Source: FE Analytics
3rd quarter performance
|Second quarter 2017
% total return
|Year to date,
% total return
Equity markets have made further progress in the 3rd quarter, building on the substantial gains of the first half of 2017. The stand out performance came from Emerging Markets with a 9.6% advance in local currency terms, although some countries in the index did succumb to profit taking at the end of the period. China made up some lost ground as the anticipated economic slowdown did not materialise.
The US, which represents over half of the MSCI world index, also made decent gains with notably low volatility. Despite the increasing tensions between Washington and Pyongyang, the S&P 500 has recorded new highs on a regular basis. Solid economic data and impressive growth in corporate earnings outweighed any negative sentiment towards expected interest rate rises.
Japan was the laggard in the quarter and now trails other markets year to date as investors await the outcome of the snap election called for October. Furthermore, the 2 ballistic missile tests carried out by North Korea over the country’s airspace triggered initial selling of equities and a retreat to safe havens, before investors re-gained their nerve.
The UK was held back by concerns about the slow progress of Brexit negotiations and the potentially damaging effect on the economy. The Pound strengthened against most currencies, with the exception of the euro, reducing returns from overseas markets.
Key events of the quarter
Geopolitics centred on the war of words between Kim Jong-un and Donald Trump. North Korea’s escalation of missile testing activity, including one over the US territory of Guam, provoked the US president to retort that his country would respond with ‘fire and fury’.
A number of regions faced the devastation of natural disasters. Floods in Texas, hurricanes in the Caribbean and Florida and earthquakes in Mexico all brought social and economic upheaval. The process of rebuilding has begun and is actually expected to provide a boost to US GDP.
Disruption to the output of oil refineries in Texas was one of the reasons the oil price reversed its poor performance of the last quarter. In addition the earlier OPEC* production cuts took effect and Turkey threatened to disrupt supplies from Iraq’s Kurdistan region. Consequently, the oil prices hit a 2 year high as stockpiles reduced and demand picked up.
September brought the re-election of Angela Merkel as German Chancellor for a fourth term in office. Investors in the Eurozone reacted with relief that the status quo was maintained, although her party’s majority reduced as the far-right nationalist party AfD took 13% of the vote. Further evidence that the tide of populism has not receded was confirmed when Catalonians voted firmly for independence from Spain in an unofficial referendum.
Brexit talks continued but the UK government was itself divided over what form any transitional arrangements should take. After much debate, tentative agreement was reached on a minimum transition period of 2 years, the exact detail of which has yet to be determined. Failure to present a united front at their annual conference, and a disappointing speech from Prime Minister Theresa May, gave Labour the opportunity to extend their lead in the polls.
Economic trends and outlook around the globe
In its latest World Economic Outlook, published on 10th October, the International Monetary Fund (IMF) nudged up its global growth forecast to 3.6% in 2017 and 3.7% in 2018. The organisation noted that the global upturn in economic activity is gaining momentum, triggering upward revisions for the Eurozone, Japan, emerging Asia, emerging Europe, and Russia. These moves more than offset downgrades for the US and the UK.
In advanced economies, inflation is forecast to pick up to 1.7% in 2017, reflecting the cyclical recovery in demand and higher commodity prices. Inflation in emerging market and developing economies is expected to remain stable at 4.2% this year.
Much of the economic data, along with business surveys, has continued to indicate a healthy and expanding global economy. Advances in investment, trade and industrial production points to a continuation of the trend. Unemployment is falling in most countries while inflation remains moderate, giving consumers the confidence to spend. This has been dubbed a Goldilocks scenario, with growth not too hot to create excessive inflation and not too cold to cause worries about recession.
The IMF reduced its economic growth forecast for the U.K. to 1.7% for 2017, and 1.5 % in 2018, as a result of weaker-than-expected growth in the first two quarters of this year. This is in contrast to other developed countries and the longer term outlook will depend on the new economic relationships formed with the EU and the rest of the world.
