Discretionary Investment Report | Third Quarter 2017
In our quarterly report we look at the political and economic influences which have driven markets over the third quarter.
5 min read
The first three quarters of 2017 have seen good gains in share prices around the world, and with little rise in long term interest rates, bonds have also delivered positive returns.
The investment team’s optimism on the resilience of the economy throughout the recent storms such as Chinese slowdown, the Brexit vote and the arrival in the White House of Donald Trump seems to be playing out well. Closely watched leading indicators of the global economy point to accelerating GDP growth, from around 3.1% in 2017 to around 3.3% in 2018.
Perhaps the most pleasing aspect of this is the breadth of the growth. Whilst China and the US continue to make up the largest part of the gains due to their size, growth is picking up in places which had previously been written off, including Spain (where GDP is rising at a 3% year on year pace), Ireland (4%) and that the components of recovery have also broadened from consumer spending and government spending to include capital spending – companies are now confident enough in the future to go out and invest in factories, buildings and people.
Inflation has stopped surprising on the downside and is starting to rise slowly in most developed markets.
Of course, as investors we need something to worry about and from here, they may start to worry about policy errors. Policy makers, especially those central banks with all their lovely low rates and money-printing, have done a good job in supporting growth and preventing the 2008-09 recessions from being repeated. However, these same central banks are now getting confident enough in the outlook to withdraw some of the extraordinary measures – the Fed has raised rates 4 times in the past 2 years and will soon end the Quantitative Easing (QE or ‘money printing’) policies. The Bank of England will surely un-do the post Brexit rate cut and take us from 0.25% to 0.5% again. The European Central Bank will likely announce the end to their own QE program. And even the Bank of Japan – the inventor of Quantitative Easing during their ‘Lost Decade’ – is likely to withdraw some policy mechanisms.
Could this seemingly simultaneous tightening upset markets? Raising rates and tightening policy could see financial system freeze up as central banks cool growth. It seems unlikely to be good for government bonds for example. However given the tiny magnitude of the moves, it does seem unlikely – Central Banks are incredibly wary of making mistakes and tend to target areas of concern through rules, rather than the scatter-gun approach of raising rates for all.
The other potential policy mistake could come in the opposite - fire. As amateur barbeque chefs should know only too well, throwing fuel on a lit grill is a recipe for disaster. And yet, despite big deficits and little sign of slack given unemployment is close to record lows, President Trump is looking to cut taxes for companies and consumers, and spend many billions of Dollars on infrastructure. Adding stimulus of this magnitude to an economy at this stage of the cycle could be dangerous – inflation could pick up sharply forcing the Fed the raise rates more than currently estimated.
The US clearly needs tax reform – the 35% standard corporate rate is far out of line with the rest of the world and simply encourages avoidance – and a trip to the US will confirm their airports, bridges and roads are in a very poor state. However, the political situation is quite difficult and most politicians are more conservative on the deficit than the more profligate president. As a result, similar to our feeling that an icing up of the system is unlikely, neither do we feel that we are about to burn upwards.
This relatively benign top-down picture is a good situation to be in for bottom-up stock pickers such as ourselves, who focus on trying to find good companies, not pay too much for them, and are patient to enjoy the benefits of compounding the growth of dividends and profits.
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We are witnessing a period of synchronised growth across most regions for the first time in many years, which is positive for the many globally-exposed companies that we own. The US and China remain the main engines, however growth is spreading to Europe and is slowly recovering in Latin America too. As a result, we would expect Global GDP Growth to be around 3.1% in 2017 and slightly better at 3.3% in 2018.
Inflation has returned to the UK as Sterling has weakened sharply since our vote to leave the EU. After a period of reflection, the Bank of England now seems confident enough in the outlook for the UK (helped by the idea of a 2 year transition period to implement the new trading rules) to un-do the quarter percent interest rate cut last August. Markets expect the US to continue to gently raise rates as the central bank continues to worry that low levels of unemployment will lead to inflation in the future.
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.
Corporate bonds have done well, however government bond prices are coming under pressure as the period of extraordinary loose policy seems to be ending, albeit very slowly.
