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Market Commentary

During the second quarter, Sterling strengthened against the US Dollar despite the Conservatives returning to government in June without an overall majority in parliament. Investors appear to be beginning to price in the possibility of a ‘softer’ Brexit with, perhaps, a transition period post the Article 50 deadline of March 2019.

During the period under review, the FTSE All-Share index returned 1.4%, whilst the FTSE World ex UK index returned 0.5% in sterling terms (FTSE World ex UK +3.3% in local currency terms).

Following Donald Trump’s Presidential election success in November 2016 US equities have performed very strongly, however during the three month period under review the S&P500 (£) index’s return has been poor (-0.8%) and some other regional equity markets have outperformed the United States. The strongest regional equity market performers (in Sterling terms) were Asia ex Japan (MSCI AC Asia ex Japan (£) index, +4.3%) and Europe (FTSEurofirst 300 (£) index, +3.5%). The Asian ex Japan region’s equity markets and currencies have benefited from Chinese policy makers decision to inject more debt into their economy in order to support activity levels. Whilst a short term benefit to economic activity, China’s continued reliance on debt stimulus without radical structural reform ensures that the medium term prospects for the economy continue to worsen. European equities benefited from stronger than expected macro-economic releases and Macron’s success in the French presidential and general elections, which alongside other election results on the continent, suggested that support for more populist anti-EU parties had waned somewhat.

European equities benefited from stronger than expected macro-economic releases and Macron’s success in the French presidential and general elections, which alongside other election results on the continent, suggested that support for more populist anti-EU parties had waned somewhat.

During the quarter, gilts produced a negative return (FTSE Gilts All Stocks index, -1.3%). Gilt prices rallied on concerns that the UK economy would start to underperform as it became clear that the consumer was beginning to struggle in the face of rising inflation. However during the last few days of June there was a fairly abrupt sell off as a result of the Bank of England being perceived to be more receptive to the idea of raising interest rates than generally expected. Given the outlook for the consumer, we are not convinced that this is the correct conclusion to draw from the Governor of the Bank of England’s comments.

The generally supportive environment for equities was reflected in the fixed income markets, where UK high yield corporate debt (BAML £ HY index, +2.0%) outperformed UK investment grade debt (BAML £ Corporate Securities index, +0.8%), which in turn outperformed Gilts.

The Brent crude oil price fell 9.3% to $47.9/barrel during the three month period to the end of June as crude oil inventory data disappointed, and an OPEC and non-OPEC Russia agreement to prolong a cut in production was deemed not to be enough to get the market back in balance in the near term.

The gold price declined marginally (-0.6%) to $1242/oz during the quarter.

Sources: CAM, FTSE, Morningstar, Bloomberg, BAML, MSG, ICE Futures.

Market Outlook

The first six months of the year have seen some underlying positives emerge which are helping to support equity markets. Most importantly, revisions to analysts’ forecasts which usually fall as the year progresses as over-optimism early in the year shifts to realism has not happened to the same extent as we have seen in recent years. Indeed, the aggregate earnings forecast in the United States for 2017 has only been cut marginally, meaning that it is likely we will see double digit earnings growth in that market this year following two years of little or no earnings growth at all.

This positive trend is not confined solely to developed markets. Indeed, the aggregate earnings forecast for emerging market equities has been revised up as the year has progressed. Over the past five years and more, emerging market equities have only seen aggregate earnings forecasts cut as the year has progressed so something interesting is happening.

Over the past five years and more, emerging market equities have only seen aggregate earnings forecasts cut as the year has progressed so something interesting is happening.

The global financial sector looks as though it has turned a corner. For many years, the bank sector’s earnings have disappointed expectations as banks have had to deal with significant regulatory fines, increased compliance costs, recognising bad debts and, at the same time, increasing reserves. Many of these pressures seem to be receding.

At the same time, companies which produce oil and/or other commodities such as iron ore have cut costs aggressively, such that downward earnings revisions have now abated.

Allied with these sector specific drivers is a synchronised economic upswing in developed markets. As yet, these positive developments haven’t fed into inflationary pressures and this has led equity investors to buy into the concept of the goldilocks recovery, where economic growth is neither too hot nor too cold.

In recent times, when such a narrative has gained ground (ie. the mid 2000’s and the mid to late 1990’s) the equity market has done exceptionally well and returns over the past year have been strong and this can continue. However, one has to guard against complacency and over confidence as such optimism in the past has led to speculative bubbles, which, when pricked, has caused economic resets.

Furthermore, investors in government bonds have not bought into the global reflation goldilocks narrative. At the end of June 2017, if one wanted to buy a UK government debt instrument which matured in ten years’ time, you would receive a return of just 1.26% per annum during the ten year term. With UK consumer prices rising at a rate of 2.9% year on year (as at end May 2017) this looks like a very bad deal unless you expect (as investors in government bonds seem to) economic growth and inflation to be very/too low over the period.

This disparity of views is important, but there is a third possibility, perhaps investors in both equities and bonds are ignoring the evidence that inflationary pressures are building. On balance, we subscribe to this view but realise the amount of slack, particularly in the US economy, may be greater than generally assumed. After all, the number of Americans receiving food stamps remains high (42 million) relative to history (26 million in 2006) despite the reported unemployment rate being close to the lows of previous cycles.

