Market Comment 09/04/2018
Market Commentary - April 2018
The Cornelian Team outline their latest views on the global economy and expand on why we think productivity is set to improve markedly in the US and why this is important for the outlook of equity markets.
Following a strong 2017, all major equity regions suffered from profit taking during the first quarter of 2018. The triggers which have caused the retrenchment are analysed in the Market Outlook section below.
The FTSE All-Share index (-6.9%) performed particularly poorly during the period underperforming the FTSE World ex UK (£) index (-4.2%) materially. In local currency terms, the FTSE World ex UK index returned -1.6%, however Sterling strength (particularly against the US Dollar) reduced overseas equity returns to UK based investors and also reduced earnings expectations of UK based companies with sizeable operations overseas. International investors are shunning the UK equity market given the perception that the Brexit process is introducing additional economic and political risk.
After the UK equity market, the US equity market exhibited the next worse performance (S&P 500 (£) index, -4.3%), from a UK based investor stand point. Better performing equity markets included Emerging Markets (MSCI EM Index, -2.2%) and European equities (FTSEurofirst 300 (£) index, -2.7%). The Japanese equity market performed poorly in local market terms as the Yen strengthened against the US Dollar thus negatively impacting earnings forecasts of exporters (MSCI Japan index, -4.8%), however Japanese Yen strength against Sterling helped ameliorate some of the fall for the UK based investor (MSCI Japan (£) index, -2.8%).
...‘riskier’ high yield debt performed better than investment grade debt.
Gilts started off the year poorly but as the equity market sell off gathered pace, gilts were bought such that the asset class produced a marginally positive return for the quarter (FTSE Gilts All Stocks index, +0.3%). Investment grade corporate debt produced a negative return (ICE BAML£ Corporate Securities index, -1.4%). Surprisingly, given the risk off environment, ‘riskier’ high yield debt performed better than investment grade debt (ICE BAML£ HY index, -0.0%).
The Brent crude oil price rose 5.1% during the period under review to $70.3 per barrel as a decision by OPEC and non-OPEC Russia to prolong a cut in production alongside better inventory data improved sentiment.
The gold price produced a positive return in US Dollar terms during the quarter rising by 1.7% to $1318/oz, however due to Sterling strength the return for UK based investors was -2.0%.
Market sentiment has changed markedly. Enthusiasm that the global, synchronised economic recovery would provide the ideal ‘goldilocks’ scenario where non-inflationary economic growth could persist allowing equity markets to continue to push higher is now being called into question on numerous fronts.
At first, there were concerns that wage inflation in the US was coming through faster than expected and that this could force the Federal Reserve’s hand to increase interest rates by more than expected. Subsequent macro-economic data releases diminished these concerns a short while later. However, just as investors were finding their poise again a double whammy of concerns arose: firstly threats of a Chinese/US trade war have become front page news; and secondly internet related stocks which have led the US market higher have come under the microscope both in terms of how social media sites are harvesting and monetising personal data and whether internet retail companies are playing on a level playing field in terms of tax. The authorities on both sides of the Atlantic are beginning to raise the possibility of a new tax on internet based revenues.
Whilst we do believe wage inflation is becoming an issue for some companies in the United States we also believe there is evidence that many companies in the US are planning to boost capital expenditure in the coming months...
Addressing these three issues in turn:
Whilst we do believe wage inflation is becoming an issue for some companies in the United States we also believe there is evidence that many companies in the US are planning to boost capital expenditure in the coming months in response to higher wages as well as Donald Trump’s tax reforms, which promote investment. Automation of both manufacturing and service jobs is coming of age such that increased expenditure will have a marked productivity enhancing effect ensuring that economy wide inflation remains well behaved. This reduces the risk that accelerating wage inflation may force the central bank into more interest rate hikes than currently expected.
On the potential trade war between the US and China, we believe that the Trump administration is correct in its analysis that current trade terms and Chinese protectionism are out of date and need to be rebalanced. After years of negotiations and limited movement from China, the United States is now responding to China ‘in kind’. This is designed to get their attention and it seems to be working.
In trying to mitigate some of the US administration’s concerns, the Chinese have recently announced plans to open up their large domestic payments market to foreigners, permit foreign financial service companies to take majority stakes in domestic institutions as well as allow beef imports from the US, once again.
What we find encouraging is that the Chinese now appear to be willing to negotiate and there is space to do so as the process of tariff implementation will take several months to enact. Furthermore, the US administration has already spoken of some potential quick wins such as getting the Chinese to agree to buy more LNG and agricultural products from the US as well as reducing tariffs on American cars imports. There is, clearly, a deal to be done.
Internet related stocks have retrenched following a period of very strong performance. The issues which have triggered the profit taking, whilst real, are likely to dissipate. The global implementation of an internet sales tax will have unintended consequences and so it is, in our opinion, likely to be a long time before we are close to seeing a globally accepted standard. The opposing dynamics of personal data privacy versus the monetization of that data by firms is a political hot potato just now. However, we do not sense that consumers are over exercised by the issue and so feel that whilst new regulations will be imposed, these companies will adapt and so will negotiate the twists in the road successfully.
The fall in equity markets has coincided with upgrades to earnings forecasts meaning that market valuations no longer looked stretched.
The fall in equity markets has coincided with upgrades to earnings forecasts meaning that market valuations no longer looked stretched. If you subscribe to the view, as we do, that companies in the United States will deliver earnings inline or better than those currently forecast, then we believe that once the issues highlighted above are behind us, investors will be able to focus once again on the positive earnings story.
This could clear the way for the final leg of the equity bull market to unfold, whereby core inflation remains well behaved and increased end demand from rising wages, increased confidence and increased investment results in a profits boom. If this occurs it would draw retail investors to the stock market, encourage company management teams to undertake aggressive merger and acquisition activity and embolden unlisted companies to list on the stock market in far greater numbers than we have seen in the recent past.
Given the risks to asset prices from the withdrawal of quantitative easing which will inevitably accompany the recovery, one should be somewhat circumspect and not be too ‘risk on’. However being too defensively positioned today would be expensive if the scenario above does indeed play out.
This constructive view is supported by an increasingly positive end demand picture that we are hearing about from company management teams that are exposed to the economic cycle. It is telling that many of the stocks that we use as indicators of how investors view the economic outlook have not led the market down and, indeed, a number of these stocks made new relative highs during the sell-off.
Since the beginning of the year, there have been some signs of stress in the US interbank funding market, however we believe these to be a result of some technical factors rather than a real indication of underlying stress. This is because there are numerous other indicators of bank sector funding stress, which are not even flashing amber. We, therefore, believe that banks will continue to ease lending terms to corporates. The next survey data (the Senior Loan Officers survey) which will give an up to date indication of the credit cycle will be issued at the end of April and we expect it to be benign, thus supporting our positive view on markets.
Given this, we remain constructive on equity risk and higher yielding corporate debt.
Cornelian Investment Team