Market commentary for Q1 2018 and the outlook ahead
Posted by Liz Rees in Market commentaries category on 23 Apr 18
Quarter 1 performance: the return of volatility
% total return
Stock markets started the year on the front foot with many leading indices recording new highs in January. Subsequently, between the last week of January and the second week of February, global equities pulled back by around 10%, marking the first stock market correction since early 2016. Price falls were exacerbated by forced selling from algorithmic strategies (automated trades which react to certain variables).
What caused the sudden sell-off? Initially the blame was pointed at some stronger than expected US wage growth numbers. This caused concern that higher inflation would mean global interest rates rise faster than expected, potentially stalling growth. A related catalyst was a sharp rise in US Treasury yields over the first few weeks of the year.
Events illustrate the fine line between the Goldilocks ‘not too hot, not too cold’ scenario, and a reflationary environment (when government actions, such as tax cuts, stimulate both growth and inflation). Indeed, the relatively swift bounce-back was probably aided by generally supportive macro-economic data. However, profit taking is not surprising at this stage in the cycle, and resurfaced towards the end of the quarter when some negative news on a few technology stocks prompted another sell off in this expensively rated sector.
At a regional level, the UK was the laggard as the domestic economy remained subdued. Brexit uncertainties led overseas investors to withdraw money from the stock market. Japan also performed poorly in local currency terms, despite an improving economic and corporate picture, as a strong Yen weighed on exporters. In fact, Japan was the only market to deliver enhanced returns in sterling terms, as the Pound’s recovery diluted returns from other overseas markets. Emerging Markets, and China in particular, delivered positive returns despite some jitters over proposed US trade tariffs.
Key events of the quarter
President Trump continued to court controversy, sacking further key members of his administration including Secretary of State Rex Tillerson. His threat to impose tariffs on steel and aluminium imports raised fears of trade wars, which rarely bring economic benefits.
Technology stocks worldwide, significant drivers of market performance in recent years, have come under pressure on speculation that they will face tighter regulation to clamp down on their activities.
A General election in Italy produced big gains for both the Populist and Euro-sceptic parties which will allow them to play a greater role in the hung parliament. Vladimir Putin, meanwhile, secured another 6 year term in the Russian elections, amid accusations of vote rigging. Britain has been supported by its allies in imposing sanctions on Russia, following the alleged poisoning incident of a former spy and his daughter in Salisbury.
The UK and the EU agreed a Brexit transition deal leading to a sharp jump in the Pound. However, the FTSE fell sharply due to the implications for companies with significant overseas earnings. It was confirmed the Brexit divorce bill will be in the region of £37.1bn, mostly incurred in the first 5 years following our departure in 2019.
The oil price was little changed over the quarter. The Energy Information Administration’s recent report showed larger than expected US crude inventories, with production rising as well. On the positive side, geopolitical unrest in the Middle East abated.
Economic trends and outlook around the globe
In its latest World Economic Outlook, published on April 17th, the IMF* said that world growth of 3.8% in 2017 was ahead of its expectations. This is attributed to an investment recovery in advanced economies, continued strong growth in Emerging Asia, a pick-up in Eastern Europe, and signs of recovery for some commodity exporters.
The IMF raised its global growth forecast to 3.9% for both 2018 and 2019, on the back of strong momentum, favourable market sentiment, supportive monetary policy and the effects of expansionary fiscal policy in the US. Over the medium term they expect growth to edge down to around 3.7% with emerging economies leading the way and advanced economies more subdued.
Latest figures show that UK GDP growth for 2017 will be 1.8%, a little below the IMF forecast of 2%. The organisation forecasts 1.6% in 2018 and 1.5% in 2019, as some companies are reluctant to commit to investment until the Brexit negotiations conclude.
The UK economy continued to present a mixed picture with manufacturing continuing to perform well countered by persistent weakness in the consumer sector, particularly amongst High Street retailers. However, there are tentative signs that things may be past their worst including a notable pick up in corporate activity as predators recognise undervaluation of some company assets. GKN, one of Britain’s oldest engineers, succumbed to a takeover bid from Melrose.
