1st Quarter 2018

“A bull market climbs a wall of worry” is an old Wall Street proverb that springs to mind as markets brace themselves for the year ahead. The “worries” confronting the equity bull during 2017 included the spread of extremist activity globally, the threat of nuclear war, concern over the European Union’s ability to accommodate the Brexit and Catalonian referendums, continuing expansion of unprecedented global debt and the growing concern that stock valuations had become potentially unsustainable!

Yet, global equities continued to reward investors handsomely, led by Wall Street where the bull market is now second only to the “December 1987 to March 2000” vintage in terms of both duration and percentage gains. While the S&P 500 rose 582% (without experiencing a setback of 20% or more) during the dotcom era, the Wall Street index is up just over 300% since the current bull market commenced in March 2009, so arguably plenty of gains still on the table if the record is going to be broken this time!

Last Quarter Review

Global equity markets powered ahead in the last quarter of 2017, as signs of genuine economic recovery at long last in the US were confirmed towards the end of the quarter with the GDP expanding at 3.2% annualized for the third quarter, the highest since the first quarter of 2015, suggesting the Trump administration may be able to generate real returns of 3% per annum despite the unprecedented (and increasing) government, corporate and private debt headwinds both in the US and worldwide. Undeniably the long awaited “Tax Cuts and Jobs Act of 2017” which was approved by the US Congress last quarter and signed into law on the 22nd December, will add to the market’s enthusiasm that the gathering momentum of growth in the second half of the year may genuinely be sustainable, and not a temporary rebuilding surge following the summer’s widespread hurricane and storm damage.

The Federal Reserve (Fed) appeared to be anticipating further growth momentum as it continued the monetary tightening begun fifteen months ago, by increasing the base rate by another quarter per cent. The fixed income market appeared uncertain about the decision, and the pronouncement to continue tightening further during 2018, albeit the yield on both the benchmark ten year Treasury note and the long (30 year) bond rose slightly following the latest rate hike, but are broadly unchanged from twelve months ago.

A couple of weeks after the Fed raised the base rate to 1.5% at its December meeting, the “MNI Chicago Business Barometer” jumped from 63.9 to 67.6, comfortably exceeding market expectations of 62, and recording the highest reading since March of 2011 as both output and demand rose to multi-year highs. Additionally, production increased the most in 34 years; new orders were the highest in three and a half years and order backlogs also grew.

In the UK, the Bank of England (BOE) raised the UK base rate from 0.25% to 0.5%, and policymakers reiterated that further modest increases in interest rates are likely to be needed over the next few years, in order to return inflation to a sustainable target. The BOE had previously lowered the rate to 0.25%, a record low, in August 2016, following fears the Brexit referendum result would negatively impact the British economy.

Another sign that global economic growth may be sustainable was the news of copper prices continuing to rise throughout 2017, and buoyed towards the end of last quarter by expectations of stronger demand from China as data showed imports of the metal rose 19 percent year on year to 329,168 tonnes in November. In late December, copper prices reached $3.28 per pound, the highest level since January 2014, and well above a record low of $1.94 per pound in January 2016.

On the negative side of the market ledger, sitting atop the wall of worry, was the fact that econometric studies have shown that when the government debt to GDP ratio has exceeded 90% for five years or more, the economy loses one-third of its trend rate of growth. Unfortunately the US government debt ratio has exceeded 100% for each of the past six years.

Key Economic & Market Data 2017 Q3 GDP 12 month GDP Base Interest Rate - End Dec 2017 Equity Index - Last Quarter Equity Index - Last 12 Months Sovereign Bond Index - Last 12 Months
% % % % % %
USA 3.20 2.30 1.50 +6.12 +19.42 +2.13
UK 0.40 1.70 0.50 +4.27 +7.63 +1.69
Euro Area 0.60 2.60 0.00 -2.51 +6.75 +0.26
China 1.70 6.80 4.35 -1.25 +6.55 -0.29
Japan 0.60 2.10 -0.10 +11.78 +19.05 +0.05
Germany 0.80 2.80 0.00 +0.69 +12.52 -1.55
NB. GDP Data shown is to the 30th September 2017; Interest Rate, Equity & Bond Index Data is to the 31st December 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.

Current Considerations

While equity markets responded positively to the Fed’s decision to hike rates in December, accepting the central bank’s reasoning that the labor market has continued to strengthen and that economic activity has been rising at a solid rate, the bond market was distinctly less enthusiastic of the Fed’s forecast for three further hikes in 2018. Ordinarily investors would have expected yields at the long end of the Treasury curve to have been steadily rising in response to the Fed’s actions, but thus far, they have refused to do so, suggesting the bond market does not believe the recent economic growth of around 3% (real GDP) is sustainable, even after the tax cuts recently signed into law.

If the bond market is correct, and the Fed is wrong, but continues to raise interest rates, and thereby causes the bond yield curve to invert (at the end of December it was the flattest it has been since 2007!), it will greatly increase the chances of a recession in the US, along with the likely end of the one hundred and five month long equity bull market. For now the equity market remains sanguine that either the bond market is wrong, or that if it is right, the Fed will quickly realise its error, and cease (or even reverse) its tightening strategy.