The UK economy slowed as household consumption and business investment faltered. UK GDP growth for the second quarter was confirmed at a lacklustre 0.3% by the ONS**. Consumer confidence continues to decline as real incomes are squeezed by higher inflation, which reached 2.9% in August. Although headline retail sales edged up August, this was driven by higher food costs while consumers cut back on non-food spending.
Brexit uncertainties weighed on businesses, leading many to defer investment plans. These headwinds to growth look set to continue for the rest of the year and into 2018, suggesting no meaningful pick up in growth. Nevertheless, the manufacturing sector, albeit only c10% of the economy, is benefitting from the weaker pound. The latest figures from the Markit PMI*** survey show manufacturing production rose for the 14th successive month in September. Export demand has remained robust.
While manufacturing is a bright spot, services and construction growth has stalled. High levels of employment provide some mitigation, but stubbornly low productivity adds to the downward pressures on wages.
The base rate was maintained at 0.25% in the period though the Bank of England Governor, Mark Carney, has recently warned that an increase is possible as early as November, along with some withdrawal of monetary stimulus in coming months. The Bank remains concerned about consumer credit growth which is rising at close to 10% year on year, as people continue to borrow to fund their expenditure.
The U.S. economy is projected, by the IMF, to expand at 2.2%in 2017 and 2.3% in 2018. This is a small downgrade on the April number mainly due to a significant adjustment in US fiscal policy assumptions. The figure nevertheless reflects supportive financial conditions and strong business and consumer confidence.
Non farm payrolls, a key measure of the health of the US economy, have risen strongly and consumer confidence remains buoyant. Inflation moved up to 1.9% in August, driven by housing and fuel prices, although wage growth remains subdued. Business capital expenditure looks set to increase quite significantly which should offset any slowdown in consumer spending if households decide to rebuild their savings. The implementation of Donald Trump’s promised cuts to corporate taxation appears to be progressing and this will provide another boost to the economy.
The U.S. dollar has had an unusual period of weakness after a deferral in the interest rate rise cycle and the US Federal Reserve (Fed) lowering its forecast for interest rates in the long run. The Fed is, however, widely expected to hike rates in December.
In September the Fed announced that it would start to reduce its $4.5 trillion bond holdings from October, finally unwinding the asset repurchase programme. This is in response to the healthy economic growth and will be executed by allowing bonds to mature, rather than continuing to roll them over.
The IMF expects the euro area recovery to gather strength this year, with growth of 2.1 % in 2017, and 1.9% in 2018. The increase for 2017 mainly reflects acceleration in export growth due to the broader pickup in global trade. However, there is also continued strength in domestic demand on the back of accommodative financial conditions.
The Eurozone has been growing at the fastest rate since the financial crisis, albeit from a low base. GDP accelerated from 0.5% to 0.6% in Q2, pushing the year on year expansion to 2.1%. The manufacturing sector has been recruiting labour to satisfy demand. Inflation touched 1.5% in August as confidence returned in the region and retail sales recovered strongly.
In July German Government 10 year Bond yields reached an 18 month high on the expectation that monetary stimulus would be wound down. The key decisions around the timeline for tapering were pushed back to the October meeting, but is expected to begin in 2018.The European Central Bank (ECB) announced it would taper its asset purchases from €60 billion down to €20 billion per month.
A new free trade deal between EU and Japan, following 4 years of negotiation, will see Europe’s farmers get prized access to the Japanese market while Japan’s car manufacturers will access new European customers.
On a cautionary note, the increased traction of populist parties in some European countries has caused some concern about the stainability of the E.U. should some regions break away. This could also put the sustainability of the common currency under threat. In recent months though, the euro has appreciated leading some investors to worry that it might undermine the growth trajectory.
For Japan, the IMF forecasts growth of 1.5% for 2017 followed by 0.7% in 2018. The slowdown in 2018 is based on the assumption that fiscal support is withdrawn, consumption growth moderates, and the boost from 2020 Olympics is offset by higher imports.
