Geopolitical events worldwide made concentrating on the markets somewhat difficult during the last quarter. A snap election in June in the UK and the German election at the end of September provided the political bookends to the quarter, certainly as far as the Eurozone was concerned, and while President Trump’s sabre-rattling in the Middle East and the Far East were a continued distraction. The results from the European elections surprised everyone, with the UK Conservatives’ losing their parliamentary majority and forced to enter into a coalition. German Chancellor Angela Merkel succeeded in securing her fourth term, but also has had to enter into coalition negotiations, with her long-term partner pulling out and a surprising increase in support for the far-right party. Throughout the quarter, major storms threatened the US and the Caribbean interrupting oil and refinery supplies. In the US, the promised tax reform is back on the table and may be difficult to pass through the respective houses as the reception was so poor earlier in the year.
World equities enjoyed a positive quarter thanks to a strong July and September either side of a lacklustre August. Emerging markets suffered their first month this year of returns worse than developed markets, but have still outperformed for the year to date. Commodities rallied during the period, but remain down for the year-to-date. The UK 10-year gilt sold off after remarks by the Bank of England’s Monetary Policy Committee, while government yields elsewhere in Europe and the US remained stable.
Politics and Central Bank policy continue to dominate the financial headlines. Mario Draghi has promised to enlighten the markets on the future of European Central Bank (ECB) policy, and the region is holding its breath until 26th October when the ECB governing council next meets.
Stock markets worldwide are at or near all-time highs with volatility at record lows, and few analysts can find anything to be overly concerned about. Although to be fair, much of the optimism is borne out by the buoyant levels of economic activity worldwide. One way of measuring how well economies are doing is the Purchasing Managers’ Index (PMI) which measures the rate at which goods and services are being produced in an economy.
The chart [Fig: 1] shows that all the major regions are growing solidly. A reading above 50 signifies growing economic activity, and below 50 means that activity is stagnating. The higher above 50 the measure reads, the exponentially better the economy is doing.
It has been rare that such economic growth has been so synchronised across regions. The growth in emerging economies, whilst not quite as strong has also been as synchronised.
As shown above, global growth is robust and seems to be sustainable. The OECD estimates that all 46 of the economies that it tracks will see positive growth this year, which has not happened since 2007. Analysts are revising their forecasts for both global and regional growth as a result of this.
The US equity market ended September with its sixth successive monthly rise and the best winning streak for four years. The Republicans’ (Trump’s) tax reform proposals, if passed, are good news for medium and small domestic businesses more than the global conglomerates which have spread their tax bases across many regions. Lowering the corporate tax rate from 35% to 20% is a sweeping measure, and it remains to be seen if the US can actually afford it. However, the market found the prospect favourable and the S&P 500 was up 4.5% for the month of September. The more broadly-based Russell 2000 was even more excited and rose 5.7%.
Janet Yellen, Chair of the Federal Reserve (the Fed), after being somewhat dovish about the future of interest rates, has signalled that the US runs a risk of raising interest rates too slowly and that the stimulus programme which has been in place since the Global Financial Crisis will begin to be reversed.
Despite the potential for concern about this announcement, the US equity market shot up in September driven by energy stocks and financials, the latter a beneficiary of increasing interest rates.
The recent increase in the oil price, after bottoming for the year at the end of June, has been good news for the US, a shale oil producer.
In Europe, equity markets rose in local currency terms as economic data surprised on the upside. Strong demand from the Far East, notably China, saw the basic materials sector lead the pack.
The PMI levels showed an even higher level of growth than many had forecast. Manufacturing activity rose to its highest level since 2011 and job creation hit highs not seen since the statistics began in 1997.
Eurozone GDP is forecast to rise to over 2% in 2017, from a mediocre consensus of 1.4% at the beginning of the year.
Two negatives coming out of Europe were the disappointment of the German election and the condition of the Greek banks.
Although Angela Merkel held on to win her fourth term as German Chancellor, her long-time coalition partner decided to go into opposition and the much-dismissed far-right party, the AfD, romped in with 12.6% of the vote, becoming the third-largest party in the Bundestag.
The soundness of the Greek banks is to be tested by the ECB earlier than was originally announced and may reveal weaknesses that have hitherto only been suspected.
In the UK, the equity market has been more muted than elsewhere in the world, weighed down by the uncertainty of Brexit. Theresa May’s and the Conservatives’ poor showing in the June election further served to dampen enthusiasm during Q3.
However, guidance from the Bank of England, stating that it would start to increase interest rates as early as November, set a hawkish tenor to monetary policy.
At company level, earnings warnings and downward revisions have been increasingly common and other economic data has been inconsistent. UK GDP growth in 2016 was revised downwards to a mere 1.5%.
