Discretionary Investment Report | Second Quarter 2017
In our quarterly report we look at the political and economic influences which have driven markets over the second quarter.
5 min read
Normally we spend time as investors thinking about where we are in the economic and business cycle. As well as these considerations, at this time there are some greater political and structural influences that seem to be almost unprecedented in their scope and importance.
The UK government is as unstable as it has been in 40 years and its economy is flirting with recession. Sterling’s value doesn’t lie and is importing inflation that is already hitting consumer living standards. The potential boost it offers exports could prove fleeting in the midst of post-Brexit uncertainty. Global security risk is high.
The financial crisis is almost a decade behind us but its aftershocks reverberate still almost everywhere we look. Or, probably more accurately, the reverberations of the trends that brought us the crisis have still to work their way out of the economic and political system. Four employees of Barclays, including ex CEO John Varley, have been charged in late June with fraud around the time of the bank’s bailout.
Political choices are for the first time being driven more by age and generation rather than class, demography or geography, at least in part. Consent for the economic and political system we have depended on since the war can no longer be taken for granted. It is remarkable. But in all moments of noise and confusion there is both risk and opportunity. At Adam Investment our advice is always to plan for the long term rather than worry about being buffeted by short-term factors. That said, distinguishing between short term noise and fundamental shifts has never been more important.
The second quarter of 2017 began with Theresa May invoking Article 50 and formally signalling Britain’s intention to exit the European Union. It ended with a weakened Tory party signing a supply and confidence deal with the DUP in order to enable a more legislatively limited Queen’s Speech to be made. This is the least stable government since the 1970s embarking on the most important negotiations since the Second World War.
The outlook for trade is uncertain, particularly as some governments have talked about taking a more protectionist stance.
This is against a backdrop of high levels of geo-political uncertainty, especially and unusually in developed markets. Companies, financial institutions and governments are battling high levels of ever more sophisticated cyber crime. The political ‘elite’ suffered some shocks over the last eighteen months and in turn is pursuing internet and social media giants they hold partly responsible. They are being taken to task over tax and conduct – witness Google’s EUR2.4bn fine announced by the European Commission. However, as investors we must not forget that technology also brings opportunity to fight climate change and poverty, and bring automation and robotics to ever more applications.
How do we, as long term investors, think about all these factors, as well as thinking of the economic cycle? Equity markets have remained reasonably robust over the quarter as many company earnings have met or beaten expectations. We seek companies that we think will continue to allocate capital in sensible ways and invest in structural trends, whilst keeping clients aware that there is, of course, investment risk as always.
A background of synchronised global growth in all major regions has led central bankers in the US, EU and UK to discuss raising interest rates. The rates roller-coaster has clearly taken summer markets by surprise. Central bankers, whether inadvertently or deliberately, have introduced a significant amount of volatility into the markets. Inflation and jobs data released over the next few months will be particularly scrutinised. We stay underweight fixed income.
We maintain our view that equities remain the best hedge against inflation, and stay overweight. We are cautious that some of the excellent returns we have seen so far this year – the MSCI Global Index has had its strongest start since 1998 – may not be repeated in the second half, making it more important than ever to be selective in the stocks we buy and hold for clients.
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We are witnessing a period of synchronised growth across most regions, which is positive for the many globally-exposed companies that we own. The US remains the engine for global growth and data is showing low levels of unemployment. Investors are also reassured that after a period of uncertainty in 2015, China is continuing to grow GDP around 6-7% and has a long term vision to reduce its dependency on infrastructure spend to drive growth. The health of the economies and markets of these two nations is vital to the rest of the world.
Inflation has returned to the UK as Sterling has weakened sharply since our vote to leave the EU. However, there seems to be some uncertainty within the Bank of England about whether this will lead to rate rises, after nearly a decade of rates at 0.5% or below. Markets expect the US to continue to gently raise rates. The oil price rally which led to higher inflation expectations has come to an end, which takes the pressure off central bankers watching their inflation targets.
Equities remain the best hedge against inflation, as companies can raise prices and dividends which are not, by definition, fixed. Valuations are not excessively cheap or expensive, and as always we look for the merits of individual companies and not the indices as a whole.
After several years of strong performance against a background of loose liquidity and uncertainty following the financial crisis, bonds are becoming more volatile and more vulnerable to rising inflation expectations.
The MSCI Global Equity Index has had a strong start to the year, returning over 11%. History would suggest such a rise would be unlikely to be repeated in the second half. Despite our confidence in the global economy, we remain selective on the individual companies and funds we select for clients. Fixed Income is likely to remain volatile, and some credit spreads have narrowed sharply.
Second Quarter 2017
Politics once again dominated headlines in the second quarter, as Theresa May sought to capitalise on a commanding lead in the polls by calling a snap general election. Over the course of the past 3 months UK stock markets have mirrored the trajectory of Theresa May’s approval ratings: starting the quarter at record highs before declining sharply in June.
In April, the FTSE100 shrugged off the headwind of a strengthening Sterling to return 5% for the month. Yet, as the quarter progressed the index’s weighting towards commodities hindered its progress, with the oil price hitting a 7 month low in June.
It was a particularly poor quarter for utilities, with the sector under pressure in the run up to the general election due to proposed policies around price caps. Selling has persisted since the vote, as hawkish comments from central bankers have hurt defensive, income paying stocks whose dividends become less attractive when interest rates rise.
