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Market Commentary

The MSCI UK All Cap NR index returned 3.6% during the three months to the end of November, outperforming the MSCI World ex UK (£) NR index which returned 1.3% in Sterling terms. The negative performance of international markets was driven by the strength of Sterling against most major currencies (MSCI World ex UK NR index returned +7.8% in local currencies).

Additional monetary policy easing was announced in September by central banks in the USA and Eurozone and this helped to support markets going into the third quarter results season. Whilst companies generally reported lacklustre numbers, investors were encouraged that the slowdown in activity appeared to be stabilising. Trade negotiations between the USA and China continue and the belief that a limited phase one deal could be agreed increased during the period.

In Sterling terms, the strongest major regional equity index was Japan (MSCI Japan £ NR index, +3.3%), where some macro-economic releases suggested that the economy was doing better than feared. Nonetheless, rising trade war risks and tensions in Hong Kong saw Asia ex Japan and Emerging Market equities perform less well.

Gilts produced a negative return (iShares Core UK Gilts ETF, -2.1%) as investors grew more confident that the decline in global growth was stabilising. Both Investment grade debt (iShares Core £ Corporate Bond ETF, -0.5%) and ‘riskier’ high yield debt (iShares Global High Yield GBP Hedged ETF, +0.7%) outperformed Gilts.

The Brent crude oil price ended November at $62.4/barrel, an increase of 3.3% since the end of August.  The oil price was relatively stable as concerns around end demand slowing, as a result of the weaker global economy, gave way to the view that global economic activity was stabilising and that OPEC may cut supply further to support the oil price ahead of the Saudi Aramco float.

Following considerable strength during the middle part of the year, the gold price drifted 3.7% lower during the three months to the end of November (to $1,464/oz). Sterling strength meant that the value of gold held by UK based investors fell by 9.4% (to £1,132/oz).  

Investment Outlook

In the past, the key to understanding where we were in the global economic cycle was to understand the outlook for the US consumer. Today, given the exceptional growth of the Chinese economy over the past two decades, we now have to assess the outlook for both the US consumer and the Chinese economy to determine the outlook for the global economic cycle. Whilst the US consumer looks well set (for now), it is fair to say the outlook for China is less strong.

The linkage between Chinese manufacturing and the US consumer has been thrown into stark relief as President Trump weighs up whether to continue to go toe-to-toe against President Xi in order to recalibrate global trade flows fundamentally.  

We suspect President Trump will continue with his hard rhetoric against China whilst agreeing limited trade deals on agriculture (predominantly pork and soya beans) and possibly oil. This means continued tariffs on manufactured goods with the threat of more to come, which will continue to undermine confidence in the global manufacturing sector where companies, in general, are reporting reduced demand and higher inventories.
The weakness in manufacturing activity is leading to a noticeable slowdown in overall global economic growth.

The weakness in manufacturing activity is leading to a noticeable slowdown in overall global economic growth. In the past, when this has happened, the Chinese authorities have implemented large scale stimulus programs which have had the result of getting the global economy back on track. This time, however, the signals coming out of China suggest less willingness to go down this route. Whilst Chinese interest rates will continue to be cut and the amount of capital banks have to lodge with the central bank will be cut to encourage more lending, a significant ramp up in private sector lending or infrastructure investment is unlikely. 

Thankfully, the services sector which is a much larger proportion of developed market economies remains in good shape. In the US, where unemployment is at cycle lows and wages are growing at a good rate, service sector confidence remains good. One of the key questions therefore has to be whether the slowdown in the manufacturing sector will take the services sector down with it. The Federal Reserve has already cut interest rates in order to try to stave off such an outcome.

One of the by-products of the fall in interest rates is that mortgage rates in the US have fallen and this is having a positive effect on US housing market activity. Whilst recent newsflow concerning the US housing market is undoubtedly better than expected and is to be welcomed, the US labour market is beginning to show signs of slowing after a long period of good growth.

Interestingly, one of the indicators used to determine whether there is an enhanced risk of recession is, counterintuitively, a low unemployment rate. If the unemployment rate is close to historic lows, it follows that the economic cycle is long in the tooth. Unfortunately, one has to go back more than 50 years to observe a United States unemployment rate as low as it is today (3.6%).
There are some tell-tale signs materialising that may be indicative of a more difficult refinancing environment.Another reason for caution is that there are some tell-tale signs materialising that may be indicative of a more difficult refinancing environment. Symptoms include the bankruptcy of Thomas Cook, the Argentinian debt default, the stronger US Dollar and indeed the failure of the WeWork listing. 

Given the above, it is difficult to accept the consensus estimate which suggests US earnings are going to grow at a double-digit rate next year. We think the real number will be much less than that due to lacklustre demand and pressures on company profitability and will provide a headwind to further material appreciation.

The third quarter results season, whilst not good, was greeted with some relief from investors which is a positive sign. This may signal that the recent slowdown in global economic activity may be coming to an end. Furthermore, credit spreads have remained tight indicating that fixed income investors remain sanguine about the outlook. We have therefore added to our positions in equities somewhat as a result.

Cornelian Investment Team
01/12/2019

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