With a timing that almost perfectly matched the arrival of the British summer, capital markets turned distinctly soggy towards the end of June. Bond and equity market sell-offs don’t happen together very often. Usually as one of them falls, the other one rises – hence why the combination of the two asset classes lowers overall investment risk in portfolios so effectively. If you’re looking for recent parallels, you have to go back as far as 2013, to the first ‘taper tantrum’, the US Federal Reserve Chairman announced the intention to scale back monetary support through its quantitative easing (QE) program.
Back to present-day, we’ve recently heard from monetary policy markers in Europe suggesting the era of ‘easy money’ was coming to an end. The UK’s Mark Carney likewise suddenly mentioned the possibility of rate rises, while the US Fed chair Janet Yellen reiterated their intention to continue with their gradual rate rises.
There’s nothing new or shocking about any of this, but – just as in 2013 – markets seem spooked about central banks acting in haste and thereby potentially committing short-term policy errors. Against the general backdrop of improving economic growth (leaving aside Britain for now), recently various early indicators have begun to suggest another growth blip in late summer/autumn. Tighter monetary policy would be the wrong policy and stagflation the unenviable result.
We currently hold the view that markets, just like in 2013, are overacting because they are trading at extended valuations and everybody is aware of it. Indeed, recent communications from central banks may have been a ‘test balloon’ to assess whether they can get market participants to self-correct and increase the cost of credit yields themselves, without the central banks having to adjustment from the interest side themselves. We suspect the bond markets will see the ruse fairly quickly and stabilise, while equity markets will continue to focus on further economic data flow, to assess by how much the expected growth blip may dent their corporate earnings expectations. We therefore expect equity markets to remain volatile in the short term.
1. Quo Vadis (where are you going) Britain?
It’s been a rollercoaster 12 months since Britain’s electorate voted to leave the European Union (EU). Extraordinary consumer resilience first catapulted the UK to the top of the G7 growth league before it swiftly sank back down to the bottom. UK politics has been equally capricious. What started with an embarrassing political meltdown, developed into what looked like it would be the biggest political majority in generations, only to crumble back down into embarrassment and uncertainty.
Unfortunately, compared to a year ago, global economic growth is not surging but very likely rolling over, and so things have started to look bleaker from a UK perspective. The content of the Queen’s speech was more of a reminder of all the initiatives that had been scrapped from the Conservative’s manifesto, rather than a rallying cry for a brighter future. The formal start of Brexit negotiations appeared to have been scripted before the election outcome, with the hard Brexit tones of leaving even the customs union leading to widespread consternation from Britain’s business representatives. Theresa May’s offer to permit most EU citizens currently residing in the UK to stay indefinitely sounded far more in line with the new direction of a somewhat more ‘business-accommodative’ Brexit route.
Even though this move ended 12 months of unpleasant limbo for three million EU citizens resident in the UK, capital markets did not seem to pick up on the subtle change in direction. Sterling came under pressure once again against the euro and the US dollar.
UK growth and inflation will continue to be influenced by the response of households, companies and markets to the prospects for the UK’s departure from the EU. The slowing in consumer spending and consumption may be temporary. However, the relative buoyancy in manufacturing and exports may also be temporary, both having benefitted from the significant depreciation of sterling after the EU referendum. It is entirely possible that the exchange rate has temporarily lost its political marking function and is now once again more sensitive to the fundamentals of economic changes. Here, the fact that the rest of the EU continues to accelerate while the UK is slowing provides ample reason for currency weakness, despite a wind of change in political positions.
2. China capital market opening 2.0
After noting the recent Chinese capital market initiative to open the domestic bond market to international investors, it’s pleasing to now see efforts made within the equity market too. MSCI, the leading provider of global equity indices, announced that from 2018 it would (at long last) include mainland Chinese stocks in its global equity benchmark index, the MSCI Emerging Market Index. MSCI had rejected this notion on three previous accounts, due to concerns surrounding liquidity, volatility and poor general oversight from the Chinese authorities and exchanges.
It means 222 Chinese onshore large cap stocks will make up around 0.70% of the global index, starting at only 5% of their market cap weighting. This will lead to forced purchases in these shares from index tracker funds as well as active managers who do not want to deviate too far from their index benchmark. Initially, this is not expected to have much impact on the shares, due to the small weight relative to the total index. Over time, however, this is likely to change, considering China’s A-Share market is now the second largest in the world by market cap (after the US). For perspective, it is worth noting that the US represents 53% of MSCI’s All World index, while China’s inclusion in just the EM sub index brings it to a meagre weight of just 0.08%.
MSCI’s past reticence has been understandable. For international investors, there are several considerations before buying the newly investable stocks in the index. First, the onshore Chinese index traditionally has a high proportion of individual investors trading stocks (80%) compared to the offshore Hong Kong exchange (27%). With Chinese investors having something of a betting mentality to their stock market investments, stocks are bought and sold in large volumes at near random, leading to potential volatility. A few more institutional international investors from overseas are unlikely to change this mind-set. Second, Chinese companies have a tendency to suspend their shares from trading when they suspect disorderly trading due to false rumours. Although MSCI has omitted stocks that have been suspended for more than 50 days over the past year, liquidity risk shouldn’t be ignored.
But MSCI’s decision should be viewed as a positive step, rather than a giant leap. The same capital control concerns we noted for bond investments exist here and are just as likely to limit the flows into China’s equity markets. Although within wealth management, and specifically standardised asset allocation, equity and bond allocation in China is likely to grow but remain small relative to market size due to the on-going risks.
3. Competing for funds: the FCA’s investigation into asset management
The asset management industry certainly has a lot to think about since the Financial Conduct Authority (FCA) published its investigation into competition within the sector. The report suggested there was weak price competition in a number of areas, including price ‘clustering’ on charges for retail funds, and active charges that have remained broadly unchanged over the last 10 years.
