2nd Quarter 2016

“The bull climbs up the stairs, while the bear jumps out of the window” is one of the timeless stock market sayings that, somewhat surprisingly, is seldom quoted in the financial press. Maybe it is because the media’s primary function is to encourage more investment, and since few investors have the desire to master investment techniques that capitalize upon falling markets, the emphasis understandably is on the more positive adages.

On the other hand around this time of year, the old saying ‘Sell in May and don’t come back until St. Ledger’s day” is always given plenty of references, although most modern day investors doubtless associate the relevance of that market saying with an era that pre-dated modern technology and when the fact that many key market influencers were on holiday during the summer months resulted in markets usually drifting lower until the autumn when everyone was fully focused and back at their desks again. However anyone who followed that course of action in the US equity market over the last few years would be most disappointed as gains of 1.12% 9.95%, and 7.12% respectively in 2012, 2103 and 2104 during the six month periods from the beginning of May to the end of October on the S&P 500 testify, while last year investors whom sold would have avoided a small loss of 1.4%, although the results from pursuing such a strategy in the UK equity market over the same period are more mixed.

Last Quarter Review

In the United States, the Federal Reserve (Fed) central bank left the target range for its federal funds rate unchanged at 0.25 percent to 0.5 percent at both its January and March meetings. At the March meeting, the Federal Open Market Committee (FOMC) said economic activity has been expanding at a moderate pace but somewhat worryingly lowered GDP growth and inflation estimates for this year.

The FOMC cut the GDP growth outlook for 2016 to 2.2 percent from 2.4 percent (its December projection). For 2017, the FOMC cut GDP projections to 2.1 percent from 2.2 percent, while for 2018 it was left unchanged at 2 percent. Meanwhile the personal consumption expenditure (PCE) inflation was projected to be 1.2 percent in 2016, while estimates for 2017 and 2018 were left unchanged at 1.9 percent and 2 percent respectively.

In the land of the rising sun, The Bank of Japan (BOJ) kept its pledge to increase the monetary base at an annual pace of about 80 trillion yen at its January meeting, but also introduced negative interest rates at a benchmark rate of -0.1 percent with the objective of achieving a price stability target of 2 percent. Effectively the bank is endeavouring to lower the short end of the yield curve and will exert further downward pressure on interest rates across the entire yield curve through a combination of a negative interest rate and large-scale purchases of Japanese government bonds (JGBs).

In the Euro Area, during its meeting on the 10th March, the European Central Bank (ECB) lowered its benchmark refinancing rate to a fresh record low of 0.0% and increased the asset purchase program by €20 billion to €80 billion a month. The deposit facility rate was cut by another 0.1% to minus 0.4%, the lending facility was lowered by 0.05% to 0.25% and a new series of long-term loans to banks was announced. The ECB said interest rates are expected to remain at present or lower levels for an extended period of time and cut growth and inflation forecasts.

In the UK, the Bank of England (BOE) Monetary Policy Committee (MPC) left interest rates unchanged at 0.5% and left the stock of purchased assets at £375 billion at its March meeting. The MPC also noted that inflation remains weak and noted that the uncertainty surrounding the referendum on UK membership of the European Union may delay spending decisions and depress growth, and that additionally given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.

In the UK March Budget, the Chancellor George Osborne reduced his growth forecast for 2016 from 2.4% to just 2.0%, while he expects inflation to be 0.7%. The UK’s borrowing forecast for 2016-17 was revised up from £49.9 billion to £55.5 billion, while debt to GDP was also revised up from 81.7% to 82.6%.

As the table below shows, most global equity markets suffered from the economic concerns during the first quarter, while the continuing global deflationary threat has resulted in sovereign debt bonds continuing to offer capital gains. During the quarter, the yield on the 10 year US Treasury Bond fell from 2.27% to 1.78% while in the UK, the yield on the 10 year gilt fell from 1.96 to 1.42.

Key Economic & Market Data 4th Quarter GDP 12 month GDP Base Interest Rate - End Dec 2015 Equity Index - Last Quarter Equity Index - Last 12 Months Sovereign Bond Index - Last 12 Months
% % % % % %
USA 1.40 2.00 0.50 +0.77 -0.39 +2.25
UK 0.60 2.10 0.50 -1.09 -8.84 +3.26
Euro Area 0.30 1.60 0.05 -8.04 -18.73 +0.79
China 1.60 6.80 4.35 -15.12 -19.85 N/A
Japan 0.30 1.60 0.00 -11.95 -12.75 +5.92
Germany 0.30 1.80 0.05 -7.24 -16.72 +0.53
NB. GDP Data shown is to the 31st December 2015; Interest Rate, Equity & Bond Index Data is to the 31st March 2016; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices courtesy of Bloomberg.

Current Considerations

2016 so far has been a wake up call for investors as the global concerns that had been ominously evident in the second half of 2015 have come back to haunt markets. The seriousness of the situation was reflected in equity markets enduring their worst start to a year in more than two decades (between January the 1st and February 11th, FTSE 100 fell 11.3%, S&P 500 fell 10.5% and EuroStoxx 500 plunged 18.0%) while gold enjoyed its best quarter in thirty years (up 16%), as numerous market commentators warned of potentially worse to come, including UK Chancellor George Osborne who warned of a cocktail of risks facing the global economy.

