Market Comment 05/10/2018
Market Commentary October 2018
The Investment Team give their Market Commentary of the month passed and also their Investment Outlook, with reference to trade negotiations between the US and China and the increasing importance of technology.
Equity market returns have varied significantly by region over the quarter to the end of September. The FTSE All-Share index (-0.8%) fell as market uncertainty intensified over the potential outcome(s) from UK/EU Brexit negotiations, ahead of critical deadlines later this year. The UK stock market remains highly out of favour with international investors. UK equity market returns significantly underperformed the FTSE World ex UK £ Index (+6.7%). Of the major regional blocks, the United States equity market produced the strongest returns in Sterling terms (S&P 500 £ index +9.1%). Companies listed in the United States reported exceptionally strong second quarter earnings growth, benefitting from both corporate tax reform and accelerating economic growth.
Aside from the UK, Emerging market (MSCI EM +0.1%) and Asia (ex Japan) (MSCI AC Asia ex Japan -0.4%) equities were the worst performing major equity regions. Sentiment was once again negatively impacted by rising trade tensions with the US, increased political uncertainty and weaker currencies.
Gilts produced a negative return during the period (FTSE Gilts All Stocks Index, -1.7%). This mirrored negative returns in other major government bond markets where yields rose due to evidence increasing that developed market economic growth was accelerating. The Bank of England raised rates from 25 bps to 75 bps (the highest level since the global financial crisis). Investment grade debt also delivered a negative return (ICE BofAML Sterling Corp -0.2%), whilst ‘riskier’ high yield debt outperformed investment grade debt (BAML £ High Yield index, +1.5%).
Venezuelan and Iranian sanctions raise the threat of a reduction in the supply of oil at a time where the demand/supply balance is relatively tight.
During the 3-month period, the Brent crude price (IFEU $/bbl) increased by 4.1%, finishing the quarter at $82.7 per barrel, despite some intra-period volatility. Venezuelan and Iranian sanctions raise the threat of a reduction in the supply of oil at a time where the demand/supply balance is relatively tight.
Despite increased geopolitical tensions, the gold price fell 4.8% in US Dollar terms, to $1,193 per ounce. In Sterling terms, the price fell by 3.7% as the Dollar strengthened against Sterling over the period.
In the nine months to the end of September, global stocks have produced a good return of 9.8% (MSCI World £ Index) for an investor based in the United Kingdom. Unusually, however, the drivers of the positive performance have been very narrowly focused. Stocks in the United States have produced the best overall returns, rising by 14.7% (S&P500 index) as earnings growth has surged. Indeed, earnings grew by an extraordinary 25% year-on-year during the second quarter, far exceeding expectations. Corporate profits have grown sharply thanks to a resurgent economy and President Trump’s tax reforms (which have seen corporate tax rates cut significantly). The information technology sector has led the US stock market up, returning 25.1% (S&P Information Technology sector index) to the end of September.
Elsewhere, equity market returns have been less appealing. Emerging market equities have produced a return of –4.2% (MSCI Emerging Market index) as the rising US Dollar has put the spotlight on some economies (such as Turkey and Argentina). These countries not only have significant fiscal issues to deal with but also have high levels of US Dollar denominated debt, which is now costing a lot more to service following the collapse in those countries’ currencies).
More idiosyncratic is the impact of political risks on the United Kingdom’s stock market. The FTSE All-Share index has produced a marginally positive return of 0.9% this year (to the end of September) as international investors have fled the field, concerned about the potential for a harmful ‘cliff edge’ Brexit and the risks of a change in government, which would herald a less ‘equity market friendly’ period.
For portfolios which are well diversified by geography and asset class, the material outperformance of the US Stock market has been a challenge, as this market has a weighting in the MSCI World Index of over 60%, whilst the UK stock market has a weighting of less than 6%.
Thankfully, the UK has many very well managed companies with strong market positions in the United States.
