Market Comment 05/09/2018
Market Commentary September 2018
The Investment Team give their latest Market Overview of the month past and also their Investment Outlook, with consideration towards political activity, digitisation and de-globalisation.
Equity market returns have been volatile during the three months to the end of August for the UK based investor and have varied significantly by region. Investor concerns over the aggressive use of trade tariffs by the US President and how this might escalate, have risen. The Dollar has acted as a safe haven in recent months and has also responded to the prospect of further gradual interest rate hikes.
During the three-month period under review, the FTSE All-Share index fell (-1.7%) as market uncertainty intensified over the potential outcome(s) from UK/EU Brexit negotiations ahead of critical deadlines later this year. Given this uncertainty, the UK remains a highly out-of-favour market with international investors. UK equity market returns significantly underperformed the FTSE World ex UK £ Index (+6.9%). Of the major regional blocks, the United States equity market produced the strongest returns in Sterling terms (S&P 500 £ index +10.3%). United States companies reported a strong Q2 earnings season with the majority beating expectations at both the sales and profit line, benefitting from tax reform and accelerating economic growth.
Emerging market (MSCI EM -2.4%) and Asia (ex Japan) (MSCI AC Asia ex Japan -2.7%) 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.
Investment grade debt delivered a positive return.
Gilts produced a negative return during the period (FTSE Gilts All Stocks Index, -0.8%) as yields rose. The Bank of England raised rates 25 bps to 75 bps (the highest level since the global financial crisis), giving greater room to manouver in the next downturn. Investment grade debt delivered a positive return (ICE BofAML Sterling Corp +0.3%), whilst ‘riskier’ high yield debt outperformed investment grade debt (BAML £ High Yield index, +1.4%).
During the 3-month period, the Brent crude price (IFEU $/bbl) fell slightly (-0.2%), finishing the month at $77.4 per barrel, despite some intra-period volatility.
Despite increased geopolitical tensions, the gold price fell (LBMA Gold Price PM USD -7.9%) in US Dollar terms, to $1,202 per ounce. In Sterling terms, the price fell by 5.7% as the Dollar strengthened against Sterling over the period.
Our central scenario is that the outlook for equity markets over the medium term is positive. However, the forthcoming months could be challenging for asset prices as there is a confluence of political events which could knock investor confidence.
The main reason we are optimistic about the outlook for equity markets is that we believe economic growth in America is likely to persist for longer than currently expected without stoking troublesome increases in core inflation and interest rates. The key to unlocking this seemingly contradictory statement is that we believe productivity (output per unit of labour and capital) is going to improve markedly in the coming years and that this will ensure core inflation does not accelerate in a destabilising manner. If we are correct, it follows that interest rate rises will not increase at a pace which undermines confidence and puts profits growth at risk.
Our opinion that productivity is about to improve is at odds with the prevalent view. The consensus among investment professionals is that the United States economy has entered a prolonged period where productivity will remain structurally low.
We are optimistic because we believe that economists are too focussed on the past.
We are optimistic because we believe that economists are too focussed on the past, believing the poor productivity growth witnessed since the 2008 financial crisis is entrenched and that they are not paying attention to what companies are saying and doing today. Furthermore, President Trump’s corporate tax reforms have incentivised an acceleration in capital expenditure and corporates are responding.
Company management teams are becoming increasingly confident (and vocal) that there are real productivity enhancements available to them via investments in technology enabled by digitalisation. Importantly, this spans both manufacturing and service companies. After years of promise but little follow through, the so called fourth industrial revolution looks to be upon us. Artificial Intelligence and process automation is now being applied efficiently and effectively with the help of scaled up processing power, cloud computing, big data and the Internet of Things.
Indeed, some of the opportunities becoming available to streamline companies’ internal shared services (such as human resources, finance and administration), let alone external customer services, are material. On the 11th June, the Financial Times reported that Citigroup’s investment bank could shed up to half of their back office staff over the next five years as ‘robotic process’ automation is rolled out. If followed through, this would amount to a fifth of the investment bank’s work force. If one assumes this technology is becoming available to all major developed market banks and insurance companies, the scale of the impact should not be underestimated (and nor, of course, should the social costs).
We have heard directly from the management teams of numerous UK listed companies (spanning both the industrial and service sectors) of tangible digitisation projects which are being implemented now to increase profitability and asset efficiency. One such example is Vodafone. The company’s Chief Executive Officer (elect) has publically identified some eight billion euros of costs which can be managed down through the application of digitisation strategies.
The thesis above chimes strongly with the experience of the mid to late 1990s when the United States economy was judged to be operating at full capacity, wage inflation was accelerating strongly but core inflation was well behaved as productivity grew impressively.
We believe that large companies will be able to absorb inflationary wage pressures...
Given this dynamic, we believe that large companies will be able to absorb inflationary wage pressures, however there will be periods where this will be questioned as the two (productivity growth and wage growth) will not move in lock step together. This means that equity market volatility will be heightened. However we believe the overall direction of travel for equity markets will continue to be up as earnings growth persists for longer than expected and core inflation doesn’t get out of control.
In the near term, a variety of potentially confidence sapping political events appear to be close to conclusion. The common theme would appear to be ‘de-globalisation’, whereby the global structures designed to integrate the global economy and manage political differences are undermined. The de-globalisation events that will soon be upon us include the Brexit deal details, European immigration policy, the US’s approach to NATO and Russia, and, most importantly, the scale of the potential trade war between the United States and her trading partners.
As at time of writing, it would appear that President Trump is intent on increasing the scale of Chinese goods caught by trade tariffs as well as implementing tariffs on imports of foreign built cars. If he does follow through with these threats, China will respond asymmetrically, slowing customs clearances and weakening the Chinese currency. All countries that become recipients of US import tariffs will respond by imposing their own. The ‘tit-for-tat’ enacting of trade tariffs could accelerate swiftly and appear chaotic. If so, this will knock investor confidence as well as the confidence of company management teams and may well result in equity markets selling off. The fact that staff turnover is high at the White House and President Trump is surrounding himself with sycophantic hawks has to be a matter for concern.
In reality, however, the impact of tariffs on global growth, whilst negative, is likely to be manageable and the inflationary pressures that build as a result, modest. Furthermore, multi-national companies are highly adaptive and provided that supply chains aren’t too badly dislocated, swift management action will ameliorate some of the impacts. Nonetheless, working capital requirements are likely to rise as the companies carry more stock and component prices will increase.
Should such a situation materialise, the private sector in the United States will swiftly publicise the negative impacts that the trade war is having and the electorate may well begin to notice some consumer prices rising in ways they weren’t anticipating. This should bring pressure to normalise trade relations ahead of the US mid-term elections this November. We, therefore, believe that the negative impacts of the developing trade tensions and the uncertainty engendered as a result should be relatively transitory in nature.
Cornelian Investment Team