2nd Quarter 2018

“When Wall Street sneezes, the rest of the world catches pneumonia” is a market adage that many of us are familiar with and which has supposedly been in common use since as early as the 1950’s! All too often historically, it has proven an accurate description for what often occurs in global markets when there is a sudden pullback in US stocks during an established bull market.

It certainly seems to have rung true last quarter as the sudden re-emergence of volatility in Wall Street equities caused a sharp sell off first in US indices and then in a powerful ripple effect across world markets. Perhaps what has been most frustrating about the early February correction is that while the US and especially the tech stocks heavy Nasdaq index has recovered most of the losses, many other equity indices including the UK’s FTSE are still down almost as much following the initial correction, lending credence to the famous old saying!

Last Quarter Review

Following the phenomenal advance in global equity markets during 2017, last quarter saw the first correction of 10% or more, for more than two years in the nine year old bull market, as volatility re-emerged and reminded investors that investing in stocks has downside as well as upside potential! It was difficult to pinpoint what exactly triggered the market reversal, with some commentators suggesting that the gathering momentum since the turn of the year had simply gotten ahead of itself and a correction was due and arguably welcome to prevent euphoria getting out of hand.

On January 26th, the S&P 500 closed at 2872.27, a new record close in the long equity bull market that began in March 2009, when the S&P closed at 667. The market sell off that followed the January 26th high, through to the beginning of February saw the benchmark index fall more than 10% (which constitutes an official correction) to a closing low of 2581.00 on the second of February, before temporarily recovering more than 7% of the loss, but closing the quarter at 2640.87, barley 2% above the correction low.

Despite economic growth in the US appearing to remain consistently good as opposed to running away, and so far scant evidence of growing inflationary pressures, the Federal Reserve (Fed) increased interest rates by another 0.25% at its March Federal Open Market Committee (FOMC) meeting. Perhaps more worryingly however, the latest quarterly report from the Fed showed that household debt in the US at the end of 2017 climbed another $193 billion to $13.5 trillion, a new record, with credit card, student, auto and mortgage debt all still rising!

In the UK, the Bank of England (BOE)’s February inflationary report reiterated that “The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target, and in a way that helps to sustain growth and employment”, and that at the 7th February meeting it had “voted unanimously to maintain Bank Rate at 0.5%.” The report also confirmed that the MPC had “voted unanimously to maintain the stock of sterling non-financial investment-grade corporate bond purchases, financed by the issuance of central bank reserves, at £10 billion”, and additionally it had “voted unanimously to maintain the stock of UK government bond purchases, financed by the issuance of central bank reserves, at £435 billion.”

Despite post-Brexit concerns that inflation could increase dramatically as the cost of imports increased on the back of a collapsing currency, inflation in the UK fell to a seven month low of 2.7% in February. Meanwhile during the quarter, the sterling exchange rate relative to the dollar improved from $1.35 to $1.40, albeit most market commentators observed this was more as a result of general dollar weakness than sterling strength.

In the second largest economy in the world, namely China, the Caixin General Manufacturing Purchasing Managers Index (PMI) unexpectedly fell to 51.0 in March, the weakest reading since November, as both output and new orders grew the least in four months, while export sales increased only marginally. However, in spite of this, confidence towards the 12-month outlook for production improved to a one-year high in March.

Key Economic & Market Data 2017 Q4 GDP 12 month GDP Base Interest Rate - End Mar 2018 Equity Index - Last Quarter Equity Index - Last 12 Months Sovereign Bond Index - Last 12 Months
% % % % % %
USA 2.90 2.60 1.75 -1.22 +11.77 +0.44
UK 0.40 1.40 0.50 -8.21 -3.89 +0.62
Euro Area 0.60 2.70 0.00 -4.08 -3.98 +3.06
China 1.60 6.80 4.35 -4.18 -1.66 +1.83
Japan 0.40 2.00 -0.10 -5.72 +13.46 +0.74
Germany 0.60 2.90 0.00 -6.36 -1.76 -0.50
NB. GDP Data shown is to the 31st December 2017; Interest Rate, Equity & Bond Index Data is to the 31st March 2018; 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

Towards the end of January this year, investors could have been forgiven for thinking that stocks would never again turn down in earnest, as all the major Wall Street indices powered ahead, and global indices happily followed in their slipstream. It seemed the only investors with any concerns were those whom had not followed the consensus trade on inflation and interest rates heading higher, and were still invested in government debt and other fixed income instruments!

Then suddenly an almost forgotten market word, namely volatility re-appeared Rip van Winkle like when we all least expected it, and fear was back on the Street! As we commented at outset, it has historically only required Wall Street stocks to wobble and begin retreating, for global markets all too often to head south even more violently!

And so it was at the beginning of February, and while US market indices quickly recovered to end the quarter almost unchanged (in fact the tech heavy Nasdaq index ended more than 3% higher), most global bourses as the table above shows ended up quite a bit lower than where they started 2018. UK equities had been struggling even before the market correction of February, largely on the continuing uncertainty surrounding the drawn out Brexit negotiations, and their implications for the British economy.

