Monthly Update | March 2018
We maintain our focus on economic fundamentals and long-term investment themes following February’s stock market sell-off
6 min read
Stock markets experienced a sudden and dramatic sell-off at the start of February, but recovered steadily over the rest of the month.
The dip followed strong jobs data from the US, which led to concerns that inflation could rise and cause the US Federal Reserve (Fed) to tighten monetary policy sooner than expected. At its lowest point, the S&P 500 fell to levels last seen in November 2017.
Although the major equity indices are gradually regaining their composure, a degree of volatility remains as measured by the VIX Index. We have taken advantage of the fall in UK equities to raise our exposure to the UK from underweight to neutral at what we see as discounted prices. Over the month, the MSCI AC World Index returned -3.5% over February, translating to a loss of -1.1% in sterling terms.
Focusing on the long term
We continue to look beyond short-term noise to longer-term fundamentals, and believe the outlook for equities remains broadly positive due to a supportive macroeconomic backdrop. Typically, markets go up and down as part of a healthy economic cycle, and we see the recent correction as part of the normal pattern of equity investing.
Research shows that bear markets are typically preceded by a US recession. We believe this is unlikely to happen in the next 12 months as the country continues to enjoy a solid economic expansion. Robust company earnings from the final quarter of 2017 also reflect healthy economic conditions, while Trump’s proposed tax cuts have led to upwards revisions for 2018 earnings.
Equity themes continue to play a key role in our investment strategy. We retain a preference for the technology sector, which has been the strongest sector in the S&P500 so far this year. The defensive nature of healthcare stocks, another of our equity themes, meant they didn’t fall as far as other sectors. We remain positive on the sector due to long-term factors such as changing demographic trends.
Senior Portfolio Manager Shanti Kelemen on why we think the long-term economic outlook is unchanged following February’s stock market sell-off.
The release of January’s inflation figures later in the month took bond markets by surprise. US consumer price inflation for January was higher than expected at 0.5%, bringing the annual rate to 2.1%. Meanwhile, UK inflation remained unchanged from December at 3%. Bond yields rose (and prices fell) in response as expectations of further interest rate rises by the Fed and Bank of England increased. At the end of the month, new Fed chief Jerome Powell struck a more hawkish tone than his predecessor, amplifying market expectations of a rise in March.
We maintain a low allocation to government bonds due to their vulnerability to rising interest rates, preferring investment grade and high-yield corporate bonds. We also see opportunities in emerging market debt due to US dollar weakness and falling inflation in emerging economies.
Positive outlook for Europe and Japan
Within international equities, we have a preference for Europe and Japan, which we believe offer more attractive valuations than the US. The eurozone economy grew at its fastest pace for a decade in 2017, rising by 2.5%, according to Eurostat. Meanwhile, the Japanese government maintains a positive outlook on the economy following eight continuous quarters of growth and an ongoing recovery in consumer spending.
The Office for National Statistics said UK economic growth exceeded expectations in the final quarter of 2017, expanding by 0.5% despite ongoing Brexit uncertainty. We topped up our holdings in UK equity to a neutral level in February, taking advantage of market falls to bring our holdings up from their slight underweight position.
Performance (%tr*, local) As of: 28-Feb-18 Current -1M -3M YTD 2017 Developed Equity (MSCI) 1,584.2 -3.5 1.3 19.3 9.6 FTSE All Share 3,982 -3.3 -0.6 7.3 16.8 FTSE 100 7,232 -3.4 -0.5 6.0 19.1 S&P 500 2,714 -3.7 3.0 24.1 12.0 Nasdaq Composite 7,273 -1.7 6.0 36.8 8.9 DJ EuroStoxx 382.4 -3.8 -1.6 12.7 5.0 Nikkei 225 22,068 -4.4 -2.7 17.7 2.4 Hang Seng 30,845 -6.0 6.0 46.0 4.3 Emerging Equity (MSCI) 62,383 -3.9 5.3 34.5 10.1 BRIC (MSCI) 736.4 -4.5 8.6 48.4 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 May August Next Date United States 2.1 1.50 1.75 2.00 21-Mar United Kingdom 3.0 0.50 0.75 0.75 22-Mar Eurozone 1.2 0.00 0.00 0.00 026-Apr Japan 1.4 -0.10 -0.10 -0.10 19-Mar Performance (%tr, local)
As of 28-Feb-18 10-year yield*
2017 US Treasury index 2.87 -0.9 -2.3 -2.4 -1.4 UK gilts index 1.53 0.0 -1.4 -4.0 7.9 Eurozone govt bond index 0.61 -2.1 -2.2 -0.4 -1.4 US investment grade index 3.71 -2.0 -2.7 -1.7 1.8 US high yield index 6.14 -1.4 -1.4 -0.2 12.0 Emerging market index 5.29 -1.1 -3.7 3.0 9.4 Source: Barclays indices; Datastream; *current yield on benchmark 10-year Treasury, gilt and bund respectively Performance (%, Dollar) As Of: 28-Feb-18 Current -1M -3M YTD 16 Commodity index (TR) 180.4 -1.7 3.2 1.9 11.8 Brent oil price (spot) 66.1 -2.5 4.0 19.7 51.6 Gold bullion (spot, per ounce) 1319 -1.7 3.1 14.0 9.0 Industrial metals (TR) 277.2 -2.2 7.0 26.8 19.9 Source: Datastream
Weak dollar, strong performance
The US dollar has fallen steadily against the pound since the end of 2016. The last peak was in January 2017 when $1 was valued at about £0.83. At the beginning of March this year, it sat at about £0.73, a fall of approximately 13%.
