Shaun McDade – Director & Head of International Portfolio Management – Latest quarterly market report for portfolio clients and subscribers to our regular updates.
The “most hated equity bull market in history” crept into its ninth year against a backdrop of broadly favourable global economic news flow and positive sentiment over the potential impact of President Trump’s intention to make America great again. The absence of any significant negative events on either the geopolitical or economic front added further to the “feel good” factor, making for a benign market environment in which broad equity and bond indices recorded gains, risk assets in emerging markets (EMs) outperformed their developed counterparts by the widest margin in five years, and the dollar retreated from its December-end highs.
|MSCI World ($)||5.85%||5.32%|
|MSCI World ()||3.57%||9.21%|
|MSCI World (£)||3.74%||27.03%|
|MSCI World (local ccy)||4.91%||6.77%|
|FTSE UK All Share||3.02%||12.45%|
|FT Europe Ex-UK ()||6.50%||-0.14%|
|FT Europe Ex UK ($)||8.00%||-3.04%|
|Japan Topix (¥)||-0.40%||-1.85%|
|FT Pacific Ex-Japan ($)||11.83%||6.58%|
|MSCI Emerging Markets ($)||11.14%||8.58%|
|MSCI Emerging Markets ()||8.75%||12.59%|
|MSCI Emerging Markets (£)||8.93%||30.97%|
Despite no shortage of gloomy comment and punditry within both the specialist financial and mainstream media, there was a palpable sense of calm within equity markets throughout the period under review. Dare we say it – and we could never tire of, or complain about, rising markets – but it was almost boring!
So much so, in fact, that the MSCI World Index did not see a single daily move – up or down – greater than 1.00% over the entire quarter. Moreover, and perhaps ominously, the average daily reading of 11.69 on the VIX Index (measuring implied option volatility on the S&P 500) was the lowest since Q4-2006 (Fig. 1).
Fig.1: VIX Index
As is quite often the case, January began with a pronounced shift in emphasis within markets. Prior to the year-end, value and cyclical stocks had led the advance, buoyed by the hopeful expectation that the planned tax cuts, infrastructure spending and deregulation by the newly-installed US administration would elevate the pace of growth in the US and, by extension, the wider world. With the New Year came a new plan however, so when allocators returned to their desks after the festive season, growth and quality were their new favourite things. It is difficult to pinpoint any specific catalyst for such a shift; indeed, rather than reflect any change in fundamentals, this would appear to be one of those arbitrary, self-fulfilling events that are used by strategists to justify their existence.
There was certainly little from the flow of global economic data to suggest that such a change in tack was necessary. Leading indicators, such as Purchasing Managers Indices (PMIs), all pointed to healthy levels of activity in the major economies’ manufacturing and service sectors, while backward-looking numbers – for example, US and Eurozone employment data, Chinese trade figures, GDP growth across the board – were all within the scope of analysts’ forecasts (Fig. 2). It was only during the latter part of the quarter that one or two of the most watched releases fell short of consensus estimates, but, even then, the data in question was still expansionary, and one could possibly argue that the “disappointment” was more a question of overenthusiasm on the part of the forecasters, rather than any meaningful deterioration in economic fundamentals.
Fig.2: Citigroup G10 Economic Surprise Index
Keeping the equity market pot on a steady simmer, meanwhile, was the continued elevated level of corporate activity: the aggregate volume of M&A transactions, by value, of US$1.8 trillion, surpassed the previous peak set in Q4 of 2015. On the results front, the latest set of quarterly reports was similarly supportive; in the US, for example, the proportion of S&P500 companies with revenues and earnings that met or exceeded forecasts held steady at 63% and 77% respectively. This picture was replicated, to a greater or lesser extent, across other developed markets (DMs), the important common factor being the absence of nasty surprises.
Alongside the aforementioned absence of volatility, the period’s other notable feature was the sharp outperformance by emerging markets. For many – ourselves included – this was somewhat counterintuitive in view of the strong protectionist rhetoric that carried over from the Trump candidacy to his taking office. A 17% increase by the Mexican bolsa in US dollar terms? So much for the efficient market theory! Though modest (but roughly neutral, in benchmark-relative terms), our EM exposure, principally through Latin America and Asia, provided a welcome boost to the performance of our portfolios’ equity component. Perhaps unsurprisingly, given this positive outcome and the context within which it took place, whether it is time to increase that neutral weighting and, if so, by how much and how we look to achieve that, is currently the subject of lively debate among our team.
With the rise in core government debt yields over recent months having reduced the relative valuation gap and, as a consequence, the strength of the TINA argument (“there is no alternative”) for equity ownership, there is no denying that DMs are, by most historical measures, on the wrong side of fair value. It is for this reason that our models’ neutral weightings for the asset class have been ratcheted down by a modest degree following our last two annual strategic allocation meetings. By the same token, a forward P/E of less than 17 for the broad global index (and less than 13 for its EM equivalent) is a long way from the sort of levels typically associated with market cycle peaks and we have yet to see that “melt up” phase that often takes them there. Equally importantly, consensus forecasts provide scope for both further market upside and a reduction in earnings multiples over the medium term; as such, there remains a compelling case for remaining invested. Indeed, our expectation is that those investors of a bearish persuasion who remain on the sidelines are likely to see their plans to get back into the market “after the next big correction” frustrated for some time to come.
Sharp rises in the US, Eurozone and UK annualised inflation rates to, respectively, 2.7%, 2.0% and 2.3% – 5, 5 and 3½ year highs – did little to unsettle core government bond markets, as the increases had pretty much been fully factored in during the preceding months’ price declines (likewise the 0.25% US rate increase). In fact, the yields on the Treasury and Gilt ten-year benchmarks declined over the period by six and ten basis points, to closing marks of 2.39% and 1.14%, respectively.
