Discretionary Investment Report | Second Quarter 2019
In our Q2 Investment Commentary, we take a look at some of the key events and drivers which have impacted global markets and asset classes in the period. Our analysis stretches from the UK, through to Europe, North America and the Far East. Trade wars were again a dominant feature in the period, however the prospect of more accommodative monetary policy was warmly received by equity and fixed income investors.
5 min read
There are few nations in history as innovative as the Japanese have been these past 50 or so years. When you think of Japan, your mind is perhaps drawn to images of the bullet train, the video recorder or the lithium-ion battery. A Japanese newspaper conducted a survey back at the start of the century asking what the Japanese considered their biggest contribution to the world and the top 3 responses were Karaoke, the Sony Walkman and, in first place, the cup noodle.
Whilst the latter may not have made quite such an impact in the west, the Japanese continue to innovate. They were well ahead of the rest of the world in having a catastrophic financial crisis back in the 1990s, although they outdid everyone in the size of their banking collapse.
Their response to this also saw innovations which have been adopted by other countries in the past ten years. Their ‘Zero Interest Rate Policy’ preceded ours by 10 years and the same is true of Quantitive Easing (where the central bank pushes down long term interest rates by buying huge quantities of government bonds).
They also invented a phrase for the relative failure of all these loose policies to stimulate demand: ‘pushing on a string’. It means that even if you move the part of the string you are touching, the rest of the string doesn’t move. In a financial context, it means that traditional methods of simulating economic growth, such as low or negative interest rates, simply don’t work the way politicians and central bankers think it will.
The Japanese have been trying these new ideas for almost 20 years now and inflation is barely positive and house prices are around 70% below their 1990 peak.
It is a phrase which may be coming our way soon, for as growth cools, central banks are running out of tools to help economies grow faster. The European Central Bank in particular has followed the Bank of Japan’s playbook, but despite all their efforts, growth is anaemic and inflation is well below their target, and the same is largely true in the UK.
Investors’ verdict on this can probably be seen most clearly in bond markets where investors in UK government bonds are currently being asked to lock up their money for 10 years at an interest rate of 0.8% p.a. This means they are guaranteed to lose money after current inflation. In places like Germany, the situation is even worse with the absolute level of yield available for ten years being minus 0.3% p.a.; investors are guaranteed to lose money in absolute terms. You are effectively paying the German government for the privilege of lending them money, just as buyers of Japanese government bonds have been doing for many years.
There are still pockets of positive yields – for example the Austrian government has bonds with a yield of around 1.2% p.a. The catch is that this bond does not mature until 2117. Buyers better hope that the next 100 years of Austrian history are less traumatic than the past 100 years.
And yet, despite these ridiculously low interest rates, demand has been rising.
There are several ways you can justify buying something which is guaranteed to lose money – in the case of bonds, this is often linked to regulations on pension funds and banks being forced to buy them – but such behaviour cannot be described as rational. As rational investors who look to grow our clients’ wealth over the long term, we increasingly see government bonds as a way of protecting portfolios against catastrophe, rather than as a way of making money.
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The buzzwords of Q2 2019 remain ’trade’ and ’tariff’. To paraphrase one US senator ‘Trump tries to use tariffs to solve every problem … bar climate change’.
A 5% tariff on all Mexican imports was the tactic used to pressurize President López Obrador into doing more to stem the tide of immigrants into the US, whilst the proposal to impose tariffs on $11bn of European imports was the approach taken to deal with a 14 year old WTO dispute involving the EU subsidies which support Airbus to the detriment of US based Boeing.
Given economic nationalism played well to Trump supporters during the 2016 elections, we anticipate an increase in tariff threats as Trump embarks on his campaign for the 2020 presidential elections.
Against a backdrop of slowing economic growth and a subdued inflationary environment, Central Banks continue to maintain their accommodative stance supporting a low interest rate environment.
The US Federal Reserve continues its dovish pivot, with markets currently anticipating an interest rate cut in July, followed by two further cuts by the end of 2019.
After a strong first quarter, equity markets continued their rally into April, propelled by the prospect of a resolution to the US-China trade negotiations and the potential for interest rate cuts in the US.