The MSCI World Index has had an extremely strong start to the year, returning over 14% in Dollar terms and but only just over 5% in Sterling due to the surge in the value of the pound in recent weeks as future interest rate rises boost its attraction. 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 as policy starts to change across the globe.
Third Quarter 2017
The FTSE All Share had another positive quarter and was up 2.1% in total return terms. Year to date the index is up 7.8%. Mid and small caps were the strongest, up 3.5%, whilst large caps lagged, rising 1.8%. The index-heavy tobacco stocks were held back by an announcement by the FDA that they may place restrictions on the levels of nicotine in cigarettes.
The pharmaceutical sector remained weak, as AstraZeneca fell by as much as 16% on the announcement that their cancer drug trial did not outperform chemotherapy in tests.
We successfully avoided some of the main fallers over the quarter such as Provident Financial, Carphone Warehouse, Capita and the AA Group. Capita is the latest support services group to face problems. We sold holdings in this stock a few years ago. And Carphone Warehouse’s warning and subsequent 30% share price fall was symptomatic of a weaker consumer and softer trading in smartphones. Phones are less innovative in each iteration and therefore we change them less frequently. Combine this with a large store base, and a drop in like for like sales falls sharply to bottom line.
As the oil price strengthened, Shell and BP contributed most to the rise in the FTSE All Share. Other materials companies also rose as China’s economy continued to steady.
Worldpay received a cash and share bid from Vantiv as the online payments sector continued to consolidate. After losing ARM to Softbank in 2016, and the aborted Kraft bid for Unilever, it is no surprise that the UK government is taking steps to change foreign takeover rules. In a post Brexit world, keeping innovative and successful companies in the UK will be vital to keep the economy growing.
US equities rose by 4.5% in Q3 in Dollar terms, finishing the quarter at all-time highs. The market’s carefree mood is reflected in new lows record by the VIX (“the fear index”) which measures implied share price volatility derived from option prices. Boosted by double digit earnings growth, Technology was the best performing sector during the quarter, rising by over 8%. Close behind was Energy, where an 11% recovery in crude oil prices lifted the sector by 6% over the quarter. Meanwhile, consumer-exposed sectors lagged the market’s advance, as cuts to earnings forecasts for a number of retailers depressed investor sentiment.
The US market shrugged off ongoing geopolitical concerns from increasing tensions with North Korea and instead was boosted by renewed hopes for US tax reform late in the quarter. According to Raymond James, a move to a 20% corporate tax rate from the current 35% rate could boost earnings by 6%. Meanwhile, changes to taxes on cash repatriation could provide a boost to investors from dividend increases and share buybacks. Currently, there is an estimated $2.4 trillion in cash held overseas by US companies.
Financial stocks generally tracked the market’s returns during the quarter. Generally seen as rate-hike beneficiaries, investors looked ahead to a likely interest rate hike in Q4 although trading revenues at investment banks have been depressed in the current low volatility environment. In Industrials, aerospace parts manufacturer Rockwell Collins was acquired by United Technologies in a $25bn deal.
European indices have been boosted by an improving economic backdrop, and more settled political conditions.
The European Central Bank have not made changes to rates or forward guidance, however ECB President Draghi has signalled that the ECB balance sheet will start to shrink as growth picks up – and that means that there will be less government and corporate bond buying, and that the Eurozone will retreat from the very loose liquidity conditions that have persisted since the crises of 2008 and 2011.
In Germany, Chancellor Merkel won a fourth term, and the CDU/ CSU remained the largest part in parliament. However, her share of the vote fell substantially and the right wing AfD managed to gain 13% of votes and a place as the third largest party. France’s President Macron has announced his bold new vision for Europe – but whether fiscal integration and pan European taxes and budgets will happen is probably less likely after Merkel’s less-than-emphatic win. The Catalan issues, Greek bailout renegotiations, Brexit, and many other issues still plague the European project.
BASF continued to deliver strong performance – it will benefit from the synchronised global growth in its end markets, and it has a diverse product base to benefit from this. Michelin’s outlook also looks positive. The stronger oil price benefited producers and oil services groups. So whilst resources and materials performed well, pharmaceuticals and some customer facing stocks (particularly food retail and advertising) lagged.