A sizeable and notable minority of market commentators believe that the Keynesian biased economists who dominate policies at the Fed and all the other major central banks have hugely underestimated the powerful deflationary consequences that have been playing out since 2008 after the multi-decade credit expansion that emerged globally following the actions of the US on the 15th of August 1971. That date of course was when President Richard Nixon announced that US dollar would no longer be anchored to the gold price as it had been since the Bretton Woods agreement in 1944.

Effectively in 1971, the dollar (along of course with all other currencies) became free floating, and the golden era of fiat money was born. It was also a signal for the major US and international banks to release the brakes, and ramp up the great credit bonanza that was to build and build through both onshore and offshore (unregulated eurodollar) debt lending that ultimately reached its pinnacle in the early noughties, before collapsing and potentially endangering the whole global financial system with the bankruptcy of Lehman Brothers, the third of the big five investment banks to collapse (Bear Stearns and Merrill Lynch had already been rescued from a similar fate).

It was arguably the beginning of the implosion of the eurodollar (or shadow banking) market in 2008 that forced the authorities into hurriedly launching the $700 billion TARP rescue package that October, before the Fed subsequently had to increase its balance sheet by more than $3.5 trillion to $4.5 trillion through a series of quantitative easing (QE) programs. Most of the Keynesian economists at the Fed and elsewhere hoped this would prove inflationary as in the past inflating your way out of debt, when it was otherwise un-repayable had proved very convenient.

Alas! This time it has proved anything but as simple, as together, the shrinking eurodollar market, and the unprecedented size of the debt headwinds have combined to ensure the “deflationary winter” remains in control. The only success that policymakers have had with their inflationary efforts has been in capital markets, where shrewd investors have been able to take advantage of the flood of excess capital from QE etc., which has driven prices relentlessly higher in most global equity, bond, and property asset-classes.

Included in the asset classes that have benefitted from the strong deflationary trend that has held sway since Lehman in 2008, has been US Treasuries. Even now as the Fed tightens policy through interest rate hikes and the commencement of the sale of the fixed income securities it acquired following the credit crunch, the bond market remains unconvinced that the US economy under the enormous debt headwinds, can succeed in returning to normal economic growth.

Many commentators believe the Fed in 2018 will likely have to cease raising interest rates and may even have to begin cutting them again unless it wants to trigger a recession. This would suggest that any short-term rise in yields at the long end of the Treasury curve is a potential buying opportunity, before the long term secular low (and high in prices) is finally reached some time in the future.

Forward Outlook

For now, the momentum is most definitely with the bulls, especially in equities, but probably in bonds also. To add to the bullish global equity scenario, the US dollar, which suffered its worst drop in value since 2003 last year, appears stuck in a narrow trading range (between 90 and 94 on the DXY index compared to more than 102 at the end of 2016), which should prove attractive not only for some of the major export companies in America, but also for the stocks of many non US markets, and especially emerging economies for whom imports (which of course are priced in $) can be a headwind when the US currency is too strong.

Additionally some market commentators have recently noted that favourable demographic factors that were closely correlated to the last two secular equity bull markets during the twentieth century, came into play again in 2013, and should prevail for another decade, albeit the debt headwinds now in place are unparalleled. Effectively US demographics recently entered the “golden ratio” previously identified in a research paper written in 2002 titled, “Demography and the Long-Run Predictability of the Stock Market.”

The research paper showed that following the second world war, there were three distinct demographic periods in the US, with the two during which the demographic golden ratio was positive, producing significantly higher annualised real GDP (and concurrent equity bull markets), than the period where the ratio was negative, which resulted in anemic GDP (and an accompanying equity bear market).

This positive demographic phenomenon is set to prevail until at least 2028, during which period more than 120 million Americans will transition into their peak earnings (which is an extraordinary 60% more than when the famous post war baby boomers powered the last positive golden ratio in the 1982-2000 era), and so we could be set for another epic equity bull market that totally eclipses anything seen before, notwithstanding the phenomenal debt headwinds. Accordingly an increasing number of commentators, whom previously believed current stock valuations were unsustainable, are revising their opinions and suggesting the existing bull could run several years yet, and reach previously unthinkable levels such as 50,000 on the Dow!

This of course is only likely to be remotely possible if the cost of servicing debt remains at the extraordinarily low levels that have prevailed over the best part of a decade, since the credit crunch in 2008. Therefore the actions of the Fed one-way or the other remain key.

For now we remain confident that sitting tight in our chosen investments with a bias towards both higher yielding mid and small cap UK stocks, as well as the shares of larger European companies is the right one. Additionally, we continue to invest selectively in some of the less popular US sectors.

We remain cautious on other asset classes including UK gilts, due to increasing inflationary concerns. We are also cautious on corporate debt, where spreads over government bonds suggest we are not being adequately rewarded for the inherent risk.

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. With very best wishes to you and your loved ones for a happy and prosperous 2018!