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Market Comment  09/05/2018

Market Commentary May 2018

The Cornelian Team outline their latest views on the global economy and address concerns over wage inflation in the US.

Following a strong end to 2017, global equity markets have proven much more volatile so far in 2018. In the quarter to the end of April, equity markets suffered a meaningful correction in February and March before recovering somewhat in April. The triggers that caused the retrenchment are analysed in the Market Outlook section below.

The FTSE All-Share index (+1.1%) outperformed the FTSE World ex UK (£) index (-2.1%) following a particularly strong recovery in April (+6.4%). There were a number of factors that drove April’s performance. Weakness in sterling following some evidence of slowing economic activity and dovish central bank commentary boosted the value of overseas 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 above $70 per barrel.  The UK remains heavily out of favour with international investors due to uncertainty surrounding the Brexit process. A number of domestic stocks that simply met downgraded earnings expectations performed very strongly during the period, suggesting that this caution may have become too extreme.

For UK based investors, returns in Sterling terms from international equities benefitted to varying degrees from foreign exchange effects.

U.S (S&P 500 index) and emerging markets (MSCI Emerging Markets index) were the worst performing major equity market regions in local currency terms during the period, falling 5.8% and 4.6% respectively. Sentiment was negatively impacted by escalating trade tensions between the US and China and the unexpectedly aggressive sanctions placed on Rusal, the second largest global producer of aluminium in the world, by the Trump administration due to purported links between major shareholder Oleg Deripaska and the Russian State. For UK based investors, returns in Sterling terms from international equities benefitted to varying degrees from foreign exchange effects as the Pound weakened against most major currencies.

Gilts performed relatively well over the period (FTSE Gilts All Stocks +1.3%) 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 negative return (ICE BAML£ Corporate Securities index, -0.7%), underperforming both ‘riskier’ high yield debt (ICE BAML£ Sterling HY index +0.1%) and the gilt market. This was a somewhat surprising outturn given the relatively high interest rate duration and low credit sensitivity of the sterling investment grade corporate bond market. 

The Brent crude oil price rose 7.0% during the period under review to $75.2 per barrel, driven by robust demand growth, rising geopolitical tensions and evidence that the OPEC production cuts are finally moving the market back to a more balanced position.

The gold price produced a modest negative return in US Dollar terms, falling 0.7% to $1,315 per ounce, however due to Sterling weakness produced a positive return of 1.1% for UK based investors.

Investment Outlook

Market sentiment has changed markedly. 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 on numerous fronts.

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, internet related stocks which have led the US market higher have come under the microscope, both in terms of how social media sites are harvesting and monetising personal data and whether or not internet retail companies are operating on a level playing field in terms of tax. The authorities on both sides of the Atlantic are beginning to raise the possibility of a new tax on internet based revenues.

Addressing these three issues in turn:

Increased expenditure will have a marked productivity enhancing effect ensuring that economy wide inflation remains well behaved.

Whilst we do believe wage inflation is becoming an issue for some companies in the United States we also believe there is evidence that many companies in the US are planning to boost capital expenditure as the year progresses in response 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.

Internet related stocks have retrenched following a period of very strong performance. The issues which have triggered the profit taking, whilst real, are likely to dissipate. The global implementation of an internet sales tax will have unintended consequences and so it is, in our opinion, likely to be a long time before we are close to seeing a globally accepted standard. The opposing dynamics of personal data privacy versus the monetization of that data by firms is a political hot potato just now, but we do not sense that consumers are over exercised by it and so feel that whilst new regulations will be imposed on such companies, these companies will adapt and so will negotiate the twists in the road successfully.

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

The fall in equity markets has 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, encourages 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’. However 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 have not led the market down and, indeed, a number of these stocks made new relative highs during the sell-off.

Since the beginning of the year, there have been some signs of stress in the US interbank funding market, however we believe these to be a result of some technical factors rather than a real indication of underlying stress. This is because there are numerous other indicators of bank sector funding stress, which are not even flashing amber. With record levels of employment, rising real wages and optimistic businesses incentivised to invest, the well-capitalised US banking system should continue to make credit available on attractive terms to support the economy. The next survey data (the Senior Loan Officers survey), which will give an up-to-date indication of the credit cycle, will be issued in May and we expect it to be benign, thus supporting our positive view on markets.

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

Cornelian Investment Team

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