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Review

Fourth Quarter 2016

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  • Despite the political volatility witnessed over the summer months, 2016 proved to be a lucrative year for UK investors. The FTSE All-Share delivered impressive returns of 16.8%, however within this there was divergent performance between large and mid-cap equities.

    The FTSE 100 returned 19.1% for the year and 13.1% since the Brexit vote on the 23rd of June. Much of this strength can be attributed to the weakness in sterling benefiting large UK listed companies that derive a significant proportion of their earnings from overseas. The rebound in commodity prices was also supportive for the index, given its high weighting towards oil and mining names. UK financials, in particular HSBC, delivered outstanding returns for investors as their share prices rose in line with interest rate expectations in the US.

    In contrast, the more domestically focussed FTSE 250 delivered comparably muted returns of 6.7%. This relative weakness is reflective of less of a foreign exchange tailwind and increased uncertainty over the outlook for the UK economy. Although economic data since the vote has surprised on the upside, investors remain cautious about sectors which would be particularly vulnerable in the event of a Brexit-related slowdown.

  • US equities delivered a return of 12% in 2016, helped by rebounding energy shares and a late surge from the financial sector. Helped by a 45% gain from the crude oil price, the energy sector rose by 24%, making it the best performing sector in 2016. This contrasted with 2015 when it was the worst performing sector. The financial sector saw a 20% gain over 2016, with almost all its performance coming in the fourth quarter. This was triggered by the prospect of rising interest rates – the Fed raised the Fed Funds rate by 0.25% to 0.75% in December - and the surprise victory of Donald Trump in the US Presidential election. Trump’s expansionary fiscal policy plans have raised long-term inflationary expectations, hitting bond prices and lifting implied long-term bond yields. This ‘steepening’ in the US yield curve boosts profits of traditional banks.

    Trump’s victory has had repercussions across the wider US equity market too. Small caps and value stocks rallied on the election news, based on the view that these companies would benefit more from Trump’s plans for fiscal stimulus, lower taxes and reduced regulation. Meanwhile, healthcare stocks lagged the wider market in 2016. Up to the election, the sector was pressured by fears of drug pricing controls under a Clinton presidency but, since the election, by a lack of investor appetite for these companies’ defensive characteristics as confidence has grown in the US economic outlook. In mergers and acquisitions activity, telecom giant AT&T announced the near-$100bn takeover of media conglomerate Time Warner. 2016 was a relatively quiet year for US initial public offerings (IPOs) but this should change in 2017 with internet social media platform Snapchat widely expected to float. An IPO could value the company at as much as $20bn, according to Bloomberg.

  • During the fourth quarter of 2016, political events once again dominated, most notably, the election victory of Donald Trump in the US. Despite anticipated concerns surrounding such a result, European equities made respectable gains; investors taking solace in a belief this may boost GDP in 2017. The banking sector in particular, experiencing the largest rise in value since 2009, supported by expected benefits of higher bond yields, as well as reassuring European economic data. Energy and commodity producers were also notable winners on the back of rising commodity prices.

    The year ended with key indexes in Germany and France up over 11% and 7% respectively. Looking forward, a range of economic, political, and financial headwinds persist, including: rising interest rates; a troubled banking sector in Italy; and critical elections throughout Europe. Nonetheless, tailwinds provide us some reassurance with the potential for fiscal stimulus and a strong job market.

  • Asian and Emerging Markets had a very poor start to 2016, suffering as they had done in recent years from worries over the slowdown in Chinese growth and the collapse in commodity prices such as oil. The talk then was of the ‘Fragile Five’ Emerging Market economies of Brazil, Turkey, South Africa, Indonesia and India – countries which had large and rising trade deficits which were causing their currencies to weaken and foreign capital to leave.

    From the start of spring, however, these markets rebounded significantly, boosted further for Sterling based investors by the weakness in the pound. This rebound was triggered initially by the Chinese government taking strong action to stimulate growth, which helped the outlook for commodities and traded goods. Furthermore, the rise and subsequent stabilisation in the oil price, driven by supply reductions by US and OPEC, helped strengthen the perception of economic recovery and caused stocks to rise again towards the end of 2016.

    Japan barely changed over 12 months but this masked a volatile year for share prices. The first six months were quiet, with shares at low levels due to the economic worries about their Asian neighbours mentioned above. The Bank of Japan’s policy to further cut interest rates and weaken the Yen to boost exports, failed as investors worried more that it signalled economic weakness. The Yen instead rose for the first 9 months of the year, hurting the profits and share prices of their large exporting companies.

    This changed during the summer, for many of the reasons the Emerging Markets and Asia recovered, and shares recovered all their losses from the early part of the year. Furthermore, signs of economic stimulus from the US, Japan’s largest export destination, helped push shares higher still in late 2016. Overall, signs of inflation picking up globally should be good for Japan, which has suffered from deflation for almost 20 years, though the protectionist rhetoric from President Trump is a worry to manufacturers such as car producers like Toyota, Honda and Nissan.

  • 2016 was another positive one for investors in UK Government bonds (gilts) and investment grade corporate bonds which delivered total returns of 10.1% and 11.8% respectively. However, this masks the volatility that took place over the year with gilts weakening by the year end (with a negative return of 3.4% in the fourth quarter). Political events and changing perceptions about the outlook for inflation dominated bond markets in the second half of the year and will in 2017.

  • The US Federal Reserve raised interest rates for the first time since 2009 in December 2015. This seemed to mark the start of the normalisation of monetary policy after the Global Financial Crisis as the US economy continued to show signs of sustained growth. Yet the next rise in interest rates did not occur until twelve months later, reflecting the subdued nature of the recovery.

    Concerns had focused at the beginning of last year on the weakness of the Chinese economy and the threat of deflationary forces spreading to Western economies. At the same time, the persistence of weak growth in the Eurozone and Japan has meant that their central banks have continued with unconventional policies of quantitative easing (QE) and negative interest rates. This underpinned support for global sovereign bonds to such an extent that over $12 trillion worth of bonds offered a negative return to redemption in June.

  • The surprise victory of the ‘Leave’ campaign in the European Union (EU) Referendum in June led to a sharp rally in gilts, with the 10 year yield falling to 0.5%. Economic uncertainty prompted the Bank of England to cut interest rates and extend its QE programme of bond purchases.

    By contrast, Donald Trump’s victory in the US Presidential Election in November resulted in bonds falling (yields rising) in anticipation of his policies to raise economic growth in the US to closer to 4% per annum. Reflating the economy through personal and corporate tax cuts, deregulation and increased investment in infrastructure should boost activity. There is concern that looser fiscal policy at this stage of the US economic cycle may stoke inflationary pressures. US rates look set to rise quicker than previously forecast.

  • With Chinese producer prices now rising consistently, deflationary fears have now been replaced by ones about inflation as the global recovery continues and commodity prices rebound. In the UK, inflation is set to reach 3% by 2018 as import prices rise after the sharp fall in sterling since June. Yet the political and economic uncertainty this year relating to the UK’s withdrawal from the EU, elections in Europe and the policies of a new US President means that central banks are likely to remain cautious and vigilant as they seek to normalise monetary policies.

    Bonds therefore continue to offer diversification but we are underweight in portfolios against a background of rising inflation and low yields. Our focus remains on the protection of capital and the generation of secure income.

Note

The source data for each graph is supplied by Thomson Reuters Datastream, as at 31 December 2016 total return, local currency unless otherwise stated.

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