Market Comment 07/04/2017
Market Commentary - April 2017
During the three month period to the end of March, Sterling strengthened somewhat from its oversold position against the US Dollar. As expected, the UK government triggered Article 50 at the end of March, thus starting the formal process for leaving the European Union....
...whiilst President Trump was unable to ‘repeal and reform’ Obamacare at his first time of trying.
During the period under review, the FTSE All-Share index returned 4.0%, whilst the FTSE World ex UK index returned 5.8% (in both Sterling and local currency terms).
Following Donald Trump’s Presidential election success in November 2016, US equities have performed very strongly...
Following Donald Trump’s Presidential election success in November 2016, US equities have performed very strongly, however during the first three months of 2017 some other regional equity markets have outperformed the S&P500 (£) index’s return of 4.8%. The stand out performers have been the Asia ex Japan region (MSCI AC Asia ex Japan (£) index, +12.0%) and the Emerging Markets region (MSCI EM (£) index, +10.1%). Both these regions’ equity markets and currencies have benefited from the decision of Chinese policy makers to inject more debt into the economy in order to support activity levels. This decision has also boosted the prices of industrial commodities such as iron ore and copper, which benefits some countries directly, whilst the indirect benefits of the developed markets’ economic upswing increased optimism that Asian and Emerging Markets would participate in the global economic upswing. 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.
It was interesting that, despite intensifying political concerns, European equities outperformed (FTSEuroFirst 300 (£) index, +6.4%). Surveys of business confidence in both manufacturing and services suggested management teams are confident about future growth in economic activity.
Surveys of business confidence in both manufacturing and services suggested management teams are confident about future growth in economic activity.
Japanese equities lagged the market (MSCI (£) Japan index, +3.3%) as inflation and economic activity continued to disappoint, calling into question the efficacy of Abenomics, the program which was supposed to kick start the domestic economy and unleash ‘animal spirits’.
Gilts, perhaps surprisingly (given renewed optimism that global growth is about to accelerate), produced a positive return (FTSE Gilts All Stocks index +1.6%). Gilt prices rallied on concerns that the UK economy would start to underperform as tentative signs began to emerge that the UK consumer was beginning to feel the pinch from rising inflation.
UK investment grade debt produced a marginally better performance (BAML £ Corporate Securities index, +2.0%), whilst UK high yield corporate debt performed well (BAML £ HY index, +3.3%) as investors sought income further up the risk curve.
The Brent crude oil price fell 7% to $52.8/barrel during the three month period to the end of March as crude oil inventory data disappointed, despite earlier announcements that OPEC and non-OPEC Russia had agreed to cut production.
The gold price rose 8.4% to $1249/oz during the three month period.
Equity market returns have been exceptionally strong over the short and medium term. Leading the charge has been the US stock market where, since the Trump Presidential election success, ‘animal spirits’ have returned and optimism for the outlook of the US economy and, by extension, the global economy has increased markedly.
Equity market returns have been exceptionally strong over the short and medium term.
Investors tend to value equity markets using ‘market multiples’, whereby the aggregate value of companies within the index is divided by a suitable denominator such as aggregate earnings, cash generation or asset values. On these measures, the US stock market has risen to levels approaching the upper end of their historic valuation ranges. This is not to say the market cannot push higher in the short term, but the air at these levels is rarefied. It is, therefore, sensible to be somewhat cautious as market valuations always, in the end, mean revert. This can happen in one of two ways either the numerator (stock prices) falls or the denominator (companies’ earnings etc) rise. If the latter is to dominate, and let’s hope that it does, then the best one can say of today’s high market multiples is that investors have brought forward returns by bidding up share prices today in anticipation of higher earnings in the future. By definition, this means that returns will be harder to come by going forward.
Coinciding with the higher market levels are a variety of factors which should give pause for thought. Firstly, market volatility has been exceptionally low which is breeding complacency. Secondly, company operating margins are high relative to history and have always reverted, over time, to the mean in the past. Thirdly, company indebtedness has been rising steadily such that current levels of leverage are very high relative to history. The policy of extraordinarily low interest rates was designed, in part, to enable companies to pay down debt but exactly the reverse has occurred in the quoted sector and this reduces resilience.
Coinciding with the higher market levels are a variety of factors which should give pause for thought.