Japanese economic data is surprising on the upside once again – the employment data are particularly pleasing with for example, the number of jobs per applicant being at the highest level in over 40 years. Japan, at the stock market level if not the real economy, is quite geared to global growth – it makes things like cars and trains and sells them around the world – so the acceleration in global growth evidenced by the 18% year on year rise in exports is quite helpful to shares.
Taking advantage of the pick-up in sentiment, Prime Minister Abe has called a snap election in an attempt to get a mandate for further economic reforms, and possibly some changes to their pacifist constitution too given the existential threat posed by neighbouring North Korea having nuclear missiles.
Emerging markets were amongst the best performing regions in the third quarter of 2017. As noted elsewhere, global growth has been strong and this has helped earnings in Asia and Latin America rise. China, the world’s second largest economy, reported growth of 6.9% for the second quarter with good rises in consumer spending and industrial production.
Better pricing of commodities such as oil and iron ore due to good demand has further helped markets such as Brazil, which 18% in local currency despite a low level of growth in the domestic economy. The US Dollar was weaker in the third quarter and this is usually good for Emerging Markets – companies often take advantage of low US interest rates to borrow in US Dollars and if it weakens they effectively pay back fewer Dollars.
The big event in Asia in the fourth quarter is in China with the once-every-five-years party congress. President Xi is expected to stamp his authority over the new ruling Politburo Standing Committee, and receive a new 5 year term as President and leader of the Chinese Communist Party.
Government bonds (gilts) delivered a negative return over the third quarter while investment grade and high yield bonds have been reasonably firm by comparison. The focus of bond investors during the quarter has been on the plans of central banks to normalise monetary policies after the actions taken to support the global economy during and after the Global Financial Crisis 10 years ago.
UK economy and inflation
Growth forecasts for the UK economy have been trimmed for this year, reflecting the fall in real incomes and uncertainty about the outcome of the Brexit negotiations.
As anticipated, inflationary pressures have increased following the decline in Sterling after the EU referendum result and the rise in import prices. The Retail Price Index (RPI) rose to 3.9% and the Consumer Price Index (CPI) to 2.9% in August, on the back of rising fuel, transport, clothing and furniture prices. While inflationary pressures are expected to moderate, the Bank of England Governor, Mark Carney, has indicated that interest rates may yet have to rise sooner than markets have anticipated. As a result, gilt yields have risen with the 10 year bond now yielding 1.35%.
The resilience of the economy and desire for income has been reflected by the performance of investment grade and high yield bonds. Spreads over government bonds have narrowed as gilt yields have risen over the quarter, and continue to offer reasonable income by comparison at a time when default rates are low.
Global monetary policies
Investors are uncertain about the implications for bonds of central banks seeking to normalise monetary policies. Since the Global Financial Crisis, fixed interest securities have been supported by low or negative interest rates, and the asset purchase programmes of central banks.
In the US, the Federal Reserve is preparing to reduce its expanded balance sheet after its extensive bond buying programme. At the same time, the economy continues to reflect reasonable growth with subdued inflation and falling unemployment. Another rise in interest rates is expected before the year end.
Further uncertainty for bond investors relates to President Trump’s plans for fiscal policy. He is seeking to introduce significant tax cutting proposals to further boost growth at a time when there is concern in Congress about the Federal government’s level of debt. The future policy direction of the Federal Reserve is also under scrutiny with Chair Yellen’s first term coming to an end next February.
In the Eurozone, the ECB has yet to make clear its plans for tapering its bond buying programme as evidence mounts of a broad based and improving European economy. However with the Euro remaining relatively strong and inflation still subdued, the ECB may not begin to wind up its programme too quickly.
While global inflationary pressures are restrained, synchronised global growth is picking up and central banks in the US, UK and Europe are set to tighten monetary policies. A cautious and diversified approach to fixed interest therefore remains appropriate.
The first three quarters of 2017 have seen good gains in share prices around the world, and with little rise in long term interest rates, bonds have also delivered positive returns. However, the outcome of Brexit negotiations remains uncertain and raising rates and tightening policy could see financial system freeze up as central banks cool growth. At Adam Investment we continue to take a long term, diversified approach to investing on behalf of our clients.
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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