Market Comment 01/01/2019
Market Commentary January 2019
Cornelian's Investment Team give their overview on market activity for the latter part of 2018 as well as their outlook for the year ahead.
The FTSE All-Share index produced a negative return (-10.3%) during the final quarter of the year, outperforming the FTSE World ex UK index which returned -12.9% (in local currencies). Investor confidence was undermined by the sharp fall in the oil price, evidence that the Eurozone and Chinese economies were growing at a slower rate than expected and concerns that US policymakers’ attempts to ‘normalise’ monetary policy (by increasing interest rates and reversing quantitative tightening) could inadvertently tip the economy into recession.
Over the period, Sterling weakened still further against most major currencies as a result of the heightened Brexit uncertainty. This helped reduce some of the overseas losses for UK-based investors. In Sterling terms, the FTSE World ex UK (£) index returned -11.0%.
The strongest major regional equity index was Emerging Markets (MSCI Emerging Markets (£) index, -5.3%), where performance had been poor relative to other major equity markets in the lead up to the final quarter of 2018. Japanese equities performed least well during the final quarter of the year (MSCI Japan (£) index, -12.2%) as the Japanese central bank expressed concerns over the outlook for the economy.
Gilts were well supported during the period thanks to their status as a ‘safe haven’ asset. Gilts were well supported during the period (FTSE Gilts All Stocks Index, +1.9%) thanks to their status as a ‘safe haven’ asset. Both Investment grade debt (ICE BofAML Sterling Corp, -0.3%) and ‘riskier’ high yield debt (BAML £ High Yield index, -3.3%) underperformed Gilts. Debt investors began to consider whether the fall in the oil price might spill over into increased default rates, prompting a turn in the credit cycle, and so started to demand a higher interest rate for holding corporate debt.
During the 3-month period, the Brent crude price fell by 35% to $53.8 per barrel. Saudi Arabia had been encouraged to increase oil production in the expectation that US sanctions on Iranian oil sales would result in the abrupt curtailment of supply from that country. In the end, the United States introduced waivers which resulted in Iranian crude continuing to be sold to specific partners. This has led to a temporary oversupply in the market. In December, OPEC responded announcing a cut in production in order to support prices.
Gold rose 7.5% to $1282.5/oz as investors sought a safe haven from equity market volatility. In Sterling terms, the gold price rose by 10% as the Dollar strengthened against Sterling over the period.
The underlying cause of the market falls observed in the latter part of 2018 has been a reassessment of risk brought about by rising interest rates and/or the drawing to an end of quantitative easing in western economies.
As a result of strong US economic growth, the Federal Reserve has been at the forefront of trying to ‘normalise’ monetary policy by both increasing interest rates and reversing quantitative easing.
However, investors have become concerned that the central bank may tighten monetary policy by more than the US economy can bear, thus tipping it into recession. This issue has become more pressing as the impact of the Trump fiscal stimulus package (tax cuts and increased federal spending) in the United States will soon start to fade and economic growth in other parts of the globe is decelerating.
Furthermore, the sharp fall in the oil price threatens to upend the US corporate credit cycle, where banks which have lent to US onshore oil companies start to experience increased levels of debt default and, therefore, decide to be more careful lending to other segments of the economy.
As a result of quantitative tightening in the United States, the falling oil price and concerns that banks may make it more difficult for corporates to borrow, investors have started to price in a higher cost of debt for corporates.
Beyond interest rates and economic growth, political uncertainty remains elevated. The risk of an escalation in the trade war between the United States and (principally) China continues. Furthermore, there is political instability in many European nations including, of course, the United Kingdom where the Brexit denouement will shortly be upon us.
Given the heightened level of doubt, investors have been reducing their exposure to risk assets given the strong returns exhibited since the financial crisis a decade ago.
