Last Quarter Review
Risk taking was very much back on the menu for investors during the third quarter as data showed US inflation remains stubbornly low. This the market interpreted as meaning that the Federal Reserve (Fed) central bank will now almost certainly resist raising interest rates as aggressively as previously anticipated.
Accordingly, monetary policy is once more a primary consideration when determining the optimal risk adjusted asset allocation for portfolios, especially as the widely anticipated fiscal stimulation from the new Trump administration including tax reforms and comprehensive infrastructure investment have been thwarted (at least for now) by a bitterly divided Congress. While the weaker US inflation data was well received by the market, the inferences from the European Central Bank (ECB) and the Bank of England (BOE) that interest rates may soon have to increase, dampened investment enthusiasm in these regions.
The news saw US equity markets hit new highs and global markets surge during the quarter on the back of a combination of reduced monetary tightening expectations in America, and positive macroeconomic news elsewhere. Corporate debt markets also surged, with credit spreads close to levels last seen pre Lehman in 2008.
A combination of exceptionally low volatility across all major asset classes together with the continuing weak dollar, which has fallen more than 10% against a basket of currencies in 2017, saw emerging markets do especially well. Volatility did temporarily spike on the back of North Korean missile threats but soon dissipated again.
Inevitably, as investors have adopted a risk-on strategy, margin debt has increased, and data shows these are now at record levels despite equity valuations, especially on Wall Street, being at historically very high levels. A further sign of risk relaxation saw issuance volumes in leveraged loan and high-yield bond markets rise while covenant standards eased.
|Key Economic & Market Data||2017 Q2 GDP||12 month GDP||Base Interest Rate - End Sep 2017||Equity Index - Last Quarter||Equity Index - Last 12 Months||Sovereign Bond Index - Last 12 Months|
|NB. GDP Data shown is to the 30th June 2017; Interest Rate, Equity & Bond Index Data is to the 30th September 2017; 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 used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.|
The good news for investors is that the market’s expectations of another interest rate hike from the Fed in 2017 have now fallen to just 30% after having been at 60% at the end of June. The even better news is that the US economy continues to show signs of accelerated growth as GDP grew by an annualised 3% in the second quarter, although the Atlanta Fed’s GDP Now model predicts it will slow to 2.3% in the third quarter, partly as a result of the disruption to oil and other industries in the gulf states following the devastation caused by the two major hurricanes.
There has also been good news in the euro area where unemployment reached its lowest level for nine years, while the manufacturing index (PMI) hit its highest for six years. Corporate profits in the euro area also increased but have plenty of potential to grow further as they remain below the total profit levels of their peers in both the US and emerging markets.
Markets will however be wary of political developments in Germany, following the re-election of Angela Merkel’s Christian Democratic Union (CDU) in late September with a much-reduced voting share of just 32.6% (from 41.5% in 2013). The CDU’s government coalition partners, the Social Democrats (SPD) suffered their worst result since the nineteen forties with just 20% (25.7% in 2013), as fringe and extreme parties, including the far right Alternative for Deutschland (AfD) increased their share of support from the German electorate.
In the UK, Moody’s downgraded our credit rating to ‘Aa2’ from ‘Aa1’, citing a weaker outlook for public finances and the expected fiscal pressures exacerbated by the erosion of the economy’s strength post Brexit. The good news however is that UK economic data is currently defying all the doomsters, who prior to the referendum warned the British economy would sink if the electorate voted to leave.
Meanwhile, the Fed has officially begun its plans to offload the $3.6 trillion in bonds (a combination of US Treasuries and Mortgage Backed Securities) that it purchased post Lehman through its various quantitative easing (QE) programs. If it continues to do so at its commencement rate of just $10 billion a month, it will be twenty years, or 2037 before its balance sheet reverts to where it was in 2007!
While the Fed’s intention is to gradually accelerate the rate at which it lightens its balance sheet, sceptics question whether realistically it will ever be able to sell all these securities back into the market. Many also fear that its QE offloading program will further exacerbate the entrenched global deflation that has existed since the credit crunch, largely due to the ongoing implosion in the Eurodollar market, and which has thwarted the Fed’s attempts to inflate away the phenomenal debt it has acquired since the sub-prime credit collapse in 2008.
However, counter-intuitively it is possible the Fed’s exercise may help in its push for greater inflation despite most thinking it will have the opposite effect, just as the widely anticipated inflation and possible hyperinflation that most economists warned of at the start of QE did not materialize, but instead deflation prevailed! Of course the fact that the US and global economy reacted (at least in terms of inflation) completely opposite to what almost all the economic experts expected as a result of QE should have been a wake up call, proving once again that economics is an art form with very little if any science upon which to base with any certainty the result of policy actions.
Arguably this begs the question, as to whether one hundred months into this recovery, the business cycle nearing its end? However, despite this credit cycle having already run almost twice as long as the historic average, the consensus view suggests it could have some way to run yet, and may eventually challenge the longest in history, namely 1991 to 2001, which lasted one hundred and twenty months.
Meanwhile, the volatility index (VIX) has been trading below 10 for some time, and is near its lowest level of the past 20 years, suggesting the market fears little currently. On the back of this market calm, and positive global economic expectation, the S&P 500 during September climbed through 2500 for the first time in its history!
Since the bull market (defined as a continuous rise without a correction of at least 20%) began in March 2009, the S&P 500 has risen almost 270%, making it the second best in history, although it has some way to go to claim top spot which saw an extraordinary gain of 582% from the vintage of 1987-2000! Even more encouraging however has been the notable improvement in market breadth on Wall Street, as September saw the strongest surge in momentum since the lows of February 2016, resulting in nearly 40% of the companies that make up the Russell 3000 index experiencing a moving average convergence/divergence (MACD) buy signal!
Most markets currently appear rosy, however, lurking in the shadows as always, is the unprecedented debt scenario. The total US funded debt went through $20 trillion for the first time ever last quarter, while just as worryingly the total unfunded liabilities in state and local pensions have roughly quintupled in the last decade!
The picture elsewhere is little better with recent estimates putting total global debt at around $230 trillion, compared to just $142 trillion ten years ago pre Lehman! Notwithstanding these extraordinary statistics, equity market investors have this year employed record amounts of margin debt to leverage up their investments, resulting in the total outstanding being substantially higher than during the dotcom boom of the late nineties, and as much as 10% higher than the previous peak of 2015!
Meanwhile, the unexpected weak dollar during 2017 (as most market strategists forecast the $ bull market would continue back in January) has been a boon for both US corporate exports and emerging markets, with Chinese and Indian stocks doing especially well. A key question going forward is will the dollar weakness continue or will the Fed potentially spoil the party by raising interest rates again despite no evidence of sustained inflation in the economy?
For now we remain confident that sitting tight in our chosen investments is the right strategy. These include higher yielding mid and small cap UK stocks, and the shares of larger European companies, as well as selectively some of the less popular US sectors.
We continue to be cautious on other asset classes including UK gilts, due to increasing inflationary expectations. We are also cautious on corporate debt, where spreads over government bonds are approaching historic lows.
As always, investment risk is at the forefront of our advice and, whilst it often necessary to undertake adjustments in portfolio allocation in order to maintain individual preferences, we are confident that our advised portfolios remain well placed and effective in meeting our client’s needs.