|3rd Quarter 2016,
% total return
Euro First 300
After an impressive recovery from the post EU referendum sell-off, most markets registered further falls in early July. Investors moved into perceived lower risk asset classes such as cash, government Bonds and gold as worries escalated over the sustainability of global growth. Regions which have struggled to extricate themselves from a prolonged low growth environment, notably Japan and the Eurozone, were worst affected.
The immediate ramifications of Brexit were highlighted in surveys showing a large fall in business and consumer confidence. The knock on effect hit sentiment towards the property sector particularly hard and several commercial property funds with over £15bn in assets suspended trading for varying lengths of time to allow orderly sales of property to meet redemptions.
Renewed monetary easing by the Bank of England pushed the Pound to a 31 year low, below $1.30, but equity markets cheered the positive impact that this would have on exports which account for a significant proportion of UK companies’ revenues. Consequently, the UK proved a resilient performer over the quarter. In spite of sharp downgrades to economic growth in 2017 data has shown that for the time being the economy is growing in line with expectations. The other bonus was that UK investors in overseas equities saw their valuations enhanced, significantly so in some markets, by the fall in sterling as can be seen in the table above.
As the quarter progressed and fears of an imminent domestic slowdown receded smaller companies returned to favour. For the period overall the FTSE Small Cap index ex IT was the standout performer advancing by 11.9% compared with 9.2% for the FTSE Mid Cap ex IT and 5.9% for the FTSE 100. This partly reflected a bounce back from the previous quarter when more domestically based businesses were marked down. Since Brexit, and for the year to date, the FTSE 100 still leads the way.
The US was somewhat subdued ahead of the November Presidential Elections and lack of decisive action on the path for interest rates. China also lagged due to a lack of conclusive data and concerns about its debt burden.
Global Bond markets performed well as yields touched new record lows with the German 10 year bund dipping into negative territory. Strong showings in UK and German government bond auctions also added weight to the record low yields.
The oil price was little changed over the period but this masked a sharp fall in July followed by a recovery. Meanwhile, gold prices initially surged to a 27-month high as demand increased for the safe-haven asset before drifting lower as investors took on more risk.
Key events of the quarter
Global growth looks set for another year of below average growth. The IMF* reduced its global growth forecast from 3.2% to 3.1% for 2016 and from 3.5% to 3.4% for 2017. The organisation called on the world’s major economies to embark upon further stimulus.
The Bank of England took concerted action to prevent the economy sliding into recession by cutting interest rates to a record new low of 0.25%. It committed to taking further action if deemed necessary.
Politics took centre stage in the UK and the US. Britain’s new Prime Minister, Theresa May, moved swiftly to appoint her new cabinet. Key roles were given to prominent Brexit supporters including Boris Johnson, who was handed the position of Foreign Secretary while David Davies became Secretary of State for Exiting the European Union.
Meanwhile in the US the debate ahead of the Presidential Election on the 8th November has reached a crescendo with the polls still close and the outcome set to go to the wire. Hillary Clinton and Donald Trump had their first face to face debate and Clinton was deemed to have had the edge.
The oil price initially drifted lower on concern about rumoured US crude stockpiles and slower global growth but spiked up after OPEC** committed to cut output. At a meeting in Algiers the organisation agreed to limit output for the first time in 8 years though no formal quotas were announced. This is the first concerted attempt to boost the oil price since its downward spiral began 2 years ago and triggered a sharp rise in the price of crude and upward moves in oil stocks. However, some analysts question whether all members will comply as they compete against each other for market share.
There has been no significant news flow from China but it remains one of the main threats to economic stability if its debt bubble were to burst. Slowing growth is also a concern; the country is seen as suffering from overcapacity and has a growing number of non-performing loans which are at risk of default.
According to the OECD’s*** September Economic Outlook, weak trade growth and financial distortions are exacerbating slow global economic growth and it has nudged down it’s forecast for global growth to 2.9% and 3.2% in 2016 and 2017 respectively. This is well below the long term historic average growth rate of 3.8% and the report concludes that low growth expectations will further depress trade, investment, productivity and wages.
Economic & political trends in world markets
The IMF predicts that the UK will now deliver the strongest growth of the G7**** group of countries with 1.8%, compared to 2.2% in 2015. However, it warned that the effects of Brexit have prompted a significantly reduced growth forecast of 1.1% in 2017. The Treasury’s compilation of various analysts’ forecasts also shows a consensus of 1.8% this year. The OECD expects 1.9% for this year and 1% in 2017.
The Bank of England Governor, Mark Carney, took swift action to support the economy and announced a package of cheap loans for banks to encourage greater lending activity. As anticipated the base rate was halved to 0.25% in August and an additional £70bn of Quantitative Easing was launched which extends to purchasing investment grade bonds as well as gilts. Sterling bond yields responded by touching record lows with 10 year gilts offering just 0.6%. The Bank downgraded UK GDP growth to 0.8% for 2017 from 2.3% while leaving the 2016 estimate at 2%.