Further market support came from the Q1 US earnings season, where the earnings figures for a number of companies surprised on the upside.
This sentiment briefly reversed in early May due to continued US tariff threats, however the June meeting of the US Federal Reserve reassured markets, providing a positive end to the quarter.
With subdued inflation providing little impetus for central banks to raise interest rates, global rates remain at extremely low levels. This has led to over $12trn of bonds providing investors with negative returns. The sector continues to function as a hedge to equity market volatility should growth concerns intensify.
Second Quarter 2019
Following a welcome recovery in the UK equity market at the start of the year, the second quarter has proved to be a somewhat more volatile time for investors. Despite a bumpy quarter, the MSCI UK All Cap index was up 3.1% meaning gains year-to-date stand at +13.1%.
The early recovery continued into the start of Q2, partly on optimism that the US and China were moving closer towards securing a trade agreement. However, this came to a halt towards the end of April, when the ongoing economic and political headwinds and more tariff threats once again weighed on consumer, business and investor confidence.
Brexit continued to dominate headlines in the period, with European Parliamentary elections and the resignation of Theresa May being key political events. These events and a heightened fear of an early General Election or no-deal Brexit drove the value of sterling lower, impacting UK markets.
Whilst domestic labour market data continues to be strong, GDP growth has showed signs of weakening over the quarter. The economy contracted in both March and April, largely driven by a significant fall in car production as a result of planned shutdowns. Statements from the Bank of England appear to be somewhat less dovish than that of the US Federal Reserve; however, this could soon change if GDP fails to show signs of picking up.
In the UK we continue to favour stocks with limited dependence on the UK economy due to their international presence. Valuations in the UK remain largely appealing; however, we appreciate that this prices in some of the political and economic risk currently present in the domestic economy.
US equities experienced a volatile quarter with gains in April undone by losses in May before a recovery was seen in June. Fears of economic slowdown acted as a brake on the market but investors were reassured by increasing expectations of US interest rate cuts to support the economy. The US 10-year Treasury yield fell to 2% p.a. (a 2 year low) reflecting the slowing growth environment and rising risk aversion amongst investors. US China trade tensions drag on, while markets were also spooked by threats of tariffs on Mexican imports during the quarter.
US earnings growth has fallen into negative territory – current estimates imply a 2% year-on-year decline in Q2, due to a weak earnings quarter expected from the Technology sector. Semiconductor manufacturers have been hit by oversupply and weak demand and analyst forecasts imply that industry earnings will drop by a third in Q2 compared to a year ago.
Despite this seemingly poor fundamental outlook, investor demand for technology stocks is buoyant with the sector outperforming during Q2, up by around 5%. Meanwhile, the energy sector’s woes continue. The sector was in negative territory in Q2, falling by 5%. Healthcare was another notable underperformer as the race to become the Democrat challenger in the 2020 Presidential election got underway and some of the candidates’ ’Medicare for All’ proposals kept a lid on performance.
2 massive deals came at the end of the quarter - United Technologies’ $79bn bid for defence company Raytheon and drug manufacturer AbbVie’s $74bn acquisition of Botox-maker Allergan.
The European Central Bank’s accommodative monetary policy stance helped European equities climb higher in the quarter. This was in spite of the macroeconomic background being plagued by Sino-US trade war uncertainties as well as three successive months of decline in European industrial production levels.
Symptomatic of the uncertainty in the market, German 10 year bund yields fell to record lows of minus 0.327% as investors’ demand for safe haven assets increased. ECB President Mario Draghi gave signs that the central bank would not seek to raise rates until at least mid-2020, holding interest rates at minus 0.4%. In addition, he noted that further quantitative easing may be required to stimulate growth in the Eurozone as GDP growth and inflation remain benign. In June, we saw the ECB announce the latest set of parameters for its next round of targeted longer-term refinancing operations, an initiative designed to preserve favourable bank lending conditions to support the Eurozone economy.
At a sector level, automotives – which are a large constituent of European stock markets – continued to suffer from the trade wars as well as the ongoing negative sentiment surrounding the future of the internal combustion engine. In addition, banks – which benefit from rising interest rates – were weaker as a result of the reduced probability of near-term interest rate rises.
