There is a broad agreement that global growth is slowing and downside risks are increasing. Inflation remains muted.
Central Bank monetary policy everywhere is becoming more dovish. The next move in US interest rates will be down with the US Federal Reserve Bank now signalling two cuts this year. Mario Draghi at the ECB is back in ‘whatever it takes’ mode whilst Bank of England policy remains (no surprise) Brexit dependent.
We have returned to the ‘lower for longer’ low inflation, low interest rate, low bond yield environment.
Global earnings growth was very strong in 2018 but marked the peak of the cycle and expectations are being sharply downgraded to mid-single digit as revenue growth moderates and input costs increase.
Equity markets have rebounded strongly in the first half of the year on the expectation that Central Banks will produce a ‘lower rates but no recession’ backdrop that is supportive for both equities and bonds.
However, we see this as a ‘best case’ scenario and our sense is that we are in a challenging environment for risk assets with financial markets more fragile than returns this year would suggest.
Geopolitics remain a problem; friction between the US and China remains high despite the recent trade truce, the Eurozone looks increasingly dysfunctional, Iran is sabre rattling and Brexit rumbles depressingly on.
Bond funds produced strong returns as Government Bond yields fell sharply in the quarter and are expected to remain at low levels almost indefinitely. Credit spreads have narrowed this year.
Currencies have been relatively stable this year, sterling remains a hostage of fortune to Brexit.
Commercial Property remains resilient but is very much a yield rather than a capital growth story at this mature stage of the cycle.
The oil price rose sharply at the end of the quarter on US/Iran tensions to US$65/bl, whilst gold finally broke through the US$1400/oz level following the Fed volte-face on interest rates.
Jacob and Karl Grimm were German academics and philosophers remembered for their classic book ‘Children and Household Tales’ which brought to the world Snow White and Sleeping Beauty. It was all the rage a few years ago in financial markets to talk about another fairy tale favourite Goldilocks, the context being the ‘Goldilocks Economy’ with steady growth accompanied by muted inflation. Not too hot and not too cold for those struggling with the analogy. This background was very market friendly so investors in both stocks and bonds lived happily ever after. Last year though we had the three bears prowling on Wall Street (recession, tight monetary policy and politics) with markets getting in a fearful tizz and collapsing in December.
This year in contrast is back to ‘Goldilocks’ with double-digit returns from pretty much all equity markets and decent returns from Bonds as yields have fallen sharply and credit spreads contracted. Economic growth, though slowing, hasn’t collapsed into recession and Central Banks have turned dovish, waving their magic wands to create greater liquidity. The bears had gone back into the forest and Goldilocks was sleeping peacefully until, mangling my fairy tale analogy yet further, the Big Bad Wolf entered the story. There may have been a temporary truce called between the US and China at the G20 in Tokyo last week but the Trump trade policy is a major concern for markets as it threatens an already fragile global economy for which the outlook has worsened over the last few months.
For the pedants out there, Goldilocks was actually written by the British Poet Robert Southey in 1837, but whereas ‘Turning Grimm’ as a title encapsulates the risks to global growth and equity markets, ‘Turning Southey’ is a bit too lateral even by my elastic standards.
Q1 GDP beat expectations in US, Eurozone, Japan and China but there is a broad agreement that growth is slowing and downside risks are increasing. Underlying indicators suggest a moderate weakening of growth ahead, with the outlook deteriorating still further should the US/China trade war continue to escalate. The temporary truce signalled at the G20 Conference in Tokyo is a relief, but the narrative of the dispute has been that Trump switches between hardliner and appeaser seemingly on a whim so no-one thinks it is going to be plain sailing from here on in. The direct effects of the tariffs themselves are not so much the issue given that the US exports less than 1% of GDP to China, the indirect effects are much more important including the disruption to supply chains as companies re-route processes currently completed abroad and the corporate sector in general scales back investment plans due to the uncertainty. Global inflation, the dog that refuses to bark, remains muted.