US economic growth is currently strong... the labour market is tight and wage inflation is accelerating. Despite the concerns described above, we believe it is too early to call time on the economic upcycle and remain constructive regarding the outlook for equities and corporate bonds for the following reasons:
US economic growth is currently strong and, as a result of this and many years of economic growth, the labour market is tight and wage inflation is accelerating. Confidence concerning the domestic economy is high and we expect this to continue to percolate through the economy resulting in a more resilient economic upcycle than investors currently anticipate.
Recent clarifications by the deputy chair of the Federal Reserve concerning the US central bank’s thinking and flexibility suggest that policymakers will not turn a deaf ear to developments in the economy and, if needed, a more supportive monetary policy could be enacted in order to extend the cycle. Importantly, inflation expectations in the US are likely to remain well anchored and this means that the Federal Reserve has room to ease the rate of monetary policy tightening or, indeed, reverse it, as required.
The Chinese authorities have been easing monetary policy and have also announced a variety of fiscal measures designed to boost the economy.Elsewhere, the Chinese authorities have been easing monetary policy and have also announced a variety of fiscal measures designed to boost the economy and these should soon start to have a positive impact on activity. In Europe, the end of quantitative easing is resulting in a loss of confidence in the bank sector and economic growth is slowing. Some European banks have been slow to restructure following the financial crisis, but already there is talk that a further package of measures could be introduced by the European Central Bank in 2019 to support the long-term funding of the sector. If enacted, this would certainly boost international investor confidence towards the region.
Concerning the oil price, it is worth remembering that at the tail end of 2014 Saudi Arabia led an OPEC sanctioned policy to reclaim market share lost to the United States and others. This drove the oil price down sharply and put several US onshore oil companies out of business and led to increased default rates. Importantly, today OPEC’s policy is to support the oil price and this has been evidenced in December by OPEC, Russia and Canada swiftly coming to an agreement to cut oil production in order to try to balance demand and supply. This action should be enough to stabilise the oil price and reduce the risk of higher debt defaults and a turn in the corporate credit cycle.
Despite the negative effect that the fall in the oil price can have on the credit cycle in the United States, as described above, it does reduce cost pressures for consumers and corporates and, therefore has a countervailing positive impact on global economic growth.
We believe that the Chinese will do enough to satisfy the Americans because it is in their interests to do so.Whilst a further escalation in the trade war certainly remains a risk, we believe that the Chinese will do enough to satisfy the Americans because it is in their interests to do so. It has recently been announced that the two sides will meet face to face in January 2019 in order to try to negotiate a deal. This is progress.
The market falls have resulted in a reset of equity and corporate debt valuations which are undoubtably attractive if you believe, as we do, that the United States will not go into recession during the next 12-18 months.
Finally, a few words on Brexit. The situation is clearly very fluid, the route to a resolution is difficult to discern and the range of outcomes remains high. Nonetheless, there is no majority in the House of Commons for a hard Brexit, which should mean that Theresa May’s Brexit plan or something softer than that is enacted, if agreement can be reached. If not and the cliff edge is reached without significant concessions from the EU, then it also follows that the Government will ask the EU for more time to consider next steps (such as a referendum) and if this is not received then Parliament will probably vote to revoke the Article 50 withdrawal process in order to achieve the same result (i.e. more time to consider next steps). This ability to revoke the withdrawal process unilaterally is, perhaps, the ultimate backstop given neither of the major parties want to be responsible for a cliff edge, hard Brexit outcome. We, therefore, continue to believe that there is only a low chance that the UK will undergo a cliff edge, hard Brexit on the 29th March this year.
International investors have deserted UK assets finding the political uncertainty deeply unpalatable. Even if the Brexit outcome (via a referendum) is a two year ‘managed hard Brexit’, as political uncertainty subsides, as it surely will, we expect investors to return as the value now seen in the UK equity market is compelling. This view assumes that the Conservatives and DUP will do all in their power to avoid an early general election, however this is clearly not a given.
Sources: Bloomberg, Cornelian, Morningstar.
Cornelian Investment Team