Japan met forecasts with Q2 GDP growth of 1% (4% annualised), the 6th successive quarter of growth driven by a combination of consumer and capital spending. Business conditions in Japan are now the strongest for a decade as the Tankan confidence index recorded its highest level since 2007. Growth should continue to improve as more women join the workforce and investment in tourism brings benefits from buoyant Chinese demand. This should boost the chances of Prime Minister Abe winning in October’s national election as it demonstrates the success of his economic stimulus policies.
Since Abe came to power, dividends have increased by 72% compared to 30% for the MSCI World Index. Yet with pay-outs still only 35% of earnings Japanese companies have some of the highest levels of net cash on their balance sheet which bodes well for growth in dividends. Share buybacks are also growing in popularity.
The Bank of Japan is expected to continue with asset purchases over this period, as it tries to hit its inflation target of 2% which has been pushed back by a year to 2019. This is in spite of unemployment falling to 2.8%; many jobs receive no applications, leading companies to warn of worsening labour shortages. Production capacity is also at limits and unable to keep pace with demand.
The IMF forecasts growth in emerging market and developing economies of 4.6% in 2017 and 4.9% in 2018. The upward revisions to the growth forecast primarily reflect stronger performances from China and emerging Europe.
Emerging markets have brushed aside geopolitical worries and consumer confidence hit a 24 year high in July. The upturn in global growth and a weaker dollar is supportive for the region.
Chinese growth accelerated for the first time since 2009. A significant positive growth surprise for Q2 means that full year growth for 2017 is now likely to be comfortably above the authorities’ target of 6.5%. There has been stimulus from infrastructure spending and monetary easing which has helped the old economy.
China’s 5 yearly national Congress takes place this month when a leader is appointed or reappointed. It will also present an agenda on growth and/or debt reduction. Significant debt reduction could lower global growth, of which China accounts for nearly 30%, so a balance between growth and stability would be welcome by those concerned about the country’s escalating debt.
The IMF has revised its estimate for India down to 6.7%, reflecting short term disruption associated with the currency exchange initiative and the national Goods and Services Tax. Despite this the country remains the world’s fastest growing economy. Further out these structural reforms are expected to help lift growth above 8%.
The most notable turnaround among emerging market economies has been in Brazil, which has finally emerged from a deep recession after a period of political turmoil. However, while retail sales, industrial production and employment data all improved, business confidence is still fragile.
Summary of the prospects for stock market investors
The outlook for global growth is positive. Company earnings are improving which should provide support for valuations. Nevertheless, we do need to bear in mind geopolitical risks, Brexit uncertainty, and the unwinding of quantitative easing. These issues could bring greater volatility to markets and it might be sensible to keep some cash in reserve to take advantage of any setbacks.
Although many stock markets do look expensive relative to history this masks considerable divergence between sectors, an environment which favours an active fund management style. It is likely that overall returns from equities will be more modest than in recent years but skilled Fund Managers will still be able to identify a portfolio of companies that can produce attractive returns.
It is important to remember that a country’s economic performance does not mirror the companies which are listed on its stock market. Thus, although the UK is having a difficult time at present, a large proportion of corporate earnings are generated overseas where demand remains robust and the weak pound is providing a boost to competitiveness. For investors seeking income, UK companies also offer a superior yield to other regions, with the caveat that dividend cover is lower.
Emerging Markets are also worthy of consideration; they have favourable demographics, and are growing faster than developed economies, so their importance and contribution to world growth is likely to increase. Valuations, particularly in Asia, remain attractive and most countries are no longer so dependent on the commodity cycle. The universe available to Fund Managers extends to nearly 1,000 companies, which provides plenty of opportunity for diversification.
*Organisation of Petroleum Exporting Countries
** The Office for National Statistics
*** Purchasing Managers Index
: 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.