Risks to growth appear more on the downside with the World Bank reducing its forecast for global growth this year from 2.9% to 2.6%. Global consumers seem to be holding up with unemployment very low and wages rising above inflation, but not global manufacturers. The US ISM manufacturing index is at the 50 level, a tipping point as below 50 is considered consistent with economic contraction. The equivalent index in Germany is printing 44, the level normally seen during a recession and the Chinese purchasing managers index also fell below the dreaded 50 level in May. The global economic expansion is now the longest since WW2 and is looking increasingly tired. The trade war is seen as the lead pipe in the library but the long term headwind is the lack of final demand which has been prevalent in the global economy ever since the financial crisis, leaving the global economy in a long-term deflationary state or ‘secular stagnation’ to use the modern parlance. This was masked by the Chinese stimulus in 2016 and the Trump tax cuts last year but both have now faded leaving the outlook for long term growth lacklustre, closer to 2% rather than the 3% we had been used to for several decades.
In response to these growth concerns and dwindling inflationary expectations monetary policy has become increasingly dovish. Jerome Powell at the US Federal Reserve is signalling up to 75bps of rate cuts in the second half of the year and the Fed Funds rate could plummet back towards zero if the slowdown in US growth gains momentum. Maybe he is Trump’s poodle after all. The ECB has become even more accommodative with Mario Draghi back in ‘whatever it takes’ mode talking of ‘considerable headroom’ for more asset purchases (QE) or interest rate cuts. We would expect the Bank of Japan to maintain its very loose policy whilst the Central Banks of both India and Australia cut their rates in June. As for the UK, you’ve heard it all before, monetary policy remains (wait for it) Brexit dependant but with the global tide favouring loosening and the chances of a no-deal Brexit increasing then a cut appears as likely as a rise. We wouldn’t expect UK base rates to be much above 1% by the end of 2020.
As always, thank you to Schroder Asset Management for the consensus economic forecasts.
Markets…..pennies in front of a steamroller?
There is quite a chasm building between the view of the world as seen by equity markets and that seen by bonds. Equity markets have notched up spectacular double-digit gains this year implying everything is hunky dory. Yields at the long end of bond markets have collapsed with the yield curve inverted in the US which is a harbinger of recession. What is the answer to this conundrum?
A weaker economic background, escalating political tensions and elevated levels of uncertainty in general have led this quarter to the major ‘risk off’ safe haven assets benefitting; gold, government bonds, Swiss franc and Japanese yen, and defensive equity relative to cyclicals. It is maybe surprising that as growth and earnings expectations have been sharply lowered stock markets have continued to climb, especially as they are starting to look increasingly fully valued after their strong returns this year. The answer lies in the market’s assumption that the ‘Fed put’ is back in play so ensuring a backdrop that is ‘low rates but no recession’ which can favour both stocks and bonds.
This means that we are not bearish on equity markets but see them as being late cycle, still able to produce gains but with increased volatility and a greater sense of uncertainty. Declining profit growth and challenging valuations are not the best backdrop to say the least whilst political news flow, for better or for worse, remains a loose cannon. Trump and US/China trade is the big issue, as discussed in detail in the end-piece to this newsletter, whilst US/Iran tensions have led to a surge in the oil price and increased tension all round. Markets, to our mind, remain fragile and while the ‘lower for longer’ narrative is working for now, we must be careful of arriving at the ‘pennies in front of a steam roller’ stage of the game. Equity markets can still produce gains, but with a far greater volatility and sense of uncertainty.
As for bond markets, Rock on Tommy. Sharply falling yields and contracting credit spreads are manna from heaven for the bondies after last years travails. Yield curves everywhere are pretty flat and in some cases inverted. US 10 year yields are now around 2%, which absolutely no-one predicted even a couple of months ago, similarly 10 year Gilts are below 1%. For much of the developed world 10 year yields are well into negative territory with German Bunds yielding -30bps, Swiss -50bps and JGBs -20bps.
A gentle reminder….
The magisterial Barclays Equity Gilt Study was published in April showing that since 1899 British equities have produced an annualised real (i.e. after inflation) return of 4.9% compared to 1.3% for Gilts and 0.7% for cash. Interestingly Gilt annualised real returns over 50 years are much higher at around 2.7%. Corporate bonds have a much shorter timeframe but tend to produce an annualised real return of around 2.5%. As we always say, don’t ever expect any consistency in these returns, the 1970s were a terrible time to be an equity investor whereas the 1980s and 90s saw double digit returns most years.
The other big takeaway from the survey is the importance of re-investing dividends. I’m sure you’ve heard this before but if you invested £100 in UK stocks in 1945 without reinvesting dividends this would now be worth the price of a couple of tickets to see Man Utd stumble to another defeat, namely £244 after inflation. If however you had wisely invested these dividends then you would have the princely sum of £5,573 after inflation, plenty enough to follow Everton home and away for the next two seasons as they ‘do a Leicester’ and claim the unlikeliest of Prem titles before going on to win the Champions League.
