In a quarter that concluded with British Prime Minister Theresa May triggering Article 50, UK equity markets have remained resilient.
The FTSE100 delivered a total return of 3.7%, with housebuilders such as Taylor Wimpey (+25.8%) and Barratt Developments (+18.2%) among the best performers in the index. The UK listed housebuilders have generally fared well as government support through the Help to Buy equity loan scheme, together with low interest rates, have supported the market in new homes. It was also an excellent period for consumer goods company Unilever, who achieved total returns in excess of 20% after a failed takeover bid from US rival Kraft Heinz. This acquisition attempt prompted CEO Paul Polman to announce a strategic review, which is expected to boost long-term shareholder returns.
It was reassuring to note the strength of the FTSE250 and AIM markets, which recorded total returns of 5.4% and 10.5% respectively. However, within this companies with significant domestic exposure, most notably to consumers, have underperformed. This is largely a result of increased inflation expectations, with the Bank of England now forecasting inflation to hit 2.7% in the UK by the end of the year. With wage growth stagnant, investors are concerned that we may see a deterioration in consumer spending power, which would adversely impact on companies that derive a significant proportion of their sales from the UK.
Looking forward, we suspect that updates on negotiations between the EU and the UK will drive the short-term value of sterling and, in turn, UK equities. The early exchanges between the negotiating teams will likely increase volatility, however it will be some time yet before the relative winners and losers from Brexit become apparent.
US equities delivered a 6.1% return during the first quarter of 2017. After President Trump’s surprise victory in the US Presidential election in November, investors were in an expectant mood. However, as the quarter drew to a close, President Trump had admitted defeat in his attempts to repeal the Affordable Care Act (Obamacare) which has raised doubts over his ability to deliver his promised infrastructure investments and corporate tax reform. These doubts contributed to a 1.2% fall in the S&P 500 on 21st March. This was the first daily fall of more than 1% for 109 trading sessions which itself reflects extremely low levels of volatility across equity markets. The VIX index or “fear gauge”, which measures the implied volatility in the S&P 500 index, hit a 10 year low during the quarter. Typically, bank profitability benefits from rising rates but despite another hike in US interest rates by 0.25% in March, the financial sector underperformed in the first quarter as investors took profits after big gains since the election.
Technology was the strongest performing sector during the quarter rising by over 10%. Sentiment towards the sector was boosted by the successful IPO of social media platform Snapchat in February, raising $3.9bn and finishing the quarter with an implied valuation of $25bn. After being the best performing sector of 2016, Energy was the worst performer in Q1, falling by over 5%. This reflects the fall in crude oil prices since the beginning of the year on inflated global inventories and rebounding US production.
European indices have built on the strength they showed in 2016 with a further rise in the first quarter. This is despite seeing some fairly large outflows from equity markets.
European Banks are still lagging behind their US counterparts in terms of their stage of recovery since the financial crisis. Several are still plagued by weak balance sheets and still unspecified LIBOR and sub-prime fines. Given improving underlying economic growth in the Eurozone, several banking stocks have done well this quarter, but we continue to avoid them, preferring financial institutions listed in the UK and US with growth opportunities outside Europe.
Richemont was a strong performer this quarter. The maker of luxury brands such as Cartier and Jaeger-leCoultre posted improving sales after some periods of weakness in Asian markets. Pharmaceutical stocks had been subdued as Trump and Clinton discussed the costs facing US healthcare, where spend as a proportion of GDP is about double that of other developed economies. Roche and Sanofi however have recovered and delivered double digit returns in Q1.
The Japanese stock market was relatively weak at the start of 2017. Economic data has been decent, but the Yen has strengthened against its trading partners which has dampened equity returns, although boosting returns to Sterling based investors.
The Yen strength sapped performance of large exporting sectors such as autos, which further weakened on worries that Trump could put up trade barriers on autos. Mazda was amongst the worst performers - it makes all its cars in Japan as so is hit hard on Yen strength, as its overseas earnings are worth less, and worries over trade barriers.
Electronics and Engineering conglomerate Toshiba was the main corporate news - it plunged as project over runs at Westinghouse, its US nuclear engineering subsidiary, caused huge losses which threaten the future of the entire group. The sale of its memory chip business may save the day, but hurt the long earnings potential of the group.
Far Eastern and Emerging markets were very strong for much of the quarter. Economic data tended to come in better than expected - for example India, which announced a shock policy move to cancel large denominations of bank notes in 2016 as a way to tackle corruption and tax avoidance, was expected to report mixed GDP in the months that followed. However growth came in comfortably ahead of expectations and the country continues to have the fastest growth rates amongst large economies. In South America, Brazil continues its climb back from recession and investors like the changes taking place in Argentina where a new government has introduced business friendly policies.
Chinese data also continues to be strong, again recovering from the slow down in 2015, partly thanks to government spending in the second half of 2016. The economy is going to be carefully managed this year to prevent any issues around the 5 year political cycle which starts again in the Autumn with changes to the politburo and the likely re-selection of President Xi Jinping as leader.
Government (gilts) and corporate bonds in the UK were firm in the first quarter of the year with total returns of 1.6% and 2.2% respectively. Perhaps surprisingly, the returns have been achieved against a background of encouraging economic data, rising inflation and signs that central banks are seeking to normalise monetary policies following the Financial Crisis.
Paths to normality
The global economic outlook has improved. The US recovery has shown traction with low unemployment and higher wages growth. The economies in the UK and Europe have been stronger than expected, particularly in Germany, while the fears about weak Chinese growth from this time last year have eased. Greater growth has been accompanied by a pick up in inflation as commodity and oil prices have recovered.
Against this background, the US Federal Reserve raised interest rates by 0.25% in March, the third increase since the Financial Crisis, and indicated that it may look to rein in the size of its balance sheet by the end of the year. Further rate rises are expected this year and next as the authorities seek to gradually return rates to more normal levels for this stage of the economic cycle.
In the UK, the extension of the quantitative easing (QE) programme introduced after the EU Referendum result is almost complete. In Europe, Mario Draghi, the head of the European Central Bank (ECB), believes the threat of deflation has passed. The bond purchasing programme will continue until the end of the year but will be tapered from the start of April 2017.
While Consumer Price Inflation in the UK has breached the Bank of England’s target of 2%, the Monetary Policy Committee is expected to keep rate rises on hold for the time being. The improvement in the economy has been driven by consumption but, with higher inflation and subdued wages growth, real incomes are set to fall.
Political uncertainty still persists, which means policy setters will remain cautious. In the UK, the 2 year process to withdraw from the EU is now underway with the outcome unclear for businesses and consumers. In the US, expectations of rate rises have been tempered as it is uncertain whether the new President will be able to implement his reflationary tax, spending and reform plans through Congress. In the Eurozone, the focus remains on the strength of populism with elections in France to the fore in April and May.
The prospect of rising interest rates and inflation has led some strategists to call the end of the bond bull market, which has been in place for over 30 years. With so much uncertainty, however, the gilt market has remained resilient with yields falling (prices rising) in recent weeks. The yield differential across the range of maturities is at historically low levels. The challenges of ageing populations, high levels of debt, and weak productivity mean growth may yet disappoint over the longer term and act as a cap on rises in yields (falling prices).
Gilts and corporate bonds continue to offer diversification from equities but, at current valuations, we still retain a cautious stance.