The Weekly- How lucky do you feel?

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23/04/2018
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Most investors are aware that 2018 has been a rather different year so far when compared to 2017.  However, as the first post-MiFID II valuations as at the end of March start to hit discretionary clients doormats or email inboxes, some may have a bit of a wake up call.  This is always more likely when investors have been used to an extended period of gains.

To put this in context and in order to determine whether you should be disappointed or not, it is important to consider the effect of Sterling on returns.  There has been somewhat of a double negative whammy, reversing the positive we saw when we voted Yes to Brexit.  Up until the end of 2017, the effect of Sterling’s weakness boosted returns in terms of the FTSE-100 and its 75% overseas earnings exposure.  In addition, overseas equity exposure in collective funds was also boosted due to the similar translation effect of foreign earnings.  Whilst the UK economy has been slowly deteriorating as uncertainty has undermined investment decisions, the Brexit effect has influenced overseas investors, political uncertainty has risen and now the UK is perceived as a no-go area for many investors due to the Corbyn effect.  This will rear its head in May 2022 when Brexit will have been judged a success or a disaster, Theresa May will have been replaced and Corbyn will be going for gold against an untested incumbent in Downing Street.

However, we know all that and Sterling has strengthened considerably over the last 6 months, mainly against the US Dollar but also as interest rate increases have been brought forward.  This has undermined the positive translation effect of overseas earnings but in addition the FTSE-100 has been the weakest major index as overseas investors have deserted the UK equity market and even institutional investors, including ourselves, have underweighted the UK.  In Sterling terms, the first quarter of 2018 has seen the FTSE-100 fall by -7.2% with the ‘strongest’ market being Emerging Markets which has lost -2.2%.  Contrast this with the first quarter of 2017 when the FTSE-100 rose by 3.7% and Emerging Markets by 10.1%.

Even the last six months has seen a gradual erosion of performance, with both the FTSE-100 and European markets losing ground in Sterling terms whilst the S&P 500 has risen by just 0.9%.  In the meantime, fixed interest markets have also fallen as the interest rate cycle has continued to turn towards a tightening phase.  The stellar returns of 2017 are a distant memory when the weakest major market in Sterling terms was the S&P 500 which returned a heady 10.6%, narrowly beaten by the FTSE-100 which returned 12.0%.  To further put this in context, the weakest major market in 2016 was the FTSE-100 which returned 19.1% (no typo) whilst the S&P 500 returned 32.7% (again, no typo).  The closely followed MSCI World Index which measures equity markets rose by 43.4% over those two years and has only retraced 3.1% in Sterling terms year to date. 

These are exceptional returns and could not be sustained indefinitely but are supported by two lines of thought to the hesitant would-be seller.  We have a rarely experienced period of co-ordinated global growth which is delivering strong earnings, most importantly from the US (China’s are a given default), which support bull market extended valuations no matter how much you choose to baulk at the prices.  Remember, asset prices can remain expensive for longer than cash returns will take to destroy a long-only fund manager’s career – therefore, sell independently of the crowd at your peril.  If we all go down at the same time, no-one loses their job and we can all point at the catalyst and say, well who could have forecast that?

The other line of thought is that there is so much liquidity still in the system that looking for positive real returns negates most asset classes apart from equities.  This means that equities remain the asset class of choice and although markets have been fretting about the turn in the interest rate cycle and inflation, the reality is that interest rates have hardly moved, central bankers remain dovish and most investors have been underweight to fixed interest for years, short of duration and have exploited high yield to at least get some sort of return, compressing spreads.

The correction in February which has delivered nil returns for the Sterling investor for the six month period to the end of March feels a little like an earthquake tremor in San Francisco or Tokyo.  Rather scary and a wake-up call reminding us that there is risk following a complacent period of record low volatility but is it a pre-cursor to the big one?  This is the question of today.  What will the catalyst be?  We know about interest rates and inflation but the central bankers are well aware of the market sensitivity to this and are managing the stage so carefully that this is unlikely to be the source of market panic.

China continues to perfectly manage its economy and deliver numbers to support their approach to a market economy, reporting first quarter annualised growth of 6.8% last week.  Even if they had a Lehman’s moment, we would know little about it.  Observe their focus on reforming the shadow banking system.  Clearly there is a problem but market forces are not allowed to function such that a contagion domino effect can take hold.  The authorities spot the problem and neutralise it, further demonstrating to the west that they have a superior system.  That will never change whilst the PRC remains in power and becomes a self-fulfilling but stable feature of smoke and mirrors that we cannot see through.  Many worry about Chinese debt but what you can’t independently measure, you can’t quantify and so we see this as an unlikely catalyst.

Trump is doing a pretty good job of stoking up global trade frictions but we see his strategy as a heavy-handed but logical approach to opening up Chinese markets to US exports in order for the Chinese to avoid the various tariffs and correct the trade deficit.  The game of cat and mouse will depend on what hurts the most to which country and we foresee a trade deal of some sort which Trump will announce as a major political coup ahead of the mid-term elections in November.  That, along with a planned summit with North Korea will give him something to bash any would-be Democrat over the head with.  His failed healthcare reforms have been matched by watered down tax cuts but all-in-all he will certainly have grabbed more headlines in his first two years than Obama did in his eight and achieved considerably more.