The Man Who Fell to Earth
The biggest talking point for investors last quarter, and which could have major ramifications for the perception and conduct of actively managed funds in the UK, was the suspension of dealing in the Woodford Equity Income Fund. This is unheard of for a daily dealt equity fund and was due to an overwhelming flood of redemptions due to the appalling performance over the last few years. This marks an extraordinary fall from grace for Neil Woodford, until just a few months ago regarded as the UK’s pre-eminent fund manager with a golden career stretching back three decades. Woodford left Invesco in 2014 to set up his own eponymous business, at which point we removed him from our Buy List. This wasn’t second sight, simply that we are never that comfortable with the dual role fund manager/business owner structure as we feel fund managers should be concentrating 100% on their portfolios without any distractions.
So what went so wrong? Woodford built his reputation at Invesco Perpetual managing huge UK equity income funds based on a contrarian style of buying typically large, out of favour, defensive stocks, notably tobaccos and the pharmaceutical giants. At his own shop his modus operandi changed with an increased focus on taking big stakes in small and sometimes unlisted companies, notably in the biotech area. The portfolio could hardly have been more different from the one he used to run at Invesco Perpetual becoming a high risk growth fund. He established an investment trust, Patient Capital, specifically to invest in such names but also bought them for his mainline open-ended vehicle, the Equity Income Fund. At its height the fund was worth £10bn but he made a fatal bet with his larger cap component by shifting the portfolio towards ‘Brexit deal’ domestic stocks which got battered as hopes of a deal collapsed. As performance worsened and redemptions increased and he was forced to sell his larger, more liquid holdings such that when the suspension came, the fund was only £3.7bn in size and invested predominantly in small illiquid companies which can be sold, if at all, only at discounts to their previous share prices.
This is not a story of schadenfreude, as too many investors have lost too much money, but maybe one of hubris. No one has a monopoly on wisdom and all fund managers make mistakes (including me sadly) but Woodford’s management does look open to challenge. So what lessons can be learnt? Firstly the FCA has said that it will re-assess how illiquid asset and unquoted assets fit into open-ended funds, with micro-caps and unquoted shares now coming into the cross-hairs alongside commercial property ‘bricks and mortar’ funds. For our part it re-iterates the need to ensure that the funds in which we invest remain faithful to their mandate with no big ‘style drift’ so as to become a completely different animal. The governance of the Woodford fund has been lamentable and industry wide governance standards must surely be overhauled and improved in the future. Also called into question is the use of broker/advisor Buy Lists channelling huge amounts of investor money into a very limited number of funds, especially those with a ‘star fund manager’ at the helm. The due diligence process and culture of some of the biggest and most influential players in the retail investment business, notably Hargreaves and St. James’s Place, are now firmly under the microscope. Reputations have been ruined in this sorry saga, not least that of the asset management business as whole.
‘Please don’t waste this time’ said European Council President Donald Tusk after the October Brexit extension but, to nobody’s surprise, we have. The Tory Leadership/new PM pantomime will take us to the end of July at which point every politician in the UK and Europe disappears on hols till the start of September. Come the middle of September the UK Parliament will again recess for the Party Conference season, a time of blagging and bravado which is absolutely the worst environment for some grown up, conciliatory, consensual thinking on Brexit. It will be deja vu all over again no doubt with emotive, pejorative and inflammatory rhetoric, finger pointing, blame mongering, Bercow shouting ‘Divisioooooon’ at the top of his voice and our self-serving and preening politicians placing their own self-interest above that of the country’s when we are risking the biggest disruption to our economy since WW2. Rant over!
The Tories are meant to be the party of competence but it hardly feels like that at the moment. With Boris still the most likely next PM, his hard-line stance on Brexit puts a disorderly no-deal outcome very firmly back on the agenda and with it the potential for a clash with Parliament that turns into a constitutional crisis which could in itself lead to a General Election, thereby placing the keys to No.10 with Jeremy Corbyn. That is one of the longest and most depressing sentences I’ve written in the thirteen years I have been producing these newsletters. Speaking of which….