One way we counter the dominance of the US stock market in the World Index is to ensure that within our UK equity investments we have stocks which are heavily exposed to the US economy. Thankfully, the UK has many very well managed companies with strong market positions in the United States. These companies are reporting strong end demand and good profit growth as one would expect, however these companies’ valuations are, we believe, being penalised currently for the perceived high level of political risk and associated uncertainty seen in the UK. As a result, we believe many stocks in the United Kingdom are demonstrating real value versus their international peers.
The good news is that it is probable that we are close to the point of maximum uncertainty concerning the Brexit outcome as we believe the risk of a ‘cliff edge’ hard Brexit on Friday, 29th March at 11pm is low. Even if there is a no deal outcome, we would expect the European Union to agree to extend the UK’s unfettered access to European markets to the end of 2020 in line with the UK’s budget commitments. This will give time for the government to plan the country’s exit properly and give companies certainty as to what they need to do to ameliorate any negative impacts. Our confidence that a cliff edge Brexit will be avoided is driven by the fact that we can see no major constituency which would benefit from such an outcome, be it in the UK or Europe.
If correct, it means that international investors may soon start to anticipate a less risky political/economic outcome and start to sniff out the ‘bargains’ to be had in the UK.
The long-term trend of global trade integration may be about to be checked by President Trump’s desire to rebalance global trade. Before the trade war, the average import tariff, in aggregate, for all goods entering the US was 3.5%, whilst the EU charged 5% and the Chinese 10%. President Trump is right to call for the Chinese protectionist barriers, erected correctly when China joined the WTO in December 2001 as an emerging market, to be brought down.
We believe a deal between the United States and the Chinese will be forthcoming after the US mid-term elections in November.
We believe a deal between the United States and the Chinese will be forthcoming after the US mid-term elections in November. China has already taken small but important steps to reduce tariffs and open up their markets. Premier Li Keqiang (arguably the second most powerful person in China) announced over the Summer that the average import tariffs on clothes, footwear, sports gear, home appliances and healthcare goods would be cut significantly.
He has also published a revised ‘negative list’ which reduced the number of protected sectors where foreign investment is barred. Furthermore, he announced that the Chinese authorities would clampdown on counterfeit goods and raise the compensation cap for intellectual property infringement. These are positive steps and show that they recognise the need to change, not just talk about change, which they have been doing for a long time now.
Actions speak louder than words and it is encouraging to observe that Tesla has been given permission to build a fully owned production facility in China and both Fitch and S&P (the credit rating agencies) have been allowed to set up fully owned subsidiaries in China. The door is opening and, we believe, there is a deal to be done.
As described above, a major feature driving the positive US stock market return in recent years and specifically this year to date has been the large ‘household name’ technology related companies such as Microsoft and Amazon. One might, therefore, be forgiven for thinking that the valuation of these stocks would be eyewatering as a result. However, earnings are being revised up and at such a pace that that it is not true that these companies are expensive. Indeed, some of these companies trade on valuation multiples which would not look out of place in more prosaic sectors. Furthermore, another notable difference today compared with the dotcom boom of the late nineties is that cash generation and balance sheets are strong.
Digitisation is set to drive the fourth industrial revolution.
What is being missed by investors, however, is that the technology on offer (internet of things, big data, automation, artificial intelligence, etc), combined with high speeds of data transmission and raw processing power means that digitisation is set to drive the fourth industrial revolution, as enormous productivity gains are generated for companies that successfully incorporate these technologies into the delivery of their so called ‘old economy’ products and services.
This dynamic (which we are hearing more and more about from the company management teams that we meet) will very likely ensure companies’ labour bills will not race away even if wage growth is beginning to accelerate.
This is the key to positive future stock market returns as improving productivity will ensure core inflation will remain relatively well behaved despite the increasingly tight labour market. As a result, central banks will not need to increase interest rates by significantly more than currently expected, which (if it were to happen) would impact asset valuations negatively.
Cornelian Investment Team