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Monthly Update | Markets rise and shine

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Summary

Global growth and attractive valuations after the recent stock market sell-off should continue to support equities, but investors must keep an eye on the broader economic picture.

4 min read

Investment markets around the world have benefitted from falling inflation and the US Federal Reserve’s more cautious approach to raising interest rates.

A sunnier disposition but shadows remain

Markets may have been positive over February but the forces that drove investor caution last year remain in play. In this environment, we are looking for outperforming assets within specific sectors, instead of broader sector positions.

Stock markets continued to bounce back in February after a tough end to 2018. We believe there are three key factors currently influencing the outlook for investors – the good, the glad and the (potentially) ugly.

Firstly, the US Federal Reserve (Fed) adopted a more patient approach to raising interest rates, signalling that it would ease off its monetary tightening plans for now. This has given investors more confidence as it reduces the pressure of rising borrowing costs, which should help companies make money and achieve higher share prices. Other central banks have also adopted a softer stance on interest rates, including the Bank of England.

Secondly, investor sentiment, while down in the dumps in December, has recovered to a more-or-less neutral position thanks to optimism over a US-China trade deal and confidence that companies are likely to achieve their earnings targets following downgrades last year. There is still some caution merited as the economy continues to slow, but generally investors like what they see in markets right now.

Thirdly, we see some potential for weakness in the economic fundamentals. Slowing economic growth means earnings are falling and business sentiment is weakening slightly. We are watching these fundamental factors closely as they are the foundations on which markets rise. But it’s worth remembering that, while we’re seeing slower economic growth, it is still growth. And although we’ve reduced our investment in equities to reflect the changing landscape, we still think they’ll make a positive return for investors this year.

 

We turn to Treasuries after Fed change

A dovish Fed and lower inflation expectations have made US Treasuries more attractive in our view.

Recent Fed policies have been negative for Treasuries because rising interest rates diminish the profitability of existing bonds. But recent economic data and the Fed’s change of direction signal lower inflation expectations and slower rate rises – which have the potential to boost government bond returns.

We have therefore taken some cash we raised from selling some equities last year and invested it in these government bonds.

We are actually seeing less aggressive monetary tightening from central banks around the world, which is supporting government bond prices in most developed markets. But we prefer Treasuries to gilts, for example, because UK government bonds have been suffering from Brexit uncertainty.

Our broader position on fixed income remains negative due to the relatively unattractive long-term returns available. But we still see value in their diversification benefits. Government bonds in particular can provide an important safety net during times of potentially higher equity volatility.

“While UK stocks have weakened, we see good value among domestically-oriented companies – typically in the mid-cap space – which should be boosted by a Brexit resolution.”

Europe caught in trade war crossfire

Europe has been hit by difficult circumstances in China, but that’s not the only thing weighing on the economy and we remain cautious for now. We believe weaker global growth will prove challenging for the region and, having reduced our exposure in 2018, we’re sticking to a more-or-less neutral allocation.

European equities continued to bounce back in February, in line with global markets, but results were subdued relative to other developed markets. Growth across Europe remains sluggish as trade tensions continue and China’s economy slows.

Trade concerns have affected demand for European exports, and potential US tariffs on European cars could have an even greater, negative impact across the region.

As the region’s largest economy, Germany’s relationship with China is particularly important. In 2018, the 30 companies included in the DAX stock index made a record 15% of their revenue, or €200 billion, from China. In addition, 5,200 German companies with a total of one million employees are active in China, according to the Federation of German Industries.

 

Brexit uncertainty creates mid-cap opportunities

While UK stocks have weakened, we see good value among domestically-oriented companies – typically in the mid-cap space – which should be boosted by a Brexit resolution.

Brexit continued to dominate the news in February. There seemed to be a new development almost daily, but at the end of the month the Prime Minister had promised MPs a vote on a no-deal Brexit and delaying the departure date if her withdrawal agreement was rejected again.

We bought UK mid-cap stocks after prices hit a three-year low in the December sell-off. When Brexit uncertainty clears, we expect these companies – which tend to focus on the domestic market – to get a boost from a surer economy and stronger sterling. They also have a healthy dividend yield – 3.1%, compared to 4.4% in the FTSE 100, and 2% for America’s S&P 500, as at the end of February.

 

Emerging markets weaken on dollar strength

Emerging markets are vulnerable to a strengthening dollar but emerging market debt still provides attractive income.

After a strong surge in January due to dollar weakness, the MSCI Emerging Markets index was more-or-less flat in February. Total return was just 1.1% in local currency terms – compared to 3.3% for developed equity – and negative for sterling investors due to the stronger pound.

We reduced our exposure in 2018 from a positive to a neutral position, as slowing global growth and a stronger dollar saw the outlook dim somewhat.

We still like the look of emerging market debt, but recently shifted exposure away from local currencies which are vulnerable to a rising dollar. This move has reduced currency risk while allowing us to maintain exposure to attractive yields.

 

Market returns

In the US, the S&P 500 returned 3.2% while the MSCI Europe and Japan indices also provided a solid gain for investors. Despite ongoing concerns over Brexit, a weaker pound boosted the MSCI UK Index – returning 2.3% over the month in sterling terms. Gilts returned -1% and yields rose slightly, reflecting the renewed investor confidence in UK equities.

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.