Looking forward, the pick up in inflation as a result of the normalisation of commodity prices and the weakness in Sterling could damage the confidence of the UK consumer. With real wages being squeezed, we anticipate that domestically focused stocks could soften. However, it is important to note that we have relatively little exposure to the UK economy in portfolios and the export-focused FTSE100 should be supported by a weaker pound.
US equities followed a positive Q1 with further modest gains, the S&P 500 rising by 3.1% to end the quarter near to its highs. It was not smooth sailing though, coming against the background of rising volatility. This was evidenced by spikes in the VIX (the ‘fear index’) which measures implied share price volatility derived from option prices. In April, this rose to its highest levels in 6 months. The source of investor nervousness was largely political. Revelations about the FBI investigation into alleged links between President Trump and Russia prompted a 2% sell off in May. Currently, attention is on Trump's attempts to push his healthcare bill through Congress, and his success or failure to do so could determine the likelihood of corporate tax reform later in the year.
Healthcare was the strongest performing sector of the quarter, recovering by 7% after a weaker 2016. The Technology sector rose by 3% during Q2, led by strong performances from the internet stocks Facebook, Amazon, Netflix and Google. Meanwhile, oil prices slumped to their lowest levels since the summer of 2016, hitting the Energy sector which fell by over 6%. Q1 earnings season was one of the strongest for many years. Earnings growth for the S&P 500 advanced by 13.6% from a year ago, according to Bloomberg. Indeed, this robust economic growth encouraged the Federal Reserve to hike rates by 25 basis points in June - a move that was widely expected by the market.
In M&A, the most notable deal was Amazon's $13.6bn bid to buy upscale food retailer Whole Foods Market which sent the retail industry into a frenzy, with significant share price declines seen in Wal-Mart and others believed to be at risk from rising competition.
Voters in the Netherlands and France, and all the indications from Germany, showed that the potential flirtation with populism and anti-EU sentiment seems to be abating. Macron’s stunning victory in the French Presidential election and then his year-old party En Marche’s win in the parliamentary elections, have provided a boost to European Centrist parties and reassured investors that the European project is still alive.
Draghi’s recent comments have suggested the very loose monetary policy of the European Central Bank is unlikely to be maintained, if growth continues to improve. Tighter liquidity conditions will likely lead to volatility, especially in Fixed Income markets. Bank bailouts in Spain and Italy have improved investor sentiment towards the financial sector.
Selectivity remains key looking forward, and we select individual companies on their merits and good collective funds that look for the same criteria as we do – stability, exposure to good markets, a robust balance sheet. The Montanaro European Smaller Companies Investment Trust has performed strongly over the quarter, up 15.5%, as French smaller companies in particular hit an all-time high.
Emerging markets continued their recent rises in the second quarter of 2017 on the back of a benign global economic environment, a weaker US Dollar and strong company earnings.
Politics in Brazil continues to frustrate investors there, however, with President Temer charged with corruption just as the country seemed to be emerging from the terrible recession of the past few years.
Chinese data was largely positive and the initial meeting of President Xi and President Trump went well, despite the anti-trade rhetoric displayed by the latter on the campaign trail.
Macro data in Japan served to support a rise in equity markets there. Economic growth continues with employment numbers especially strong, with more job offers to applicants than at any time in the past 30 years.
Consumer price rises also signal that the years of deflation may be at an end - the absolute levels of price rises are still small but the signs are good for the economy for the rest of the year at least.
These data points, when combined with corporate tax cuts and a slightly weaker US Dollar, mean that the earnings of listed companies should continue to rise in 2017.
The re-emergence of inflation in the UK has contributed towards a mixed picture in the gilt market. The devaluation of Sterling since the Brexit vote and a normalisation of commodity prices have brought headline inflation back up to 2.9% in May. Not only is this a negative for real household incomes, because we are not seeing an increase in wages, but it is also bad news for assets where coupon payments are fixed at the time of issue.
The traditional response to an inflation rate above 2% is for the Bank of England (BOE) to gradually increase interest rates as a countermeasure. However, given uncertainty over Brexit, high levels of household debt and anaemic wage growth the BOE is reluctant to begin the tightening cycle. The complex nature of this dilemma is reflected in the increasing number of dissenting voices within the Bank of England’s rate setting Monetary Policy Committee. The most recent vote narrowed to 5-3 in favour of keeping rates on hold.
If you also factor in the possibility of softening austerity and a widening deficit then it becomes very difficult to anticipate which direction gilt yields will move in next. Variations of this scenario are being played out at the US Federal Reserve and the European Central Bank. As investors dissect the speeches of central bankers in the months ahead we expect a step-up in volatility within government bond markets.
Corporate bonds have delivered a stronger performance and we continue to watch exposures carefully as we see that the yield spreads over government bonds have reached very low levels. It’s important as always to consider whether investors are being properly compensated for risks taken.
The second quarter of 2017 began with Theresa May invoking Article 50 and formally signalling Britain’s intention to exit the European Union. The outcome of Brexit negotiations is as uncertain as ever, particularly in light of the General Election result. At Adam Investment we continue to take a long term, diversified approach to investing on behalf of our clients.
About Adam investments
We offer discretionary investment management to individuals and their families, and to charities. We take a long term approach to investing and we believe this gives us an advantage in a world where markets and media are increasingly focused on short term news.View more from investments