Emerging markets across the world have experienced modest returns this quarter, boosted by currency moves, with the MSCI Emerging Markets Free index up 3.0% in sterling terms, and MSCI Pacific ex Japan Free up 7.7%.
In May we saw a further escalation in the ongoing trade war between the US and China. The US announced an increase in tariffs from 10% to 25% on $200 billion of US imports from China, who retaliated by raising tariffs on a range of imports from the US themselves. The US also announced a ‘blacklist’ of Chinese companies who are prohibited from purchasing certain US technologies. The precariousness of the situation has driven significant volatility across emerging markets, and led to sharp falls in Chinese equities as well as those of key suppliers to China, such as Japan, South Korea and Taiwan.
At the most recent G20 summit in June, however, the US and China agreed to resume trade talks and this has had a positive impact on markets.
Japan entered a new era with the ascension of a new emperor on May 1st following his predecessor’s abdication. Economic data in the period for Japan was mixed: whilst industrial production data and export data has continued to be weak, the release of first quarter GDP of 2.1% was encouraging. We also saw the yen strengthen against other major currencies, driven by global trade worries and the perception of its ‘safe haven’ status. This negatively impacts export-dependent companies.
The second quarter was another positive one for government and corporate bonds following the strong start to the year. The investment background has been favourable with expectations for future economic growth, interest rates and inflation all being lowered.
Outlook gets gloomier
Global growth forecasts have been further revised down during the quarter, most recently by the World Bank to 2.6% (from 2.9%) for this year. Trade tensions between China and the US have yet to be resolved with the threat of tariffs being further extended by the US Government. Countries particularly sensitive to global trade, such as Germany and Japan, have been negatively affected, which is reflected in data for exports and manufacturing output.
In the UK, the Bank of England now expects growth in the second quarter to be flat when compared to the first. This reflects caution ahead of the original Brexit date in March when activity had been boosted by companies building their inventory.
Interest rate and inflation expectations change
There has been a significant change in interest rate expectations in the US. After the most recent meeting of the Federal Reserve’s rate setting committee, investors now expect interest rates to be cut at least twice by the end of the year. Rates were expected to rise to over 3% last autumn from their current target range of 2.25%-2.5%. This change has resulted in the yield on the US 2 year Treasury falling (price rising) from 2.3% to below 1.8% in the last 3 months, reflecting investors’ belief in the need for rates to be cut in the US.
Government bonds have been strong (with yields falling) elsewhere as investors expect central banks to pursue supportive monetary policies. ECB President, Mario Draghi, has flagged that policy makers should use all tools available if growth continues to be weak and inflationary pressures subdued. Measures could include further interest rate cuts (from their current level of minus 0.4%) and an extension of the bond buying programme (‘QE’). In this context, the German 10 year bond has fallen to below minus 0.3%.
Indeed, the strength of bond markets has resulted in around $12 trillion of bonds (or 20% of the Barclays Global Aggregate Bond index) having negative returns to maturity. These bonds are mainly European and Japanese ones but falling yields reflect the willingness of central banks to adopt policies to encourage growth and inflation.
Corporate bonds rally
The focus on the strength of government bonds had seen the spread between yields available on government issues and corporate ones widen during the quarter. However these spreads have narrowed again as investors are attracted by the superior returns available from ‘riskier’ corporate bonds. While there are concerns about the maturity of the economic cycle, default rates are still very low by historic standards.
The strength of bond markets reflects fears about the outlook of persistent weak growth and low inflation, and the supportive monetary policies and guidance being pursued by central banks. For the longer term investor, the real (after inflation) returns from government bonds are not attractive beyond being a safe haven and providing diversification. As the outlook for the global economy is more subdued, we have trimmed our exposure to corporate bonds in the fixed interest sections of client portfolios.
Despite ongoing trade tensions, the second quarter proved to be another positive period for equity markets. Global stocks were supported by the prospect of more accommodative monetary policy as well as optimism relating to US-China trade talks. US markets reached record highs, whilst the UK also had a positive quarter despite the political uncertainty. It was also a positive period for fixed income assets, with both government and corporate bonds continuing their strong start to the year.
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