Market Comment 06/02/2020
Market Commentary February 2020
Cornelian's Investment Team give their Investment Outlook and analyse activity in the markets over the past month.
The MSCI UK All Cap NR index returned 2.0% during the three months to the end of January, underperforming the MSCI World ex UK (£) NR index which returned 3.4% in Sterling terms. The outperformance of international markets would have been greater if it weren’t for Sterling strength which reduced international returns for UK based investors (MSCI World ex UK NR index returned +5.5% in local currencies).
Additional monetary policy easing allied with the announcement of a ‘phase one’ trade agreement between the USA, and clarity on the Brexit issue following the UK’s general election, helped equity markets perform strongly during the first part of the period. In local currency terms however, concerns around the potential economic impact of the emergence of a novel coronavirus in China knocked investor confidence in January.
In Sterling terms, the USA was the strongest major regional equity index.
In Sterling terms, the USA was the strongest major regional equity index (MSCI USA NR £ index, +4.9%), as the trade deal improved sentiment and technology stocks remained in demand.
Gilts produced a positive return (iShares Core UK Gilts ETF, +1.3%) as investors grew concerned that the coronavirus could impact global economic growth materially. Investment grade debt performed particularly strongly (iShares Core £ Corporate Bond ETF, +2.9%), whilst ‘riskier’ high yield debt (iShares Global High Yield GBP Hedged ETF, +1.7%) also outperformed Gilts.
The Brent crude oil price ended January at $58.2/barrel, a decrease of 3.4% since the end of October. The oil price rose initially as the view that global economic activity was stabilising gained ground and OPEC+ announced further supply restraint. However, concerns that demand would be reduced due to actions taken to reduce the spread of the coronavirus put downward pressure on the oil price in January.
The gold price rose 5.0% to $1589/oz in the quarter to the end of January. Sterling strength, however, meant that the value of gold held by UK based investors rose by 3.0% (to £1,204/oz).
Following a poor year in 2018, risk assets (such as equities and corporate credit) performed strongly in 2019. The first month of 2020 started off brightly, but the news that a novel coronavirus had emerged in China impacted investor confidence as the negative impact on Chinese economic activity of the authorities’ attempts to restrict the spread of the virus became all too evident.
The major contributor to the positive change in investor sentiment during 2019 was the adjustment in stance by the Federal Reserve. In 2018, the central bank’s chairman made it clear that 2019 would herald a period of small but sustained interest rate rises. As economic growth slowed and risk asset prices fell in value, the Federal Reserve capitulated and in fact delivered three interest rate cuts during the year. This, alongside the restart of quantitative easing in Europe, reduced the yield on government bonds materially and pushed investors into higher yielding ‘riskier’ assets. These central bank policies made it clear to investors that policymakers continue to believe that actively supporting asset prices remains a valid transmission mechanism for the delivery of sustained economic growth. Our belief that this is a perversion of the economic and investment cycle remains irrelevant for now.
At the tail end of the 2019, the US announced that a ‘phase one’ trade deal with the Chinese authorities had been agreed. Details are scant, but enough appears to have been agreed to postpone the insoluble strategic decisions that need to be taken until after the Presidential election in early November 2020. Furthermore, the progress to ratify the USMCA (United States, Mexico and Canada) free trade agreement helps diminish risk from this area as well. Both developments have been taken well by investors.
The breaking of the UK domestic Brexit impasse and the avoidance of a socialist UK government via a decisive election victory for the pro-Brexit Conservative party has also been supportive to asset prices.
Share prices continued to appreciate despite the turn in government bond yields in the latter part of the 2019.
Government bond yields had started to rise as the belief gained ground that the global economic slowdown was coming to an end. Whilst lower government bond yields supported risk asset prices earlier in 2019, it is interesting to note that share prices continued to appreciate despite the turn in government bond yields in the latter part of the 2019. The basis for this decoupling would appear to be that investors sensed that the profit warnings, so prevalent in economically sensitive stocks during 2019, may be replaced by positive trading updates in 2020.
