Monthly Investment Perspective
Strong economic growth but interest rates remain low
6 min read
The outlook for the world economy continued to improve in July, with synchronized growth providing a supportive environment for financial markets.
Global equities, as measured by the MSCI All Countries World Index, gained 1.8% over the month (translating to a gain of 1.3% for UK investors).
In the US, the S&P 500 Index reached its highest level since its previous peak set before the dotcom bubble burst in 2000.
Meanwhile, investment flows into European stock markets climbed to their highest level since President Macron’s French election victory in May, although the rise in the value of the euro presents a potential headwind.
A strong mining sector and President Trump’s promises to implement a post-Brexit trade deal with the UK led the FTSE 100 higher towards the end of the month. Benchmark 10-year gilt yields continued to be volatile, ending the month down 3bp.
The UK Consumer Price Index dropped unexpectedly for the first time in nine months, falling from 2.9% in May to 2.6% in June. The Office for National Statistics said the shift was mainly due to lower fuel prices, which reflected weaker global oil prices.
Despite inflation remaining above the Bank of England’s target rate of 2%, the latest figures have thrown into question the chances of an interest rate hike later this year.
The European Central Bank (ECB) said any tightening of monetary policy would be gradual. Its cautious approach reflects the region’s subdued rate of inflation, which fell to 1.3% in June. However, the International Monetary Fund (IMF) revised upwards its 2017 growth forecast for the region on the back of strong performance in the first quarter.
Meanwhile, the EU and Japan announced a proposed trade agreement, representing an advance for free trade after the US pulled out of the Trans-Pacific Partnership.
In the US, Federal Reserve chair Janet Yellen acknowledged the country is facing inflation uncertainty, leaving the reference rate unchanged at the July monetary policy announcement. The dovish tone on inflation led to reduced expectations for a rate rise this year with the chances falling to 38% after the meeting compared to 50% before, according to the price of US rate futures.
In the meantime, the IMF downgraded its 2017 and 2018 growth forecasts for the US economy due to doubts that Trump will be able to implement promised tax cuts. Yellen maintained, however, that the central bank is still on course to raise interest rates gradually as employment conditions improve and consumer confidence increases.
Donald Trump’s setbacks in his attempts to reform US healthcare had little impact on the sector. While some insurers fell, investors appear to have largely priced-in his policy difficulties.
Economic activity is expected to slow slightly over the coming months due to tightening credit conditions in China and the manufacturing slowdown in the US. Trump’s trade stance remains unclear, with the US and China unable to reach a trade agreement after recent talks in Washington. Meanwhile, elections will soon take place in Germany and uncertainty continues to surround Brexit negotiations.
Performance (%tr*, local) As of 31-July-17 Current -1M -3M YTD 16 Developed Equity (MSCI) 1,480.5 1.5 3.1 10.2 9.6 FTSE All Share 4,046 1.2 3.0 6.7 16.8 FTSE 100 7,372 0.9 3.2 5.6 19.1 S&P 500 2,470 2.1 4.1 11.6 12.0 Nasdaq Composite 6,348 3.4 5.3 18.6 8.9 DJ EuroStoxx 374.2 0.4 -0.2 9.6 5.0 Nikkei 225 19,925 -0.5 4.0 5.3 2.4 Hang Seng 27,324 6.6 13.3 27.5 4.3 Emerging Equity (MSCI) 56,555 5.0 9.4 20.7 10.1 BRIC (MSCI) 625.8 7.7 11.9 25.1 8.2 Source: Datastream, all returns in local currency; *tr=total return, including reinvested dividends. Inflation & Interest Rates Current Inflation (%) Interest Rate Forecasts (%) Rate Announcement Current June Sept Next Date United States 2.4 1.25 1.00 1.25 14-Jun United Kingdom 2.3 0.25 0.25 0.25 11-May Eurozone 1.9 0.00 0.00 0.00 08-Jun Japan 0.2 -0.10 -0.10 -0.10 15-Jun Performance (%tr, local) As of: 31-July-17 10-Year Yield* -1M -3M YTD 16 US Treasury index 2.29 0.0 0.1 0.7 -1.4 UK gilts index 1.28 0.5 -1.9 -1.2 7.9 Eurozone govt bond index 0.48 0.7 0.1 3.5 -1.4 US investment grade index 3.12 0.4 1.1 1.8 1.8 US high yield index 5.41 0.6 0.6 2.3 12.0 Emerging market index 5.56 2.8 0.4 1.9 9.4 Source: Barclays Indices; Datastream
*CURRENT YIELD ON BENCHMARK 10-YEAR TREASURY, GILT AND BUND RESPECTIVELY
PERFORMANCE SHOWN AS % TOTAL RETURN IN LOCAL CURRENCY TERMS
*tr=total return, including reinvested dividends.
Performance (%, Dollar) As Of: 31-July-17 Current -1M -3M YTD 16 Commodity index (TR) 171.4 2.3 0.7 -3.1 11.8 Brent oil price (spot) 52.0 10.4 3.2 -5.8 51.6 Gold bullion (spot, per ounce) 1269 2.0 0.1 9.6 9.0 Industrial metals (TR) 242.0 4.1 6.5 10.7 19.9 Source: Datastream
Rising inflation good for banks but we still prefer bonds
Share prices in the financials sector have strengthened gradually this year as inflation has picked up. Rising inflation has increased the chances of interest rate rises, which are good for lenders, leading to gains in UK financials equity.
