Quarterly Review

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Quarter ending July 2018

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

Market Backdrop

The good news was not to be found everywhere, and the UK equity market soon began to falter in response to upward revisions to US interest rate expectations, as well as some (largely Brexit-related) concerns around the UK’s economic outlook. Adding to the gloom was the collapse of the FTSE 100 construction company, Carillion, which dominated the UK headlines mid-month.

In February those commentators were proved right with global equity markets suffering a sharp correction as government bond yields in the major markets increased, not least in the US. The trigger for this was investors fearing that inflation was on the rise following data which showed that wage growth in the US was ahead of market expectations, and that the tax cuts would widen the US government budget deficit. They knew that rising inflation would lead to an increase in interest rates (which came through in March) and could place at risk the economic growth outlook. Despite the fall-out in the markets, economic indicators suggested a continuation of steady growth with inflation seemingly well contained for now, but one thing was certain: volatility is back. Throughout the whole of 2017 the US S&P 500 Index moved by 1% or more only 10 times, but since the start of February it has done so 17 times. The historical average over the last 60 years of ‘1% days’ has been about one per week.

March will be remembered as the month when the two biggest economies in the world decided to go head-to-head on trade and, understandably, the financial markets didn’t like it. Equity markets in the US, Japan and Germany each fell by about 5% in the week ending 23 March. But it wasn’t just trade-related issues that created a risk-off mood; investors also decided to sell their exposure to the big-tech stocks as the data security scandal concerning Facebook escalated. Of course, a possible trade war carries by far the greater significance for the global economy and as Li Keqiang, the current China Premier, stated at the end of the recent National People’s Congress ‘there are no winners in a trade war’. By the end of March US officials were toning down their rhetoric and appeared to be seeking a deal to avoid tariffs – time will tell?

Market Returns to 30 June 2018

Asset Class 3 Months 6 Months 1 Year 3 Years
FTSE All Share 9.2 % 1.7 % 9.0 % 31.6 %
S&P 500 9.7 % 4.9 % 11.9 % 64.0 %
FTSE World Europe ex UK 3.4 % -1.4 % 2.5 % 40.3 %
TOPIX 3.1 % 0.4 % 9.5 % 48.9 %
MSCI Asia ex Japan 0.5 % -2.4 % 8.1 % 46.0 %
MSCI Emerging Markets -2.2 % -4.4 % 6.5 % 40.3 %
UK Gilts 0.2 % 0.4 % 1.9 % 14.7 %
IBOXX Sterling Corp Bond 0.4 % -1.8 % 0.4 % 17.0 %
IPD UK All Property 2.2 % 4.5 % 10.9 % 27.3 %
Brent Crude Oil (US$/bbl) 24.0 % 26.1 % 66.9 % 13.8 %
GSCI Commodities Index 14.8 % 13.1 % 27.9 % 4.2 %
Gold (US$/ounce) 0.4 % -2.2 % -1.4 % 24.7 %

Source: FE Analytics – rebased in Pounds Sterling

Market Insights

It is hard to believe that we are already at the start of the second quarter of 2018, perhaps reflecting the fact that over the last three months market conditions, the macro-economic backdrop and the geo-political climate have shifted markedly. Given this, it would be reasonable to ask if we have altered the views that we expressed in our last quarterly update. In short, the answer is no, but at the time of writing one of the risk factors has come to dominate the headlines, namely: Any application of protectionist policies by the US could cultivate trade wars.

Trade Wars

President Trump has stated that he wishes to reduce the US annual trade deficit in goods with China from $375bn to $100bn, choosing to ignore the fact that to deliver this ‘immediately’, as is his expressed wish, is economically impossible.

What started off with the appearance of a ‘phoney’ trade war now appears to be more real with US tariffs already introduced on imports of steel and aluminium from certain countries, even though these would have only a marginal impact on China. But since then, President Trump has upped the rhetoric by announcing plans for tariffs on some $50bn worth of Chinese imports and triggering a tit-for-tat response from the Chinese authorities which announced plans to impose tariffs on $50bn worth of US agricultural products, cars, aircraft and whiskey. Immediately, the US responded by announcing the consideration of $100bn worth of additional tariffs on technological goods and aerospace. China’s response to this was to announce that it would fight back ‘at any cost’ with fresh trade measures, if the US continues on its path of protectionism.

