Review of the year
2017 was full of political noise but investors pushed risk assets higher. Trump’s approach to politics has been met with incredulity but investors have focused on the potential gains for corporate profits. In Europe, political risk had been well flagged thanks to the UK’s Brexit referendum and the Italian referendum the previous year. 2017 could have been the year populists took control of the monetary union; they didn’t and investors piled into European equities. Korea, Brazil, Zimbabwe and South Africa also had their moments as leaders were pursued for corruption and cronyism. The 19th National Congress of the Communist Party of China saw President Xi Jinping cemented as one of the most powerful Chinese leaders in modern times. The many imbalances threatening economic and financial stability still have to be addressed. Mrs. May called a snap UK election in order to strengthen her political base but a poor campaign and a backlash against a hard Brexit cost her party its majority. In Japan, Shinzo Abe had better luck, winning a snap election in order to secure a new mandate for increasing the public deficit and to allow its military to become more active. Back in Europe, Germany’s general election ended in stalemate and the search continues for a solution. Spain’s problems with Catalonia’s pro-independence movements also continue.
Economic growth was revised up most of the year and 2017 looks like being the best year for growth since 2013. Republicans in the US agreed the long-awaited tax reform bill. Markets rallied on the news, with big permanent cuts for corporations as the centrepiece of the package. Trump’s claims that the package is self-funding are dubious. More likely they will lead to a ballooning of US government debt.
Central banks began changing policy last year
Developed market interest rates continued to rise modestly. In addition to US hikes, other central banks joined in, notably the Bank of Canada and the Bank of England. The European Central Bank kept quantitative easing (QE) going, but did reduce its purchases and announced a further tapering and extension for 2018. The Bank of Japan did not change its policies at all and continues to print money and suppress rates. Emerging markets were a mixed bag. Brazil and Russia were able to cut rates as inflation plummeted. Currency weakness in Turkey and Mexico however forced them to hike rates. Finally, Chinese monetary policy has been somewhat tighter more by market channels than changes to policy rates.
Asset class performance- the currency effect
Global equities were the best performing asset class last year in dollars, up 23%. Corporate bond markets had a decent year as the search for yield continued. In dollars, global high yield bonds returned 10% and quality corporate bonds 9%. Returns, however, differed a lot in terms of investors’ home currencies. Sterling for example was up nearly 10% against the dollar so that would have wiped out gains from bonds and nearly halved global equity returns. It went precisely in the opposite direction against the Euro. The best equity market was Emerging Markets, up 37% in dollars. That masks wildly different performance for the underlying components- China for example beat the index by 20% whilst Russia underperformed by 30%.
The second half of 2017 saw the recovery phase of the cycle accelerate as economies became synchronised in growing. Expectations are for that to continue. That doesn’t mean returns will necessarily follow, given that much of the returns so far have been down to higher valuations- or multiple expansion- in equities. A lot is already priced into markets. Bond markets exhibit very low yields which is curious if we are truly in a reflationary environment. Unfortunately, we can no longer rely on bond markets for an accurate assessment of conditions due to central bank policies of quantitative easing. They have added trillions of money printing to their balance sheets in order to suppress the yields on bonds. This year will see a transition to overall reduction of balance sheets. If inflation rises, interest rates will have to rise at the same time central banks stop buying bonds; that will push up yields. All assets will get repriced in the process. It is therefore important that strong equity earnings expectations are met in order to offset a likely derating process despite strong global growth.
We have already positioned portfolios for this eventuality. We exited virtually all government bonds during 2017 and maintained a shorter bond duration approach, which is more resilient to rising rates. Our view is that with full employment in the US, Japan, UK, and Germany, wages will eventually rise forcing reluctant central banks to normalise interest rates. Portfolios have been conservatively positioned since inception. A focus on quality and good asset allocation has enabled us to produce competitive returns with lower average levels of risk than the peer group. At this stage of the cycle, some repositioning of equities towards cyclical ‘value’ stocks is to be expected.
Our longer-term view remains that ageing populations and a massive debt accumulation, will reduce economic growth and inflation and therefore long-term interest rates. It is therefore likely that we will use any market turbulence to reposition portfolios accordingly.