3rd Quarter 2018

“The desire for constant action irrespective of underlying conditions is responsible for many losses in Wall Street even among the professionals, who feel that they must take home some money every day, as though they were working for regular wages. Money is made by sitting, not trading.” – Jesse Livermore, legendary Wall Street investor

“Most stock returns are made on relatively few trading days. Just as it is important not to be out of the market on those days, it is important not to omit key stocks from your portfolio.” “The best defence is to diversify broadly across markets and assets as well as stocks. That includes bonds and cash of course.” – A recent article in The Economist titled, “The Lucky Few”

Last Quarter Review

The Federal Reserve (Fed) raised interest rates by another 0.25% to 2.00%, and the price of crude oil climbed to more than $74 for the first time in four years, but markets had every reason to be upbeat about future growth prospects. The fiscal stimulus provided by the Trump tax cuts appears to have had a positive impact upon the US economy as forecasts for GDP growth last quarter soared, but understandably markets remain nervous of the increasing US budget deficit (exacerbated by the tax cuts) and the escalation in trade war threats between the US and China.

During the quarter, the S&P 500 climbed almost 3%, but finished some way short of its all-time high in February of this year, with some analysts suggesting this is a bearish sign for the long-term health of the nine year old Wall Street bull market. However, four of the five stocks that represent approximately 20% of the market’s value, and make up the market acronym FAANG (Facebook, Amazon, Apple, Netflix and Google) hit new record highs on the 20th June, which helped the tech heavy Nasdaq index climb almost 14% last quarter, leading others to believe it is just a question of time before the rest of the equity market follows these company titans to new peaks.

The Bank of England (BOE) resisted raising interest rates at its Monetary Policy Meeting (MPC) in June, but hinted at the possibility of an August rate rise after its chief economist Andrew Haldane joined two other members of the MPC in voting for an immediate hike in borrowing costs. The latest rate decision came following a difficult winter for the UK economy plagued by heavy snow and the “Beast from The East” which rendered much of the construction industry idle, while forcing shoppers to stay away from the shops with the result that the economy grew by just 0.2% during the first quarter.

Overall however, the outlook for the British economy looks good, both in absolute terms and relative to other developed nations, with an example being the military ship building export contract worth £20 billion won from the Australian government by BAE systems in June. The health of the UK economy was also reflected in the stock market with the FTSE 100 index climbing more than 8% during the quarter and indeed reaching a new record high of 7877 on the 22nd May, before giving up some of those gains by the end of the quarter.

In Europe, equity markets struggled to make much headway during the quarter, reflecting political tensions and uncertainty once more in several member countries including Italy where there are concerns that the economic policies of the Five Star and League coalition government formed on the 1st June is almost inevitably going to be in conflict with the fiscal rules set by Brussels. The threatened trade tariffs by the US on all EU motor cars and other goods also unsettled European markets. Stocks rallied however on the last trading day after European Union leaders working overnight knocked out an agreement on refugees, without which many commentators had feared German Chancellor Angela Merkel’s credibility and future would have been irreparably damaged.

Meanwhile, Chinese equities officially entered into bear market territory during the quarter, having fallen more than 20% since the volatility shock of early February that shook global markets. During the quarter the yuan exchange rate with the US dollar came under pressure again, doubtless in part due to the deteriorating trading relationship with America, prompting the People’s Bank of China (PBOC) to twice lower its Reserve Rate Requirement for Chinese banks, first by 1% in April and then by another 0.5% that is due to take effect at the beginning of July.

Key Economic & Market Data 2018 Q1 GDP 12 month GDP Base Interest Rate - End Jun 2018 Equity Index - Last Quarter Equity Index - Last 12 Months Sovereign Bond Index - Last 12 Months
% % % % % %
USA 2.00 2.80 2.00 +2.95 +12.18 -0.43
UK 0.20 1.20 0.50 +8.22 +4.43 +1.98
Euro Area 0.40 2.50 0.00 +1.01 -1.34 +1.52
China 1.40 6.80 4.35 -10.14 -10.81 +3.71
Japan -0.20 1.10 -0.10 +3.96 +11.34 +0.89
Germany 0.30 2.30 0.00 +1.73 -0.16 +1.54
NB. GDP Data shown is to the 31st March 2018; Interest Rate, Equity & Bond Index Data is to the 30th June 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

While global growth during 2018 appears to have been slowing, the US economy on the back of the fiscal stimulus provided by the Trump tax cuts and spending binge, appears to be gathering momentum. The Federal Reserve Bank of Atlanta who produce the closely watched “GDP Now” forecasts expect US second quarter GDP to be 3.8% annualised, almost double the annualised growth rate of the first quarter.

This has led some to suggest that the Fed was right to increase interest rates again in June, on its way to supposedly normalising rates at somewhere between 3% - 4% by the end of 2019. The central bank justifies its rate hikes on the basis of the perceived inflationary threats within the economy, which seems rational when considering that the unemployment rate in the US is now approaching typical business cycle lows, albeit there are also serious questions about the accuracy of the data from the Bureau of Labour Statistics (BLS) when labour market participation numbers are also factored in, i.e. there are potentially millions of eligible workers who are not registered as being unemployed for various reasons.