Analysts at Oxford Economics estimate that both the US and China would suffer a slowdown in real GDP growth of about 1% and that global economic growth would shrink by about 0.5% in 2019

With President Trump seemingly playing a game of chicken with the US economy one wonders where this will end? Naturally, the hope is that at some point a negotiated settlement will ensue because a full-blown trade war will have damaging consequences. Analysts at Oxford Economics estimate that both the US and China would suffer a slowdown in real GDP growth of about 1% and that global economic growth would shrink by about 0.5% in 2019. It should be no surprise that a spat between the two largest economies in the world has roiled global financial markets, hitting equities, the US dollar and riskier assets such as copper, whilst simultaneously boosting perceived safe-havens such as the Japanese yen and gold.

Already we have seen how the slightest whisper of possible negotiations brings some relief to the markets, but until there is a clear settlement the markets will continue to gyrate. Whatever the outcome, we expect volatility to be a feature of the markets throughout 2018. But, it is worth putting this whole episode in context, and a recent research bulletin from Capital Economics suggests three reasons why, even if the US and China go ahead and levy 25% tariffs on $150bn of each other’s exports, the direct impact on the world economy would be small. These are:

  • $150bn of exports is equivalent to just 0.8% and 1.2% respectively of Gross Domestic Product (GDP) in the US and China, respectively
  • Other major economies are generally not that exposed to the US-China global supply chain
  • Trade of the targeted goods will not simply stop if the tariffs come into force

Of course, this is not to say that the current situation is without risks because increased uncertainty makes financial markets more prone to a sell-off, which could in turn damage business confidence and therefore weigh on global growth.

Tipping Point?

Despite the generally held view that the underlying fundamentals of the global economy remain sound, some recent economic data and business surveys raise the question of whether the global expansion is running out of steam. Notwithstanding the possible impact of an all-out trade war, the consensus view is that global growth may well have peaked although this is not to be mistaken for a marked slowdown.

World trade volumes have been strong since the start of 2018 with both air freight and sea container traffic growth ticking up, although recent survey data suggests that this may also peak relatively soon

Despite retail sales appearing to have contributed little to global growth in Q1, surveys in advanced economies indicate that consumer confidence remains strong, (although it is worth noting that the relationship between confidence surveys and actual household spending has been slowly weakening since early 2017). Furthermore, world trade volumes have been strong since the start of 2018 with both air freight and sea container traffic growth ticking up, although recent survey data suggests that this may also peak soon.

The unemployment rate has levelled off recently in both the US and the UK as both economies nudge towards full employment, although it has continued to fall in the eurozone. It is surprising that average earnings growth in major economies has not been stronger given the increase in employment, and this may be down to productivity. The exception to this is the US where wage growth is clearly strengthening.

Furthermore, underlying (core) inflation is currently still below target in all the major advanced economies except for the UK, and possibly soon the US. We expect to see several interest rate rises in the US in 2018, probably just one increase in the UK, but no change in either the eurozone or Japan.

How Might Markets React?

Having been concerned about rising bond yields (generally indicative of an expectation that interest rates will climb), investor focus has now moved to the potential for corporate profits to be damaged if a trade war materialises. Certainly volatility is back, but the fundamentals have not yet shifted and corporate earnings could act as tailwind to support equities over the next quarter, especially now that the recent retreat in the markets has made equity prices less stretched.

Historically protectionism has boosted inflation which is likely to make interest rate policy setting by the US Federal Reserve more challenging, and lead to periodic bouts of market weakness. Investor confidence could also be shaken by worries over Korea and ongoing Middle East tensions, but we believe that this is probably a healthier investing environment and one which could keep markets buoyant for longer.

Despite this view, we are looking at ways to reduce risk within our portfolios and are seeking potentially less volatile and less market-sensitive positions in asset classes. We are also exploring diversifying away from equities into markets that do not carry the same current risks as bonds, as well as seeking to identify alternatives with low correlation to traditional market risks.

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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