Stock and bond markets ended the first quarter of 2017 on a surprisingly strong note, particularly considering political developments during March. It was a month when both capital market segments posted modest positive returns, although the stock markets of the Eurozone and emerging markets clearly outpaced the rest. This must be of particular surprise to those who believe equity markets are trading at elevated valuation levels that already anticipate a considerable amount of positive economic news in the near future.
The mainstream explanation for the strength of markets this year has been the ‘Trump effect’ and the ‘reflation trade’ both inspiring investor sentiment. But if that were so, a formidable correction should have been on the cards. President Trump’s agenda was dealt a severe blow by his own Republican party, and declining oil and commodity prices quashed the return of inflation expectations. On top of this, the US Federal Reserve raised interest rates for the second time in three months, which should have hurt bond valuations, and the European Union was handed a long-awaited ‘Dear John’ letter by the UK.
It would seem that, compared to recent years, investors are now a lot less easily scared. Or rather, they may have determined that economic momentum – not political posturing – is what really matters. Instead of constant ‘Armageddon paranoia’, the new market paradigm seems to be that real events turn out to be far less radical than initially portrayed. This is very encouraging; particularly as of the biggest deficiencies of the post-global financial crisis recovery has been the general lack of confidence among businesses. Perhaps we should therefore align our medium to longer term views with the markets’ new found optimistic approach and propagate ‘where there is a will there is a way’?
It’s tempting to interpret the resent durability of market and business sentiment as the beginning of a more resilient growth phase, but right now, it still feels premature. Nothing is changing in the shorter term, but the potential and apparent willingness of major global figures to fundamentally change the terms of global trade – and with it the framework that has brought us growth and prosperity – remains truly concerning. So while we can all enjoy the unexpected economic sunshine, it makes senses to keep a watchful eye on the many clouds looming on the horizon.
Article 50 triggered – Quo Vadis UK?
Theresa May’s letter to the European Council invoking Article 50 was an historic event, but for market participants, it was merely a rubber stamp on old news. While the letter itself struck a welcome conciliatory tone, it didn’t take long before the cracks in diplomacy started to appear. A veiled threat that an acrimonious split could lead to the withdrawal of security support was subsequently labelled a “misunderstanding” but highlighted just how tense these negotiations could prove to be. There will be no margin for loose rhetoric or unforced errors.
That slight aside, Mrs May’s letter – and accompanying speech to Parliament – was far less antagonistic towards the bloc than previous “Brexit means Brexit” rhetoric. From a business perspective, this is indeed good news. A crash exit would leave many businesses in an extremely uncertain position with regards to their trading arrangements with the world’s largest single market.
In the long term, Brexit will undoubtedly have wide-ranging investment impact, particularly if the fundamentals of the UK’s economic framework change drastically. This is what economists refer to as ‘change of institutions’. The new UK/EU relationship will take shape in the coming two years but, until then, news flow from businesses about their own arrangements will be almost as important as news from the political side.
In the short-term, the effects of Brexit are mostly currency dependent, and therefore harder to predict. Since the referendum, the suppressed value of sterling has pushed the FTSE 100 to record highs, as UK equities have become comparatively cheaper for foreign investors and UK-based multinationals have been buoyed by the fact that much of their revenue stream is in foreign currencies. This has led many to wonder whether sterling recovering could see a reversal of their UK stock gains. Indeed, many big market players have substantial short positions on the currency, lending credence to the argument that a correction on the trend of the last nine months is on the cards.
While short-term spikes in the value of sterling from sellers could trigger a ‘short-squeeze’, we don’t expect GBP will increase in a sustained enough manner to cancel out the stock gains. For as long as uncertainty about the UK’s future terms of trade with the EU persist, then a prolonged upswing for sterling is highly unlikely, and any increase that is seen would likely be capitalised on by short-sellers viewing it as a selling opportunity.
Central Bank monetary policy divergence
Is the Fed falling “behind the curve”, as some analysts suggest? Its decision to increase the Federal Funds rate by 0.25% (raising its target range to between 0.75% and 1.0%) was widely expected and effectively priced-in by the markets. Less expected was the “dovish” language chosen to explain the decision, reiterating their expectation of just three interest rate increases this year, whereas some analysts were hoping for four or possibly more.