Traditionally, a bank extends loans to consumers and businesses at an interest rate higher than the one at which it borrowed the money, typically the Bank of England (BoE) base rate. The difference (or spread) between the two drives its profits. When interest rates are low, this spread tends to narrow, which squeezes profit margins.
Rising inflation in recent months has brought with it the potential for rising rates. In July, the monetary policy committee showed the biggest split in voting intentions since May 2011, with three of the eight members voting to raise the base rate – based on inflation of 2.9% for May, well ahead of the BoE’s 2 % target. This trend has encouraged investors to start putting money back into the financials sector.
While a rate rise still seems some time off, we believe the UK financial sector remains in good shape. Notably, many UK financial institutions look financially fit, with the result that their bonds are now more attractively valued than their shares.
Owing largely to increased regulatory capital requirements in the wake of the 2008 financial crisis, balance sheets across the sector are strong and default risk is low. This is true in most developed markets. Our financial credit holdings are focused on large ‘national’ banks where this risk is particularly low.
We believe financial markets are overly discounting default risk in the sector, which makes financial credit valuations attractive. This view is in line with our contrarian investment principle of looking for assets that are inexpensive and may be out of favour with other investors.
Headline inflation not the whole story
The UK’s Consumer Price Index (CPI) dipped unexpectedly to 2.6% in June from 2.9% in May 2017. However, CPI doesn’t tell the whole story about price inflation. Depending on your spending habits, you may be exposed to stronger inflationary pressures.
To calculate CPI, the Office for National Statistics uses a “shopping basket” of around 700 goods and services that people typically spend their money on – from bread and ready-made meals to cinema tickets and the price of a pint at the local pub.
To help our clients understand the impact of inflation on their spending power, we have launched the Coutts Luxury Price Index (CLPI). Like the CPI, it tracks the changing prices of a basket of goods to measure the overall impact of price rises. However, we have created a basket of luxury goods, based on our analysis of the spending habits of Coutts clients.
Over the past 12 months, this measure has increased by 6.2% (in sterling terms). This result is not entirely surprising – luxury goods are scarce and so the laws of supply and demand act on them more acutely. In addition, the weakness of sterling has had a pronounced effect on some sectors, such as ‘Hotels and Travel’, where prices quickly adapt to the spending power of a global audience.
Nobody’s spending will be entirely in line with the CLPI’s basket of luxury goods – your exposure will depend on the proportion of your income you spend on luxuries. We estimate that someone spending half their outgoings on luxuries would be exposed to annual inflation of about 4.6%.
From an investment perspective, higher rates of inflation underline the fact that holding large reserves in cash does not make good financial sense. With interest rates anchored at record lows, inflation could be eroding the value of your wealth more than you thought, depending on your spending habits.
Coutts House View
US - UK - Europe + Japan + Emerging Markets +
The outlook for global equities continues to be positive, supported by a strong US economy and growth in all major global regions. US incomes continue to rise at a modest pace, contributing to consumer spending and growth. President Trump’s plans for cutting taxes and spending on infrastructure could also reinforce domestic growth longer-term should they get through the US congress. However, we see US equities as highly valued.
We believe that UK equities will continue to be supported by a strong economy based on continuing healthy retail and jobs data. While fears of a post-Brexit recession continue to fade, political uncertainty remains after the shock general election result left the UK with a hung parliament. It now looks like the government is more likely to pursue a pragmatic stance towards Brexit negotiations which could prove to be supportive for UK businesses.
We have taken some profits in global equities that have delivered strong returns off the back of sterling weakness and redeployed the proceeds into assets denominated in sterling, which we believe will recover from its historically low level.
Within international equities, we favour Europe and Japan on relatively attractive valuations compared to other major markets and strong global economic activity. We see both as offering superior earnings growth potential supported by an improving manufacturing sector.
Government - Investment Grade - High Yield + Emerging Market Debt +
Our general view of bonds versus equities is that the latter provide the potential for better long-term returns. Although bonds have attractive diversification qualities, we are cautious on government bonds, believing long-term returns could be poor and vulnerable to rising interest rates. The US Federal Reserve has hiked the US reference rate twice so far this year and there is the potential for a further rise before the end of the year. In the UK, we believe rates will remain low for some time, although Bank of England Governor Mark Carney has raised the possibility of the emergency Brexit rate cut being reversed.
Within bonds, we prefer credit over governments, and continue to favour financial credit as a theme. Earlier this year we added emerging market local currency debt to portfolios and funds which we saw as attractively valued for the level of yield available and with the potential to benefit from local currencies appreciating against the US dollar. We believe markets overestimated the protectionist risks presented by President Trump.
Alternatives Equity Themes Commodities - Energy Infrastructure + Absolute Return + Technology + Property + Banks + Healthcare +
We are modestly underweight commodities, and in particular we see limited upside for gold in a rising interest rate environment. We are broadly neutral on oil. Despite an agreement among the OPEC nations to reduce oil production at the start of the year, we still see oversupply as an issue but demand is growing in emerging markets led by India and China.
Our view towards UK commercial property remains positive in the long term. Economic growth continues to be supportive and Brexit risks are discounted in the price, so we are maintaining our property weights.
Alternative asset types with a low or negative correlation to equities can help mitigate the risk of large falls in equity markets and continue to be attractive in our view. For example, absolute return strategies, which we favour, have the potential to make money in a range of market environments.
About Coutts investments
With unstinting focus on client objectives and capital preservation, Coutts Investments provide high-touch investment expertise that centres on diversified solutions and a service-led approach to portfolio management. Our investment process is as disciplined as it is creative – ensuring tailored solutions with robust results.Discover more about Coutts investments