Q4 2019 Report by Adam & Company’s Investment Management Team.
The TV show sweeping up prizes in the current awards season is the HBO/Sky mini-series Chernobyl, which on the face of it is about the run up to the disaster and the battle to contain the political and literal fall-out (as with the film ‘Titanic’, I don’t think a ‘spoiler alert’ about the plot is necessary).
As with all great works, it is not simply telling a story or painting a picture. It goes much deeper, and deliberately works on many levels. For example, when asked why he thought it was proving so popular, the writer said that ‘we live in a time when there is a global war on the truth’ and explicitly linked it to the 45th President of the USA, Donald John Trump.
The depiction of the Soviet Union in the show is of a catastrophically inefficient system built on corruption and lies. The script seems to be saying that under such a system, a disaster was inevitable – indeed, the end of the Soviet system itself was inevitable. Does such a fate await Trump in coming months, or at November’s election?
He was of course impeached by the House which meant that he faced a trial for ‘high crimes & misdemeanours’ in the Senate – ironically, given where Chernobyl is, for actions in the Ukraine. The chances of him being ejected from office by this process were always slim, given the high number of Republicans who would need to vote against him. And, indeed, he has now been acquitted of all charges.
Following his trade war with China and the lowest level of unemployment in 50 years, he is also enjoying reasonable poll ratings, certainly better than any Democratic candidates currently though things can of course change. The stock market would certainly be worried if he repeats the ‘America First’ mantra of the previous campaign, and sparks more damaging tariffs wars with China and Europe which hurt global trade.
“When people believe in a system strongly enough they tend to ignore facts to the contrary.”
However the stock market is also extremely worried that one of the more left-wing candidates will beat him in November and reverse his tax cuts. Indeed the popularity of Elizabeth Warren seems inversely correlated to the US market, and when her ratings slipped in the final quarter the stock market surged higher.
There’s a specific scene in Chernobyl which summarises the stupidity of the system to viewers. Not wanting to admit things are as bad as they are, and certainly not wanting American help, a West German company is called on for a robot to clear the radioactive fuel rods. The bright yellow robot called ‘Joker’ fails instantly. The junior staff seem mildly amused - German engineering is not as good as we thought. The viewers of course know that it was always going to fail because the Soviets would not admit how high the radiation was.
When people believe in a system strongly enough they tend to ignore facts to the contrary. One part of the markets where such a situation may exist is in government bonds. Part of our current presentation to clients shows that around 30pct of all global government bonds yield less than 1% and around 25% yield less than zero. Buy these latter ones and hold to maturity and you guarantee yourself a loss. But the system dictates that pension funds are forced to buy them as they are seen as low risk; banks are forced to buy them due to rules around holding capital to protect against losses on loans; and insurance companies are forced to buy them for protection against future claims.
Whilst there are undoubtedly political risks to equities and bonds this year, we far prefer the former due to the long term potential for compounding rising profits and dividends. The latter are surely not a way to accumulate wealth, but rather to protect against ‘fall-out’.
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Market
Spotlights
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Global growth should continue to tick along at an annual rate of between 4.5% and 5% on a nominal basis (including inflation). The negatives which have kept the growth rate down in the past couple of years should start to dissipate, such as the trade dispute between the USA and China and as the tightening policies of the US central bank turned to loosening in 2019. Of course there remain risks – the dispute between the two superpowers is more like a ceasefire in what is set to be a long drawn out Cold War 2. Businesses may not respond to lower interest rates by increasing investment. However, with unemployment and inflation at or close to historic lows, consumption is robust and government spending is gently rising again.
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With decent growth, unemployment at 40- or 50-year lows in countries such as the US and the UK, you would probably expect inflation to be on the rise and central bankers set to raise rates to slow things down. However, inflation continues to be below targets across the developed world and in fact there has been a dramatic reversal in policy at central banks such as the US Federal Reserve. A little over 12 months ago they were telling the world how worried they were about future inflation, raising interest rates and saying they were a ‘long way’ from a neutral level. In fact, they ended up cutting three times in 2019.
There remain large structural issues which are keeping inflation in check, including globalisation and technology, and there doesn’t seem to be an end in sight to these. Consumers and businesses (possibly still suffering the hangover from the 2008 Great Financial Crisis) remain reluctant to borrow. Of course, there could be risks ahead – for example, the tariff dispute raised prices for US consumers; globalisation could fall if economic nationalism increases; and escalations in disputes in the Middle East could push up energy prices. But overall, the outlook for inflation is benign and major central banks are unlikely to raise rates this year.
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The big picture background to equity markets is supportive. Global growth remains positive, many worries from the last couple of years (the US-China trade war and UK politics for example) have dissipated for the moment, and company earnings continue to grow. Central bank policy, especially the rapid reversal in the US interest rate rises of 2018, is also supportive.