The Question most asked…
…is not Brexit anymore but Corbyn, the one possibly leading to the other of course. I’ve discussed a Corbyn Government before but probably worth a few paragraphs on what it may entail for business, the economy, financial markets and personal finances. A Corbyn Government would take us in a political direction not seen since the 1970s, rolling back decades of capitalism and bringing back ‘Big Government’ intervention in the economy. So renationalisation of water companies, the postal service, energy companies and the railways with the current shareholders possibly being compensated with Government Bonds with, worryingly, the price being set by the Government, possibly at a discount to the market price. Maybe ‘confiscation’ rather than ‘nationalisation’!
Under a Labour regime public spending will likely outstrip tax revenues leading to a deterioration in public finances just when they had been approaching an even keel, a decade after the great financial crisis. This has major implications for the bond market and the cost of borrowing. In the short term Gilts may benefit from being a ‘safe haven’ asset, especially in conjunction with a softer Brexit or second referendum which is the (presumed) Labour policy. In the medium and long term though bond yields should rise, especially if as likely sterling falls heavily which is itself inflationary. Interest rates and mortgage rates will rise, stifling business and hitting households in the pocket. Growth forecasts are likely to be downgraded at this point. Inflation and the bond market would take particular fright if Labour resort to what is euphemistically called Modern Monetary Theory (MMT) but is practise just printing ‘helicopter money’ to fund government spending rather than borrowing it through the issuance of Government debt.
The stock market is going to be wildly confused by the idea of a Corbyn Government though fair to say it will hardly see it as good news. Marxist theory, at its most basic, preaches that personal wealth is always theft , if you are wealthier than average then you have exploited someone else. It would be wrong though to think of it a complete ‘lose, lose’ for the equity market. A lot will depend on how far sterling falls given the tailwind it provides to the earnings of the big multinationals that dominate the FTSE100. However, more domestic earners could be carried out and there are a host of special situations which could be very badly mauled, most obviously the re-nationalisation club. Expect huge volatility and a lot of head scratching, remembering also back to 2016 when market moves post the Brexit referendum and Trump were the opposite of what received wisdom had predicted.
Labour has big plans for infrastructure spending with a £250bn National Transformation Fund to spend on railways, broadband and renewable energy. Also likely is much more worker participation on corporate boards and a rise in the minimum wage. These policies will of course cost money so corporation tax will rise as will income tax, maybe to 45% on those earning more than £80,000 and 50% above £123,000. Interest/mortgage rates are likely to rise as unfunded spending will hit the pound and be inflationary. CGT will surely rise, as could stamp duty and in particular inheritance tax alongside further cutbacks in pensions tax relief and a big rise in council taxes on larger homes. A new 2% financials transactions tax is mooted and also talk of a one-off wealth tax of 20% on assets above a certain threshold, high-value residential property being an target. Private landlords could also be in the firing line so ‘buy to let’ owners will be looking for their tin hats. An outlier could be a forced redirection of some proportion of assets within pensions into ‘national bonds’ to finance Labour’s spending plans. Capital controls are another option, harking back to the 1970s, which could prompt a rush into overseas custody of investments
Scores on the Doors
Figures from Financial Express Analytics
Phew, that’s not too dusty is it. It might not last, but both equity and bond markets have been flying so far this year, equities in full-on rebound mode after the Christmas Crash and bonds with the sharp fall in yields as growth expectations have moderated. Sterling has been weak over the last two months, falling by as much as 5% against the major currencies, which has enhanced returns from overseas, funds, though for the year as a whole this effect is relatively muted. Growth has outperformed value this year quite markedly with low quality, recovery stocks taking a bit of a kicking and the high quality ‘bond proxy’ stocks doing very well, increasing the considerable valuation differential still further. Notwithstanding, most sectors have done pretty well with Technology the standout and last year’s big winner Healthcare, the laggard. Divergence of performance has been more at the stock then the sector level. The bricks and mortar commercial property stocks have juddered to a halt on Brexit fears, Gold has been strong, breaking through its long-term US$1350/oz resistance level whilst oil has risen back to US$65/bl on fears of US sanctions against Iran.
Conclusion…..the Song Remains the Same
I’m sticking with what I said last time out, 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 so capital preservation remains increasingly important for more risk averse portfolios.
Valuations are no longer cheap following the strong returns this year and fundamentals are increasingly difficult to predict and have deteriorated in the last quarter. The bear case is much 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 and perpetuates the idea that Central Banks will always come to the rescue. This worries us. Political news flow, for better or worse, remain a loose cannon. The bulls have the upper hand currently but the bear case remains plausible and eminently possible so portfolios need to be constructed with this in mind.