Quarter 4 performance
Over the final quarter markets have made further progress. The key driver was the victory of Donald Trump in the US Presidential Election which propelled the US market to record highs. The rally reflected hopes of fiscal stimulus to boost economic growth and was replicated in other developed markets with Europe and Japan performing particularly well since the election.
The probability of further interest rate rises from the US Federal Reserve contributed to a strengthening of the US dollar against other leading currencies. Japanese equities were the most noticeable beneficiary of this trend as a weak Yen helps exports on which they are heavily dependent.
Emerging Markets, which had been leading the way, gave up some of their gains on concerns over possible US protectionist policies and the stronger dollar, in which much of their debt is denominated. Latin America had recorded the biggest advances but also suffered the biggest Trump related falls due to the importance of trade with the US and the threatened wall on the Mexican border.
A vintage year for equities
|Fourth quarter 2016
% total return
Euro First 300
|Calendar year 2016
% total return
Overall, 2016 proved to be a surprisingly good year for those who stood firm and remained invested through the turbulence of the first half when the oil price fell to a low of $27 amid political and economic uncertainty. Confidence returned as downgrades to Chinese GDP growth avoided worst expectations and oil price recovered to $50 per barrel.
The UK was the standout performer in local currency terms with the Shanghai Composite the only index finishing in the red. The FTSE 100’s gain of 19% for the year masked considerable volatility with a trough to peak move of nearly 30%. It suffered from its high exposure to commodities earlier in the year but later profited from its high quota of overseas earnings as the value of the pound declined.
Furthermore, returns for sterling based investors in overseas markets were significantly enhanced as illustrated in the table above. Asia proved to be the year’s underperformer reflecting worries about the Chinese economy, an upturn in commodity prices and potential trade tariffs.
A more subdued performance from UK Mid and Small Cap stocks due to their domestic bias pulled back the returns of the FT All Share index. Advocates of the value style of investing also reaped rewards as investors switched from defensive bond proxies such as utilities and tobacco stocks into those which benefit from rising interest rates and inflation such as Financials.
The Gold price was very strong in the first half on recession fears, lower real yields and extended Quantitative Easing programmes but gave up a lot of its gains by the year end as these factors reversed.
Key events of the quarter
The main political event was the unexpected success of Donald Trump in the US Presidential Elections. Once again a large number of voters expressed their dissatisfaction with the effect of globalisation on their standards of living. President Trump’s stated agenda is to boost US domestic growth with aggressive fiscal stimulus through a programme of infrastructure spending and various tax cuts and incentives.
The US Federal Reserve delivered the long awaited hike in US interest rates, to a 0.5-0.75% range, in December. This action was behind a sell off in US Treasuries and had a knock- on effect on Government Bond markets elsewhere, with UK and German Government bond yields also lifting from record lows. Trump’s proposed stimulus will require greater bond issuance putting further pressure on prices. In the Fixed Interest asset class, global high yield returns delivered the best returns as default risk faded in the US energy sector as the oil price recovered.
Italy’s Prime Minister, Matteo Renzi, gambled his career with a referendum on political reforms, but the electorate resoundingly rejected his proposals. His subsequent resignation had a negative impact on the country’s banking sector.
OPEC agreed its first production cuts in eight years in November which contributed to a further rally in the oil price. The deal, which extends beyond OPEC members to include Russia and ten other oil producers, proposes a reduction in output of around 1.8 million barrels per day. However, OPEC’s efforts could be undermined by US shale producers, who are likely to increase output to take advantage of the higher oil prices.
In the UK Chancellor Philip Hammond delivered his maiden Autumn Statement. He provided an estimate for GDP growth of 2.1% this year, the highest in the G7* group of largest economies, followed by 1.4% in 2017 as investment and consumer spending slow due to Brexit uncertainty. Growth is expected to recover to 2.1% in 2019 and 2020 but with a deferral of the public sector surplus target there was little in the way of tax giveaways. He emphasised the need to tackle housing shortages, low productivity and imbalances across society. A National Productivity Investment Fund will receive £23bn for spending on innovation and infrastructure over the next 5 years.