Valuations remain high in the United States, but reasonable elsewhere and pretty cheap in the UK. Low interest rates are driving companies to buy back shares, or buy out rivals, or increase dividend payments. In the UK, the last time there was such a large gap between government bond yields (which are extremely low) and company dividend yields was around 100 years ago.
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In absolute terms, the income offered by government bonds is extremely low. It is pretty difficult to accumulate wealth when a 10-year bond is paying 0.75% a year, and pretty difficult to retire on your savings if bonds are your source of income. That said, we think inflation (which erodes this income well into negative territory in real terms) is benign at very low levels globally and central banks seem unlikely to raise rates in the next 12 months. The main reason for holding them is to protect against potential volatility in equity markets – bonds should remain robust performers if equities suffer.
Asset Class
Review
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In stark contrast to the fourth quarter of 2018, the UK market delivered strong returns in the final quarter of 2019. The MSCI UK returned 2.3% in the period, lifting returns for the year as a whole to 16.4%. Whilst a number of factors contributed to the final quarter performance, the most significant driver of stock market gains was the easing of political tensions in respect of the US-China trade war and Brexit.
The US and China avoided a further escalation of the trade war by moving toward signing a trade deal, and this provided a welcome relief for global investors. In the UK, markets welcomed the announcement of a further extension to the Brexit deadline until 31st January 2020, and then all eyes turned to the general election on 12th December.
Markets rallied on a resounding victory for the Conservative party. It provided investors certainty that the UK will leave the EU by the January 31st deadline. It also removed the fear of a Corbyn government, whereby several sectors such as utilities had been threatened with renationalisation. Domestic banks and housebuilders were significant beneficiaries of the election result with share prices rising sharply. Furthermore, the more domestically exposed FTSE 250 index, in addition to smaller UK companies, enjoyed impressive gains.
MPs have now backed Boris Johnson’s plan to leave the EU by the January deadline. Once formally approved, this will mark the start of the transitionary period, with a clause prohibiting any extension should the UK and EU be unable to reach a trade deal by the end of 2020. As such, whilst investors have welcomed the certainty of the UK’s withdrawal from the EU, uncertainty and fears of a hard Brexit do persist.
Source: Thomson Reuters DataStream, 31 December, 2019.
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US equities had a strong quarter, the S&P 500 rising by 8.5% in US dollar terms. This capped the second best year for US equity returns in the last 20 years at 31.5%. The principal driver of returns in Q4 was optimism for a US-China trade deal. After months of speculation, the US and China appear set to sign Phase One of a trade deal in January. The agreement stopped the imposition of tariffs on $160bn of Chinese imports, due to come into effect in mid-December, prompting a relief rally in markets. Meanwhile, fears of an economic slowdown appeared to dissipate, helped by soothing comments from Federal Reserve Chairman Jerome Powell who described the current economic trajectory as “pretty sustainable” in December. The 10-year Treasury yield recovered from a low of 1.5% in early September to end the year at 1.9%.
Sector performance was slightly lopsided, with 7 out of the 10 S&P economic sectors underperforming the market. Technology led sector returns on optimism for a recovery in chip demand after weakness for much of 2018. Healthcare stocks rebounded after Democratic Presidential election candidate Elizabeth Warren lost ground in the polls, making her ‘Medicare For All’ proposals less likely to be enacted.
Q4 saw a number of deals. Drug retailer Walgreens Boots Alliance was subject to a $63bn bid from private equity giant KKR in November. In tech, printer manufacturer Xerox made a $31bn bid for its rival Hewlett Packard. Stockbroker Charles Schwab bought TD Ameritrade for $29bn and in luxury goods, Tiffany has agreed to be purchased by LVMH in a $16bn deal.
Source: Thomson Reuters DataStream, 31 December, 2019.
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Being an export-dependent economy, Europe continues to be sensitive to global political developments, especially with regard to the US-China trade wars. That said, with rhetoric around the signing of a trade deal emerging, as well as better Brexit news flow, European markets finished the year on multi-year highs. Eurozone unemployment remains low by historic standards; however, more than a decade on from the global financial crisis, the Eurozone economy remains challenged.
The ECB recommenced its quantitative easing (QE) programme in the fourth quarter, committing to 20 billion Euros per month in bond purchases. Despite years of negative interest rates and previous significant QE programmes, growth in the Eurozone continues to be weak. In addition, achieving the inflation target of 2%, as set by the ECB, remains a significant challenge. New ECB President Christine Lagarde took up office and is expected to place more pressure on governments to stimulate growth through fiscal policy given the relative lack of monetary policy tools left for the central bank President to deploy. She is also expected to promote greater unity amongst European central bankers after outgoing President Draghi’s tenure ended with some well-publicised discord.
