Commentary on September 2018
Share prices recovered from a mid-month sell-off to finish barely changed at the month-end, the exception being the nearly 3% rise (in sterling terms) in Japanese shares. Major bond markets fell by around 1%. All major markets saw further losses in early October.
Several central banks raised interest rates during the month; the most significant being the expected 0.25% rise in the US, the largest being a further 6.52% by Turkey, closely followed by a 5% increase in Argentina’s rates, taking the benchmark interest rate to 65%!
The persistent fall in unemployment, and further signs of rising prices, prompted tougher rhetoric from leading central bankers. President of the European Central Bank, Mario Draghi, commented that whilst measures of underlying inflation remained generally muted, domestic cost pressures were strengthening and broadening. Jerome Powell, Chair of the US Federal Reserve Bank, was more emphatic, warning that he still viewed policy as ‘accommodative’ (in stark contrast to investors’ take on the earlier statement accompanying the rate rise) and that they may need to take rates above the mythical ‘neutral rate’, which was deemed to be a long way off. This caused 10-year Treasury bond yields to rise to 3.25%, their highest in seven years.
The Italian coalition government proposed a budget representing 2.4% of GDP, outside of EU guidelines and significantly higher than previously indicated. Subsequent statements claiming that the deficit would fall to 2.2% and 2% in 2020 and 2021 respectively, were based on some fairly heroic growth assumptions. This pushed Italian 10-year bond yields above 3.5% and hit domestic banking shares.
Brexit continued to dominate domestic news, though still lacking in substance. Theresa May showed anger and defiance after being humiliated by EU leaders, which, combined with some embarrassing Dad-dancing at the party conference, helped stave off any leadership challenge-for now. The voice of doom, Bank of England governor Mark Carney, was wonderfully mis-quoted as warning that a ‘No Deal’ Brexit would wipe a third off of house prices.
Whatever you think of the man, Donald Trump is having some success at Making America Great Again. The economy is growing with more conviction than other developed markets and this is reflected in the divergence between record-breaking US stock-markets and the rest of the world, which is now at historic extremes.
Unfortunately, President Trump isn’t making the rest of the world quite so Great! The combination of a strong dollar and rising US rates is particularly painful for those countries in Asia, Latin America, and Africa that have relied heavily on dollar debt.
In the developed world, monetary tightening is now a reality. Previously the US Federal Reserve, the European Central Bank, the Bank of Japan, and the Bank of England, had together injected an average of $1.2 trillion a year into the global financial system. This stimulus peaked at $1.7 trillion in 2016, but the reduction in bond-buying has gathered pace over the past two years and will fall to minus $500bn in 2019 as the ECB halts bond purchases and the Fed cuts its portfolio of bonds by $50bn a month. This comes at a time when the US Treasury needs to issue a substantial increase in bonds to fund Trump’s tax reforms.
Politics will be to the fore over the coming weeks. Italy will ‘discuss’ its proposed budget with the EU, where the Italians have vowed not to back down, but the EU can’t be seen to condone actions that transgress its deficit rules. Around the same time is the (movable) deadline for the UK and EU agreeing a Brexit deal. Also, fast-approaching are the US Mid-term elections, which could determine the future direction of Trump policy. Opinion is that if Republicans do well then Trump will press ahead with further measures to keep the economy sweet in 2020, the year of the next presidential election, but also the consensus year for a US recession. If Democrats take the votes then Trump is expected to focus more on overseas matters, with ramifications for global trade, or worse!
How are we currently positioned?
We remain underweight fixed interest, preferring equities, property and alternative investments. Where we do hold fixed interest, we mostly use funds that have limited exposure to rising interest rates.
Emerging markets are now at a significant valuation discount, but we may see even cheaper levels as Fed tightening and US$ strength continue to bite. Longer term, valuations always speak for themselves, but we await more extreme levels for an entry point.
Looking forward, bull markets tend to out-last rationale analysis. For this reason, we have to date been reluctant to reduce our overall exposure too aggressively. Rather, we have opted to mitigate the risk by avoiding inflated areas such as technology and high-priced growth stocks, owning more out of favour markets such as Japan and the UK, while gradually increasing exposure to out of favour value and defensive stocks.