However, there was a reversal of these trends during the first month of 2020 as investors tried to assess the possible extent of the economic impact of the coronavirus.
The reasons why investors were becoming more positive about economic growth going forward were several fold:
The belief was building that the Chinese have introduced enough stimulus to stabilise their economic growth rate which has been slipping for some time. This view was supported by the strong performance of mid-sized mainland China property developers (listed on the Hong Kong stock exchange) which have in general, performed strongly in anticipation of better times ahead.
The US consumer remains in remarkably good shape.
In developed economies, labour markets, whilst strong, appear to have become less tight which suggests that inflationary risks remain fairly muted despite real wage growth moving ahead at a healthy clip. In addition, the US consumer remains in remarkably good shape (good real wage growth, relatively low indebtedness and rising house prices) and they certainly have the wherewithal to prolong the economic upcycle given few signs of consumer overexuberance creeping into the domestic economy.
Furthermore, countries such as China, Japan, France and the UK are beginning to increase fiscal spending and this should help underpin economic growth going forward and is helping sentiment.
However, reasons for caution were being overlooked. US equity valuations are high relative to history and decent earnings growth needs to return to justify current market multiples. However, corporates continue to hold too much inventory (for trade war and Brexit related contingency reasons, for example) and this will need to be worked down which means a positive turn in the earnings cycle may be a little further away than people hope and so could result in some near-term market indigestion.
If global economic growth does start to accelerate, concerns about inflation are likely to resurface resulting in a steeper yield curve.
Moreover, if global economic growth does start to accelerate, concerns about inflation are likely to resurface resulting in a steeper yield curve (productivity boosting technology capital expenditure notwithstanding) which may undermine valuations.
The positive outlook is also tempered by the high levels of global indebtedness (both at the government and corporate levels) which means that resilience to an exogenous shock is fragile. The recent ramp up in tension between the USA and Iran is clearly worrying in this context, given the potential for oil supply disruption which might produce a material rise in the oil price (and derail the global economy).
The premium that investors pay for government bonds relative to riskier corporate debt is currently very low relative to history (despite government bond prices being high). This suggests that corporate debt is currently expensive and therefore caution is needed. Corporate bonds are particularly vulnerable to any whiff of either (a) a return of inflation or (b) a further deterioration in macro-economic outlook.
One of the few justifications for holding government debt currently is that it will act as an insurance policy against an unexpected slump in global growth as quantitative easing would be fully deployed again and this would support government bond prices.
Our working assumption is that the coronavirus outbreak will be dealt with successfully and the overall negative global economic impact will be manageable.
As at the date of writing, our working assumption is that the coronavirus outbreak will be dealt with successfully (in line with previous infectious diseases) and the overall negative global economic impact will be manageable. We anticipate material stimulus (both monetary and fiscal) in the economies which are most hard hit. As it is a dynamic situation, we reserve the right to change this view. We are keeping a particularly close eye on how the virus is spreading in developed economies and the mortality rate associated with this spread.
Providing there are no material exogenous shocks, returns during the first half of the year could be strong as investors move into equities as the goldilocks narrative gains ground and investors allocate to equities in the fear of missing out. After all, the consensus is forming that 2020 will see enough global growth return (due to fiscal and monetary stimulus) to drive earnings upgrades but not increase inflation expectations. In such a scenario, European and Emerging market equities could do well as the asset classes play catch up concerning the global/Chinese reflation trade.
This ‘not too hot/not too cold’ pathway is narrow with risks on either side. Given the high valuations in debt and equity markets and the narrowness of the pathway, it is less clear that such market performance could be sustained through to the end of the year. Of the major asset classes, equities are probably best placed to generate positive returns given their relatively attractive dividend yield and a probable return to earnings growth.
Whilst UK equities are likely to continue to perform well in the near term on the back of the global reflation trade and the acknowledgement of a pro-business government with a large majority in the House of Commons, the complexities of negotiating a favourable trade agreement with the EU are likely to become more apparent as the year progresses.
Cornelian Investment Team