Synchronised Global Growth
Synchronised global expansion remained in place in the first quarter, with most lead indicators pointing to continued growth during the rest of the year. Yet, after an initial surge in January, primarily due to US tax reductions and government spending increases, equity markets began falling. Given worries over North Korea have subsided, that leaves Trump’s protectionist policies as the main cause for market concern. Rising US bond yields were also a factor early in the quarter, which tend to have a negative impact on equity prices.
Interest Rate Rises
The new Chairman of the US Federal Reserve, Jerome Powell, raised interest rates by 0.25% in March to a new range of 1.25% to 1.75%. He cited a stronger economic growth outlook as the reason and hinted that the Fed may have to move more aggressively in an economy operating close to full capacity. Inflation in the US is 2.2% against a target of 2.0%.
Back home, the Bank of England, indicated it may raise rates in May. Arguably, the Bank is not doing a very good job. Consumer Price Inflation (CPI) has been above the target of 2% for the last year and closer to 3%. In December, the Bank raised its key rate to 0.5%, the first increase in 10 years, having pre-emptively reduced rates by 0.25% post BREXIT vote in June 2016. This lack of concern for savers 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 has kept Quantitative Easing (QE) going but seems likely to cease in September with rate hikes to follow much later. The Bank of Japan continues to print money. In both geographies real interest rates are negative. Savers are penalised in this environment as they have to pay to keep money in the bank. These two regions are supplying enough liquidity to offset the reversal of QE in the US. That continues to provide support for asset prices at least for now.
Business remains very positive. Merger and acquisition activity has accelerated significantly. Global deal making has surpassed the $1.2tn mark already this year, according to Reuters, up more than 67% from a year ago.
Asset Class Performance
Global equities fell 4.4% in the first quarter, giving back some of last year’s strong gains. European markets fell by 4.7% and the UK by 6.9%. Sterling was up 4.2% versus the dollar and 1.3% against the Euro negatively impacting returns from overseas investments.
Bond yields had a roller coaster ride. The UK 10-year gilt yield started the year below 1.2%, rose above 1.6% in February and fell to 1.35% by end March. These are big moves for bond markets. Other countries showed similar volatility. Our view is that market participants continue to press the same risk off buttons that they have for many years. When equities weaken, buy long term bonds. We think this strategy may no longer be wise. Synchronised global growth remains on track; full employment leads to higher wages and higher inflation. It makes little sense to hold long term bonds when inflation and interest rates are rising. Negative returns have been registered in most long bond categories so far this year, ranging from 0% to -6%. Sterling corporate bonds fell by less, approx 1.5%, indicating investors believe company debt is preferable to government!
The majority of our bond exposure is company related and the maturity profile is short dated, therefore only slightly negative returns were registered. All our bond funds hedge currency risk so were largely unaffected by sterling strength.
We anticipate a year of solid economic global growth, with softer patches in Q2-Q3, based on some of our leading indicators. We have begun factoring in a more general slowdown from late 2019. In equities, earnings will grow but because valuations are already high, earnings need to meet or exceed expectations. The low yields in bond markets are likely to rise if we are truly in a reflationary environment. Central banks will also likely withdraw liquidity created by QE later this year in an environment of rising interest rates. This is likely to create headwinds for equity and bond markets.
The main cause for concern, however, is Trump’s seemingly ad hoc introduction of protectionist measures. These have been met with countermeasures from affected countries. Our central view is that this is unlikely to escalate much, given the supply chain reliance of many US corporates to Asia and the massive holdings of US debt in China. Indeed, the US has demanded a reduction in Chinese tariffs on US cars, increased purchases of US semiconductors and greater access to financial sectors for US firms. Trump’s imposition of $60bn tariffs on some Chinese goods in March was not very specific but immediately impacted stocks that might be subject to retaliation by the Chinese. The same applied in Europe, particularly to Germany’s export stocks. Although we anticipate China and the US will come to some agreement to reduce China’s trade surplus with the US, there is clearly a possibility that Trump truly believes a trade war can be won and things deteriorate further.
From current levels, we do anticipate gains from equity markets this year, although it seems prudent to reduce risk in portfolios a little by lightening equity positions. We maintain a short maturity stance in bond allocations and are adding to positions there as well as to absolute return funds as a hedge against downside risks.
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 use any dramatic weakness in bond markets to reposition portfolios accordingly.
Looking at other assets; Property returns are under pressure in London centric portfolios and consequently we prefer infrastructure assets. The latter have performed poorly recently due to a combination of higher interest rates and ‘renationalisation’ rhetoric from Corbyn. Yields there are relatively attractive in our opinion so we get paid to wait. Commodities look to have bottomed but are unlikely to rise much generally given the outlook so we have no direct exposure there.