Even the Chancellor, Philip Hammond, sounded a note of optimism in his Spring Statement as he upgraded growth estimates slightly for this year and declared forecasts were there to be beaten. He revealed that the government is on course for lower than expected borrowings this fiscal year and there are tentative signs of improving productivity growth, albeit to a modest 0.8% this year. Inflation has slipped back from its 3.1% peak as 2016’s sterling depreciation has now worked its way through the system.
The Bank of England maintained interest rates at 0.5% while signalling tightening ahead, so markets are anticipating an increase in May. Governor Mark Carney warned that rates need to rise ‘somewhat earlier and by a somewhat greater extent’ than he indicated in November. That said, the Monetary Policy Committee voted for no change in the amount of government and corporate bond purchases.
Progress has been made on Brexit, with a transition deal agreed, though the uncertainty clearly remains a deterrent for overseas investors. Jeremy Corbyn announced that the Labour party was backing a post Brexit Customs Union, which is seen as a challenge to those Conservatives favouring a hard Brexit.
The United States
The IMF has upgraded its US GDP forecasts to 2.9% for 2018 and 2.7% for 2019, following growth of 2.3% in 2016. The economy is expected to benefit, albeit temporarily, from the Trump Administration’s fiscal measures.
GDP growth for the final quarter of 2017 was revised upwards to 2.9% while unemployment is at its lowest since 1973. The upward revision was led by consumer spending which accounts for two-thirds of economic activity. Business surveys and manufacturing indices are all indicate strong performance ahead.
Inflation is at its highest for a year, confirming that the strong economy and tight labour market are pushing it toward the 2% target. Despite earlier concerns over levels of wage growth, the latest employment numbers were well received.
Jerome Powell took over as Chair of the Federal Reserve and marked his arrival with a rate rise in March, along with guidance of four increases this year rather than the expected three. Confirmation of the withdrawal of Quantitative Easing pushed US treasury yields higher.
The technology sector, a large weighting in US indices, has been unsettled by recent negative news. This includes accusations of data privacy breaches by Facebook, a fatality during testing of a Tesla car in autopilot mode and Amazon coming under pressure for tax avoidance.
The ECB (European Central Bank) maintained its GDP growth estimates for the Euro area to 2.4% for 2018 and expects 1.9% in 2019, similar to the increased IMF forecasts of 2.4% and 2.0% respectively. These numbers reflect stronger-than-expected domestic demand, supportive monetary policy, and improved external demand prospects.
GDP growth reached 2.7% in the final quarter of last year and has continued at a healthy pace. The Euro area composite Purchasing Managers Index (PMI) fell to 55.3 in March, but remains at an elevated level. Expansion is being driven by increases in manufacturing production and services sector output. Eurozone labour productivity growth is forecast to rise 1.1% this year, approaching the levels before the financial crisis.
The ECB left benchmark refinancing rates unchanged at 0% and President Mario Draghi also made comments about the potentially negative effect of protectionist trade measures. On the positive front, inflation picked up to 1.4% in March compared with 1.1% in February.
Angel Merkel embarked on a fourth term in office after her Christian Democrat party reached a collation deal with the Social Democrats, paving the way for action on reform within the Eurozone.
The IMF has left its forecast for 2018 unchanged at 1.2% in 2017 and anticipates 0.9% in 2018. The country is benefiting from improved external demand and rising private investment.
GDP growth has continued to improve quarter on quarter, albeit from low levels. Consumption and investment in the domestic economy have strengthened. Stronger domestic demand has encouraged investors as the recovery to date has been reliant on exports.
While confidence in economic growth has increased, inflation remains subdued. The Bank of Japan made no change to monetary policy, as widely expected, and their assessment of growth and inflation was unchanged.
Headwinds are the risks of a global trade war and continued strength of the yen. The Yen surged to a 16-month high, on the back of remarks from the Central Bank suggesting a possible reduction in monetary stimulus if Japan is able to meet inflation targets in 2020.
