Investment Strategy:  Second Quarter – General Market Review

Summary

  • Global growth is slowing but risk of recession remains low for now. The US remains relatively robust but there has been a marked loss of momentum in Europe, UK and Asia.

  • Inflation remains muted globally, with a return to deflation a risk In Europe.

  • We appear to be returning to the ‘lower for longer’ low inflation, low interest rate, low bond yield environment.

  • Central Bank monetary policy everywhere is becoming more dovish. The US Federal Reserve Bank has moved from tightening to neutral and the ECB has deferred its first rate rise until next year.

  • Equity markets rebounded strongly in Q1. Markets at year end had been pricing in a ‘worst case’ scenario on growth, earnings, US monetary policy and politics and whilst some of these concerns continue the news flow has been more positive this year.

  • However, 2019 signalled a move into in a more challenging environment for risk assets and financial markets remain fragile.

  • Geopolitics remain a problem; trade issues between the US and China remain unresolved, the Eurozone looks increasingly dysfunctional and Brexit…what can you say?

  • Bond funds produced strong returns as Government Bond yields fell in the quarter and are expected to remain at low levels for a long time. Index linked Gilts produced particularly strong returns due to their long duration effect.

  • Credit spreads narrowed in line with ‘risk on’ sentiment across all asset classes.

  • Currencies have been relatively stable this year, sterling has been a hostage to fortune of Brexit and strengthened slightly during the quarter.

  • Commercial Property remains resilient but is a yield rather than a capital growth story at this mature stage of the cycle.

  • The oil price bounced back to US$68/bl by the end of the quarter whilst Gold continued to languish around the US$1300oz. level.

The changing seasons

I wandered lonely as a cloud, that floats on high o’er vales and hills,
When all at once I saw a crowd ,a host, of golden daffodils
They flash upon that inward eye, which is the bliss of solitude;
And then my heart with pleasure fills, and dances with the daffodils.

I’ve led with the quintessential spring poem but are the markets in similar mood? I titled the Q1 newsletter, rather melodramatically, ‘In the eye of the storm’ as markets had pretty much collapsed into year-end discounting worst case scenarios on pretty much everything; US monetary policy, trade wars, Brexit, and a sharp slowdown in global growth and earnings. Brexit remains unresolved (at the time of writing) but the clouds have lifted somewhat on the other issues that matter. The US Federal Reserve had moved to ‘pause’ on monetary policy, implying an end to interest rate hikes. The rhetoric between the US and China on trade has improved, arguably because Trump has his eye on the stock market reaction if he kept playing hardball. Finally, the US economy hasn’t fallen off the edge of a cliff and whilst growth is slowing, global recession is not imminent.

The clouds may have lifted but they have not gone away. The sun may have been shining these last few weeks and there are signs of spring everywhere around us; the smell of newly mown grass, cherry blossom, birdsong, gambolling lambs, lighter evenings, the start of the cricket season, Line of Duty back on TV. But is Wordsworth reading the market right? Whilst undoubtedly one of our greatest romantic poets, I fear he’s maybe a bit too bullish when it comes to stocks. The global economy is losing momentum with Europe in particular a weak spot with the spectre of deflation floating in the wings. Global earnings growth is slowing markedly with estimates in the US for 2019 falling from 10% at the beginning of the year to barely 4% now and the prospect of an earnings recession next year. As for the politics, well its looking a bit brighter for now (bar the UK!) but is so unpredictable that events may well have changed for better or worse between my writing and your reading this sentence.

Macro….when doves cry

Global growth forecasts are being downgraded by all and sundry, including the OECD and the Central Banks. The US economy is slowing, though growth is still at a relatively healthy rate and predictions of a severe slowdown as the Trump tax cuts wane look wide of the mark. The Eurozone, UK and Japan are all stuttering though with Europe in particular feeling sickly with Italy and export oriented Germany both teetering around recession with flat or negative growth in the last couple of quarters. Higher US interest rates and the stronger dollar continue to impact growth in Asia and the Emerging Markets with trade tariffs a further headwind.