The bond market however, thus far appears unconvinced, and instead continues to reflect the deflationary trend that has been in place since the credit crunch of 2008, and arguably even before that following the dotcom crash of 2000. This is evidenced by the historically low yields on the benchmark government debt of all developed countries, with of course US Treasuries (USTs) being the most widely followed as well as the most liquid bond market in the world, at more than $14.5 trillion.

If the market believed the Fed was behind the curve in terms of raising interest rates in order to pre-empt anticipated inflation, then we could expect the yields on longer dated USTs to have been increasing since the Fed ended its zero interest rate policy (ZIRP, that had been in place since December 2008), and began gradually normalising interest rates in December 2015

On December the 16th 2015, when the Fed first increased its base rate (during this business cycle) by 0.25%, the yield on the benchmark 10-year UST was 2.30% while the Long Bond (30 year) yielded just over 3%. Since then, the Fed has increased the base rate further to 2% making a total increase of 1.75% since it began normalising, but the yield on the 10-year UST is only 2.85%, and the 30-year UST has actually gone down to 2.98%.

If the Fed continues raising short term interest rates, it must hope that the market will come round to agreeing with its view that current economic growth will be sustained, and that inflation will become a problem, resulting in yields at the longer end of the Treasury interest rate curve also rising, and effectively ending the extraordinary secular UST bull market that has run since June 1981 when then Fed chairman Paul Volcker raised short term interest rates to an unprecedented 20%, which pushed yields on the benchmark 10 year UST to more than 15%.

If however the market continues to believe that the sustained economic growth and accompanying inflation anticipated by the Fed will not occur, and that instead the headwinds of unprecedented government (the budget deficit for this fiscal year alone is expected to exceed $1 trillion or more than 5% of GDP), corporate, and private debt will ensure the deflationary trend of the last decade or so continues, then yields at the long end will remain subdued and eventually, with the Fed continuing to raise interest rates, the yield curve will invert. This happens when yields at the longer end of government debt duration are lower than the interest paid on cash type instruments such as Treasury bills and shorter dated Treasuries.

Historically, when this has occurred, recession has almost always followed within the next year or two. The yield curve inverts because investors fear a recession is coming, which will almost always result in the Fed subsequently having to cut interest rates, and accordingly investors prefer to invest into longer dated bonds (10 – 30 years), in the expectation that they will produce better capital returns during the recession as yields across the entire curve fall on lower growth expectations.

The UST yield curve inverted shortly before the recessions of 2000, 1991 and 1981. Prior to the recession of 2008, the UST yield curve first became inverted in December 2005 when the yield on the 2-year Treasury Bill (T-Bill) was 4.41% while the 10-year UST yielded just 4.39%. By July 17th 2006 the inversion had steepened to the point where the 10-year UST yielded 5.07%, compared to the 3-month T-Bill yielding 5.11%.

Unfortunately, by the time the Fed decided to take the UST yield curve inversion seriously in September 2007, and began reducing interest rates, it was already too late. The Fed interest rate reduction of 0.5% to 4.75% in September 2007 resulted in the UST yield curve reverting, whilst the central bank continued to lower interest rates a further ten times until it reached zero in 2008 – by then the economy had entered the worst recession since the great depression.

Forward Outlook

While the US Treasury yield curve has appreciably flattened since the beginning of the year, it is nowhere near inverting just yet, with 1-month T-Bills paying 1.77% interest, and the 2, 5, 10 and 30-year UTS’s yielding 2.52%, 2.73%, 2.85% and 2.98% respectively as at the 30th June. At the moment, it appears most unlikely that the yield curve will invert anytime soon, but if and when it does, we shall of course be looking to adopt more defensive portfolios at that stage.

Meanwhile, the most immediate threat to continuing global growth and smooth markets is the trade wars between the US and other countries including the European Union but most especially China. Upon careful analysis, it is difficult not to conclude that the underlying tensions have been caused in part by China’s decision to try and slowly become less dependent upon the dollar for international trade (and especially when it comes to buying its oil from Russia and other Middle Eastern countries), by launching an oil futures contract on the Shanghai Exchange that is denominated in yuan.

Additionally, it has been three and a half years since foreign central banks (FCBs) including the PBOC purchased UST’s, placing additional strains upon the US when it comes to funding its budget deficit, albeit to date there has been no major selling of their existing holdings by any of the FCBs. Our view is that the aggressive threats from the US are all part of the Trump style of negotiation to try and secure a better deal for America, much as we saw in its dealing with the North Korea nuclear threat.

Therefore, for now at least, we believe the trade disputes are unlikely to escalate into anything that will damage the global economic outlook. We would reiterate our thoughts from the last market view that the biggest concern may therefore be the Fed’s insistence to continue raising short-term interest rates as part of its normalisation strategy, and as a pre-emptory measure to anticipated future inflation, especially if the market continues to disagree, causing the Treasury yield curve to eventually invert.

Should that occur, the central bank’s pre-emptive monetary strategy could well prove to be responsible for both crashing the stock market and bringing on a recession earlier than otherwise would have been the case. As ever, monitoring and determining the macro picture including the likely direction of key indicators such as the dollar and Treasury yields will play a key role in advised portfolio asset allocations going forward.

If and when a more defensive investment strategy becomes necessary, we shall of course advice accordingly. For now, we remain positive towards markets and sectors where we believe relative value exists.

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 in meeting our client’s needs.