  • 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 December
    As of:  28-FEB-19 Current -1M -3M YTD 2018 2017 2016 2015 2014
    Developed Equity (MSCI) 1,593.0 3.4 2.2 23.1 -6.9 19.1 9.6 2.6 10.4
    MSCI UK 2,044 2.3 2.2 8.1 -8.8 11.8 19.2 -2.2 0.5
    MSCI UK large cap 1,006 2.4 1.8 8.5 -7.7 11.5 22.8 -3.9 -0.8
    S&P 500 2,784 3.2 1.4 29.9 -4.4 21.8 12.0 1.4 13.7
    Nasdaq Composite 7,533 3.6 3.1 43.3 -2.8 29.6 8.9 7.0 14.7
    DJ EuroStoxx 362.5 4.1 4.3 10.3 -12.1 13.4 5.0 11.1 5.0
    Nikkei 225 21,385 3.0 -4.1 16.4 -10.3 21.3 2.4 11.0 9.0
    Hang Seng 28,633 2.7 8.3 40.4 -10.5 41.3 4.3 -3.9 5.5
    Emerging Equity (MSCI) 57,786 1.1 5.7 28.1 -9.7 31.0 10.1 -5.4 5.6
    BRIC (MSCI) 685.4 1.7 6.3 41.7 -8.9 40.6 8.2 -5.3 5.8
    Source: Datastream, all returns in local currency; *tr=total return, including reinvested dividends.
    Inflation & Interest Rates Current Inflation (%) Interest Rate Forecasts (%) Rate Announcement
    Current April July Next Date
    United States 1.6 2.50 2.50 2.50 20-Mar
    United Kingdom 1.8 0.75 0.75 0.75 21-Mar
    Eurozone 1.5 0.00 0.00 0.00 07-Mar
    Japan 0.2 -0.10 -0.10 -0.10 26-Mar
    Performance (%tr, local)
    12 month performance to end December
    As of 28-Feb-19 10-year yield*
    -1M
    -3M
    YTD
    2018 2017 2016 2015 2014
    US Treasury index 2.72 -0.5 1.8 -1.2 -1.2 0.1 -1.4 -1.6 2.6
    UK gilts index 1.31 -1.2 1.6 -4.0 -2.0 -1.5 7.9 -2.3 10.7
    Eurozone govt bond index 0.19 -0.2 4.8 -5.2 -9.5 2.3 -1.4 3.4 -1.6
    US investment grade index 3.91 -0.1 3.2 -2.9 -6.4 1.6 1.8 -5.6 2.2
    US high yield index 6.54 1.3 2.4 -2.4 -8.3 1.1 12.0 -10.1 -4.3
    Emerging market index 11.15 -2.7 -0.4 -14.4 -22.6 6.8 9.4 20.6 -8.2
    Source: Barclays indices; Datastream; *current yield on benchmark 10-year Treasury, gilt and bund respectively
    Performance (%, Dollar) 12 month performance to end December
    As Of:28-Feb-19 Current -1M -3M YTD 2018 2017 2016 2015 2014
    Commodity index (TR) 170.1 1.0 -0.8 -3.9 -11.3 1.7 11.8 -24.7 -17.0
    Brent oil price (spot) 65.0 4.1 13.1 17.8 -24.2 20.9 51.6 -33.5 -50.3
    Gold bullion (spot, per ounce) 1316 -0.5 7.9 13.7 -1.7 12.6 9.0 -10.5 -1.8
    Industrial metals (TR) 254.6 3.5 6.1 16.5 -19.5 29.4 19.9 -26.9 -6.9
    Source: Datastream
  • Chapter 03

    Coutts House View

    Equities

    US -
    UK +
    Europe -
    Japan =
    Emerging Markets =

    The short-term outlook continues to be better than at the end of 2018 as central banks – and in particular the US Federal Reserve – signal a pause in interest rate rises for now. Economic indicators still show an ongoing slowdown in global economic growth, but we are monitoring our indicators for any potential stabilisation or reversal.

    In a typical balanced portfolio, our overall position on equities is marginally below neutral. We are holding cash to allow us to move quickly when we see investment opportunities in the event of a pull-back after the steep rebound we’ve seen so far this year.  

    Within equities, two themes continue to play a key role. The long-term investment case for the health care and technology sectors is supported by continued innovation and demand created by demographic trends.

    Portfolios are tilted towards developed markets and we have gradually positioned them to favour those that look more attractive in a slower-growth environment. We have a small, positive position in UK equities based on attractive dividend yields and substantial under-investment by foreign investors. In February, international investors started to slowly come back to UK equities, which is an encouraging development.

    We are neutral on Japan and have a cautious view on Europe, which we see as vulnerable to any further economic or political instability.

    We are also neutral on emerging market equities. While we continue to monitor developments in the trade negotiations between the US and China – the progress of which could benefit such stocks – we believe that most of the positive news is already priced in.

     

    Bonds

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

    Government bonds provide valuable diversification benefits, particularly in volatile markets, so we increased our investments in US and UK bonds throughout 2018 and in January. Overall, though, our government bond position is still negative.

    Outside of government bonds, we continue to invest in specialised credit themes – such as subordinated financial credit and emerging market debt – based on attractive valuations and income, and positive prospects over the medium term. In emerging market debt, we hold local currency government bonds and short-dated corporate bonds, as valuations are attractive and the trade negotiation progress provides some support.

    Other Assets

    Alternatives Equity Themes
    Absolute Return
    + Technology
    +
    Property + Health care
    +

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

    Absolute return strategies had a difficult 2018 and our conviction in their value as diversifiers in difficult markets has diminished. But we continue to hold some specific investments and remain on the lookout for attractive diversifiers.

    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

Most markets were up in February as the US Federal Reserve signalled a softer approach to interest rate rises and investor confidence returned.

But the factors that fostered fear at the end of 2018 remain in play – slower economic growth and uncertainty brought on by the trade war, China and Brexit.

Overall, we still see an environment that’s positive for long-term investing, with fresh opportunities across the world. These include good value UK mid-cap companies for potentially growing a portfolio, and more stable US Treasuries for potentially preserving it against equity volatility.

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