This is most frustrating for investors as most of the suggested economic downsides that many respected market commentators forecast would occur if Brexit happened, have not materialised. Instead the British economy has remained resolutely firm with little inflation and steady economic growth that many independent analysts believe is sustainable regardless of which Brexit deal is finally agreed by the British and EU governments.

Meanwhile almost unnoticed by the mainstream media a development that could eventually have economic implications on a tectonic scale occurred on Sunday March the 26th when oil began being traded for the first time ever in yuan on the Shanghai Futures Exchange. China's historic crude oil futures contract began with well over 10 billion yuan notional traded within the first hour.

This could potentially have major implications for the existing decades old petrodollar trading system, as the birth of the petroyuan will enable countries to sell China oil and other natural resources to be paid for in yuan (or renminbi) instead of dollars. While the emergence of the petroyuan is unlikely to see the immediate demise of the petrodollar, the fact that China has declared that countries can choose to be paid in gold instead of yuan if they prefer, should ensure it gains traction over time especially with other Asian trade partners such as Russia.

Ever since the Bretton Woods agreement of 1944, the US dollar has been the de facto global reserve currency. To begin with it was backed by gold, and anchored at a price of $35 an ounce (effectively the price at which anybody could convert their greenbacks into bullion), hence the term “good as gold”.

At the inception of the Bretton Woods agreement in July 1944, the US had over 26,000 tons of gold, but as a result of its worsening trade deficit as time went on, many countries began insisting on being paid in actual gold instead of the paper dollars for the goods they were selling America. The result was that by the late sixties the US’s bullion reserves had been reduced to barely 8,000 tons, forcing President Nixon in August 1971 to finally close the gold window, and resulting in the US dollar becoming a wholly free floating currency.

The historic 1971 decoupling of the greenback from gold coincided with a rapid increase in debt, and credit based derivatives, and while the shadowy eurodollar offshore market almost certainly existed prior to then, Nixon’s historic decision on August 15th hastened its appearance centre stage as a means for major American and other Western banks to partake more freely in the lending bonanza, while sidestepping the much more stringent home based (onshore) rules. The credit party was to continue (albeit with some serious but repairable cracks along the way such as the Long Term Capital Management and Asian crises of 1998) until the collapse of Bear Stearns in 2008, resulting in the disappearance of interbank counterparty trust, and then several more major institutions collapsing including Lehman Brothers, prompting the authorities to step in and bail everyone out!

Despite the 2008 credit debacle, and all its repercussions, the US (government, corporations and individuals) has continued to borrow, while its trade and budget deficits have continued to grow, and it would appear that some of the emerging markets, especially in Asia have finally had enough! Those whom have been following events in the oil and gold markets will know that China and Russia have almost certainly been planning the advent of the petroyuan for many years, and while this is definitely not the end of the road for the petrodollar, it could potentially be the beginning of the end!

Forward Outlook

The return of volatility at the end of January, and the continuing rollercoaster action in global equity markets subsequently suggest we may be nearing an important inflection point. It is however most unlikely that March 26th will prove to have been the peak of this nine year old equity bull market.

It is more likely to prove to have been a warning that the market is getting frothy and closer to the point where the bears finally gain control. However history as well as technical and fundamental indicators suggest that the crucial turning point may yet be many months, and even years away.

Some respected contrarian market analysts are even questioning the consensus trade in government and corporate debt, as all the talk of increasing inflation at least for now appears a little premature, especially with all the monumental US and global debt headwinds in the system. The existence of the latter, suggests instead that the strong deflationary forces that have prevailed ever since the 2008 credit crunch and the collapse of the shadow eurodollar banking system, remains firmly in control, and that bond bears may have to wait some time to see the yields of 4% plus that they have been forecasting for benchmark US Treasury bonds.

The biggest concern may therefore be the Fed’s insistence to continue raising short-term interest rates as a pre-emptory measure to expected inflation, especially if the latter doesn’t materialize. With total government, corporate, financial institutions, and individual debt in the US now standing at just over $69.8 trillion or 351% of GDP (according to the latest data from the Fed), there has to be a serious concern that the central bank will be responsible for both crashing the stock market and bringing on a recession earlier than necessary through its tightening monetary actions.

While the unwelcome arrival of volatility last quarter has alerted us to the increased possibility of a market decline in equities, we remain confident for now that global stocks offer the best returns on a risk adjusted basis. We remain biased towards funds investing in mid and small cap UK stocks, together with high quality European and American companies, with the latter benefitting also from the weaker dollar.

Despite the lack of convincing evidence of increasing inflation either side of the Atlantic, we remain cautious on both UK gilts and US Treasuries, along with corporate debt, where the low additional yields over government bonds suggest we are not being adequately rewarded for the inherent risk. We also retain some exposure to commercial property where appropriate for diversification purposes.

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.