Monthly Investment Perspective
The Bank of England raises interest rates for first time in a decade while global growth continues to support equities.
6 min read
The global economy continued to expand in November providing a supportive environment for equities.
In the US, the S&P 500, Dow Jones and Nasdaq indices reached new highs. A buoyant services sector lifted the FTSE 100 to a record level at the start of the month before it faltered at month end. In Japan, the Nikkei 225 Index reached a 25-year high, bolstered by strong corporate earnings and the yen’s weakness against the dollar.
Overall, the MSCI World Index climbed 1.3% in local currency terms, although a stronger pound following the Bank of England rate rise negated these gains resulting in a flat return in sterling terms. Meanwhile, gilts rose by 0.3% by the end of the month.
The Bank of England (BoE) raised interest rates from 0.25% to 0.5%, its first rate rise in a decade. The decision reversed the cut imposed after the Brexit vote in 2016. The latest figures from the Office for National Statistics show the UK Consumer Prices Index remained at a five-year high of 3% in October as lower fuel costs were offset by higher food prices. Inflation is now well above the BoE’s 2% inflation target and the economy is proving more robust than expected. However, growth estimates were cut in the Chancellor’s first Autumn Budget, with the projected costs of a post-Brexit transition considered to be a major potential drag on growth.
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The eurozone recovery continues to gather momentum. The region’s economy grew by 2.5% year-on-year in the third quarter, its fastest annual growth rate since the beginning of the sovereign debt crisis. The manufacturing sector continues to provide support for the economy, while eurozone unemployment dropped to 8.9% in September, its lowest level since 2009.
The US economy maintained solid growth in the third quarter, expanding by 3% year-on-year on the back of increased consumer and business spending. President Trump achieved his first major legislative success on 1 December, with the passage of his tax reforms through Congress. This is likely to support equity prices.
Meanwhile, the President announced that the next Federal Reserve chair will be Jerome Powell, who will succeed Janet Yellen when her term ends in February 2018. Powell is expected to continue the Fed’s current strategy of gradual interest rate rises.
Prospects for the global economy look positive, but risks remain. Brexit negotiations continue, with questions mounting over the UK's financial settlement with the EU. Meanwhile, political uncertainty has increased in Germany after coalition talks collapsed between Chancellor Angela Merkel’s Christian Democrats (CDU), the Greens and the Liberal Free Democrats (FDP).
Performance (%tr*, local) As of: 30-Nov-17 Current -1M -3M YTD 16 Developed Equity (MSCI) 1,570.4 1.6 6.7 17.8 9.6 FTSE All Share 4,034 -1.7 -0.3 7.9 16.8 FTSE 100 7,327 -1.8 -0.7 6.6 19.1 S&P 500 2,648 3.1 7.7 20.5 12.0 Nasdaq Composite 6,874 2.3 7.2 29.0 8.9 DJ EuroStoxx 389.7 -2.0 4.9 14.5 5.0 Nikkei 225 22,725 3.3 16.5 20.9 2.4 Hang Seng 29,177 3.4 4.9 37.8 4.3 Emerging Equity (MSCI) 59,489 -0.8 3.5 27.7 10.1 BRIC (MSCI) 680.7 0.6 5.3 36.7 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 Feb May Next Date United States 2.0 1.25 1.50 1.50 13-Dec United Kingdom 3.0 0.50 0.50 0.50 14-Dec Eurozone 1.5 0.00 0.00 0.00 14-Dec Japan 0.2 -0.10 -0.10 -0.10 20-Dec Performance (%tr, local)
As of: 30-Nov-17
-3M YTD 16 US Treasury index 2.42 -0.3 -1.7 -0.1 -1.4 UK gilts index 1.36 0.0 -3.2 -2.7 7.9 Eurozone govt bond index 0.37 -0.3 -2.8 1.9 -1.4 US investment grade index 3.28 -0.6 -1.2 1.0 1.8 US high yield index 5.68 -0.7 -0.4 1.3 12.0 Emerging market index 4.49 -0.9 1.3 7.0 9.4 Source: Barclays indices; Datastream; *current yield on benchmark 10-year Treasury, gilt and bund respectively Performance (%, Dollar) As Of: 30-Nov-17 Current -1M -3M YTD 16 Commodity index (TR) 174.7 -0.5 1.5 -1.2 11.8 Brent oil price (spot) 63.5 3.6 20.6 15.1 51.6 Gold bullion (spot, per ounce) 1279 0.8 -2.8 10.5 9.0 Industrial metals (TR) 259.0 -4.2 -2.4 18.5 19.9 Source: Datastream
Oiling the global economy
Four years ago the oil price appeared stuck above $100 a barrel. But from mid-2014 it dropped precipitously as new supplies from the US, Libya and Iraq emerged at a time of slowing global demand. A stronger dollar and easing of geopolitical tensions also contributed, pushing prices as low as under $30 at the start of 2016.