Haruhiko Kuroda was reappointed as governor of the Bank of Japan for another six year term. He repeated the ‘need for powerful monetary easing’ which suggests the 0% target for 10 year government bonds remains in place for now.
India remains the power house of growth for the region with the IMF forecasting growth of 7.4% in 2018 followed by 7.8% in 2019, after a slight setback in 2017 when growth of 6.7% was recorded. China is expected to deliver growth of 6.6% and 6.4% respectively. For the Emerging Markets and developing economies as a whole the estimates are 4.9% and 5.1% (which compares with 2.5% and 2.2% for advanced economies).
Stocks in the region initially retreated when Trump first announced tariffs on imports from China. The most widely reported were those on steel but the US accounts for only around 1% of China’s steel exports, and just 0.25 % of GDP. Beijing was swift to respond with its own duties on US goods, including 25% on recycled aluminium.
Having surpassed expectations in 2017, China continues to transform itself to a more service based economy. It has become a major driver of innovation as companies reinvest a large portion of profits into research and development. Latest figures show that the economy grew 6.8% in the first quarter, ahead of the government forecast for the year of 6.5%, due to a jump in private sector investment. A key manufacturing activity gauge did fall in February but this was blamed on the lunar New Year.
India’s economy, and stock market performance, has been held back by temporary disruption following the introduction of the Goods & Services tax and the move towards digitisation of transactions. Longer term the significant and growing young population, with a high degree of financial inclusion, should underpin growth prospects.
Higher commodity prices will support corporate and government revenues in areas where mining constitutes a significant part of GDP such as Brazil, Chile, Indonesia and Russia. Structural reforms have helped both Brazil and Russia improve their current account balances.
Continued disinflation in many countries in the region has enabled central banks to pursue loose monetary policies, although interest rates remain generally higher than in developed countries.
Confirmation of summits between North Koreas’ Kim Jong-Un and both South Korea and the United States, raised hopes that the military conflict threatened last year might abate.
Outlook and prospects for stock market investors
We are enjoying a period of synchronised global growth and if the recovery in Emerging Markets accelerates, this could produce further improvement this year. The OECD** reports that the 45 largest economies are now all growing, a scenario not seen in over a decade. However, the biggest risks lie with inflation and how Central Banks respond to it.
The prospect of monetary policy normalisation, including higher interest rates, could become a headwind for equity market performance. Nevertheless, as long as inflation is contained at acceptable levels (and in many countries it is still below target) the outlook remains positive for equities, particularly against a background of relatively low yields on bonds and cash.
At this stage in the economic cycle we would expect greater volatility to become commonplace. There could be a change in sector leadership as investors pay more attention to fundamentals and valuation criteria. While it is unlikely investors have lost their appetite for technology, given the outstanding long term prospects, now is the time to be selective; the current shakeout should help identify the true long term winners.
The key thing is to remember is that volatility is part and parcel of investing. Indeed, it can present buying opportunities for long term investors, particularly those who regularly drip feed money into the market. So be disciplined, stick to a strategy to achieve your goals and don’t be panicked by episodes of volatility. Also be realistic; we have had a period of extraordinarily strong returns which are unlikely to be repeated. In such a scenario, stable dividends form an important part of total return and the Janus Henderson Global Dividend Index forecasts solid growth of 6.8% in 2018.
The final risk is geopolitical risk, something that is impossible to predict. The best way to mitigate this is to ensure your portfolio is well diversified by asset class and geography. On valuation grounds Japan stands out while Emerging Asia offers more spicy growth opportunities. Indeed Emerging markets are both drivers and beneficiaries of the global growth upturn.
It may also be worth revisiting the UK market which has been out of favour of late. Contrarian investors believe that there is significant value in certain areas, including financials and healthcare, and yields are attractive, albeit with low dividend cover. Growth expectations are low which gives room to surprise on the upside.
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* International Monetary Fund
** Organisation for Economic Co-operation and Development
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