But the Fed’s steady approach seems sensible. Its analysis suggested there have been no substantive changes in the economic variables and data (or forecasts) since December 2016, and the gradual tightening of monetary policy is consistent with a gradual and sustained improvement in the economy (and steady increase in inflation). Moreover, tightening policy in advance of understanding the potential extent (and timing) of President Trump’s proposed fiscal reforms could be counter-productive.
Whereas the direction of US, and, to an extent, European monetary policy, is reasonably clear, the direction of monetary policy in the UK is less straightforward. Economic consensus suggests that consumer spending in the UK is likely to slow later this year (and into 2018), and this view was echoed in the BoE’s announcement. Its Monetary Policy Committee forecast a slowdown in aggregate demand, in line with declining household demand growth, which is itself a reaction to lower real income growth as rising inflation begins to take effect. The BoE’s analysis indicates that Consumer Price Index inflation increased to 1.8% in January and is expected to rise above the Bank’s 2.0% target over the next few months. However, while it is forecast to peak at around 2.75% in early 2018, it is set to drift gradually back down towards the target thereafter.
Given the level of uncertainty around the prospects for the UK economy, the BoE is keen to indicate that monetary policy is presently finely balanced. It is, however, considerably more accommodative than the historical long-term average. Assuming economic forecasts are broadly met, one would expect to see higher interest rates, although there are risks in both directions. A more marked slowdown in activity could imply more monetary support (lower interest rates).
The increased levels of uncertainty make our domestic market somewhat less attractive target for our investment strategy than other global regions. But there are still plenty of good investment opportunities available in the UK’s stock markets – it may just become a little harder to identify them.
Why Chinese policymakers can’t resist playing ‘whack-a-mole’
China’s credit binge since the financial crisis has been remarkable. Its total outstanding debt pile now stands at around 264% of the nation’s GDP, up from 164% in 2008. This is quite a feat, given Chinese GDP has more than doubled in this time. It is therefore ironic that the Chinese government is now so determined to deflate the bubble. Still, there’s no doubting their intent.
What started with restrictions on property lending intended to curb rising house prices has since developed into an all-out attempt to stem the risks of overheated growth in the debt market. In March, Chinese Premier Li Keqiang announced before the National People’s Congress that the government’s focus is now on curtailing risks and “high leverage in non-financial Chinese firms”. The People’s Bank of China (PBoC) then raised short-term interest rates for the third time in as many months, only hours after the US Federal Reserve (Fed) raised its benchmark interest rate.
In truth, the hike in short-term rates isn’t solely to contain the debt situation. China relies on its comparatively high deposit interest rates to incentivise investors to keep money in the country. When US rates go up, this incentive drops. China has been having troubles with capital outflows for a while now, as rich individuals and companies have noted the perceived risks in the Chinese economy and sought to diversify their wealth through international investments. So, when the Fed raises its rates, the PBoC has little choice but to follow suit to stem the money flowing out of the mainland, even if the underlying economy doesn’t warrant such a rise.
Engaging in economic intervention on a case-by-case basis is like a game of ‘whack-a-mole’. Dealing with the smaller problems when they pop up, rather than trying to holistically treat the situation, simply increases the likelihood of making an interventionist error.
Needless to say, with debt levels of this magnitude, a significant downturn would be felt around the world. However, the one thing that would be truly disastrous – a run on the Chinese economy – is unlikely. China is holding its five-yearly National Congress in the autumn, where president Xi is widely expected to further consolidate his leadership by retiring a number of his adversaries and appointing a more closely aligned executive. Until then, we expect the game of whack-a-mole to continue.
Long-wave economic analysis: a new ‘K-wave’ up-cycle dawning?
Human progress does not occur in a straight line, but instead features peaks and troughs. Or as Shakespeare put it: “There is a tide in the affairs of man”. The same can be said for economics and investment returns. Investors should consider that the strong investment returns experienced over the past few years, even in lower-risk portfolios with a higher proportion of fixed income investments, may experience ‘mean reversion’ and moderate back towards long-term averages.
