Market Comment 03/01/2018
Market Commentary January 2018
The Investment Team outline their Market Overview and Investment Outlook for 2018. Both the FTSE All-Share index and the FTSE World ex UK (£) index returned 5.0% during the three months to the end of December (FTSE World ex UK index rose +5.5% in local currency terms).
Stronger regional equity market performers (in Sterling terms) included Japan (MSCI Japan (£) index, +7.6%) and Asia ex Japan (MSCI AC Asia ex Japan (£) index, +7.3%). Sentiment towards Japanese equities improved following a resounding victory by the Liberal Democratic party led by Prime Minister Abe in the snap general election, which reinforced Abe’s economic policy mandate.
The S&P500 (£) index also performed well rising 5.8% as investors welcomed company trading updates which, in aggregate, continued to be positive...
The S&P500 (£) index also performed well rising 5.8% as investors welcomed company trading updates which, in aggregate, continued to be positive and investors began to price in an increased probability of corporate tax reform being enacted in the United States, which then duly happened just before Christmas.
European equities lagged the rest of the market (FTSEurofirst 300 (£) index, +1.4%) as political concerns weighed on sentiment and Euro strength constrained earnings revisions.
Gilts produced a positive return (FTSE Gilts All Stocks index, +2.0%) as the Bank of England continued to talk up the prospect of interest rate increases which investors fear, if enacted, may impact longer term economic growth prospects.
UK investment grade debt has, on average, a longer maturity profile than high yield debt and this benefited the asset class during the period.
Despite the ‘risk on’ environment, UK high yield corporate debt (ICE BAML £ HY index, +0.9%) underperformed the UK investment grade debt market (ICE BAML £ Corporate Securities index, +2.1%). UK investment grade debt has, on average, a longer maturity profile than high yield debt and this benefited the asset class during the period.
The Brent crude oil price rallied 16.2% during the final quarter to finish the year at $66.9 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 small positive return during the period rising by 1.8% to $1303/oz.
The outlook for economic growth in most major developed markets is better today than a year ago. Manufacturing and service companies across the globe are expressing optimism; inventory levels are falling and order books are growing. Furthermore, banks in the United States are easing lending terms to companies which will help lubricate their economy. Importantly, we believe that wage growth is likely to accelerate as the year progresses. This may hold back company margins somewhat but the positive benefits to end demand should be enough to see upgrades to aggregate earnings forecasts. It is, therefore, increasingly likely that 2018 will see the first consecutive years of meaningful earnings growth since the financial crisis.
This positive outlook is further enhanced by the significant tax reforms enacted by the United States government, which are expected, in aggregate, to reduce the actual corporate tax rate paid by around five percentage points. This positive one-off earnings upgrade has now been largely anticipated by investors (although it has yet to come through in earnings forecasts). What is less clear is how corporates will react to the tax incentives to boost capital expenditure in the United States and also repatriate cash that had been stranded in overseas subsidiaries. This cash could be used to increase capital expenditure and/or be returned to shareholders. Either outcome will be positive for equity investors.
We anticipate corporate announcements of investment in the United States will build as the year progresses and this will have a positive impact on confidence. This could lead to suggestions that productivity will improve such that economic growth can persist without inflation getting out of hand. Should investors start to believe this (and it is a big leap in faith) then equities can continue to perform well.
Eurozone manufacturing and service companies have seldom been so confident about the outlook for the future.
Whilst focussing the above commentary on the US, it is important to understand that both the Eurozone and Japanese economies are also showing good signs of life. Eurozone manufacturing and service companies have seldom been so confident about the outlook for the future. Unemployment is falling sharply and consumer confidence and spending is recovering. In Japan, Abenomics is beginning to show some bite, not just in the stewardship and governance of companies where Boards are becoming more aligned to shareholders’ interests, but also the economy where there are, at long last, encouraging signs of a return to growth. It is more than 25 years since Japanese businesses were as confident as they are now (source: Bank of Japan’s Tankan survey).
So it is intriguing that despite the accumulation of evidence which suggests economic growth in 2018 and beyond is likely to be good, government bond investors are not buying into this reflation thesis. Indeed, the price of longer term debt remains very inexpensive for most of the major developed economies.
This is difficult to rationalise given our views expressed above, but it would appear that bond investors believe that monetary policy tightening, be it from interest rate increases or quantitative tightening (the process of reversing quantitative easing) will push economies back into sub-par growth and that inflation will remain elusive. We think it is too early to come to this conclusion. Policymakers will remain behind the curve for some time when it comes to tightening monetary policy such that the first moves to tighten policy will have little impact on the global economy (which is building a head of steam), let alone confidence. As the year progresses, we expect investors will start to recognise that higher than expected interest rates are more likely. If this transpires then longer dated debt should start to underperform.
As long as this projected sell-off in longer dated debt remains moderate, then risk assets such as equities and high yield corporate debt can continue to do well given momentum in company profits. However, if any sell off becomes more pronounced then this may well negatively impact the interest rate assumptions that fund managers use to value investments across a range of asset classes. We do not believe that this is a risk which will materialise during the first half of the 2018, but we remain vigilant as the possibility of this outcome is growing.
The commentary above is conspicuous in the absence of talk about China. The authorities there are attempting to transition the economy away from an investment-led expansion to a services based economy and in doing so they want to enhance the role of banks in the creation of credit and reduce the scale of the unregulated (or ‘shadow’) banking sector. This is an important and long overdue acknowledgement of risks inherent in this part of the economy, however the transition is fraught with danger and we are suspicious that there have not been reports of any high profile causalities as yet.
the stronger global economy should ensure continued decent demand for exports and domestic consumption growth is expected to persist.
However, the stronger global economy should ensure continued decent demand for exports and domestic consumption growth is expected to persist. Furthermore, the formal banking sector is accommodating demand for credit which is being diverted from the shadow banking sector. So all-in-all we expect the Chinese economy to muddle through satisfactorily. A positive spin-off is that a Chinese economy which is neither too hot nor too cold is unlikely to introduce unwanted volatility in industrial commodity prices globally.
Finally, a word on Brexit. International investors have shied away from investing in UK equities as a result of the enhanced political uncertainty and associated near-term impacts on economic growth. As the political fog clears during 2018, investors may well reappear. The equity market is not expensive and dividends feel secure. However, the near term news flow is likely to be difficult as initial ‘Phase II’ negotiating stances have yet to be publicised. Importantly, from a global multi-asset perspective, Brexit is a sideshow and will not be able to derail the global recovery if it does not go well.
It should be noted that London listed companies with operations in the United States will also benefit from US tax reform measures either directly, because they currently suffer a high corporate tax rate in the United States (such as Balfour Beatty and Keller Group) or because they will be at the forefront of supplying goods and services to the anticipated investment wave (such as Balfour Beatty, CRH and Ferguson).
So in summary, we think the outlook for equity markets is generally good, however for this to be sustained we will need to see a consensus forming that productivity will improve alongside higher wages and increased investment and that the Chinese authorities are able to contain any problems that arise from their structural reforms.
Cornelian Asset Managers