Hawkish comments from the heads of both the ECB and Bank of England, which followed on from another (widely expected) US interest rate rise, sent bonds and equities into retreat at the end of June and took the shine off what was an otherwise decent quarter in most markets. Though the scale of the sell-off was, thankfully, modest when compared with the infamous 2013 “taper tantrum”, it was enough, in combination with a falling dollar, to put broad global equity benchmarks in negative territory when measured in sterling and euro terms. Outside of the US, bond markets also ended the period in red numbers, as did most commodities, on the back of weaker energy prices. For the second quarter running (and six months in succession), emerging markets outshone their developed counterparts by a comfortable margin.
Equities
Central bankers and politicians were a major focus of investors’ attention for much of the period, with the Federal Reserve revealing plans to begin shrinking its balance sheet, President Trump’s proposed tax reforms, a decisive victory by rising (pro-EU) star Emmanuel Macron in the French presidential contest and UK Prime Minister May’s disastrous decision to call a snap general election all moving the needle to a greater or lesser degree. After a faltering start, markets headed higher throughout the latter part of April and all of May, with the MSCI World Index recording a succession of record highs before topping out in the middle of June. Save for the occasional and very brief upward spike, volatility indicators remained at subdued levels.
Fig1: Eurozone GDP YoY
The quarter’s market movements played out against a backdrop of data flow that, although falling short of expectations in many instances, continued to paint a reasonably healthy picture in the western world. In terms of GDP growth, the upward revision of initial US figures elevated the rolling annualised rate to 2.1%, while the equivalent Eurozone (EZ) measure edged up towards a post-crisis high at 1.9% (Fig. 1). US new jobs numbers, meanwhile, though some way below their cycle peak, remained consistent with an economy at near full employment. Eurozone figures also continued their improving trend. At the same time, the most recent composite purchasing managers indices (PMIs) of 53.6 (US) and 56.8 (EZ) suggested that activity within both manufacturing and service sectors is ticking along very nicely.
Elsewhere, China bears, of which there is certainly no shortage, would have been disappointed by solid economic news from the Middle Kingdom: Q1 GDP improved marginally at 6.9%, the composite PMI was 51.5 (any number above 50 indicates growth) and the 10.7% rise in retail sales pointed to a buoyant consumer sector. Leaving aside perennial questions over the veracity of any official Chinese data, there certainly wasn’t much within these headline numbers to cause concern.
On the corporate front, whereas aggregate normalised earnings for S&P 500 Index companies for Q1 showed a modest (2.01%) decline in the previous quarter, they were up 15% on the corresponding period in 2016. From a sentiment perspective, the proportion of reports in which revenue and earnings met or exceeded consensus forecasts rose to 72.5% and 80.2% respectively. There was a similarly positive tone in both Europe and Japan, where first-quarter results showed their strongest increase for six years. Meanwhile, there was a pronounced fall in merger and acquisition (M&A) activity which, as we have commented on numerous occasions, has provided strong support for equity markets throughout the past few years. As such, it is one of a number of indicators that we watch closely. For the period under review, although the number of transactions was little changed from the previous quarter, their aggregate value declined almost 28%, from USD 1.72 trillion to USD 1.29tn. Does this mean, therefore, that the M&A cycle may be peaking? We certainly can’t rule out this possibility, but recent history suggests that such a large variation is not unusual over shorter periods – there was a 42% drop between Q4 2015 and Q1 2016 for example (Fig. 2). On that basis, it is “wait and see” for us.
Fig2: Global M&A (US$ Trillion)
Whatever the exact point at which we currently find ourselves in the economic and market cycles – though opinions vary greatly, we can safely conclude that it certainly isn’t the beginning! – there can be little doubt that, within a historical context, broad valuation metrics are on the expensive side of fair value in the developed world. This does not, however, mean that equities, as an asset class, are without merit in investment terms. Indeed, drilling down into the headline numbers reveals a wide variation at both geographical and sectoral level. Thus, while we are less enthusiastic about the performance potential for the US, for example, we see plenty of scope for strong returns from Europe and Japan, where the combination of cheaper valuations and superior earnings growth forecasts make for a more attractive proposition. Similarly, while high-quality consumer growth stocks look pricey on a P/E:growth (PEG ratio) basis, the biotech sector (among others) offers significant value. Irrespective of a region’s or individual market’s fundamentals, we believe it particularly important to favour active managers over a passive (index) approach at the mature stages of an investment cycle. Unsurprisingly, bottom-up stock-pickers predominate within the equity components of our portfolios and model solutions.
Bonds
The growing prospect of a shift in central bank policy towards a tighter global monetary regime sent bond market investors onto the back foot in the quarter’s final days, with UK and Eurozone government bond yields, in particular, rising sharply. Whereas the US 10-year Treasury yield closed little changed from its March-end opening level (at 2.31%, down 7 basis points), rates for the equivalent Gilt and Bund jumped to the top of their recent trading ranges to, respectively, 1.26% (+12bps) and 0.47% (+14bps – Fig.3).
Fig3: German 10-Yr Bund Yield
Though modest in nominal terms, the latter’s move from a yield of 0.25% to 0.47% over just four trading days equated to a fall of over 2% in price terms: more than eight times the bond’s annual coupon. As measured by Bloomberg’s >1-year sovereign bond indices, quarterly returns for the US, UK and German markets were +1.16%, -1.35% and 1.22%.
