Market Comment 09/01/2017
Market Commentary January 2017
During the three month period to the end of December, Sterling weakened sharply following the surprise ‘Leave’ result in the UK’s European Union referendum in June and confirmation that the government was looking to trigger Article 50 before the end of March 2017.
Hopes of a ‘soft’ Brexit rose during November and the currency rallied somewhat, however Sterling weakened again during December.
The FTSE All-Share index returned 3.9% over the period, whilst the FTSE World Ex UK index returned 7.1% in sterling terms, although in local currency terms, the return was ‘just’ 4.9%.
US equities performed strongly following Donald Trump’s Presidential election success as investors started to price in the effects of a significant hike in infrastructure spend, deregulation and the possibility of substantial declines in corporation tax. During the period under review the S&P500 index returned 9.2% in Sterling terms, helped by a strengthening currency as investors began to discount higher interest rates.
US equities performed strongly following Donald Trump’s Presidential election success as investors started to price in the effects of a significant hike in infrastructure spend, deregulation and the possibility of substantial declines in corporation tax.
Gilts performed poorly as prices retraced from the highs stimulated by the Bank of England relaunch of quantitative easing and its bond buying program (FTSE Gilts All Stocks index, -3.4%). UK investment grade debt took its cue from the Gilt market (BAML £ Corporate Securities index, -2.8%), however UK high yield corporate debt performed well (BAML £ HY index, 1.7%) as investors sought income further up the risk curve.
The Brent crude oil price rose 15.8% to $56.8/barrel during the three month period to the end of December. OPEC surprised the market by announcing that it had been agreed to limit output and non-OPEC Russia agreed to cut production as well.
The gold price fell 12.4% to $1152/oz during the three month period. This translated into an 8% loss for UK based investors due to Sterling weakness against the US Dollar.
Investor reaction to Trump’s success in the US Presidential election has been remarkable. The US equity market (as well as the US Dollar) has risen strongly as investors anticipate the success of a switch away from extraordinary monetary policy towards a more traditional fiscal stimulus via both tax cuts for corporates and individuals, deregulation and increased spending on infrastructure. Optimism abounds that such policies will be the panacea which will enable US (and thereby global) growth to rebound and economies to reflate. Indeed, regional surveys of company management teams are beginning to suggest confidence that global economic growth will accelerate during 2017.
Investor reaction to Trump’s success in the US Presidential election has been remarkable. The US equity market (as well as the US Dollar) has risen strongly as investors anticipate the success of a switch away from extraordinary monetary policy towards a more traditional fiscal stimulus...
We, at Cornelian, have been vocal for some time for the need for policymakers to switch from a playbook which meant any misstep in the economy was met with additional money printing (and bond buying) to that of fiscal stimulus. However, we fear that the gulf between what can be promised in speeches (and is being priced into markets) versus what can be delivered is growing and that at some stage during the year reality may set in and there is likely to be a reappraisal of what can be achieved during the Trump Presidency. Despite being relatively expensive, the US equity market is likely to continue to do well during the early days of the Trump administration but soon investors will be demanding policy detail and assessing the probability that the policies will be enacted; perhaps we are close to ‘Peak Trump’.
One counterargument to current investor optimism is that in the real world actions have consequences. Ripping up trade treaties and implementing targeted import tariffs (or their equivalent) will create significant trade tensions, let alone disruptions to existing supply chains. Such actions will also intensify inflationary pressures which are already building given the tight US labour market. If taken to its logical conclusion, investors will start to price in considerably higher interest rates than currently expected, which would strengthen the US Dollar still further. This will reduce the US economy’s competitiveness and dampen some of the positive ramifications of Trump’s pro-growth policies. The 30 year mortgage rate has already responded, rising sharply. This, combined with a stronger US Dollar, is tightening financial conditions in the US before any of Trump’s policies have been enacted.
Despite being relatively expensive, the US equity market is likely to continue to do well during the early days of the Trump administration but soon investors will be demanding policy detail and assessing the probability that the policies will be enacted; perhaps we are close to ‘Peak Trump’.
The best case outcome is that the more sensible, growth-promoting Trump policies are enacted without much controversy (whilst his wilder policy platforms are quietly dropped) and that this manages to extend the US economic cycle by encouraging domestic investment, the repatriation and cash held by corporates overseas, significant tax breaks for corporates and increased share buy backs.
In geopolitical terms, the new US regime appears to have a strong desire to drive a wedge between Russia and China, in order, perhaps, to try to isolate China. Any US import trade tariffs could have significantly negative consequences on the overly indebted Chinese economy and this, alongside a threat to rip up the ‘One China’ policy over Taiwan, may be used to try to pressurize China to bring North Korea ‘to heel’ and demilitarise the South China Sea. However, this might strengthen China’s resolve to fight back against the proposed tariffs/import tax policies of the new administration. The most obvious way of doing this would be for them to devalue their currency in a dramatic and one-off nature to such an extent that Chinese economic competitiveness is once again achieved despite the actions of the US Government. This could threaten another wave of global deflation. Unfortunately, in such a scenario whereby the Chinese economy starts to undershoot its economic growth projections, the authorities may well view external geopolitical tensions as worth playing up if it deflects the populace’s attentions from economic problems at home. Such an outcome would have negative consequences for emerging market assets.
The best case outcome is that the more sensible, growth-promoting Trump policies are enacted without much controversy...
Elsewhere, Teresa May has committed to trigger Article 50 at the end of the first quarter of 2017. Nothing to date assuages our fear that the European Union members will ensure that the UK is ejected unceremoniously from the European Union with no trade agreement in place in two years’ time. Given the poor state of the UK’s finances, let alone the unbalanced nature of the economy, this could have negative short term consequences to domestic consumption as imported inflation rises and high value jobs move out of the UK. Dutch elections in March are followed by French Presidential elections in May, whilst German State elections are held in the Autumn. All of these have the potential for generating more political uncertainty.
Nothing to date assuages our fear that the European Union members will ensure that the UK is ejected unceremoniously from the European Union with no trade agreement in place in two years’ time.
With all the uncertainty evinced above, we believe that the pendulum which swings between investor greed and fear has moved into greed territory. Whilst there may be further to go in the short term, it is only a matter of time before it changes direction and starts to swing back towards fear, not least because the ultimate consequence of reflation is higher debt prices for governments and corporates, which are already accommodating significant debt levels, and this (rising finance costs) can in itself become an headwind to further equity market performance.
Given the risk of higher inflation going forward (which would put pressure on bond yields and, therefore, prices), we continue to remain underweight government bonds which mature a long time in the future as these would be most affected. We are relatively comfortable about the near-term economic outlook and so prefer corporate debt (both investment grade and higher risk debt).
We are not yet prepared to cut our equity positions, despite markets having done so well (in Sterling terms) over the past year as we believe that news in the short term could push equities higher. However we remain vigilant of numerous potential catalysts which could reverse this view.
Chief Investment Officer