Note though that for now at least (fingers crossed) this year’s slowdown is not forecast to spiral downwards through 2020. The US will slow from its high base as the fiscal boost fades and with monetary policy now tighter as the interest rate cycle ends. The hope is that Europe should rebound from its current malaise as several of the factors causing the current weak spot should be temporary, notably the change to car emissions testing in Germany whilst any improvement in the US trade wars will be a positive for such a big exporting bloc. The big unknown is China where despite monetary and fiscal loosening the suspicion is the current rate of growth is much slower than the official figures indicate.

The first phase of post-financial crisis monetary normalisation has come to an end and Central Banks are turning dovish. Monetary policy is tighter than it was a couple of years ago after a plethora of US interest rate rises, a shrinking Federal Reserve balance sheet (equivalent to a 1% rise in interest rates) and the ending of QE in Europe. We think policy is unlikely to tighten further this year, the US Fed has made it clear it is on ‘hold’ with no more interest rate rises and an ending to quantitative tightening (shrinking the balance sheet) by September. Indeed, the next move by the Fed is more likely to be down rather than up with a cut in interest rates some time in 2020. Given the weakness of the Eurozone economy, the ECB can’t contemplate any tightening with deflation, rather than inflation, the risk. Central Banks in Australia and Canada are sending the same signals. Inflation continues to be dog that isn’t barking in the night with forecasts below 2% this year for the developed economies.

It feels as though we are getting back to where we were a few years ago. Debt, deflation and demographics threaten to keep growth below long term historic averages. Maybe 2% rather than 3% GDP growth is now the norm for the developed world whilst the EMs and China slowing as their economies mature and grow leaving the early, dynamic phase of growth well behind them. The return of the Larry Summers ‘secular stagnation’ theory in other words, something I’ve always had a lot of time for. As far as interest rates and bond yields are concerned, this means a return to ‘lower for longer’. The big concern is should growth slow significantly and threaten the Central Banks outside the US have minimal fire power to deploy. As always, thank you to Schroder Asset Management for the consensus economic forecasts.

Markets…fragile

We left Christmas in despair, we approach Easter with more of a spring in our step. Our stance in the Q1 Investment Strategy was that there were three main problems:

  • Tighter monetary policy, especially in the US
  • Much slower US and global growth and a collapse in corporate earnings
  • Politics – US/China trade war and Brexit

We considered at this juncture that maybe the markets were jumping to the worst-case outcomes and that valuations looked far more supportive after the big falls in share prices. If there was any alleviation of the bad news then equity markets could actually generate some return in 2019, albeit with a rocky ride. The cavalry came to the rescue pretty pronto in January.

  • US Fed Chairman Jerome Powell has indicated he will be ‘market aware’ in setting monetary policy, effectively putting monetary policy in neutral.
  • The rhetoric on US/China trade has improved.
  • The US economy and earnings may be slowing, but we are not heading into a recession.

The markets have produced a rather spectacular bounce regaining much of the ground lost last quarter which is obviously very pleasing. However, the problems that so consumed the market at the end of last year have not miraculously gone away. There is a dangerous school of thought that short, sharp bear markets are the new normal and the Q4 correction is done and dusted, the Powell put has done its magic and we are off and running again.

No, no, no. Quick bounces from corrections are the norm in early/mid stages of economic and stock market cycles but the current cycles are now over a decade old and the major drivers feel more like headwinds than tailwinds. The political news flow may have improved, but remains the most fickle of friends. The Central Banks may be sitting on their hands for now but global money supply is significantly tighter than it was a year ago and debt remains piled high. We may not be heading into an immediate recession but global growth will slow markedly and earnings estimates have been revised down precipitously over the last few months in all geographies. Tighter money and slower growth is not a bull market recipe!

Following the strong returns this year valuations feel more in line with long term averages rather than being as supportive as they were at the beginning of January. In this challenging environment capital preservation remains increasingly important for more risk averse portfolios. Markets feel fragile and we may have seen most of this year’s gain already, though we are not bearish. The ‘lower for longer’ interest and bond yield environment has probably further elongated the ten year economic and stock market cycles and as long as economic and earnings growth remain positive then the outlook remains supportive for risk assets. We have though entered the later stages of the bull market cycle where equity markets can still produce gains, but with a far greater volatility and sense of uncertainty.

Mission (still) Impossible

I’m writing this note on, appropriately enough, April Fool’s Day. As this is after March 29th then we should have Brexited, but of course haven’t. I’m not going to speculate on the politics because by the time you read this newsletter a lot will, or at least should, have happened. Though maybe not if the last three years are anything to go by.

