Quarterly Review

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Quarter ending December 2019

Our Reviews look back at the markets over the last quarter as well as our thoughts on today's major issues.

Review of the markets over Q4 2019

Three factors helped to generate a wave of investor optimism in October which manifest in a rise in global equity markets. The first was the third cut in US interest rates in 2019 as Jay Powell, chairman of the US Federal Reserve, pointed to uncertainty in the economic outlook. Immediately the US equity market responded and closed the day at a record high. The other factors supporting the rise in global markets were the positive news flow around a possible US-China trade deal and a raft of solid corporate earnings.

Whilst positive investor sentiment is good for equity markets it has the opposite effect on bond markets, which were generally weaker in the month. Bond yields moved higher, with the biggest increase seen in government bonds, reflecting the easing of US-China trade tensions and the signing of a revised Withdrawal Agreement between the UK and the EU which caused an immediate strengthening of sterling. Despite the markets taking comfort from a decreased likelihood of a no-deal exit from the EU on 31 October 2019, the predominance of ‘overseas earners’ caused the FTSE 100 Index to post its worst single day return in more than three years. The move in the value of sterling, together with the release of poor economic data, resulted in the UK equity market posting a negative return over the month.

The improved investor optimism was maintained through November as fears of a global recession continued to fade and some progress was reported in the US-China trade talks. The US equity market was the strongest among the advanced economies, both in local currency and sterling terms, reflecting a more bullish trade outlook, coupled with increased merger and acquisition activity as well as resilient corporate earnings. Across the Atlantic, the UK and European equity markets were also buoyant and there was some evidence of investors choosing to favour shares from ‘cyclical’ rather than the defensive sectors. In contrast, emerging market equities had a mixed month reflecting a maelstrom of economic, political and corporate factors. Meanwhile, fixed interest markets posted another poor month with yields rising as prices fell, although the high yield corporate bond sector performed relatively well reflecting its closer correlation to economic sentiment.

The chances of 2019 being a year of very strong returns, more than making up for the losses suffered in 2018, were enhanced by the avoidance of two significant political risks. News that the US and China had come to an agreement in principal to sign a ‘phase-one’ trade deal on 15 January 2020, thereby avoiding the increase in US tariffs on Chinese goods scheduled to take effect on 15 December, and the US decision not to impose tariffs on EU auto exports helped to support a further rise in equities.

Further support came when on 12 December the Conservative Party secured a working majority in the general election, thereby removing the threat of nationalisation for some utility companies. But perhaps more importantly, Boris Johnson’s election mantra of ‘get Brexit done’ was closer to becoming a reality, providing some respite during the transition period until the end of 2020. UK stocks rose, especially those focused on the domestic economy, and sterling strengthened against the US dollar by over 2%. However, the pound’s initial rally proved short-lived when the government announced that a law would be passed to prohibit any extension to the transition period beyond the end of 2020, giving the government an extremely short period in which to strike a trade deal with the EU and avoid a hard Brexit.

Despite a backdrop of geopolitical disruption and uncertainty, heightened trade tensions and a slowing global economy, 2019 has been a very good year to be invested. However, it should be acknowledged that the actions of central banks in instigating further policy easing has been a major contributor to the strong performance of financial markets. It is unlikely that the same level of reward will be achieved in 2020.

Market Returns to 31 December 2019

Asset Class 3 Months 6 Months 1 Year 3 Years
FTSE All Share 4.2 % 5.5 % 19.2 % 22.0 %
S&P 500 1.3 % 6.3 % 25.7 % 40.3 %
FTSE World Europe ex UK 0.9 % 2.5 % 20.5 % 28.2 %
TOPIX 1.2 % 7.7 % 15.8 % 22.3 %
MSCI Asia ex Japan 4.0 % 2.6 % 13.6 % 33.8 %
MSCI Emerging Markets 4.0 % 2.9 % 13.9 % 29.6 %
UK Gilts -3.9 % 2.1 % 6.9 % 9.5 %
IBOXX Sterling Corp Bond -0.2 % 3.5 % 11.0 % 14.0 %
FTSE EPRA Nareit Global Real Estate -3.9 % 2.5 % 17.8 % 22.0 %
Brent Crude Oil (US$/bl) 8.1 % 5.0 % 30.3 % 23.0 %
GSCI Commodities Index 0.8 % -0.3 % 13.1 % 0.0 %
Gold (US$/ounce) -3.9 % 3.1 % 13.5 % 20.7 %

Source: FE Analytics - rebased in Pounds Sterling

The Outlook

Where will it go from here?

In the first few days of the new year global equity markets were in a buoyant mood, but on 03 January the first geopolitical shock of the year occurred when the US assassinated a senior Iranian military official. This caused an immediate spike in oil prices and global equity markets retreated as investors sought the safety of haven assets such as government bonds and gold. It would be unwise to assume that the lack of any immediate retaliation by Tehran, despite the rhetoric, means that the threat has dissipated, but at the time of writing global markets have rebounded and oil has given back some of its gains as investors have reassessed the likelihood of direct confrontation between the US and Iran.