In economic terms, progress can be measured by examining how shorter-term confidence cycles operate as an integral part of ever longer-wave economic and business cycle. This long-wave cycle is known as the Kondratieff Cycle (K-Wave), and it lasts some 46-60 years from peak to trough, with the frequency of those peaks and troughs increasing as the time frames decrease. The next longest cycle is the Juglar Cycle, which takes roughly 7-11 years. An example might be the rise of Asian economies versus the relative ‘decline’ in the west. Following this is the Business Cycle, lasting between 3-5 years and usually correlates with changes in parliaments or presidents. This leaves the annual Seasonal Cycle (more confidence or trend based). Cyclical trends are highly significant for long-term investors as they can drive movements in economic activity over shorter periods to produce trends in assets, stock prices and even sectors that we can identify and benefit from.
The global economy has improved markedly since the global financial crisis, and now operates on a more stable base, having regained a certain resilience against short-term expectation changes. It is from these steadier foundations that we consider it possible that the world has entered a long-term upswing. We may be at the beginning of a new K-spring, or rebirth of growth in the global economy.Is it possible that a new, fifth cycle is beginning, after the Great Financial Crisis?
|Cycle number||Date range||Cycle length (years)||Tech driver?|
|5||2007-2061?||?||Robotics/Alt Energy/ Genetics|
However, just because we may be at the beginning of a long-term upswing, it doesn’t mean that short-term activity levels will not dip or stock markets will not correct. Indeed, we see evidence of a slowdown in the short-term business cycle, as investors ponder the new policies of the Trump presidency. We also anticipate the possibility of another sharp downward correction in markets over the course of the year – before calm returns once again with another asset price recovery. We also think that the pace at which events are happening is accelerating, predominantly as a result of the ever-faster rate of technological change.
We suggest investors should prepare for a period of lower realised returns. Though, as the K-Wave cycle suggests, these short-term movements should be viewed, however disconcerting, as small parts of ever larger cycles of activity that point to an overall upswing in the global economy.
EZ does it – the welcome return of broad-based European growth
Instead of being a drag on the world’s economy, the Eurozone (EZ) appears to be in rude health. According to ECB economic data, the EZ has now achieved 14 consecutive quarters of economic growth. The unemployment rate, measured across the region as whole has finally returned into single digits (9.5%), and economic sentiment continues to improve towards ever-healthier levels.
Moreover, the latest economic and business surveys show that the forward progress appears resilient and sustainable. The Euro-area composite Purchasing Manager Index (PMI) climbed another 1.6 points in February to a six-year high of 56.0. Analysis also indicates that sentiment and growth is well distributed across the EU, and not just a reflection of the health of the “northern economies” of Germany, France, etc. We are also encouraged by the overall performance of the EZ “periphery”, not least, Spain and Portugal (and to a lesser extent Italy).
In addition, the favourable financing conditions are driving improvements in corporate profitability and, therefore, a recovery in business investment. In the fourth quarter of 2016, business investment picked up while construction investment also rose, albeit at a slightly slower pace than in the third quarter (although construction may have been higher in Q3 to avoid higher input cost inflation in Q4 and beyond).
Moreover, sustained employment gains, which are also benefiting from past structural reforms, provide support for private consumption via increases in the real disposable income for households. And, all of this is happening against the backdrop of a somewhat stronger global recovery.
Of course, part of the EZ’s resurgence is due to it starting from a relatively low point. Also, the UK’s vote to exit the EU has not had the negative material impact some were expecting and, noting arguments to the contrary, all countries in the EU appear to have benefitted from the accommodative monetary policies of the ECB.
The ECB’s outlook for the EZ remains cautious but positive, describing conditions as expansive and strengthening, driven mainly by domestic demand. That said, the ECB’s accommodative (monetary) policies will be required for some time yet and there may be other potential risks on the horizon - Greece’s ongoing “rescue” package and the challenges posed by Italy’s banking system. The main other risks facing the EZ are the same as those in many regions around the World, protectionist policies and/or monetary tightening in the US, and the ongoing political cycles and risks.