Mr Carney warned of a ‘challenging outlook for financial stability’ as it takes time to establish new relationships with the EU and the rest of the world. There has been much debate over when and how Article 50 will be triggered and what new trade agreements will be put in place but Mrs May announced at the recent Conservative Party conference that Britain would leave the EU by 2019, becoming a ‘fully independent, sovereign country’ which suggests a complete severance from the EU. Following her speech the pound fell to a 5 year low against the Euro.
In contrast her chancellor Phillip Hammond is an advocate of retaining the fullest possible British access to EU markets declaring that ‘the British people did not vote to become poorer or less secure’. He cautioned that the UK faces 2 years of economic turbulence and a period of fiscal uncertainty for markets during negotiations.
However, data released over the period suggests that economy remained in robust shape overall ahead of Brexit with GDP growth for the second quarter confirmed at 0.7% and forecasts for the rest of this year have held up.
In the aftermath of the referendum July saw a knee-jerk deterioration in the UK economy with business activity falling at the fastest rate since the financial crisis. The Gfk consumer confidence survey recorded one of the biggest falls in its history, falling from -1 to -12 by the end of July but subsequently recovered in September to pre-referendum levels.
Nevertheless, retail sales held up reasonably well over the period. Wage growth remained strong and employment levels stable despite Mr Carneys warning that 1/4m jobs could be lost as a result of the Brexit vote. Inflation remains low with a small increase from 0.5% in June to 0.6% in August year on year.
The composite Purchasing Managers Index (PMI) fell to 47.7 (below 50 signals contraction) with manufacturing holding up better than services as exports benefitted from weak sterling. More recently manufacturing has surprised on the upside with the manufacturing PMI rising to 55.4 in September against expectations of 52.1.
The weak Pound may be behind a pick up in takeover activity from overseas predators including the £24bn all cash offer for ARM group from Softbank of Japan while Henderson Group has agreed a merger with US based Janus Capital.
The IMF cut its forecast for US growth 1.6% blaming slower global growth, contraction of the energy industry, and uncertainty ahead of the election. For 2017 they anticipate acceleration to 2.2%.
US Q2 GDP growth of +1.2% disappointed; data on manufacturing, retail and factory prices all came in below expectation suggesting the world’s biggest economy may be slowing. Nevertheless, reduced expectations of an imminent interest rate rise and a decent corporate earnings season helped the S&P 500 reach new highs and the index ended the quarter 6.7% ahead.
However, some recent data, including a better than expected unemployment report in August, led the Fed to adopt a more aggressive view on interest rates observing that ‘near term risks to the economic outlook have diminished.’ Consequently, at the end of August equities touched a 3 week low as Fed Chair Janet Yellen said the case for a rate rise had strengthened in recent months. However, given the mixed data her policy committee are divided over the timing and extent of any action.
The keenly watched jobs report for September was slightly weaker than hoped which investors interpreted as delaying the chance of a rate hike. This inspired global markets to rally. A disappointing US ISM non-manufacturing index for August also helped shift rate rise expectations towards the year end although the Federal Reserve reiterated that they expected the economy to expand at a modest pace in coming months and noted that the tight labour market and rising wages were not generating excessive inflationary pressures. The expectation is currently for a 0.25% rise in December followed by a further 2 rises in 2017 bringing the Fed Funds rate to 1.25%.
The imminent Presidential Election is likely to be the main driver of equities, particularly with regard to Donald Trump’s policies which have not been revealed in detail. Trump advocates large tax cuts which should boost growth but how they are to be funded is unclear and one outcome could be accelerated monetary tightening. Hillary Clinton will adopt more of a tax and spend approach which should also boost activity but probably to a lesser extent.
The IMF lifted its GDP growth for the Eurozone to 1.7% for 2016 and 1.5% for 2017. Previously it expected 1.6% and 1.4% respectively.
For most of the period the European Central Bank adopted a wait and see position, keeping policy unchanged while waiting for signs of momentum from its domestic economies and the looming US election.
In the first half of September a government bond sell off originated in Europe after the ECB left interest rates and its Euro 1.7bn stimulus programme unchanged. As a result the German 10 year bund rose above zero for the first time since June.
Economic data was generally uninspiring and investors worried about prospects post Brexit. In Germany GDP was +0.4% in Q2 and the key industrial production data has continued to be sluggish. Low inflation persists across the region with the CPI for the Eurozone standing at 0.2% in June.
The European Banking sector was the focused of heightened concern as Deutsche Bank shares came under severe selling pressure. It faces a $14bn fine in the US for mis-selling mortgage backed securities compounded by rumours of major losses on derivative contracts in which other major banks may be counterparties. Investors are seeking assurance from German Chancellor Angela Merkel that the bank will not be allowed to fail.
The IMF expects the economy to grow by 0.5% this year and 0.6% in 2017, which represents upgrades of 0.2% and 0.5% for the worlds 3rd largest economy, due to a government spending package announced in August, as well as a decision to delay a consumption tax hike.
Equities rebounded from the falls of the previous quarter although a stronger Yen has weighed on the competitive edge of exporters. Of course, for UK based investors in Japan this has boosted the value of their holdings. Early in the quarter, the Yen gained as the Bank of Japan stimulus extension of Yen 6trn in increased ETF purchases failed to satisfy the markets. Government bond yields had also started to move back towards positive territory as uncertainty over the Banks policy stance prompted selling.