It is virtually impossible to determine the pattern of events from here and clearly Iran could expedite a number of ‘attacks’ on US assets, possibly including cyber-attacks. The danger is that the situation spirals out of control and the US launches a full-blown military assault on Iran. Capital Economics, a highly respected economics consultancy, estimates that the collapse of the Iranian economy could knock as much as 0.3% off global GDP – equal to its estimate of the impact of the US-China trade war – but it highlights a potentially greater concern which is the possibility that Iran would try and block off the Strait of Hormuz, causing oil prices to spike to as high as $150pb and pushing up global inflation by as much as 3.5-4.0 percentage points in OECD countries. Although this may not automatically predispose a spike in interest rates in the developed world, it is likely to be a different picture in some developing economies. Clearly, any such action by the Iranians would have a broader disruptive impact on shipping and hit overall sentiment thereby deferring any global economic recovery. Furthermore, it is likely that investors would adopt a more cautious approach causing equities to fall and safe-haven assets to rally.

For the moment, it would be helpful to park this additional uncertainty and look at the outlook had the events of 03 January not taken place.

Global growth, asset prices and positioning

It is likely that global growth in 2020 will be slow and steady limiting recession risks, supported by robust labour markets and a degree of carry-over from the easing of monetary policy in 2019 which helped to offset the negative effect of rising trade tensions. It would be unwise to expect interest rates in 2020 to have the same impact upon asset prices and market returns, despite inflation expected to remain relatively benign, although if inflation were to fall further then we could see some further modest policy easing by central banks. This means that economic growth will need to be the key support of risk assets in 2020, and we could see some modest recovery in the first half of the year if global manufacturing begins to pick up from its recent trough and areas such as housing begin to contribute. Some support may also come from fiscal policy, particularly in the UK, the EU, Japan and Emerging Markets.

We expect geopolitical uncertainty to act as a constraint on growth throughout 2020 and caution on US equities could prove to be wise given this year’s presidential elections. If corporate earnings growth stagnates (given the pressure on margins) then current equity valuations may begin to look a little stretched. This would likely limit any upside in share prices and consequently we expect investment returns in 2020 could begin to look mediocre compared with 2019.

However, this may not be the case if markets were to re-price themselves once again, but this requires either some unexpected policy easing or if the reward for (falling) perceptions of risk pushes asset prices higher. Of course, this points to equities and equity-like assets, which still appear to be more attractively priced than other asset classes.

We consider that government bonds, despite low yields, still have a role to play in providing some form of insurance and a buffer in times of stress, as will other diversifiers such as infrastructure and real assets, such as gold.

Diversification will create opportunities to benefit if some of the current geopolitical issues are resolved, especially those linked to trade. The inclusion of exposure to real assets will also provide a buffer in the event of any surprise resurgence in inflation.

In summary, the recent days serve to remind investors that ‘risk remains out there’. They must be prepared for periods of heightened volatility together with the prospect of lower returns, albeit still beating inflation and the return from cash. In this environment investor expectations need to be realistic.

Trends and themes

In November this year, the United Nations’ COP26 climate change conference meets in Glasgow with up to 30,000 delegates expected to attend with the objective of producing an international response to the climate emergency. The stakes are high, and the atmosphere in the negotiations is likely to be tense given the inevitable arguments over phrases or individual words. Although some may consider such events to be a toothless talking shop, even a shallow study of the topic indicates its complexities. Nevertheless, climate change is perhaps the greatest challenge currently faced by mankind.

There is little doubt that investor interest in ‘sustainability’ is growing at a pace. Different opinions will be held on the methodology of bodies such as Extinction Rebellion, schoolchildren going on strike to demonstrate about climate change, the publicity around Greta Thunberg, but all of this should be viewed against a backdrop of repeated extreme weather events around the world.

Some consumers are already responding by rejecting plastic packaging and consuming less meat. Electric vehicle sales are also on the increase, although certainly in the UK the current lack of charging infrastructure is a headwind. There is little doubt as we enter this new decade that we are about to embark on a period of significant change, with regulators and policymakers adding to the momentum. Sustainability positioning will impact the competition for capital, the choice of investment and the construction of portfolios.

It is encouraging that many companies have already embarked on a pathway of change, but this will pose a number of problems for others where the challenges are virtually insurmountable. Investors who seek to adopt a sustainable oriented strategy through their choice of investments will need to ensure that there is substance behind a company’s claim to be delivering an environmental solution – where the reality differs from the headline is a phenomenon known as ‘greenwashing’.

Clearly, there are some current areas of economic activity which will cease to exist as soon as the transition to a sustainable economy has matured, and this demands careful and thorough analysis to be aware of the changes taking place as well as avoiding hidden ‘greenwashing’.

The structure of investment portfolios is likely to change over time with a thematic approach becoming the primary driver of returns. Less attention may be given to the geographic allocation within a portfolio in order to gain access to the companies of tomorrow that have unquestionable sustainability credentials. If(?) we are about to enter a prolonged phase of low growth and low inflation investing in such companies may turn out to be the source of superior returns.

There is little doubt that a shift to a more sustainable economy is underway and this will create both opportunity and risk for companies and investors alike.

Risk warning: Investors should be aware that past performance of investments is not a reliable indicator of future results and that the price of shares and other investments, and the income derived from them may fall as well as rise. The content of this bulletin is for general information and reflects the general market view of Parallel Investment Management Ltd. - it should not be interpreted as recommendations or advice. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of the content.

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