Along with a stronger currency and superior stock market returns in Q2, the Eurozone’s improved economic performance was also manifested in the sovereign debt space by a marked relative outperformance by peripheral nations’ bonds. Even though the reduced rate of asset purchases implied by comments from ECB President Mr Draghi might be construed as a negative in the medium term, yield spreads tightened across the board. In the outer periphery, for example, ten-year yields on Greek and Portuguese paper narrowed by 169bps and 109bps to +496bps (a 33-month low) and 256bps respectively. Meanwhile, Italian and Spanish benchmarks ended the period 29bps (at +169bps) and 27bps (+107bps) tighter vs. Bunds and, even at the very centre, France’s relative borrowing costs tightened by a meaningful amount, ending the period at just 35bps over Bunds, down 29bps on the quarter. Emerging Market bonds outperformed their developed counterparts by a sizeable margin with the broad JP Morgan EMB Total Return Index up 2.21%, thanks in part to a marginal tightening in the average credit spread from 331 bps versus US Treasuries to 328bps. The standout event within the EM debt markets was the successful issue of 100-year bonds by Argentina – a nation that has defaulted on its foreign debt seven times in its 200-year history, five times in the last century that has never gone more than sixty years without reneging on its creditors. The fact that the USD 16bn issue was more than 3½ times subscribed suggests a triumph of hope over experience on an epic scale.
Elsewhere in the fixed income space, a largely unremarkable period for investment grade corporates ended with credit spreads ending the period modestly tighter and, in terms of that tightening European paper marginally outperforming that in the US (-16bps on the broad IG index versus -8bps). There was a similar picture in high yield, where the margin of improvement was greater (-61bps for the broad European HY benchmark and -19bps in the US).
The positive returns delivered by our preferred fixed-income managers in a period during which mainstream bond markets (in the UK and Europe, at least) encountered brisk headwinds is gratifying on a number of levels. Not only does this represent useful outperformance of the prevailing market trend in absolute, relative and risk-adjusted terms, it also suggests that our strategy of selecting fully flexible strategic vehicles and targeting specialised areas of the credit markets, is on the right track. If the move towards “normalised” monetary conditions implied by the quarter’s market movements continues, we remain confident in our preferred managers’ abilities to generate solid, positive returns.
Currencies
The 4.71% fall in the DXY spot index represented the US dollar’s largest quarterly decline since Q3 in 2010 and took the index to a nine-month low (Fig. 4). In terms of individual currency movements, the Danish krone was the biggest gainer among Bloomberg’s list of 17 major currencies (+7.31%), followed by the euro (+6.78%) and Swedish krona (+6.39%). The pound ended the period up 4.12% in US dollar terms, while the Japanese yen (-0.89%) was among a small number of losers headed by the Brazilian real, the 5.59% decline in which reflected the escalating political crisis caused by a wide-reaching corruption scandal.
Fig 4: DXY Dollar Spot Index
Our strategy relating to currencies within our various portfolio models remains unchanged: broadly speaking we are neutrally positioned. While, currencies should, in theory, be one of the easiest calls to make in the world of investments, experience shows that they are anything but. So much for the efficient market theory! Unless, therefore, we have a very strong conviction one way or the other there’s little reward to be gained from neutralising forex exposure through taking an active forex position.
Commodities
Save for strong gains in Lean Hogs (+37.99%) and Wheat (+19.81%) and marginal increases in Copper (+1.75% and Corn (Maize, +1.72%), the commodity sector’s quarterly scorecard was dominated by red numbers, resulting in a loss of 3.00% in the Bloomberg Commodities Index in US dollar terms.
A renewed commitment by OPEC and other prominent petro-nations to keeping a lid on output by extending current quota levels for a further nine months had little, if any, positive effect on an oil market in which inventory levels remained stubbornly high on the back of a ramp-up in onshore US production. As a result, the two leading “front month” contracts – West Texas Intermediate and Brent – ended the quarter down respectively US$4.56 and US$5.32 per barrel in price terms, or -9.01% and -9.84% (Fig. 5). It would appear that the world is awash with both crude oil and refined product and for the time being, is likely to remain so. Accordingly, based on both this “top-down” picture and our recent meeting with a specialist energy manager, we see little prospect of upside in energy prices in the foreseeable future.
Fig 5: Crude Oil (WTI) USD per Barrel
Turning to the precious metals complex, gold ended the period barely changed at US$1,241.55 per Troy ounce, down US$8.80, or 0.40%, after visiting the upper (twice) and lower end of a US$75 trading range during the quarter. This price action took place against the backdrop of a meaningful rise in the aggregate stock of bullion held by exchange-traded funds (ETFs), which increased by 1.8 million troy ounces (3.06%) over the quarter – a second successive increase after a similar advance in Q1. While we would not necessarily expect to include gold within our asset allocation, based on where we sit the very long-term investment/economic cycle, the small allocation within our portfolios is a nod towards the metal’s safe haven properties in times of market stress. As such, it represents a tactical, rather than strategic, position.
[Source: All chart data sourced from Bloomberg – July 2017]
Q2-2017 Market Commentary - International
