Quarterly Offshore Report – Q4, 2017

There’s plenty of life in the old dog yet! Despite approaching its tenth year, the bull market in equities showed no signs of slowing during the quarter under review, as global indices recorded a succession of all-time highs against a backdrop of healthy corporate earnings growth and favourable economic conditions. Interest rate hikes and reduced quantitative easing from western Central Banks signalled further movement down the long road towards a normalisation in global monetary conditions, amid signs from bond markets of a possible peak in the credit cycle. Strength in commodities, meanwhile, signalled a renewed confidence in the outlook for a continued synchronised global expansion, as the US Dollar ceded further ground on the foreign exchanges. Concern over President Trump’s antagonistic tone towards an increasingly isolated (and nuclear-capable!) North Korea was offset by enthusiasm over prospective US tax reforms.

Equities

Another positive quarter without a meaningful correction lifted global developed market indices to new highs, while those in the emerging world extended their run of outperformance.

In terms of market movements, Q4 was largely uneventful and, save for a brief pause during the first half of November, the MSCI trundled steadily higher throughout. Much of the markets’ stability was attributable to an almost uninterrupted flow of global economic releases that either met or exceeded consensus forecasts. Among these, and perhaps the most watched of the data, the latest monthly PMI (purchasing managers’ index) reports indicated a continued healthy level of service sector and manufacturing activity in the US, Eurozone and China at levels of 54.5, 57.5 and 51.6 respectively. Q3 GDP numbers showing growth of 3.2%, 0.6% (2.6% y-o-y) and 6.8% for these economies were similarly well received, as was the report from Japan, where the 0.6% quarterly figure translated to an annualised 2.1% and maintained the progress seen since early 2016 (Fig. 1).

Accompanying this favourable economic news flow was an equally positive stream of corporate results, which, according to figures published by Bloomberg, saw global earnings advance by 25.3% over 2016’s corresponding quarter. More impressively, the same comparison for emerging market companies yielded a 42.6% improvement (wow!) and, importantly, even after stripping out exceptional items, growth in both sets of operating earnings was equally strong. Though much is made by commentators – particularly those of a bearish disposition – of prevailing valuation levels within the context of historical averages (cyclically adjusted or otherwise), it’s worth noting that, based on a metric such as the PEG Ratio (P/E : growth), global equities in aggregate don’t actually look excessively priced. Having said that, irrespective of what the current forecasts may suggest, it’s difficult to imagine a repeat of the past year’s progress over the next twelve months. Indeed, 2017 has been unique among recent years in that, unlike the usual pattern of events, initial consensus earnings forecasts proved entirely realistic and were not downgraded over time. Based on past history, it would be unrealistic to expect the same again. If that sounds like we’re sitting on the fence as far as our market outlook is concerned, that’s probably about right; while we see plenty of opportunity at a bottom-up stock level, markets appear fully (but, n.b. not excessively) valued and the absence of a meaningful (5%) correction for almost two years makes us a little nervous in the short-term.

Following recent changes, that leaves us neutrally weighted in equities within our models, albeit with a greater exposure to long/short managers than previously, which has been achieved at the expense of scaling back on conventional long-only managers. Within that overall exposure, we are underweight in the US (where valuations are highest) versus the global benchmark index and correspondingly overweight in Asia and emerging markets (specifically Asian emerging markets), where ratings are cheapest and growth rates higher.

Bonds

With the 25bps increases in US and UK interest rates seen during the quarter and the ECB’s decision to scale back its asset purchase programme (by half, to €30billion per month) having been almost completely discounted by investors well in advance of each event, core government bond markets delivered few, if any, surprises during the period under review. Ten-year benchmark yields in the US and Eurozone traded within narrow ranges throughout the quarter to end little changed at 2.41% (+7bps) and 0.43% (-4bps) respectively, with the corresponding Bloomberg (>1year) Government Bond indices up marginally at +0.05% and +0.03%. Disguised by these modest headline numbers was a further shift in the profile of the US Treasury maturity curve, with the 2yr : 10yr yield spread declining from 85bps to 52bps, to continue the curve’s flattening over the course of the year (Fig. 2) and signalling expectations of additional future rate rises. By contrast, comments accompanying the Bank of England’s first rate rise since Q3 2007, suggesting that the pace of future tightening may be slower than previously anticipated, made for a rally in Sterling bonds that sent the 10yr Gilt yield down 17bps and the Bloomberg market index up 2.22% over the quarter.

Whereas a tightening of yield differentials seen within the majority of credit markets during the period under review was entirely consistent with the prevailing “risk-on” environment, notable exceptions to this broad picture were the high yield (HY) markets in both the US and Europe, where, depending on the particular benchmark used, spreads widened by between 5bps and 20bps. Might this move against the general trend signal a watershed in the fortunes of HY bonds? Having seen the strategic bond fund managers with whom we either invest or follow closely cut the HY exposure in their portfolios during recent months to the lowest levels in the ten or so years since their funds were launched, it is not inconceivable that this is the case (Fig. 3).

