Monthly Update | February 2018
Our monthly update covers the likelihood of a US recession and why the outlook remains healthy despite the recent sell-off
6 min read
Stock markets start 2018 on a high but have since fallen back.
The New Year got off to a strong start as stock markets once again reached record highs, then pulled back in the first week of February as investors took profits. In January, global equities - as measured by the MSCI AC World Index - rose by 4.1%, translating to a gain of 0.5% for UK investors, as sterling strength muted the returns of non-sterling assets. Meanwhile, gilts returned -2.2%.
However, February has seen a stark turnaround with most of January’s gains lost before the first week of the month was over. While investors no doubt found this alarming, we see this as a long-overdue market correction after an extended period of strong performance.
In our view, the global economy continues to be in good health with
Global economy in good health
In the UK, inflation appears to have peaked with December’s number falling slightly to 3
Meanwhile, other data indicated a buoyant UK economy. The UK Purchasing Managers’ Index (PMI – a measure of UK industrial health) rose from 53.8 in November to 54.2 in December, suggesting an improving outlook for British companies. The hourly productivity of UK workers was also on the rise, up 0.9% in the third quarter of 2017, the biggest rise for six years.
The UK economy is faring better than many anticipated, but growth forecasts continue to raise concerns about the post-Brexit environment.
The IMF upgraded its 2018 US growth forecast from 2.3% to 2.7% in January on the basis that tax reforms passed in December would stimulate economic activity. The country’s
Eurozone industrial production exceeded expectations in November, rising by 1%, while unemployment fell to 8.7%, the lowest since 2009. The region’s strengthening outlook has been bolstered by solid performance in Germany, which saw its economy expand by 2.5% in 2017 – the fastest pace in six years and the eighth consecutive year of growth. This makes it the fastest growing of the major economies.
Global growth maintained the positive trajectory seen last year, and in January the IMF raised global growth estimates by 0.1% to 3.7%. This reflected growth surprises in Europe and Asia and the global effect of higher US growth.
Worldwide inflation could be a challenge for investors as growth continues to pick up. As noted in our 2018 investment outlook, Investing Through Disruption, we see inflationary pressures building in both Europe and the US that could chip away at real returns, particularly from poorly performing government bonds.
This environment of ongoing
Global government bond yields also rose (prices fell) towards the end of
Meanwhile, commodities are suffering from oversupply issues, and share prices in the energy sector have lagged rises in oil prices in recent months.
Performance (%tr*, local) As of: 31-Jan-18 Current -1M -3M YTD 16 Developed Equity (MSCI) 1,645.0 3.8 6.7 23.6 9.6 FTSE All Share 4,138 -1.9 1.1 10.9 16.8 FTSE 100 7,534 -2.0 1.1 9.8 19.1 S&P 500 2,824 5.7 10.2 28.8 12.0 Nasdaq Composite 7,411 7.4 10.4 39.2 8.9 DJ EuroStoxx 397.8 3.3 0.3 17.1 5.0 Nikkei 225 23,098 1.5 5.1 23.1 2.4 Hang Seng 32,887 9.9 16.6 55.3 4.3 Emerging Equity (MSCI) 64,978 6.8 8.7 39.9 10.1 BRIC (MSCI) 772.6 10.5 14.4 55.4 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 April July Next Date United States 2.1 1.50 1.75 1.75 21-Mar United Kingdom 3.0 0.50 0.50 0.75 22-Mar Eurozone 1.3 0.00 0.00 0.00 08-Feb Japan 1 -0.10 -0.10 -0.10 19-Mar Performance (%tr, local)
As of 31-Jan-18 10-year yield*
2016 US Treasury index 2.71 -1.6 -1.8 -1.5 -1.4 UK gilts index 1.52 -2.6 -1.4 -4.0 7.9 Eurozone govt bond index 0.64 -0.6 -0.4 1.7 -1.4 US investment grade index 3.45 -1.3 -1.3 0.3 1.8 US high yield index 5.78 0.0 -0.8 1.2 12.0 Emerging market index 5.10 -2.4 -3.5 4.2 9.4 Source: Barclays indices; Datastream; *current yield on benchmark 10-year Treasury, gilt and bund respectively Performance (%, Dollar) As Of: 31-Jan-18 Current -1M -3M YTD 16 Commodity index (TR) 183.5 2.0 4.5 3.7 11.8 Brent oil price (spot) 67.8 1.6 10.5 22.8 51.6 Gold bullion (spot, per ounce) 1342 2.9 5.7 15.9 9.0 Industrial metals (TR) 283.4 0.2 4.9 29.6 19.9 Source: Datastream
US Economy remains strong
As the world’s largest economy, what happens in the US matters for investors everywhere. In addition to being a key export destination, the US dollar is the most widely used currency in global trade and financial transactions.