Economic trends and outlook around the globe
In its latest World Economic Outlook, published on January 16th, the IMF** maintained its 2016 global growth forecast at 3.1%, the weakest since 2008/09. However, it expects a pick up to 3.4% this year and 3.6% in 2018.
The OECD*** expects (as at November 2016) 2.9% in 2016 followed by 3.3% in 2017. However, most forecasters have not yet factored in any improvement in the outlook for the US under the Trump Administration although there have been tentative signs of improvement in the latest indicative PMI**** surveys for several regions.
Despite widespread warnings of a Brexit induced slowdown from many organisations, including the Bank of England, the UK has held up relatively well in 2016 with GDP growth of 0.6% in the final quarter leading to an anticipated outcome for annual growth of around 2%.
The IMF has reversed its October downgrade and now expects growth of 1.5% this year. However, it has reduced its estimate for 2018 to 1.4% from 1.7% as the economy adapts to trade agreements outside the E.U. An FT survey of 122 economists showed an average growth forecast of 1.5% for 2017.
Growth will be affected in 2017 by rising inflation which will have an impact on household incomes and consumer spending. Unemployment fell to 4.8% in November, the lowest since 2005, but commentators will be keeping an eye out for a reversal of the trend which could hit consumer confidence.
Business investment may stall while the Brexit process gets underway although it is hoped exports will make up some of the slack as they have not yet fully registered the impact of weak sterling, falling by 2.6% in the third quarter.
The UK base rate remained at 0.25% in Q4, the level to which it was reduced to support the economy in the aftermath of Brexit, and economists are not expecting much change unless inflation rises significantly. In November CPI inflation reached 1.2%, removing the threat of deflation, but still well below the Bank of England’s 2% target.
Henderson Global Investors noted in their dividend outlook that the weakness in sterling will boost dividends by 6.6% in 2016 due to the fact that 40% of pay-outs by UK listed companies are declared in US dollars. Another result of the fall in the pound has been a pick up in takeover activity with 37 takeover bids from Japanese companies alone.
The United States
The IMF has upgraded US GDP growth to 2.3% for 2017 and 2.5% for 2018, following 1.6% in 2016, still well below the 4% level which Donald Trump thinks is achievable by taking on more debt, spending on infrastructure and creating millions of jobs.
President Trump takes office on the 20th January and it remains to be seen if he will carry through some of his more extreme proposals which include: ending the North American Free Trade Agreement (NAFTA), building a wall across the Mexican border, deporting illegal immigrants, pulling out of NATO and introducing widespread trade tariffs.
The Federal Reserve rate rise, only the second in a decade, came on the back of of rising inflation, low unemployment and improving growth prospects. The only minor surprise was the forward guidance revision from two to three hikes for 2017.
The ECB (European Central Bank) downgraded its GDP growth estimates for the Euro area to 1.6% for 2016, and 1.4 % for 2017, a little below the IMF forecast of 1.7% and 1.6% respectively. The IMF expects 1.6% again in 2018. The region delivered moderate growth of 0.3% in the third quarter, in line with expectations.
The ECB also signalled a continuation of its bond-buying program until the end of December 2017, or beyond, if necessary. From April the program will continue at a monthly pace of USD 60 billion, down from the current USD 80 billion. The bank had already announced added corporate debt to the mix of assets it will purchase. The ECB sees inflation remaining below its target of under 2% and projects levels of 1.3% in 2017 and 1.5% in 2018.
The Brexit process brings the prospect of disruption and uncertainty as does the plethora of forthcoming Elections in various member countries. Key votes take place in France and Germany over the course of the year. Angela Merkel is expected to win a 4th term as German chancellor but there is always a chance of further populist protests against falling living standards, banking crises and youth unemployment.
The IMF forecasts growth of 0.9% in 2016 followed by 0.8% for 2017 and 0.5% in 2018. Growth in the third quarter came in at 2.2% annualised, well above expectations, which has led to the Bank of Japan turning more optimistic on growth as recent weakness in the Yen improves the outlook. Prime Minister Shinzo Abe has also announced plans to defer the increase in sales tax from 2017 to 2019.
