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Monthly Update | Looking beyond Brexit

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Summary

The US mid-term elections and Brexit dominated the news in November but we think changes in the macro-economic environment are more important to investors.

3 min read

The UK and EU unveiled a draft Brexit agreement and US stock markets rallied following the mid-term elections. But falling oil prices and a potential slowdown in monetary tightening in the US could be more significant for investors.

Brexit bumps along

At the end of November, the UK government published the withdrawal agreement that had been negotiated with the European Union (EU). The publication of a draft political statement earlier in November – defining the direction of travel for the future relationship with the EU – proved controversial. Several ministers resigned in protest, including Brexit secretary Dominic Raab.

When it comes to Brexit, there potentially remains a long and difficult road ahead. Sven Balzer, Head of Investment Strategy at Coutts, says, “We see portfolio diversification as being particularly important during unpredictable times. Our equity holdings are diversified across international markets and we maintain a position in gilts, despite a negative long-term view, that should provide some stability in times of equity market volatility.”

 

Oil prices prove slippery

Oil prices fell by over a third between mid-October and mid-November. Oil prices can be significant to equities. Many companies will see reduced transport and manufacturing costs that will improve their bottom line, potentially improving dividends and boosting share prices, and a lower oil price should also see reduced inflationary pressure.

Energy companies, however, tend to see margins squeezed when oil prices fall. This is particularly relevant for the UK, where energy companies account for about 17% of the FTSE 100. However, more efficient extraction processes and more diverse income streams mean they aren’t as vulnerable to lower prices as they once were.

Oil prices edged higher at the beginning of December, after an agreement between the US and China to negotiate further on trade boosted market optimism. A vote by the Organisation of Petroleum Exporting Companies (OPEC) at their December meeting to limit production is also likely to put upward pressure on prices in 2019, but we don’t expect strong price growth in the immediate future.

“Our equity holdings are diversified across international markets and we maintain a position in gilts, despite a negative long-term view, that should provide some stability in times of equity market volatility.”
Sven Balzer, Head of Investment Strategy, Coutts

Will rate rises slow down in the US?

In a speech at the end of October, US Federal Reserve (Fed) chair Jerome Powell suggested that the relentless cycle of Fed rate rises might come to an end. He said that rates were currently “just below the level that would be neutral for the economy” – in other words close to the point where rates neither spur future growth nor act as a brake.

This suggests that he sees current policy as having its desired effect, reducing the need for further rises.

Sven Balzer says, “Markets have been watching the Fed rate closely this year – market corrections in February and October were at least partly seen as a result of concerns of higher US borrowing costs. Removing that extra pressure should be beneficial for equities, although the Fed continues to be driven by economic data and further rises are by no means out of the question.”

 

Trump’s wings clipped but US economy remains in flight

In the meantime, the US continues to drive global growth.

Mid-term election results that saw the Republicans lose control of the House of Representatives are unlikely to see a change in economic direction. There is broad cross-party consensus for increased infrastructure spending, which should provide some stimulus over the next two years.

President Trump is likely to focus on what he can influence without having to go through Congress. After announcing progress on a trade agreement with China at the G20 conference in early December, global trade is likely to be a focus for him in the coming months.

 

The Italian job

Italy’s populist government defied the European Commission as it stood by its plans to target a budget deficit of 2.4% in 2019. The Italian economy shrunk in October, and the deficit would result in a further increase in its large debt stock as a proportion of GDP. The commission could impose sanctions on Italy if the budget does not change.

Overall, growth in the eurozone remains positive, rising by 1.7% year-on-year in the third quarter. However, the region is vulnerable to a downturn in the business cycle as well as a slowdown in emerging markets, where it draws around 20% of its revenues.

We rotated stocks out of Europe and into the US earlier in the year but maintain a modest preference for Europe over other areas. However, we are continually reviewing our positioning and will watch developments closely.

 

Market movements

In November, the MSCI All Country World Index returned 1.4%, translating to 1.7% for sterling-based investors. Gilts returned -1.3% with yields rising by 4 basis points to 1.47% as prices fell slightly.

  • Chapter 01

    Market Performance

    Source: Datastream, MSCI, rebased to 100

    Important: This graph shows a very isolated period of past performance. For further context of historic performance over the last five years, please click on the “Equity Markets Performance” heading above. As always, past performance should not be taken as a guide to future performance.

    Source: Datastream, MSCI, rebased to 100

    Performance (%tr*, local)