It was inevitable that Obama would fail to live up to his electoral expectation but Trump’s advantage is that everyone wrote him off before he even took up office, appalled at the thought.  It is not that difficult for him to over-deliver and the last six months have seen him achieve much.  At the end of the day, if he agrees a pathway to a peace and unification deal for North Korea, which would be enough for any President to claim as a legacy.  He may be unconventional and abrasive but his approach certainly stirs things up and gets to the heart of the issue.

So, we know equities are expensive and we know that we have had stellar returns for the two years to the end of 2017 (and before that) and we also know that for the six months to end Q1 most Sterling investors haven’t made any money.  However, it is difficult to see what will cause an immediate sell-off but then again, it is always difficult as it was in the first week of February – no-one saw that coming.

Perhaps the best advice is to stop fretting about the short-term and all the political noise and focus on a three year time horizon.  If you have to take some money out of the market inside that period, then it is probably better to do it sooner rather than later.  If you can remain invested for longer than three years then don’t overthink the current situation, don’t try to be too clever but perhaps reinvest any cash from dividends on weaker days, like when the FTSE-100 was briefly below 7,000 recently.  Regularly rebalance as different markets ebb and flow - Europe has been quite weak in Sterling terms.  Have a bit of everything, don’t be too UK centric as there are some really interesting things going on in Emerging Markets but don’t bet the farm as a recovery in the US Dollar could be painful.

And don’t shoot your investment manager if he should have sold in May and gone away because that is a short-term, statistically dubious adage with baseless logic which after trading costs, will guarantee to lose you money over time.  But if you have to sell between now and St. Leger day (12th September), probably best to get your skates on and not run the risk of trying to time these volatile markets which have just perked up from the recent lows.  One final short-term temptation of influence – we have a big reporting season this week with the first US GDP Q1 estimate, US durable goods and over 100 S&P 500 companies reporting including Amazon, Alphabet (Google), Boeing & Caterpillar.  With markets valued where they are, do you feel lucky?

Equities edge higher as UK real wage growth turns positive

Most major global equity indices closed the week in positive territory as geopolitical tensions eased in Syria and North Korea.The FTSE 100 gained +1.4% whilst overseas markets also made similar gains; The S&P 500 recorded +0.5% whilst in Europe the German DAX 30 closed +0.8% higher and France’s CAC 40 climbed +1.8%.  Markets were thankful for a week of relatively muted news following the Syrian airstrikes last weekend carried out by American, British and French forces. Furthermore, tensions between North Korea and the US continued to ease ahead of President Trump’s proposed meeting with Kim Jong Un expected in the coming months.

UK inflation dropped to a headline rate of 2.5% according to the latest Consumer Price Index (CPI) data and in doing so, fell below the current level of wage growth for the first time in a year. Price increases of clothing and footwear failed to match that of last year, whilst the change in budget cycle this year also likely reduced this month’s tobacco and alcohol prices relative to last year.  The data cools expectations that Bank of England Governor Mark Carney and his Monetary Policy Committee will raise interest rates in May. The Governor also cast further doubt this week referring to mixed UK data in recent months as well as uncertainty surrounding Brexit.  Sterling eventually closed the week -1.2% and -1.6% lower, respectively.  Interest rate futures are now pricing in a little less than a 50% probability of a rate rise at May’s policy meeting.

Sovereign bond yields continued to rise last week, adding to a trend that has seen the US 10-year Treasury yield rise 50 basis points since the turn of the year to Friday’s close of 2.95%. The International Monetary Fund (IMF), despite raising concerns about protectionist policies and increasing trade wars last week, revealed economic growth forecasts that continue to increase.  The global economy grew 3.8% in 2017 according to the fund and is expected to grow 3.9% next year.

The price of oil reached a three-year high this week following comments from Saudi Arabia targeting a price range of between $80 and $100 a barrel. This attracted the attention of President Trump who criticised OPEC’s intentions to keep crude prices artificially high.  Brent crude oil rose 2.0% during the week to $74 per barrel.

The Week Ahead

The standout domestic data of the week arrives on Friday with the economy forecasted to have grown by +0.3% over the first 3 months of the year. If proven accurate, it would represent a 10 basis points reduction on the level seen during Q4’17. Other data includes Nationwide’s latest housing figures which will provide an indication of house price movements over the last month. Economic growth data is also due from the US this week with a quarterly growth rate of +2.0% expected. Housing sector sales figures are also likely to receive plenty of attention with existing sales numbers released this afternoon, followed by new build sales tomorrow. In the Eurozone, this morning PMI figures were largely as forecast with both the Manufacturing and Services sectors growing at a steady rate. Later this week, the European Central Bank hosts its latest policy meeting although no changes to rates are expected. The Bank of Japan also hosts its policy meeting this week which will be followed by the Bank’s latest outlook report which will provide commentary on growth and inflation expectations amongst other things. Unemployment, industrial production and retail sales are the standout numbers to keep an eye on. Chinese data is in short supply.