Research shows that there’s a relationship between the US economy and stock markets – most of the US recessions since the 1950s have coincided with a cautious, bear market. That is why we continuously monitor a variety of indicators for early signs of a US recession.
One of the most reliable barometers of US economic health is the ISM Manufacturing Index. This measures employment, production, inventories, new orders and supplier deliveries. The latest reading is a multi-year high, suggesting activity at manufacturing firms is buoyant.
Other indicators confirm that a US recession is unlikely in the next 12 to 18 months. The unemployment rate is holding steady at a 17-year low of 4.1%, and the return on equity for companies in the S&P 500 suggests decent profits. Meanwhile, the US Financial Conditions Index shows that credit is readily available and remains cheap.
In recent months the bond yield curve has flattened, meaning that the difference between yields on short and long-term bonds has fallen. High longer-dated yields are associated with future growth and inflation expectations, and so when the gap between long and shorter-dated bond yields narrows it implies that investors expect relatively lower growth and inflation in the future.
This is therefore often seen as a sign that a recession is on the way. But in this instance, the flattening of the curve is largely due to technical factors including central bank monetary policies that have impacted longer-term interest rate expectations.
For this reason we don’t believe the current shape of the curve is any cause for concern.
Inflation is another important factor because it has implications for monetary policy, bond yields and asset allocation. Although US prices have been rising, the increases do not appear to be harming the economy. Notably, inflation is low enough that it is not putting additional pressure on the Federal Reserve to raise rates quickly.
In an environment of synchronised global growth, strong financial conditions, decent company profits and low unemployment, we see no US recession on the horizon right now, despite the recent equity sell-off. But we will continue to watch closely for any signs of that changing.
Searching for value in equity markets
Stock markets around the world delivered strong returns in 2017, with several leading indices reaching record highs at the start of 2018, including the S&P 500 and FTSE 100. Despite the recent sell-off, which we see as a market correction rather than a sign of any downturn, we still see plenty of opportunity.
As we outline in our 2018 investment outlook, Investing Through Disruption, our detailed analysis indicates that valuation multiples remain attractive for equities in Europe and Japan as well as the global technology and healthcare sectors.
Europe’s economic recovery appears to be gathering momentum amid a wealth of surveys indicating a rebound in confidence and a boom in manufacturing. In addition, Japan’s economy has now expanded for the past eight quarters, which is the longest stretch of uninterrupted growth since 1994.
The disruption of economic activities through new technology is one of our long-term investment themes. Stellar profits from the US technology giants helped to propel its stock market to new heights last year. The sector continues to look attractive based on strong underlying growth and optimistic earnings forecasts.
Meanwhile, pharmaceutical and healthcare companies are benefiting from long-term global demographic trends including ageing populations and increasing longevity. After some uncertainty in the run-up to the US presidential election in 2016, the sector has stabilised and continues to combine attractive valuations with a positive fundamental outlook.
Coutts House View
US - UK - Europe + Japan + Emerging Markets -
The outlook for the global economy remains positive. Within international equities, we continue to favour Europe and Japan because of attractive valuations and the strong macroeconomic upswing in both regions. We see both markets as offering superior earnings growth potential supported by an improving trade outlook for these export-oriented economies.
We believe UK equities will continue to be supported by the robust global economy. It’s worth remembering that the FTSE 100 generates about 70% of its revenue from outside the country. Sterling has appreciated by 4.5% against the US dollar since the start of the year, which has had a dampening effect on returns. But on the other hand, sterling’s strength should weaken UK inflation going forward and support the UK consumer’s purchasing power, which has been under pressure in the last year.
While fears of a post-Brexit UK recession continue to fade, some political uncertainty remains. However, it now looks like the government is more likely to pursue a pragmatic stance towards Brexit negotiations, which would be supportive for UK businesses and assets. The increased likelihood of a transition period also alleviates near-term fears.
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, especially as inflation expectations are starting to pick up in the US and Europe.
After last year’s rate rises the US Federal Reserve is signalling further rises in 2018, depending on economic data. 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 as long as the economic backdrop remains positive.
Within bonds, we prefer credit over government bonds, and in particular continue to favour subordinated financial credit as a theme. We like emerging market local currency debt because of attractive valuations and income. It will also benefit from local currencies appreciating against the US dollar.
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. Positive economic activity and a weaker US dollar have boosted commodity prices, but upcoming increased supply may limit the upside from here.
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. Ongoing interest in commercial property in London from 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.
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