The markets thus far have been pretty sanguine, not least because they haven’t a clue what’s going on either. When they finally have an outcome on which to ponder the market reactions could be wide ranging. A no-deal exit would likely see a collapse in sterling back below US$1.20, which would be good news for the large cap multinational stocks (earnings translation) but very bad for the FTSE 250 smaller domestics as the markets would begin to factor in a UK recession. Gilt yields would remain low and the Bank of England could cut rates. A deal or long extension could see sterling at current levels or a touch higher, a small rise in Gilt yields, a more hawkish BoE and a recovery in the FTSE 250 stocks as the market senses a gradual, though still subdued, economic recovery. This is a highly speculative forecast of course with caveats aplenty, not least because of the possibility of a general election and Corbyn and McDonnell in Downing Street. The Brexit process has confounded the markets all along, and with I would suspect further twists in the tail.

As we noted last quarter, for what we had assumed would be the final time, we have tried to manage client portfolios through whatever form Brexit could possibly take rather than trying to second guess what this form will be. The range of Brexit outcomes has been uncomfortably wide and the balancing act has been to protect assets against a disastrously hard Brexit whilst retaining the capacity to benefit from the opportunity afforded by the cheap valuation and high dividend yield of the UK equity market should the eventual solution be seen as market friendly.

Cheap as Chips?

The UK stock market is normally a bit on the dull side compared to fireworks elsewhere but the Brexit farrago leaves it posing an interesting dilemma to investors. Overseas investors have shunned the market post the 2016 referendum whilst many domestic institutional investors have allocated less than they traditionally would have done to the home market. The UK now trades on forward P/E of around 12x which is relatively cheap by historic standards and certainly compared to other developed markets. Moreover the dividend yield is 4.7% with over twenty FTSE100 stocks yielding over 6%, which looks very attractive when 10 year Gilts are yielding only 1%. This though is to an extent an index composition issue, with a high index weighting in lower growth and cyclical sectors such as oil and banks and only a small weighting in the sort of high growth stocks that pay minimal dividends as they invest the cash back into the business. Technology makes up just 1% of the FTSE100 index compared to 21% in the S&P 500.

So yes, optically the UK looks a bargain but, and it is a big but, is it instead a value trap with companies about to slash earnings forecast and cut their dividends making P/Es soar and dividend yields shrink? Our sense is that the UK is actually a cheap market and should the Brexit process produce an outcome welcomed by markets then the flow of money back into the market could be substantial. The caveat is at an individual stock level because yes, there will be some value traps around, especially in weak balance sheet, leveraged companies in more cyclical industries which could be hurt by the slowing economy.

Hi Tech Heist

The US/China trade war tends to be portrayed as Trump battering Beijing, demanding tariffs on this and that or limiting imports of the other. It is actually somewhat more nuanced in that Trump is actually articulating the view of Europe and most of Asia that China is unfairly distorting global trade by funnelling cheap capital to state firms, bullying private companies and breaching the rights of foreign companies by demanding their intellectual property and technological secrets. This happens because China’s strict foreign-ownership restriction laws require foreign businesses to form joint ventures with domestic Chinese companies leading to claims that the Chinese company in effect ‘steals’ the technological IP from the foreign firm. What particularly alarmed the west was the ‘Made in China 2025’ plan which was perceived as an aggressive approach by China to use state direction to dominate the high-tech industries such as aerospace, renewable energy, robotics, AI and electric vehicles.

China has underestimated this backlash and so rather sleepwalked into a trade war just as its model of debt, heavy investment and central control is struggling with GDP falling towards 6%, the lowest for a decade though admittedly from an increasingly large base. China should be doing better and in terms of ‘westernisation’ has gone backwards since Xi Jinping took power in 2013, with the state taking an increasing grip on the free market with entrepreneurial culture taking a backward step. Government-owned firms share of new bank loans has risen from 30% to 70% and the previously exuberant private sector has been stifled. Resources are being sucked up by wasteful projects and inefficient state firms so debt has surged and productivity slowed. To deal with hostility abroad and to increase productivity Xi needs to limit the state’s role in allocating capital, allow failing state firms to go bust and free up the Banks and financial markets. Ten years ago this seemed to be Chinese policy but now such reforms seem unlikely and the challenge for Xi is how liberal he is prepared, or forced, to be in order to placate the rest of the world and at the same time rejuvenate the Chinese economy.