However, Japanese stock markets reacted positively to Prime Minister Abe’s ‘super majority’ win in Julys Upper House Elections which means his Liberal democrat party can change constitution. Markets soared on hopes of a fiscal stimulus package and Abe’s commitment to defeat deflation. Technology stocks were buoyed by the rise in Nintendo share due to the success of it’s ‘Pokémon Go’ app.
In August Abe announced a new $130bn fiscal stimulus package to revive the economy, addressing concerns that monetary policy has reached its limit. Further funding was announced for infrastructure, welfare and support for small businesses. In a new kind of monetary easing the Bank of Japan announced in September it had set a cap of zero on the 10 year bond yield. The aim is to steepen the yield curve and weaken the yen. It also left deposit rates at 0-0.1% and kept annual purchases of Japanese government bonds at Yen 80 trillion.
The IMF predicts that overall growth in Emerging Markets will be 4.2% in 2016 followed by 4.6 % in 2017. This masks considerable divergence with growth this year estimated at 6.6% for China and 7.6% for India while Russia and Brazil are expected to see declines of -0.8% and -3.3% respectively.
China reported GDP growth of 6.7% in Q2, with growth in the services sector particularly strong and approved a full year growth target of 6.5-7.0% which abated some worries of an imminent slowdown. Factory output picked up in August but exports, the traditional engine of growth fell 2.8% in dollar terms. The State Council pledged to support domestic demand with a more proactive fiscal policy and the latest data revealed industrial output grew by 6.3% in August year on year while retail sales rose an impressive 10.6%.
The appointment of Dr Urjit Patel as the new Governor of the Reserve Bank of India was well received, raising hopes that he will tackle the plummeting currency and narrow the current account deficit by attracting more foreign investment to sustain high growth rates.
The increasing attractiveness of Emerging Markets on relative valuation grounds has been helped by the stabilisation in commodity markets, a weaker US dollar and persistently low interest rates. Thus there have been significant inflows into both the equity and bond markets this year.
Conclusions and market outlook
Political events will remain to the fore in the final quarter. Once we have confirmation of who is to be the next US President this should pave the way for interest rate rises from the Federal Reserve. Expectations are for a 0.2% rate rise in December with perhaps 2 further hikes in 2017 taking the Fed funds rate to 1-1.25%. The latest polls show Clinton ahead and historic experience is for the currency and stock markets to react positively to a Democrat victory.
UK investors will now look to November’s Autumn Statement for the detail of Chancellor Philip Hammond ‘flexible and pragmatic’ plan which he has insisted does not mean an end to austerity or fiscal discipline. Some commentators, however, believe that austerity measures will be replaced with infrastructure spending and other measures to enhance activity and employment.
Nevertheless, Theresa May’s commitment to a complete break from Europe could detract from economic growth in the short term. Despite the buoyant performance of stock markets and the fact that the economy has been resilient to date, many observers still expect little or no growth in 2017 as the Brexit process gets underway and investment plans are put on hold.
Weakness in sterling is expected to persist giving some comfort to exporters and producing translational benefits. On the other hand it may also contribute to a pick up in inflation as the price of imports rises and less immigration puts wages under pressure.
With around a third of Government debt worldwide now yielding less than zero, long term investors such as pension funds and insurance companies are being forced to take greater risk to secure ever decreasing returns as they run out of options. A number of respected fund managers, including Richard Woolnough of M&G, have expressed concern on bond valuations with some likening the situation to a bubble.
All regions have areas of concern. In Europe it is the threat of negative rates, deflation and debt. In the UK it is the uncertainty surrounding the Brexit negotiations, in the US it is the election, in Japan it is whether monetary policy is working and in China it is the health of the Banking System. Global debt has exceeded $152 trillion for the first time according to the IMF which warns this could supress further economic progress. The IMF* expects Emerging and Developing markets to drive global growth with Advanced Economies growing at a more pedestrian 1.8% so it will not be surprising to see investors turn to such markets to deliver attractive returns.
Dividends remain a concern in the UK where cover is low and some large companies face the possibility of having to divert cash-flow to plug escalating deficits in their defined benefit pension schemes. Respected fund manger Neil Woodford is one of those positioned for a scenario of low growth, deflation, debt problems, weak productivity and worrying demographics. However, there will be winners and losers and, like other successful active managers, he still sees good opportunities in carefully selected areas.
In summary, the performance of the economy in the first quarter post Brexit does not appear to have been as bad as worst fears but uncertainty will remain until the process is completed. For the private investor it remains important to revisit your long term goals and ensure you have a well diversified portfolio which corresponds to your appetite for risk. Review your chosen funds regularly to confirm that the managers are delivering against objectives and ascertain whether your asset allocation needs rebalancing.
* The International Monetary Fund
** Organisation of Petroleum Exporting Countries
*** Organisation for Economic Co-operation and Development
**** The G7 (The Group of Seven) is an informal bloc of industrialised countries comprising: the United States, Canada, France, Germany, Italy, Japan, and the United Kingdom.
Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.