In the first half the Yen appreciated sharply as the Bank of Japan lowered its base rate into negative territory. Japanese investors returned to the safe haven of the yen and it rose just under 20% by July. However, this trend reversed equally swiftly when the Bank changed its policy later in the year and Fed raised rates. The Bank of Japan held interest rates at -0.1% and said it would continue to cap 10 year rates at zero while maintaining Quantitative Easing at the same level. It conceded it will not reach its inflation target of 2% until at least 2018.
The Tankan survey revealed that optimism among Japanese companies rose for the first time in 18 months on hopes that Yen weakness will assist in beating deflation. Abe was one of the first world leaders to meet with Donald Trump and declared his trust and confidence in him as ‘a man he could do business with’.
These are a diverse set of countries with different levels of development and risk but most offer superior growth prospects to developed markets. Asia incudes 4 of the world’s fastest growing economies: India, Indonesia, the Philippines and Vietnam, and is prospering from the strong growth in middle class consumers.
China which accounts for a quarter of the EM index seems set to produce GDP growth in line with The Peoples Bank of China target range of 6.5-7% this year but worries do still persist about inflated corporate debt levels and an over-heated property market. The Central Bank has set a wider range for 2017 of 6-7%. The IMF expects 6.5% in 2017 and 6.0% in 2018.
India has the fastest growth rate of the larger developing economies (the IMF predicts 7.2% for 2017) though suffered a setback in November when high denomination notes were withdrawn from circulation. The aim was to eliminate corruption but it has affected production and consumption activity in the short term. Nevertheless, it has favourable demographics and is seeing strong growth in financial services, infrastructure and healthcare.
Emerging Markets, particularly those with close links to the US, could face challenges if Trump proceeds with trade barriers and reverses the ‘globalisation’ process from which they have been the winners.
Conclusions and prospects for stock market investors
2016 will be remembered as a year of political shocks when the ballot box was used to protest against the status quo. While the proposed policies of Donald Trump and Theresa May are intended to support their respective economies they may take time to filter through to corporate profits and will undoubtedly encounter headwinds.
The New Year has started with optimism and several markets have reached new highs. On the positive side the high levels of cash which many investors had built up during the political uncertainty continues to find its way back into equities. Shares may also benefit from some switching from fixed interest instruments which rising US interest rates and higher inflation make look less attractive to investors. Sentiment towards Government bonds may be hurt as some QE programmes near their end.
On the other hand valuations are now quite demanding in some equity markets, notably the U.S., and if the expected growth pick up does not materialise then they may be vulnerable to a sell-off. In Japan, Europe and selected Emerging Markets valuations and expectations for growth are lower so if they can surprise on they upside they could perform well.
Oil has recovered strongly to the current price of $58 a barrel, albeit well below previous highs, and should be supported if growth improves. Whether OPEC sticks to its resolve to cut production remains to be seen but if carried through should be supportive for countries with a large oil sector, for example Russia. Obviously, this would be less helpful for net oil importers such as the US and Japan.
The events of the last year have provided a valuable lesson in the risks of attempting to time the market which did not react to events in the way many expected. A lot of investors, including seasoned professionals, built up high cash levels ahead of Brexit and the US Election and failed to reinvest before markets rallied. The dramatic turnaround in commodity prices also caught out a number of active fund managers and cost them relative performance. Nevertheless, going forward it is unlikely that such a small number of sectors (but highly represented in the FTSE 100) will drive performance and it may be worth trying to hunt out those fund managers whose style is suited to picking the winners in the much changed environment we face.
Stronger economic growth and higher inflation should theoretically continue to favour equities over bonds and some commentators have suggested that the multi decade bull market for bonds may be ending. However, as pointed out, valuations are not outstandingly cheap and if there is any disappointment versus expectations money could flow back into bonds reminding us of their role as a defensive asset class and a diversifier in your portfolio. Despite this there will always be good opportunities for skilled stock-pickers.
More than ever it is important to ensure you have a portfolio that is aligned with your appetite for risk. Don’t be put off by short term disruption and remember that investing is for the medium to long term. The ups and downs of 2016 will probably look like blips on the horizon when we look back in years to come. So hold your nerve and make the most of our research tools to help you take your next step with confidence.
*The Group of 7 (G7) is a group of major economies consisting of Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.
** International Monetary Fund
*** Organisation for Economic Cooperation and Development
****Purchasing Managers Index
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