Absolute Return Funds…..the dream that died

One of the biggest selling fund sectors since the 2008 financial crisis has been Absolute Return funds. The term covers a multitude of sins but the most popular have been the Global Macro funds, led by the Standard Life GARS Fund which at one time had reached the scarcely believable size of £40bn. These funds invested across all asset classes, equities, bonds, currencies, commodities and in other more exotic areas such as volatility. The objective/aspiration/selling point was their supposed ability to make money in all market conditions, whether up or down. This was achieved until a couple of years ago because markets went up most of the time and there were some very obvious directional trades; strong dollar, falling bond yields, narrowing credit spreads. Ever since the Brexit vote and the Trump election in 2016 however, markets have been more problematic and volatile and these funds have not coped well. They have either lost money or made a virtually zero return over the last three years and just as bad, have shown a directional correlation with equity markets so offering little diversification or protection benefit. We had been recommending the Invesco Perpetual Global Target Return Fund but eventually our faith/patience ran out and we have now taken the fund off our Buy List. The only Global Macro Fund we still have on our Buy List is the Natixis H2O MultiReturns Fund which is a completely different kettle of fish in that it is solely targeting returns, which it has successfully delivered.

This then leads on the question of how best to construct portfolios in volatile times to both capture upside but also keep a wary eye on mitigating losses. We think it best to do this by having widely diversified portfolios and to avoid taking binary bets, especially on unpredictable outcomes like Brexit or anything to do with Trump. With regard to our more defensive funds, whilst we have abandoned Global Macro funds we retain faith with the simpler structure long/short equity funds as well as the conservative multi-asset funds from Troy, Newton and Ruffer which include index-linked bonds and gold in their asset allocation.

Scores on the Doors

It’s nice to see some positive returns after the misery of last year. The theme of this little segment is really ‘flip-flop’, both for markets themselves and then within markets. What comes around goes around, outhouse to penthouse, the last shall be first etc. In other words, what got absolutely battered in Q4 last year bounced the most this year, so the energy, industrials and technology sectors have produced some big winners. The sharp fall in Government Bond yields and some narrowing of credit spreads produced strong returns from fixed interest funds. Our conservative multi-asset funds returned around 3% whereas the bricks and mortar commercial property funds were flat to slightly down with the sector now very much a yield play with little or no capital growth expected in the next few years. Sterling strengthened around 3% against the other major blocs which reduced the local currency returns from these markets when translated back into sterling for UK domiciled funds.

Conclusion….Losing Control

In March 2009 stock markets hit rock bottom, in the case of the S&P500 an entirely appropriate 666 and 3512 on the FTSE100. There have been a few nasty wobbles since then but otherwise it has been one-way traffic for ten years, rocket fuelled by ultra-loose monetary policy, with end March 2019 readings of 2834 for the S&P500 and 7279 for the FTSE100. With dividends added in as well this represents a total return of around 372% for the S&P and 203% for the FTSE in local currency. This gives context to where we are now and expectations must surely be tempered after such a stellar decade of returns.

We are not bearish, but have entered the later stages of the bull market cycle where equity markets can still produce gains, but with a far greater volatility and sense of uncertainty. Valuations are neither expensive nor cheap and the fundamentals are changeable and increasingly difficult to predict. The bear case is tighter money, slower growth and collapsing earnings; the bull case is ‘lower for even longer’ interest rates and bond yields which further extends the economic, earnings and stock market cycles. Political news flow, for better or worse, remain a loose cannon. For the moment the bulls still have it, but the bear case remains plausible and eminently possible so portfolios need to be constructed with this in mind. We are still at the dance, but edging closer to the door.

On a more personal note there are a number of things in life I hope for. You will be pleased to know that strong and consistent portfolio returns for all our clients is high on in my list, alongside Everton winning the Champions League, and my gaining bragging rights over one of my close HFMC friends (now rival) in the Standard and Chartered Great City 5k race in July. I’ve also recently added a Brexit wish and no, its not for a particular outcome, its simply that whatever that outcome, it brings compromise and healing to our fractured and polarised country.

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