...perhaps investors in both equities and bonds are ignoring the evidence that inflationary pressures are building. On balance, we subscribe to this view but realise the amount of slack, particularly in the US economy, may be greater than generally assumed. 

As direct investors in UK companies with global operations, we have been focussing on the issue of wage inflation, particularly in the United States, and this has helped inform our view that some companies in specific sectors are beginning to have to manage wage inflation pressures proactively.

One case in point is the US construction tool hire company Ashtead (listed in the United Kingdom). They have reported that their drivers are being approached at traffic lights with offers of employment on better terms elsewhere. As a result Ashtead have had to make a provision in their accounts to pay retention bonuses to staff at year end, whilst reshaping their remuneration policy to remain competitive in future years.

Another example is Firstgroup, which has a large student bus business in the United States as well as owning the iconic inter-state Greyhound bus company. The company has had to increase wages appreciably in order to fill bus driver vacancies. Importantly, they report that having done so, they are finding that they can pass these additional costs on to their clients. This is how inflation seeps into an economy. We are also seeing evidence that wage pressures are building in the home building and restaurant sectors in the United States and we believe that these pressures will spread, in time, to other sectors.

Optimism, at the corporate level, concerning the reflation of the United States economy remains undiminished but we note that some macro-economic data points need to start to improve soon to support this view. Car sales, although at an admittedly high level, are tracking sideways, the issuance of house building permits is growing but at a subdued rate and the demand for credit from banks by small companies is actually falling. Overall, US macro-economic data are coming in below recently raised expectations.

Optimism, at the corporate level, concerning the reflation of the United States economy remains undiminished but we note that some macro-economic data points need to start to improve soon to support this view. 

We, therefore, have a contradiction. Equity investors have focussed upon the improving ‘bottom up’ corporate confidence surveys, whilst also buying into the view of investors in government bonds that ‘top down’ macro-economic data releases will remain subdued. If bond investors are correct, there will be a negative impact on company earnings forecasts. If bond investors are wrong, and bond yields start to rise (ie. bond prices fall) appreciably, there will be a negative impact on equity valuations.

Our emphasis on the economy of the United States is deliberate as it is the outlook for the investment cycle of this economy which sets the tone for most major asset markets. However, focussing upon the domestic UK economy suggests underlying frailties. Inflation has risen swiftly on the back of Brexit related currency weakness and wage growth is now lagging inflation. Consumers, having already maxed out their credit cards, are finding it increasingly difficult to save. Providers of credit card debt have signalled an intention to tighten lending criteria, whilst the Bank of England has recently instituted a requirement on banks to build a counter cyclical capital buffer in case consumer bad debts rise in the future. This will have the effect of diminishing banks’ propensity to lend to consumers. These moves by the providers of debt may compound the problem of negative real wage ‘growth’. The two crumbs of comfort here are that (i) this is well known and largely priced in, whilst a relaxation of the public sector wage cap is not, and (ii) the companies which comprise the FTSE 100 index have, as a whole, relatively little exposure to the UK consumer.

On a separate note, we believe that it is likely that the European Union will start to ratchet up the pressure on the UK government concerning the Brexit negotiations and that this may well result in Sterling falling back to recent lows.

On a separate note, we believe that it is likely that the European Union will start to ratchet up the pressure on the UK government concerning the Brexit negotiations and that this may well result in Sterling falling back to recent lows.

More positively, growth in both the European and Japanese economies would appear to be accelerating. Optimism is good, unemployment is falling and output surprising on the upside. The equity markets of both regions have lagged the US stock market and valuations are not nearly as stretched. We increased exposure to European equities at the beginning of the year and have recently added, at the margin, to existing Japanese equity holdings.

The reason we continue to temper our enthusiasm for Japanese (and indeed emerging market) equities is that we take issue with the perception of Chinese economic stability. Should the Chinese authorities fail to manage the (yet to materialise) bursting of their credit bubble successfully, the ramifications for the region, in particular, will be significant.

Whilst retail sales growth has stabilised and some indicators of Chinese growth have improved, we note that the value of land sales in the top 30 cities is falling, the momentum of house price growth in the top 70 cities is stalling and the value of ‘entrusted loans’ extended has been negative in April and May.

An entrusted loan is a direct loan made between one company with excess cash to another which is looking to borrow. The participants use a bank as an agent to facilitate the transaction. Importantly, however, the bank does not carry the loan on its balance sheet and so the loan constitutes part of the ‘shadow’ banking sector, which is unregulated and has grown hugely over the years. Whilst having a couple of months where, in aggregate, loans have been called in rather than extended does not a crisis make, the fact that it has been nearly ten years since we last saw this market contract is worthy of note.

In summary, whilst the trend in analysts’ global aggregate earnings forecasts is undoubtedly positive for equity markets, we question how long the narrative of a ‘goldilocks’ global economic revival can persist given the fragilities we observe, which may result in either the overheating or the undercooking of the global economy.

Sources: CAM, FTSE, Morningstar, Bloomberg, BAML, MSG, ICE Futures.

 

Hector Kilpatrick
Chief Investment Officer
July 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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