At the end of last year, the Organisation of Petroleum Exporting Countries (Opec) agreed to cut production in an effort to bolster prices. The group also reached a deal with Russia and other non-Opec states to curb supply. Oil prices surged in response, with Brent crude rising above $55 for the first time in more than a year.
Yet markets have been subdued for most of 2017 owing to the scale of oversupply. Near-record levels of oil inventories in America have also frustrated Opec’s attempts to prop up prices. Meanwhile, the US shale energy industry has helped to insulate the market from cuts to Middle East production.
More recently, oil markets rallied as Opec officials spoke of extending the deal to cut output. The group did just that recently, agreeing to limit output until the end of 2018.
Since production cuts began in January, the price of a barrel of Brent crude oil has risen from about $50 last year to more than $60 today. This rise has been spurred by uncertainty stirred by a sweeping political shake-up in Saudi Arabia as well as escalating tensions with Iran.
Coutts believes oil prices will remain between about $40 and $60 owing to the impact of US shale producers. The recent Opec decision supports prices staying in the higher end of that range – within which oil becomes profitable for US drillers and supply increases. If prices were to fall back towards $40, shale would become uneconomical and producers would withdraw from the market. As a consequence, supply would fall and in time prices should start to rise again.
We have a broadly neutral view on oil. We still see oversupply as an issue, but demand has been strong because of synchronised growth across major economies.
A Great British economy?
Political uncertainty in the UK has risen over the last several months. Brexit negotiations continue to divide politicians across the political spectrum and the government’s small majority makes it vulnerable to rebellions from within its own ranks, raising the possibility of another snap election within the next 12 to 24 months.
Our long-held view is that markets tend to over-react to political turmoil. Events of the last 18 months have shown that markets can bounce back quickly from the initial shock of an electoral surprise.
The FTSE 100 fell 1.5% in the immediate aftermath of the EU referendum result in the summer of 2016, but investors quickly recovered their composure.
It fell again after the snap election in the summer of 2017 saw Theresa May’s Conservative government left with a reduced majority against all expectations. Once again, though, investors quickly got used to the new circumstances.
In the end, UK politics hasn’t had a long-term impact on equities. From the day of the referendum result to its early November peak, the FTSE 100 grew by nearly 20%. Continued global growth and a weak sterling – boosting the overseas returns of the largely multinational companies in the index – have been key drivers of returns.
In the current political climate, a change of government in the event of another snap election is a possibility. But again we would not see this having a major, long-term impact on markets. While current Labour policies represent a clear shift from Conservative policy of the last decade and half, they remain within the mainstream of policy that has produced stable, market-led economies elsewhere.
In the meantime, the UK economy is in reasonably good shape, supported by global growth. GDP expanded by 0.4% in the third quarter (compared with the second), which was faster than expected and up from 0.3% in each of the previous two quarters. The unemployment rate is holding steady as well at a 42-year low of 4.3%. Industrial production has risen ahead of expectations and the country’s trade deficit has narrowed, Office for National Statistics data showed.
It is these fundamental forces that will continue to drive the UK economy. Political noise makes headlines and can lead to short-term shifts of sentiment, but at Coutts we continue to be guided by the macroeconomic view rather than the rumblings of Westminster.
Coutts House View
US - UK - Europe + Japan + Emerging Markets -
The outlook for the global economy and global equities remains positive. Within international equities, we favour Europe and Japan because of relatively attractive valuations and a strong macroeconomic upswing compared to other major markets. We see both as offering superior earnings growth potential supported by an improving trade outlook for these export-oriented economies.
While there remain short-term fears about UK equity following the EU referendum, it’s worth remembering that the FTSE 100 generates about 70% of its revenue from outside the country. We therefore believe UK equities will continue to be supported by the robust global economy. In simple terms, global markets matter more to most large UK companies than developments in Britain.
While fears of a post-Brexit UK 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 should prove supportive for more domestic UK businesses predominantly found within the FTSE 250.
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. We believe that sterling will return to its longer-term levels against other currencies and expect a slow movement back towards our judgment of fair value.
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, despite the reversal of the emergency EU referendum rate cut in November. We don’t believe this modest rate rise will have a significant impact on UK households.
Within bonds, we prefer credit over government bonds, and in particular continue to favour subordinated 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 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. Recent overseas purchases of large London office blocks by overseas investors would appear to support this view.
Alternative asset types with a low or negative correlation to equities can help mitigate the risk of large falls in equity or bond 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
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