Continued low rates on corporate debt fuelled further merger and acquisition activity with a number of large deals announced in the quarter including LVMH’s $16bn takeover of Tiffany & Co. and the merger of Peugeot owner, PSA, and Fiat Chrysler. Healthcare stocks finished the year strongly with Roche and Sanofi shares up on improving macroeconomic conditions and positive pipeline updates.
Source: Thomson Reuters DataStream, 31 December, 2019.
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The Japanese stock market had a very strong run in the final quarter of 2019, led by companies which export goods such as makers of cars and machine tools. As a market which tends to be affected by the global economic trends – the Japanese tend to make things which consumers in other countries buy – there was a certain amount of relief around the de-escalation in the US-China trade dispute.
In the domestic economy, Prime Minister Shinzo Abe seems set to increase government spending. With the eyes of the world on Japan this year – Tokyo hosts the Olympic Games this summer – they want to make sure they present a strong, confident face to visitors.
Shares in Emerging Markets saw a very strong end to 2019, for reasons mentioned elsewhere – a ceasefire in the US-China trade war which had been so damaging, and some signs in economic indicators that confidence was returning to companies and consumers.
The region has been affected – and will continue to be – by this trade dispute. The two superpowers are engaged in a fight which goes well beyond tariffs and trade deficits and this will not end anytime soon, especially if Trump is re-elected in November.
Emerging Markets are buffeted by whether the Chinese are in stimulus mode (good for shares) or engaged in warning banks about rising loans (bad for shares).
Fundamentally we continue to have a positive long term outlook for the region due to the potential economic growth as more and more consumers become wealthier making these markets compelling on a 10-to 20-year view.
Source: Thomson Reuters DataStream, 31 December, 2019.
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2019 was a good year for bonds. UK government bonds (‘gilts’) provided a total return of over 7% while corporate bonds performed even better with returns being over 10%. Given the prevailing political uncertainty, sovereign bonds benefited from their safe haven status and changes in the monetary stance of central banks to support a slowing global economy. This benign backdrop began to change towards the end of the year with the result that gilts produced a negative return of over 4% in the final quarter.
Political uncertainties ease but new ones arrive
Concerns about slowing growth last year were reinforced by uncertainty around the seemingly fractious trade talks between China and the US. In the UK, parliamentary gridlock meant that there was no clarity about the nature and timing of the UK’s withdrawal from the EU. These worries have eased slightly with China and the US due to sign a first phase trade deal in mid-January and the decisive General Election confirming the UK’s withdrawal from the EU. However, trade talks will remain a key theme this year as will heightened tension in the Middle East, given the unpredictability of events in the region.
Economic optimism improves
The outlook for the global economy has improved, aided by the actions of central banks. The US Federal Reserve cut interest rates on three occasions in 2019. Fears of a recession had grown as reflected by the US bond market’s yield curve. This lead indicator had ‘inverted’ which occurs when longer dated bonds provide a lower yield than shorter dated ones. This inversion has now unwound. The US economy is displaying reasonable growth, driven by the consumer, while there are signs that the slowdown in global growth has now bottomed. Central banks remain supportive. In the EU, the resumption of the quantitative easing (QE) programme, which purchases government and corporate bonds, has been confirmed by the new head of the ECB, Christine Lagarde. In Emerging Markets, both Brazil and Turkey have cut rates in recent weeks.
Risk appetite and hunt for yield supports corporate bonds
While improved sentiment about the economic outlook has resulted in government bond yields rising (prices falling) in the final quarter, investors have continued to favour corporate bonds. While this economic cycle may be maturing, the levels of default are low by historic standards and balance sheets in aggregate are not unduly stretched. The relentless hunt for income by investors means that
corporate bonds performed well last year and held up well in the final quarter. The spread between government and corporate bonds – a measure of investors’ risk appetite – is low and indeed is back to levels last seen before the weakness in financial markets at the end of 2018.
A background of weak global growth, accompanied by low inflation and low interest rates, as well as still supportive monetary policies and rising geopolitical tension is favourable for bonds. However, concerns focus on governments being encouraged to adopt looser fiscal policies (more borrowing) and on the length of this business cycle. After a strong performance in recent years by government and corporate bonds, current valuations do not look particularly attractive. We therefore still adopt a cautious and diversified approach in the fixed interest section of portfolios.
Source: Thomson Reuters DataStream, 31 December, 2019.
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.
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The information in this document is not intended as an offer or solicitation to buy or sell securities or any other investment or banking product, nor does it constitute a personal recommendation. Nothing in this material constitutes investment, legal, credit, accounting or tax advice, or a representation that any investment or strategy is suitable for or appropriate to your individual circumstances.
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