Arguably the real elephant in the room spooking global markets yet again was China, as markets grew increasingly concerned that the Middle Kingdom might have to abandon the yuan (or renminbi)’s peg to the United States Dollar ($). China had reportedly spent the best part of a trillion dollars worth of its reserves during 2015 defending the yuan being pegged to a rising $, which of course increasingly made its own exports less and less competitive.

Several prominent hedge fund managers made it known in the Financial Times during February that they expected China to take similar action to that in 1994 when the Middle Kingdom devalued the yuan by 33% against the $, which was a major contributory factor to its great industrialization, as it resulted in major capital inflows. The hedge fund managers argued China should devalue before its $3.3 trillion hoard of reserves shrinks much further, and while it could still convince markets it was acting from a position of strength.

China however resisted the temptation and will doubtless be breathing a sigh of relief to see the eighteen month rally in the $ (that has hurt all emerging markets and commodity producers) halt at least temporarily as the greenback’s trade weighted index value has fallen by almost 4% sine the 20th January. Whether or not the $’s bull market is over is almost certainly an absolutely crucial question to ponder for all emerging economies, since commodities are priced in dollars, and for those with free floating currencies (i.e. not pegged to the $ as in the case of the Chinese yuan) their debts are usually denominated in the reserve currency, thereby pushing up their servicing costs when the $ rises.

As evidenced by some of the comments from the Fed both in the minutes of its March FOMC meeting, and in the subsequent speech made by Janet Yellen, concerns surrounding the adverse impact of a continuing $ bull market on China and other emerging markets almost certainly influenced the decision not to hike US interest rates further, and to say there would now be at most two further quarter point hikes (subject to the economic data supporting such moves) in 2016 instead of the four suggested back in the December FOMC. If the $ rally is not over, and it is set to recommence at some stage in 2016 with the next Fed rate hike a possible catalyst, then that could spell very bad news for international markets as a long term chart of the $ since it became the defacto reserve currency unhinged from gold in the early seventies, shows that its two previous major bull markets resulted in the Latin American debt crisis in the eighties and the Asian debt crisis in the nineties, and many fear another major fall out this time should its climb resume.

On the other hand, due to the unprecedented global debt that exists today, the end of the $ rally could mean serious trouble for the developed markets of Europe and Japan, which are reliant upon an increasingly competitive Euro and Yen versus the $ and all those currencies pegged to it (such as the Yuan) to maintain economic momentum through exports. Since these economies are net energy importers, the benefits (and unintended inflationary consequences) of lower oil prices over the past twelve months could raise the very serious spectre of stagflation in these markets at a time when “Abenomics” and “Draghenomics” are both heavily positioned to resist further deflation!

As reported in a recent edition of The Economist in an article titled “Bucking the trend”, ”Japan’s economy continues to struggle, more than three years after the launch of Abenomics, the latest figures show that industrial production fell by 6.2% in February. This suggests that the Bank of Japan (BOJ) will be concerned about the yen’s strength”

Similarly an end to the $ bull market could result in the Euro Area’s encouraging signs of recovery in 2015 being stillborn, as growth in exports due largely to the weaker Euro were a key element of an otherwise lacklustre economy where both wages and inflation remained stagnant. Arguably therefore the two biggest challenges for investors in 2016 will be firstly determining whether the $ bull market has ended, or is set to continue after a brief pause, and secondly what the consequences of that will be for both the global winners and losers of that outcome!

Forward Outlook

While the unprecedented global debt remains an uncomfortable reference point for all future monetary as well as potential fiscal policies going forward, arguably of even more current importance is whether or not $ bull market is over, since a weaker $ will undoubtedly prove a challenging headwind to sustained European growth. While China’s woes may have abated for now, Japan’s economy, despite the best efforts of the BoJ and yet more accommodative and stimulatory policies looks set to weaken further, with a weaker dollar potentially exacerbating this further.

In the UK, uncertainty surrounding the outcome of the European referendum in June (when the British electorate decides whether or not to remain within the European Union) and which has impacted the strength of sterling (which ended the first quarter at a sixteen month low against the euro, and fell 7% on a trade weighted basis) will continue to worry markets. However, since most academic studies suggest the long term economic impact is likely to be minimal, regardless of the outcome, UK companies are potentially trading at a discount to other markets, as is the currency although some commentators suggest the £ was overvalued in the first place.

We would reiterate that the remainder of 2016 will remain a tough challenge with numerous economic headwinds as well as political uncertainty in both the US and UK adding to volatility. Nevertheless there remain relatively attractive areas of value across many sectors which should now begin reflecting the economic premium from lower energy prices over the past eighteen months, and these include UK smaller companies which typically have more of a domestic bias, selective European stocks notwithstanding the stagflation threat, commercial property for diversification benefits, and possibly a small exposure to emerging markets again now that the dollar rally (at least for now) appears over.