By contrast, the equivalent German bund climbed 13bps from 0.21% to 0.33%, reflecting speculation over the potential impact of improving economic activity on the ECB’s monetary policies and political uncertainties within the EU. This latter factor was further manifested by a widening in the yield spreads between the sovereign bonds of individual member states and those of Germany (the de facto Eurozone benchmark), which, in the case of France and Italy, backed up at one point to margins not seen since November 2012 and October 2013 (Fig. 3). Following on from the previous quarter’s Italian referendum, a further risk to the status quo came and went when the Dutch general election returned the incumbent to the post of Prime Minister ahead of his far-right challenger. With this potential banana skin avoided, attention has now turned to France’s upcoming presidential contest, in which a prominent anti-EU candidate also poses a threat to both domestic and wider regional political stability.
Fig.3: Italy 10YR Yield vs. Bunds
Elsewhere, in the sovereign bond space, strong inflows of investor capital into emerging market debt mirrored those seen in equities, sending the JP Morgan EM Bond Index up 3.90% in US dollar terms and in so doing recovered all of the precipitous fall seen in the aftermath of the US election result. The Index’s aggregate yield spread versus US Treasuries ended the period down 34bps to 331bps – a 2½ year low. By comparison, there was very little movement in investment grade corporate yield spreads over the quarter in the US, Europe or UK, with those at the very top of the ratings spectrum marginally higher, by a matter of one or two basis points, and those at the bottom up to 8bps lower. Continuing this progression, credit spreads in the US high yield market also tightened (by around 20bps, depending on the particular benchmark), resulting in returns of 2.3% to 2.9% in broad index terms.
As the result of a decline in Treasuries that, from peak to trough, has taken the ten year benchmark yield from 1.36% to 2.63% since July – a 10.3% fall in price terms – US government bonds are actually approaching levels that, by some metrics, could actually be considered relatively attractive according to our favoured strategic bond fund managers. Accordingly, both the proportion of US Treasuries within their portfolios and their share of those portfolios’ duration – interest rate sensitivity – has risen significantly during recent months. At the same time, however, the overall duration of those portfolios has been significantly reduced through the sale of assets from other areas of the bond market (notably high yield), with the result that these funds have de-risked meaningfully over the last quarter. Taking our cue from these managers – who are, to our mind, among the very smartest in the business – we took advantage of market strength during the quarter to further reduce interest rate risk within the fixed income component of our models by selling the one remaining fund among our preferred list with any meaningful exposure to duration.
It is not something one should necessarily bet the farm on, but it is often the case that the kind of benign market backdrop that prevailed over the period under review coincides with a soft dollar; even with the US Federal Reserve hiking US interest rates, on this occasion that proved to be so. Every single one of Bloomberg’s list of “major currencies” appreciated in US dollar terms over the period, with the largest gains recorded by the Mexican peso (+10.69% – Fig.4), South Korean won (+8.00%) and the Taiwanese and Australian dollars (+6.35% and +5.84%). Of the “major majors”, meanwhile (apologies to Joseph Heller), the yen was up 5.00%, while the euro and pound were +2.20% and 2.04% respectively. Spreading the net wider (Bloomberg’s “expanded majors”), only the Turkish lira lost ground versus the US currency. As a result, the trade-weighted DXY Dollar Spot Index ended the quarter down, albeit by a relatively modest 1.82%.
Fig.4: Mexican Peso Vs. USD
Nothing during the quarter, in terms of economic data or geopolitical events, has altered our view that we should maintain a broadly neutral currency policy with respect to our portfolio models. We are, however, keeping a close eye on the French presidential election process, as this has the potential to create serious shockwaves within Europe and has significant implications for the Euro’s standing on the foreign exchanges over both the short- and long-term.
There were mixed returns across the range of commodity complexes, with no real discernible pattern to speak of: Aluminium (+15.92%), Silver (+14.18%) and Cotton (+9.46%) headed the list of winners, while Orange Juice (-20.75%), Natural Gas (-14.34%) and Sugar (-14.10%) were at the opposite end of the returns spectrum.
Broad commodity benchmarks moved lower over the quarter, reflecting a decline in the energy components that make up a sizeable proportion of their underlying weightings. Thus, whereas the Thompson/Reuters CRB and Bloomberg Commodity Indices were down 3.44% and 2.33% respectively in US dollar terms, the Rogers ex-Energy Index recorded a gain of 3.74%.
Crude Oil prices surrendered some of the previous quarter’s gains in response to evidence that non-OPEC production had begun to drift above previously agreed levels (on the plus side, the cartel’s members remained compliant). This was compounded by an unexpected increase in US inventory levels (although the combined stock of crude and refined products actually declined) and an unwinding of non-commercial – i.e. speculative – market positions. The “front month” futures contract for West Texas Intermediate ended the period down 5.81% at US$50.60 per barrel, while the equivalent Brent Crude contract fell 8.40% to US$53.53 bbl. Those closing levels were, in fact, some way above the intra-quarter lows, as expectations of a reversal in the inventory situation began to be factored in towards the end of the period.
Fig.5 Gold USD per Troy Ounce
Elsewhere, a rise of 8.30%, to US$1,249.35 per troy ounce, lifted the Gold bullion price to the middle of its 12-month trading range and some 10.72% above the December lows (Fig. 5). The modest (3.16%) increase in the total holdings owned by exchange traded funds (ETFs) that accompanied this increase suggests that the supply side of the gold market is relatively tight, offering the potential for further upside.MitonOptimal Quarterly Offshore Market Report - Q1, 2017