policy initiatives.
We believe that there may be a near term challenge to markets.
However, we believe that there may be a near term challenge to markets. As mentioned, risk asset prices have risen swiftly during the first quarter of the year and whilst there are tentative indicators pointing to an improvement in the global economic outlook, the hard evidence concerning a better US housing market and Chinese economic stabilisation may take a while yet to come through. It is possible, therefore, that the first quarter rally will be challenged in the near term, particularly if manufacturing companies have to reduce inventories.
We will be assessing the reaction of investors to first quarter trading updates closely, as the way investors react to these will provide an important signal concerning the risk of a short term market correction. Nonetheless, we remain constructive on the medium term outlook for risk assets for the reasons given above.
Cornelian Investment Team