But, for now, investors are ignoring these issues and are bidding stocks higher on the belief that the higher operating leverage will drive stronger earnings growth in a reflationary environment and, it must be said, we have sympathy with this view in the short term.
With increased confidence observed in a variety of sectors in the US (such as house builders, manufacturers, small businesses in general and consumers) order books are likely to grow as end demand increases and the current destocking cycle abates. In addition, the US consumer has been disciplined (unlike in the UK) and has been saving a relatively high proportion of their disposable income. In a period of rising confidence, due to further job creation and accelerating wage growth, it is likely that the American consumer will loosen their purse strings and retail spending will accelerate.
This all sounds very encouraging and from a real economy perspective should be welcomed and embraced. The problem is that stock market dynamics do not necessarily correlate with real economic activity as valuations are already discounting a lot of the good news and investors have yet to focus on what comes next.
We believe investors are materially underestimating the risk that US interest rates could rise much faster than is currently expected and, if this came about, believe it would knock confidence in company valuations regardless of the economic outlook. After all, company valuations have been bid up aggressively over the last eight years on the promise that the US economy has enough slack in it to ensure interest rates will remain low for a very long time and that the Federal Reserve is prepared to conjure money out of nowhere to buy assets and support market levels as needed.
We believe investors are materially underestimating the risk that US interest rates could rise much faster than is currently expected...
We are now being asked to believe that reflation and accelerating economic activity will not reverse some of the gains made over the period since the financial crisis. This does not feel credible in our view.
Whilst the theme of accelerating US growth is our central scenario for the rest of the year, there is a risk that Trump’s infrastructure spending and tax reforms are watered down as the year progresses. If this comes about, the optimism inherent in many share prices could dissipate and the equity market ‘Trump bounce’ that we’ve witnessed since last November could reverse.
Whilst the theme of accelerating US growth is our central scenario for the rest of the year, there is a risk that Trump’s infrastructure spending and tax reforms are watered down as the year progresses.
Either way (higher than expected US interest rates or a reversal of the Trump bounce) the outlook for the US equity market looks challenged. The only question is timing. The US economic upswing and suspension of belief that interest rates will have to rise faster than expected could last for some time yet and returns during this period could be strong, whilst the Trump bounce could unwind relatively quickly. So we have to get the balancing act right, whereby we ensure clients participate in the potential upside in equity prices whilst not taking undue levels of risk this late on in the investment cycle. For this reason, we have sought to broaden exposure to a variety of asset classes in order to diversify risk.
Should the US economy resurgence be sustained, higher interest rates are inevitable and the US Dollar with strengthen still further. This could be problematic for some Emerging Market (EM) economies particularly if, concurrent with this dynamic, Chinese economic momentum weakens (which looks likely given recent policy announcements designed to cool down the Chinese property market, etc). If this transpires, the Chinese would need to devalue their currency versus the US Dollar, thus exporting deflation and becoming more competitive versus other EM countries and stimulating further capital outflows from China.
Perhaps a smarter place to be invested is Europe, where sentiment towards the region is rock bottom, valuations are relatively compelling and their indices hold a greater proportion of ‘value’ stocks which tend to do well during periods of reflation. If the region’s important elections do not throw up any nasty surprises then the area could well be the top performing equity market this year.
Perhaps a smarter place to be invested is Europe, where sentiment towards the region is rock bottom...
Given the synchronised developed economy upswing that is currently underway, investing in government bonds with longer dated maturities looks particularly problematic in the United States. The investment case for United Kingdom government debt is more nuanced, despite being more expensive than that of the United States. The impact of the Brexit negotiations will be slower economic growth in the short term as foreign direct investment is curtailed and consumers’ purchasing power is reduced due to rising prices induced by the fall in Sterling. It is, therefore, hard to argue that interest rates will rise meaningfully in the near term as the Bank of England has shown that it is prepared to look through short term fluctuations in the inflation rate. Nonetheless, we err on the side of caution and continue not to be exposed to what we consider to be expensive longer dated gilts.
In a reflationary economic environment the chance of debt default in more risky corporate debt diminishes and we, therefore, expect so called ‘high yield’ debt to produce relatively decent returns, particularly as the negative impact of higher interest rates is reasonably limited for this asset class compared with ‘safer’ investment grade and government debt.
Chief Investment Officer