At the risk of stating the obvious, the onset of a normalisation in global monetary policy and a maturing (peaking?) credit cycle are not macro factors that are synonymous with a bond-friendly environment. Equally importantly, however, since any interest rate rises are likely to be small and gradual and the economic/corporate environment remains supportive of even “post-peak” credit, this does not, in our view, signal the beginning of an abrupt turning point in bond markets. Moreover, as demonstrated by the performance of our preferred funds over the past quarter and year, it is entirely possible to generate meaningful returns from this asset class within a flat or even declining market. As such, exposure to this asset class within a multi-asset portfolio is not only desirable for its diversification benefits, but also for the returns that can be delivered by the right managers. For us, those are managers who operate with a flexible mandate that takes in the widest possible range of instruments and hedging strategies, or those with a defined and exploitable edge that operate within niche market areas.

Currencies

As we have occasionally commented, although currencies should be amongst the easier things in financial markets to predict, attempting to do so can make a chump of even the smartest and most informed of forecasters (it’s why, as a rule, we don’t take active currency positions and also why there aren’t any consistently successful currency funds that we’re aware of). And so it was that, despite an interest rate hike, stronger than expected economic performance and the prospect of large-scale capital repatriation prompted by changes in US tax legislation, the US Dollar lost 1.02%, as measured by the DXY Spot Index, over the quarter under review.

Of the 17 “major currencies” listed by Bloomberg, the South African Rand was the quarter’s biggest winner, gaining 9.50% in USD terms. This represented a remarkable turnaround, as the prospect of a debt rating downgrade and concern over the outcome of the ruling African National Congress party’s December leadership election had seen the currency weaken by as much as 6.30% during the first half of the period under review. The only other gainer of any note was the South Korean Won (+6.98%), which extended the gains seen earlier in the year to hit a 3+ year high on the back of a strong upturn in exports. At the other end of the scale, questions over the future of NAFTA put the Mexican Peso (-7.14%) under selling pressure, while internal political issues relating to an ongoing corruption scandal sent the Brazilian Real 4.12% lower in US Dollar terms. In the middle of this range, the Euro (+1.17%) Pound (+0.37%) and Yen (-0.16%) were little changed.

Though its credentials as a “proper” currency are questionable and it certainly isn’t investable for us, it would be remiss of us to ignore cryptocurrencies, after a quarter in which they received more coverage in the mainstream and financial media than ever before and, on that basis alone, gained a greater degree of legitimacy from investors’ perspective. There is no question that the existence of a medium of exchange that has both a finite supply and is immune to the whims of central bankers is both conceptually sound and, in the era of QE, positively desirable. Similarly, the potentially transformational impact of the blockchain technology that creates them is, in our view, beyond dispute. As innovative and exciting as their long-term outlook may be, however, the frenzy surrounding Bitcoin et al. has eclipsed (perhaps even undermined) those attributes by turning them into a plain old-fashioned speculative bubble. New and exciting they may be, but the (spookily accurate) comparison between Bitcoin’s price chart and Dr John-Paul Rodrigue’s textbook classic “Stages of a Bubble” would seem to suggest that, in terms of “investor” behaviour at least, there’s nothing new under the sun (Fig. 4).

Commodities

A double-digit surge in the price of crude oil propelled broad commodity benchmarks to healthy gains; the Bloomberg Commodities Index was up 4.71% in US Dollar terms, while the Rogers ex-Energy Index gained a more modest 2.00%.

Although the growth, development and demand/supply dynamics of “new” energy (fracking) within the US and the influence of geopolitical events means that movements in the benchmark West Texas Intermediate and Brent oil contracts are not always synchronous, the quarter under review was not one of those instances, suggesting that the respective 16.93% and 18.75% increases in their front-month prices were due to structural, as opposed to localised, factors. Interestingly, whereas the rise in WTI to a closing level and 2 ½ year high of $60.42 per barrel signalled a break out from a long-established $40 – $55 trading range, the quarter’s market action assumes far less significance from a technical perspective when measured in, for example, Euros (Fig. 5). On that basis, while the recent big drawdowns in inventory levels of both crude and refined products, together with rising demand forecasts, are certainly supportive, talk of a new bull market in energy is perhaps a little premature.

As our in-house commodity specialist often reminds us: industrials are driven by macro, agriculturals by weather and energy by politics. Rises in base metal prices (Nickel +21.52%, Copper +11.69%, Aluminium 7.90%) thus pointed to a positive shift in the outlook for global growth (supported by recent upgrades in IMF forecasts). Meanwhile, the divergent moves in Cotton (+13.82%), Sugar (+7.52%), Soybeans (-2.89%), Coffee (-4.01%) and Corn (Maize -4.89%) reflected shifts in the balance between stock levels and crop forecasts.

Finally, a brief word on Gold (+1.56% to $1,303.05 per troy ounce for the quarter). Though it may have been usurped by the likes of Bitcoin as the vehicle of choice for investors that don’t like, or even actively avoid, conventional assets, we maintain our faith in Gold’s attributes as a diversifier and a safe haven asset. Such has been the benign nature of the market environment that has prevailed for the past twelve months, however, that neither of these qualities has been tested for some while. Accordingly, Gold remains a holding within our portfolios.

[Source: All chart data sourced from Bloomberg – October 2017]

MitonOptimal Quarterly Client Report Q4-2017