The FCA’s report also raised concerns around investment performance. It indicated that, on average, actively managed and passively managed funds did not outperform their own benchmarks after fees (retail and institutional investors). Moreover, the FCA’s analysis suggests there is no clear relationship between charges and the gross performance of retail active funds, and there is some evidence of a negative relationship between net returns and charges. Perhaps most damning from a competition perspective is the relative and absolute profitability of the sector. The FCA’s investigation found high levels of profitability, with average profit margins of 36%. As expected, the FCA is proposing a wide range of remedies to address the competition issues it has identified.
The FCA also found that investors are not always clear what the objectives of funds are (and investors' awareness and focus on charges is mixed and poor), and that fund performance is not always reported against an appropriate benchmark. Finally, the FCA was very concerned about the way the market of investment consultants for the institutional investors (large pension plans etc.) operates. This, it stated, was evidenced by relatively high and stable market shares for the three largest providers, a weak demand side, relatively low switching levels and potential conflicts of interest.
The FCA’s report has wide-ranging implications for the asset management industry, and we will be closely following the FCA’s programme, not least the market study into direct-to-consumer and adviser-led investment platforms. This will examine to what extent platforms enable retail investors to access products that offer ‘value for money’, and assess what can be done to enhance competition between platforms. However, all of the FCA’s proposals will ultimately be dependent upon the behaviours of the demand side. Unless it can be ensured that consumers and advisers have strong incentives to inform themselves, are able to track performance and, if needed, switch funds, there is little market-driven incentive for asset managers to improve their pricing or their performance.
We believe the best remedy for a better functioning of the market in asset management services is a combination of education of the wider public, standardisation of fund information and ready availability of researched access to what has become a vast universe of available investment options. Only when investment product providers’ fee-paying clients start ‘voting with their feet’ will they display truly competitive behaviours. It is only too human for inertia to reign when revenues continue to flow regardless of service levels.
4. Japan – An arrow headed in the right direction
With Japanese stock markets up around 25% over a year and 6% year-to-date (in local currency), investors’ faith in Premier Abe’s “third arrow” of Japanese economic and social reform continues to gain momentum. Most recently, industry activity data positively surprised, rising 2.1% month-on-month for April compared to the widely expected decline. Forward-looking manufacturing indicators, in the form of PMI’s, also remained positive, which means Japanese manufacturing has expanded for 10 consecutive months and is now at levels not seen since 2013.
So what is driving this momentum? Well, labour market reforms are proving influential. The unemployment rate in Japan is at a 20-year low for April (2.8%) and the labour force participation rate continues to rise, with data from Bloomberg showing prime-age employment-to-population at a record high. This is partly due to the rising number of women in the work force but also the changing culture towards working hours. Previously, the working culture in Japan encouraged long working hours, which management would use as a guide to an employee’s promotion potential. This led to a tired and less productive workforce. A shift to a more ‘normal’ working hour culture means productivity has risen per hour, but more employees now undertake the same amount of work. On the flipside, this is keeping wages lower, thereby limiting inflationary pressures.
Consistent central banking policy has also provided support to the market. The Bank of Japan remains upbeat for 2017, forecasting higher growth and prices in its recent monetary policy meeting. Of course, when it comes to investing in Japan, “this time it’s different” has been heard many times before. However, unlike in 1990, when the market was at the peak of a bubble while the labour market displayed similar characteristics to now, there is far less fear of wage pressures generating significant inflation. There is, however, a hope that it will be enough to prevent Japan returning to deflation. This, combined with the accommodative monetary policy and the platform of economic and social reform, has confidence growing in allocating investment assets to Japanese equities.
What to make of Amazon’s quest for global dominance
Amazon’s $13.7 billion purchase of premium organic supermarket chain Whole Foods proves the ‘T-Rex’ of the online retail world is getting serious about bringing its disruptive technologies into the general retail industry. Given its past history, it would be hard to bet against Amazon succeeding in food retail, one of the largest areas of consumer discretionary spending, and changing grocery distribution in the same way it forever changed traditional ‘bricks and mortar’ retailers – high street books, electronics and clothing stores.
Market participants seem to think so. Whole Food’s largest competitors lost a combined $32 billion in market capitalisation in a single day, while Amazon’s stock continued its relentless march higher. On 16 June, a total of 11 out of the 12 largest one day biggest losers on the S&P 500 all appeared to be either direct competitors or in industries that could be impacted by Amazon’s acquisition. Interestingly, the loss in Wal-Mart’s market capitalisation nearly equalled the amount Amazon paid for Whole Foods.
Investors should not be fooled by the fact that Whole Foods is an organic foods specialist, it will not stop there. Amazon did not just buy 431 Whole Food stores; it actually ended up with 431 prime-location upper-income distribution nodes for everything that Amazon supplies to the public. The company could end up further reducing the margins of existing competitors, while now also putting pressure onto grocery retail margins on a global basis.
However, there is a wider story in play. Amazon’s purchase touches on the role that monopolies and oligopolies (market dominance by a few) have. Monopolies might also impact wealth distribution in wider society, particularly as ownership of assets lies in an increasingly narrow spectrum. We suspect there is the potential for a measure of political backlash over that narrow ownership, as governments look more closely at perceived wealth inequalities, along with possible revisions to competition and tax laws.
For investors, Amazon’s business and shareholder model remains purely growth focused. Rather than enhancing shareholder returns through dividends or engaging in share buybacks, Amazon has only ever ploughed earnings back into more business investment. For now, investors appear content for the company to reinvest again and again for future growth, which is what makes the company such a formidable competitor.