Sterling fell dramatically after the EU referendum in 2016, of course, and so some uplift in the sterling-dollar value was inevitable. At Coutts, we moved a number of our assets out of other currencies and into sterling to take advantage of the pound’s historic low. A resurgent sterling has seen that trade begin to pay off.
But sterling strength is not the whole story. Dollar weakness has been a far more significant factor, accounting for about 75% of the move against sterling.
Another way of gauging the strength of the dollar is using a trade-weighted index, which tracks the value of one currency against its trading partners. By this measure, the dollar has fallen 10%, showing that it has been weak not only relative to sterling, but against all its trading partners.
This has been positive for exporters in the S&P 500, boosting performance from our US equity holdings. Our investments in local-currency denominated emerging market debt have also benefitted – as the dollar has fallen, the value of emerging market currencies has risen, boosting the value of these holdings.
President Trump started the dollar on its downward slide shortly after his election victory at the end of 2016, stating that in his view the currency was “too strong” and that American companies could not compete because of it, particularly against the Chinese.
At this year’s World Economic Forum in Davos, Treasury Secretary Steven Mnuchin inflamed the situation when he said a weak dollar was good for the US, raising the prospect of a currency war. In response, the dollar index plummeted to a three-year low.
It staged a brief come back at the end of February, when the new US Federal Reserve chair Jerome Powell outlined his views of the US economy to the House of Representatives. He struck a hawkish tone, painting a picture of a country enjoying substantial growth supported by low unemployment and a growing manufacturing sector. In response markets have priced-in a March rate rise as a near certainty, and the chances of four rises during the year rose dramatically.
The trade-weighted US dollar index bounced by 0.8% in response to the idea that interest rates might rise faster. However, the gains soon evaporated when President Trump announced the imposition of trade tariffs on aluminium and steel. The very negative reaction from the rest of the world to the announcement has been taken by markets as a sign that the US will find it harder to find trading partners, reducing the demand for dollars.
We expect dollar weakness to continue for the time being, supporting our positions in sterling and emerging market debt. Three to four rate rises have already been priced-in by markets so there is little upside to be gained from monetary policy outside of a real economic surprise. And markets might find such a surprise disturbing in its own right.
Measuring market fear
When markets fell at the beginning of February, some commentators blamed funds using trading strategies based on the VIX Index. While there were surely various drivers behind the market falls, it is clear that sales triggered by volatility strategies played a part.
Since its introduction in 1993, the VIX – more formally known as the Chicago Board Options Exchange (CBOE) Volatility Index – has become a popular barometer of investor sentiment and market volatility. Unlike other volatility measures that are based on past price performance, the VIX quantifies market views on the degree of future volatility.
It’s based on the volume of puts and calls on the S&P 500. These are contracts where parties agree to buy or sell shares on a future date at a certain price – basically, they are bets on whether the price will go up or down. The VIX views all of these in aggregate and derives an estimate of investor expectations of price movements over the next 30 days. A high value implies that prices over the next 12 months will be less stable, while a low value implies that prices will be steadier.
Over the past decade, central banks have flooded the markets with liquidity to the extent that they have been perceived to be underwriting asset prices. As a result market conditions have been unusually calm. During 2017, in particular, the VIX was very low. As a result, speculating against a rise in volatility had become a profitable investment strategy.
At the beginning of February, volatility returned to markets, perhaps triggered by US economic data, perhaps by investors taking some profit after strong performance in December and January. As a result, the algorithms that dictated the buying and selling in volatility-based strategies switched strongly to sell, causing markets to fall further. Notably, many traders have blamed the collapse of two exchange-traded products tied to the index for exacerbating the sharp drop in share prices.
Should investors be concerned? At Coutts we believe in looking at market fundamentals rather than sentiment, and currently the economic backdrop remains supportive for equities.
In the meantime, we note that the VIX has spiked 50% above its one-month moving average 15 times since the 1990s, outside of a recession. The average return from the S&P 500 in the following three months on each occasion has been 7%. This suggests that spikes in volatility can be good for investors that hold their nerve and stick to their long-term view.
Coutts House View
US - UK = Europe + Japan + Emerging Markets -
The outlook for the global economy remains tilted towards the positive. Although the momentum of growth may have peaked it remains above trend. Within international equities, we maintain a small overweight to Europe and Japan because of attractive valuations and the ongoing macroeconomic upswing in both regions. We see both markets as offering solid earnings growth potential.
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. We believe long-term returns on such bonds could be poor and vulnerable to rising interest rates, especially as inflation expectations are picking up in the US and Europe.
Within bonds, we prefer credit, and in particular continue to favour financial credit as a theme. We also like emerging market local currency debt because of attractive valuations and income, and believe it will benefit from local currencies appreciating against the US dollar.
After last year’s rate rises the new US Federal Reserve chair Jerome Powell is signalling further rises in 2018, depending on economic data. In the UK, another rate rise looks likely in May but overall we believe rates will remain low for some time. We don’t believe this modest rate rise will have a significant impact on UK households as long as the economic backdrop remains positive.
Alternatives Equity Themes Commodities - Energy INFRASTRUCTURE + Absolute Return + Technology + Property + Banks + Healthcare +
We are underweight commodities, and in particular 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 is neutral at this stage. Economic growth continues to be supportive and a degree of Brexit risk is discounted in the price, but it is hard to see the sector outperforming over the next 12 months..
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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