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Market Comment  06/06/2018

Market Commentary June 2018

The Investment Team give their latest Market Overview and also their Investment Outlook, with a view towards markets in the US, China and Italy.

Following a sharp sell-off in equity markets during February and March, global equity markets have produced positive returns during April and May. This has resulted in positive equity returns during the three months to the end of May. The triggers that caused the sharp retrenchment during the earlier part of the year are analysed in the Market Outlook section below.

During the three-month period under review, The FTSE All-Share index (+7.4%) produced by far and away the best regional equity return, outperforming the FTSE World ex UK (£) index (+2.3%). There were a number of factors that drove the outperformance of UK equities. Sterling weakened against the US Dollar following evidence that the pace of economic recovery in the UK was slower than expected and dovish commentary from the Bank of England. This boosted the value of US earnings of many of the global multinationals that dominate the UK stock market index. The relatively high weighting of the oil & gas sector was also supportive as the oil price rose during the period. The UK remains heavily out of favour with international investors due to uncertainty surrounding the Brexit process, however a number of domestic stocks that simply met downgraded earnings expectations performed strongly during the period, suggesting that this caution may have become too extreme.

US equities did well in Sterling terms (S&P500 (£) index, +3.7%) as Sterling weakened appreciably against the US Dollar.

Aside from the UK equity performance, US equities did well in Sterling terms (S&P500 (£) index, +3.7%) as Sterling weakened appreciably against the US Dollar. In local currency terms, the S&P500 index returned just 0.2% during the period. Emerging markets equities (MSCI Emerging Markets (£) index, -2.4%) were the worst performing major equity market region. Sentiment was negatively impacted by escalating trade tensions with the US, a rise in political uncertainty in a number of important emerging market countries and weaker currencies.

Investment grade corporate debt produced a modest positive return, outperforming ‘riskier’ high yield debt.

Gilts performed strongly over the period (FTSE Gilts All Stocks +2.8%) as deteriorating economic data and dovish central bank messaging drove interest rate expectations lower, pushing up bond prices. Investment grade corporate debt produced a modest positive return (ICE BAML£ Corporate Securities index, +0.6%), outperforming ‘riskier’ high yield debt (ICE BAML£ Sterling HY index +0.1%). Investment grade debt was helped by its relatively high interest rate duration versus the high yield index.  

Despite news towards the end of the period suggesting that Russia and OPEC may be about to sanction higher production levels, the Brent crude oil price rose 18.0% during the three-month period to $77.6 per barrel. Continued robust demand growth, together with rising geopolitical tensions (and evidence that the OPEC production cuts are finally moving the market back to a more balanced position), helped drive the price of oil up. 

The gold price produced a modest negative return in US Dollar terms, falling 1.5% to $1,298 per ounce, however Sterling weakness against the US Dollar produced a positive return of 2.1% for UK-based investors.

Investment Outlook

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.

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 anticipated. 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 political risk has increased markedly both within the Eurozone as well as in some key emerging market countries.

Automation of both manufacturing and service jobs is coming of age such that increased expenditure will have a marked productivity enhancing effect.

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 firmly believe there is evidence that many companies in the US are planning to boost capital expenditure as the year progresses, as they respond 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 rebalancing. 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.

The two major populist parties in Italy have, against the odds, formed a coalition and will take over the government of the country. If they institute fiscally imprudent policies as their rhetoric suggests they will, then investors will quickly call them out and another ‘Euro crisis’ could descend on the region as Italian government financing costs balloon. We currently believe that they will recognise that their room for manoeuvre is limited and will adjust policy accordingly, however the situation is fluid and requires close monitoring.   

The fall in equity markets coincided with upgrades to earnings forecasts, meaning that market valuations no longer looked stretched.

The fall in equity markets 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, which draws retail investors to the stock market. This will encourage company management teams to undertake aggressive merger and acquisition activity and unlisted companies to list on the stock market in far greater numbers than we have seen in the recent past.

However, 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’. We believe that 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 continue to perform strongly. Furthermore, banks in the United States are continuing to ease lending standards to corporates.

Given this, we remain constructive on equity risk and higher yielding corporate debt.

Cornelian Investment Team

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