    12 Month performance to end November
    As of:  30-Nov-18 Current -1M -3M YTD 2018 2017 2016 2015 2014
    Developed Equity (MSCI) 1,566.3 1.2 -4.9 20.4 12.9 18.6 11.2 -0.2 15.9
    MSCI UK 2,022 -1.5 -4.9 5.8 5.9 11.1 18.5 -5.9 6.0
    MSCI UK large cap 1,001 -1.3 -3.6 6.7 6.5 11.2 21.1 -9.1 6.2
    S&P 500 2,760 2.0 -4.4 28.1 17.9 18.6 15.4 -0.6 19.7
    Nasdaq Composite 7,331 0.5 -9.4 39.0 25.2 23.7 16.4 4.0 20.6
    DJ EuroStoxx 349.0 -1.1 -7.8 5.8 0.3 23.3 3.6 3.9 13.4
    Nikkei 225 22,351 2.0 -1.5 21.3 20.8 26.0 -3.6 9.4 13.8
    Hang Seng 26,507 6.2 -4.3 29.6 4.4 23.0 16.1 -5.9 4.4
    Emerging Equity (MSCI) 54,947 3.0 -6.1 21.2 3.0 22.2 13.4 -6.8 8.6
    BRIC (MSCI) 647.2 5.3 -3.4 33.3 3.6 26.6 14.5 -6.0 7.8
    Source: Datastream, all returns in local currency; *tr=total return, including reinvested dividends.
    Inflation & Interest Rates Current Inflation (%) Interest Rate Forecasts (%) Rate Announcement
    Current February May Next Date
    United States 2.5 2.25 2.50 2.75 19-Dec
    United Kingdom 2.4 0.75 0.75 0.75 20-Dec
    Eurozone 2.0 0.00 0.00 0.00 13-Dec
    Japan 1.4 -0.10 -0.10 -0.10 20-Dec
    Performance (%tr, local)
    12 month performance to end November
    As of 30-NOV-18 10-year yield*
    -1M
    -3M
    YTD
    2018 2017 2016 2015 2014
    US Treasury index 3.02 0.7 -1.0 -3.0 -3.7 -3.9 1.7 1.2 -0.1
    UK gilts index 1.36 -1.6 -2.6 -5.5 -2.0 -7.2 10.5 5.9 1.9
    Eurozone govt bond index 0.31 -1.0 0.9 -9.6 -9.7 -2.7 6.1 -2.0 0.6
    US investment grade index 4.37 -0.5 -3.0 -5.9 -5.3 -2.3 4.1 -3.4 1.4
    US high yield index 7.22 -1.5 -3.5 -4.6 -3.0 2.4 7.5 -9.1 0.0
    Emerging market index 11.09 -3.1 1.3 -14.0 -15.40 3.8 26.6 -0.3 1.9
    Source: Barclays indices; Datastream; *current yield on benchmark 10-year Treasury, gilt and bund respectively
    Performance (%, Dollar) 12 month performance to end November
    As Of:30-Nov-18 Current -1M -3M YTD 2018 2017 2016 2015 2014
    Commodity index (TR) 171.5 -0.6 -0.8 -3.1 2.6 -0.3 -2.6 -26.0 -6.6
    Brent oil price (spot) 57.5 -23.1 -25.0 4.2 45.1 18.4 2.0 -50.2 -12.2
    Gold bullion (spot, per ounce) 1219 0.3 1.4 5.3 -7.2 -2.9 18.6 -8.1 -8.9
    Industrial metals (TR) 240.0 1.9 -1.7 9.8 -2.4 24.0 3.7 -25.3 -0.4
    Source: Datastream
  • Chapter 03

    Coutts House View

    Equities

    US* -
    UK +
    Europe +
    Japan +
    Emerging Markets =
     * including equity themes the overall US equity exposure is roughly neutral

    We maintain our modest preference for equities over bonds, despite the significant equity market corrections over the final quarter of 2018. We believe that equity markets will recover over the near term as investors re-evaluate their positions in light of a less hawkish US Federal Reserve (Fed) and some flexibility between the US and China on trade. Recent activity indicators in the US still show a resilient economy and low risk of recession. Outside of the US, other developed and emerging markets are feeling the effects of the current cyclical downturn more keenly.  

    Recent falls in the value of the euro and yen should be positive for exporters in Japan and Europe, increasing the value of international earnings, and we have maintained positive positions. While activity in Europe is likely to improve somewhat over the coming months, the US remains the stronghold of economic activity.

    We have an overall positive position in UK equities based on an attractive dividend yield and substantial under-investment by foreign investors. Falling inflation will have helped the purchasing power of UK consumers, which has been under pressure. 

     

    Bonds

    Government -
    Investment Grade -
    Financial Credit +
    Emerging Market Debt +

    Our general view of bonds is that they provide valuable diversification benefits, particularly in volatile markets, and over the summer we invested more in government bonds in anticipation of the changing economic landscape.

    Within bonds, we continue to have exposure to specialised credit themes – such as subordinated financial credit and emerging market local currency debt – due to attractive valuations and income. We have, however, sold our exposure to generic global high yield bonds as our analysis finds them to be unattractive.

    Other Assets

    Alternatives Equity Themes
    Absolute Return
    + Technology
    +
    Property + Banks +
        Healthcare
    +

    We don’t have direct exposure to commodities. Positive economic activity and a weaker US dollar boosted oil prices in the first quarter of the year, and geopolitical events maintained the upward momentum in the latter half. But currently, weaker economic activity and an expected, traditionally weak Q4 and Q1 lead us to see volatile prices over the coming months. The longer-term outlook for gold remains difficult as long as US rates and the US dollar continue on their upward path, although short-term gold (priced in US dollars) may recover somewhat on the basis of a slightly less hawkish Fed.

    We are maintaining our exposure to UK commercial property. Economic growth is still supportive and many associated Brexit risks are already priced in.

    Alternative assets have had a difficult year and we see mixed results across asset classes. We continue to monitor the situation closely.

    When investing, past performance should not be taken as a guide to future performance. The value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment.

Key Takeaways

Brexit appeared to take a step closer to the finish line in November and the US mid-term elections saw President Trump’s Republican Party lose control of the House of Representatives. But falling oil prices and the suggestion of an easing in the US Fed’s programme of rate rises are ultimately more significant for investors.

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