Synchronised Global Slowdown?
Synchronised global expansion has remained in place so far this year. Economic consensus is that this will continue this year and next. However, the first quarter showed slower growth than expected. That was blamed on bad weather so a big bounce back was anticipated for the second quarter. That seems not to have materialised. There are a number of reasons this might be the case but in our view the principal ones are a slowdown in China and a resurgent dollar. Both impact Emerging Markets negatively, the first on trade and the second on large dollar borrowings by emerging governments and firms. Given that worries over North Korea have been put to one side for now, Trump’s protectionist policies are another cause for market concern. In Europe, political concerns resurfaced as Italy elected a Euro sceptic, anti-austerity government. Growth in Europe has also disappointed, possibly due to less demand from China.
Safe haven assets have seen an increase in demand this quarter. Government bond yields which had been rising due to inflation worries, came down again. Counterintuitively, those lower yields provide some support for equity prices.
Interest Rates Rising
US Federal Reserve, Jerome Powell, raised interest rates by another 0.25% in June to a new range of 1.5% to 2.0%. With a record low unemployment rate of 3.8% and rising inflation, Trump’s fiscal over-spend means the Fed may have to move more aggressively. Another two hikes are expected this year.
The Bank of England did yet another U turn on a broadcast May rate rise, due to weaker growth and a projected decline in inflation. The pound fell 8% against the dollar from the high in April, thereby guaranteeing inflation will rise again! Punishing savers and rewarding borrowers has created a massive debt build up and inflated asset prices. The long-term consequence will be lower growth with or without Brexit.
The European Central Bank, concerned that Italian debt held by banks throughout Europe might create another crisis for the banking system extended Quantitative Easing (QE) to year end and assured that interest rates would not rise before the second half of 2019. The Bank of Japan continues to print money. In both geographies real interest rates remain severely negative. The two regions are supplying enough liquidity to offset the reversal of QE in the US but that will fade in the second half and remove some liquidity support for asset prices.
Business confidence remains very positive but looks to have peaked. It remains to be seen whether that leads to increased investment which helps growth or is limited to acquisition activity, which doesn’t.
Asset Class Performance
Global equities were mixed in the second quarter. For the UK investor, gains were largely propelled by sterling weakness. In local currency, US equities gained 2.7% in the second quarter and European equities were flat. But in sterling, these markets returned 9.9% and 3.4% respectively. UK equities rose by 9.2%. Emerging Markets were the worst performers, down 2.4% in sterling, as dollar strength made investors fret over their external finances.
Bond yields were mixed depending on whether the relevant central bank was in a mood to raise interest rates. The UK 10-year gilt yield moved from 1.35% to 1.56% then fell to 1.20% before settling at 1.27%. All these large moves were due to unhelpful guidance from the Bank of England regarding the UK’s economic outlook. Other countries showed similar volatility but yields were up where interest rates are rising or are likely to rise. Rates are up in the US due to economic strength and are on the rise in Emerging Markets to defend currencies. Our view remains that buying bonds with negative real yields is unlikely to be rewarding in the long run. All our bond funds hedge currency risk so do not benefit from sterling weakness.
Outlook
Globally, we expect a softer economic patch to continue for several months before firming again. We aren’t forecasting recession but have begun factoring in a more general slowdown from late 2019.
For equities, earnings need to meet or exceed expectations to warrant current valuations in our opinion. We continue to expect bond yields to resume an upward rise if we are truly in a reflationary environment. Central banks will also likely withdraw or reduce Quantitative Easing later this year, creating another headwind for equity and bond markets.
The main cause for concern continues to be Trump’s protectionist measures which are now being met with countermeasures from affected countries. Whilst we believe common sense will eventually prevail, since tariffs hurt everyone, Trump is likely to play hardball in the months leading up to the November mid-term elections. That means appealing to the voters on his two election pledges- immigration and trade.
In our last quarterly overview we noted these issues and reduced risk in portfolios by lightening equity positions. We moved to the lower limit of our risk bands accordingly. The resultant cash from equities was deployed to bonds, absolute return funds, and cash as a hedge against downside risks. We maintain a short maturity stance in bond allocations. This quarter, we retain our current asset allocation, allowing us to perform some fund switches in portfolios without being ‘out of the market’.
Looking at other assets; Property returns are under pressure in London centric portfolios. That tends to lead the rest of the UK and consequently we prefer Infrastructure assets with an international spread. The latter have not yet recovered from a first quarter sell off due to ‘renationalisation’ rhetoric from Corbyn. Yields there are relatively attractive and largely inflation linked so we get paid to wait. Commodities look to have bottomed but are unlikely to rise much generally given the outlook. The recent OPEC deal on increasing oil output should keep a lid on energy prices. We have no direct exposure to physical commodities although some of our managers naturally have periodic exposure to resource stocks.
Our longer-term view remains that ageing populations and a massive debt accumulation, will reduce economic growth and possibly inflation, creating a ceiling on long term interest rates. It is likely that we will take any notable weakness in equity and bond markets to reposition portfolios accordingly.
