Review of the quarter
Both equities and bonds rallied strongly across the world, the opposite of the previous quarter. At the end of last year investors worried about trade wars, rising US interest rates, and slowing world growth. The trigger for the relief was the US Federal Reserve changing stance to become softer on interest rates hikes and ending withdrawal of its quantitative easing program in September. Given that the US mid-term election saw the Democrats take control of the House of Representatives, it was no surprise a protracted federal government shutdown rolled into 2019 as Trump was denied funding for his Mexican wall. Trump is still trying to get a China trade deal done having passed his deadline in March. Soon he will move his tariff policy on to Europe and Japan.
Central banks generally tried to reassure markets that they would remain accommodative. That means continued inaction on removal of quantitative easing or raising interest rates. They can do this because global growth is slowing down and inflation has yet to be a problem. The objective is to supress long term interest rates to push investors in search of yield into riskier assets in the belief that this creates a ‘wealth effect’. Markets responded accordingly but the worry remains that central banks have little firepower left if the economic environment deteriorates significantly. Furthermore, given full employment in the US, UK, Japan, and large parts of Europe, and a rebound in the oil price, what will they do if inflation picks up?
For the recovery in markets to continue, the weakness in global growth will have to recede, extending what has already been a very long economic expansion by historical standards. The weakness in the global economy has been most stark in the manufacturing and export sectors. Eurozone industrial production is down 2.5% since its peak in 2017. Korean and Taiwanese exports both declined about 8% year on year in March. While it is tempting to blame this on the trade war, softer Chinese domestic demand has also been a contributor. The Chinese authorities are now stimulating domestic demand with a package of tax cuts, infrastructure investment and measures designed to support bank credit growth. This should lead to a stabilisation in Chinese growth but the magnitude of stimulus is likely to be less significant than the last time China saved the world from a growth slowdown in 2015-16.
Asset class performance comparison
In sterling terms, the FTSE All-share index returned 9.4% in Q1 compared to the FTSE All-world’s 9.6%. Emerging markets returned 7.9%, MSCI Asia ex Japan 8.9% and Japan 4.4%. Growth stocks outpaced value stocks. UK Government bonds (Gilts) made 3.6%. World corporate bonds returned 5.1%. Sterling rose against the dollar in the quarter which dampened down returns from overseas markets. Best returns came from the S&P 500, up 11.1% in sterling, despite suffering severe earnings downgrades during the quarter. Much relies on a strong rebound in profits in the second half of the year.
Our view has been that economic growth and profits were likely to disappoint this year and this would cause lower valuations. US valuations looked particularly rich to us. After a v shaped market recovery in Q1, this is still the case. In addition, government bonds have got even more expensive. 10-year yields are 2.5% in the US, 1.1% in the UK, 0% in Germany, and -.07% in Japan. You are virtually guaranteed to make a real loss on these bonds for 10 years! Trump’s policies have led to a rapid deterioration in both the US fiscal and trade balances and so we remain underweight dollar assets. We continue to prefer the better long-term dynamics of emerging markets to developed markets, with a focus on the engine of global growth, Asia.
A good result from trade talks is priced into markets so any concerns now are about growth and politics. We think markets are somewhat sanguine on trade, the stock cycle, and company margins. Although we expect some firming of growth in the second half of the year, we think markets are somewhat optimistic. There remains upward pressure on wages and hence inflation, given very low unemployment. Although unlikely, it is possible the US Fed will increase rates again. And the UK, for that matter, should Brexit fears fade.
Outside the US, developed economies are already in low growth mode. China’s rebalancing of its economy has essentially been put on hold as it boosts fixed asset spending to counter slowing growth. However, it has also provided a tax boost to consumers and is encouraging more lending to smaller businesses. The scale of these are rather less than previous bouts of stimulus so whilst good for China, do not necessarily provide growth for the rest of the world. Still, the chances of global recession in 2019 have diminished. We remain concerned about the level of debt and leverage in the system but that looks like an issue for 2020 as the US stimulus fades further.
We did not feel enough value had been revealed in the US by the Q4 correction and it was particularly brief, so we maintained portfolios at the lower end of risk bands in the first quarter. We are therefore underweight equities versus long term allocations and overweight fixed income, absolute return funds, and cash. Within fixed income, we maintain a short duration stance as long term yields are unattractive. Our preference for infrastructure assets over commercial property remains and we believe there is further value in the sector. Commodities are unlikely to rise much given the lack of fixed investment spending globally.
Our long-term view remains that economic growth and inflation will stay in lower ranges compared to history. The search for yield for retirement income will persist. Our job remains to try and provide that whilst not taking undue risk.