That stated, a return of 7.8% from the FTSE All Share for the nine months to September is a sound real return, even if poorer than some other developed markets.
Market news from the Far East was influenced by the ongoing spat between the US and North Korea. Any military engagement between the two countries would have lead to a likely increase in volatility across all asset classes. China still shows robust growth, though considerably below the highs of a few years ago. The Central Committee continues to experiment with capitalism and monetary policy and suffered a ratings downgrade from Standard & Poors during September, the first since 1999.
In Japan, following the example set in Europe, Prime Minister Abe announced a surprise election in an effort to boost his position for the next round of “Abenomics”. The election takes place at the end of October and may yield a few surprises, similarly to the Eurozone, as the Governor of Tokyo has founded a new party to take on Mr. Abe in the election.
In emerging markets, equity performance is comfortably ahead of their developed market rivals, although September was the first month in 2017 that they underperformed. Russia and Brazil were the leaders of a poor pack, while Mexico battled to recover from two devastating earthquakes. An increasing oil price helped performance in Russia, a country heavily dependent on resources.
Political tensions, a weakening currency, and faltering consumer confidence led to the JSE All Share in South Africa sliding nearly 1% for September, although it remains a satisfactory 12.6%, up for the year-to-date.
Increasingly hawkish tones from Central Banks worldwide have introduced a note of caution in the fixed interest markets. In the US, the Fed has signalled a return to consideration of rate increases, which seemed to have stalled, as well as a gradual reduction of its balance sheet, which has ballooned since 2009 when QE was first introduced. The interest rate moves have been well-telegraphed and the balance sheet reduction modest, so the short-term effect on long-term interest rates in the US was muted. It is tempting to think that the US 10-year Treasury yield at 2.3% – 2.5% is not in high territory, especially with US inflation running at a similar rate. It is worth remembering, however, that it traded at 1.5%, as little as a year ago.
One note of caution is that the composition of the Fed’s Board of Governors may look entirely different in a year’s time. Janet Yellen’s term ends in February 2018, and several other governors’ terms expire shortly after that. During his election campaign, President Trump stated publicly that Yellen was not his first choice for Chair of the Fed, so it is unlikely that her tenure will be extended. The financial press is already full of speculation about her successor and the change in the team could have far-reaching effects on the direction of policy at the Bank.
In Europe, with the uncertainty of the result of the ECB meeting at the end of October, the German 10-year Bund has oscillated between 0.35% and 0.45% for most of 2017. However, it too was trading at -0.12% a year ago.
In the UK, the guidance coming from the Bank of England has been unequivocal and the reaction of the market more certain. Interest rates seem sure to rise, and the long bond has reacted accordingly moving more than 10 basis points in the quarter and up over half a percent since a year ago.
It is important to note that the investor perception of a 1% change in interest rates is heightened at rates prevailing in the low single digits than it would be in some emerging markets where rates are in the high single digits or even low teens.
After a protracted period of weakness, the US dollar has started to strengthen against most currencies. Sterling’s weakness, post-Brexit, caused it to be the only major currency against which the dollar strengthened this year. However, there were signs towards the end of September that the dollar had turned the corner and was about to show some strength.
In economic theory, currencies move against each other based on the level of prevailing interest rates and/or inflation rates in their host countries. While this may be valid in the very long term, the actual short-term fluctuations of one currency against another can be severe and difficult to explain.
In our global portfolios, we tend not to forecast currencies unless there is an extremely strong and well-supported view in the portfolio management team. Hence, our focus is analysis on the underlying investments rather than the currency in which they are denominated.
The oil price depends on both the policy of the oil-producing countries (both within OPEC and without) and then the willingness of the countries to subscribe to the policy. Several countries seem ambivalent about adhering to the agreed quotas. Hence, supply is impossible to forecast especially with the knowledge that countries store oil above ground in inventory, as well as buy it from drillers. As a result, the oil price in recent years has dropped 50% in 2014, fell a further 33.5% in 2015 and then increased 50% in 2016. So far, the price has been relatively flat in 2017, increasing a mere 3% since the beginning of 2017.
Gold is even more difficult to forecast as it has little industrial use and as a store of value depends on the eye of the beholder. The price increased 10% in the first nine months of 2017, but it was showing weakness in September, falling 2.5%.
The broad-based CRB Index, which reflects a basket of commodities, is down 4.3% for the year so far, but up 5% in the third quarter. As most commodities are priced in US dollars, the price is also subject to fluctuations in the value of the dollar as much as the fundamentals of the underlying commodity.
[Source: All chart data sourced from Bloomberg - October 2017]
Q3-2017 Market Commentary - International