Investment Review Quarter 1 2017

Market Review

Investment markets started 2017 with momentum. Supported by positive global growth data, rising inflation, and stimulated further by Donald Trump, promising huge tax cuts and infrastructure spending. Markets showed a lot of belief that the world had progressed from the low growth, low inflation, low interest rate world we have endured since 2008, and optimism soared on the back of growth for reasons beyond government backed fiscal manipulation.

It doesn’t seem like that long ago we were worrying about low growth and deflation (falling prices) but now the buzzword “reflation” (strong economic growth and rising inflation) is heard on a daily basis. The earlier pessimism was unwarranted, and we believe the current optimism will prove likewise. Let’s not forget that despite the talk, Mr Trump has achieved less than any other US President in his first two months in office. As we will discuss in our outlook, whilst we are not negative on the medium term outlook, we worry that expectations are still running ahead of reality; leading to the risk of disappointment.

It probably won’t surprise you that we’ve have been cautious ever since the Trump election. Primarily this is due to the big difference between talking and acting, especially when US Congress is involved. In Q4 we wrote “there are still some significant hoops to jump through before all this change is implemented, so investors need to be careful not to go gung-ho”. Of course, they did through January and February, before starting to come round to reality in March. Overall though, Q1 2017 was a good quarter for all equity markets, with the UK and US up 3.65% and 4.28% respectively.

Staying over the pond, we also saw another interest rate increase from the US Federal Reserve; the second in the same number of policy meetings. Interest rates are normally increased when an economy is thought to be booming, but in this case we believe the action is more aimed at providing flexibility when the next rainy day comes around.  

In the UK, we officially triggered Article 50 to begin the process of leaving the EU. In a similar vein to the US interest rate move, policymakers signalled the event well in advance, removing the risk of a violent market reaction. Early signs suggest we won’t attain Brexit clarity for at least another 18 months, but whilst this is disappointing for most, it may, at least, allow markets to concentrate on what really matters; company performance; rewarding the good and bad ideas accordingly.

Both sides of the Brexit negotiations are actually seeing relatively positive economic data, with UK and Eurozone GDP looking rather resilient, and inflation on the rise. European equities in particular had a good quarter after the far-right party made little progress in the Dutch election, contradicting fears that Europe will be the destination of choice for populism in 2017. If consumers keep spending and business investment picks up, we could see an upside surprise in both these regions. 

To round-off the asset classes, whilst equity markets were on the rise, bond markets were more mixed. As we had been predicting; inflation-proofed assets were buoyed by rising inflation through the first quarter, but US bonds struggled against a backdrop of rising US interest rates. Commercial Property on the other hand, had a very solid quarter as overseas demand for London property remained strong on the back of the weaker pound. After the difficulties faced last year, the asset class has regained its steady income profile, offering investors a nice chunky yield of between 3.5%-4% per annum.

Residential property markets in London look less secure than they were, with house price growth nationwide slowing relative to the previous year.

Overall it was a positive quarter, driven by overoptimistic equity markets on the back of Trumpmania. Only time will tell whether such positivity is sustainable, but outside of the politics, we do see some great opportunities in selective areas…

Portfolio Review

Those of you who have been invested with us for some time will be familiar with our focus on reducing downside risk to generate sustainable, long term returns. This strategy helps ensure your financial plans are not derailed through speculative investing. We certainly prefer consistency in returns over unpredictability and as such, our portfolios tend to produce their best relative (to a benchmark) performance in difficult markets therefore it is always pleasing to see our portfolios keep up when markets go to the races, as was the case this quarter.

Overall the portfolio range added between 1.18% and 3.77% in the first three months. No one area stood out as a weakness, as we avoided all areas that struggled in Q1.

Equity wise, our overweight to Emerging Markets was a big plus. We built this position through 2016 when developed equity markets became expensive, and we continue to believe there are a lot of tailwinds for emerging market economics; not least demographics and improved political stability. In fact, it’s quite ironic that at a time when emerging market politics is improving, we have seen a rise in populism in the developed world.

Elsewhere, the inflation-linked bond positions we have been talking about for some time continued their upward trends. UK inflation is now at 2.3% – its highest rate in four years, with the rest of the world quickly catching up. Other assets that tend to do well in an environment with rising inflation are gold and property, so again our holdings here added nicely to performance.

It is all too easy to forget about risk when you are in a rising market environment, but in our view this is the most important time to be aware of it. Some ideas, such as emerging markets, may take years to play out fully, but others can just as quickly reverse in fortunes. Therefore, it is vitally important to remain open to change, rotating out of expensive assets and into areas where you see greater value. Blending these changes in a way that reduces portfolio risk is what active management is all about.  Rest assured, we are continually looking to alter the portfolios ready for the environment in front of us.

Looking back to the longer term numbers, we continue to achieve the return objectives we set ourselves over a rolling five-year time horizon (see below). With diligent risk controls in place and a client centric philosophy, we will continue to strive to ensure these goals are met in the years ahead:

Market Outlook

There’s still a raft of factors to be cautious about for the rest of 2017, but we will be buying the dips.

Cautious optimism is our recipe for long-term success. It means understanding the risks, but positioning with conviction in the areas you believe in. For the rest of 2017, the risks are a populist movement in Europe, a Chinese financial system crisis and a US recession. The opportunities exist in Emerging Markets, UK and European equities and selective areas of bond markets. We will be positioned accordingly.

Rarely does an opportunity have no risk, and the European conundrum is no exception. On the one-hand, the recovery in Europe looks to have legs; corporate profitability is on the rise, export markets remain strong and equities offer cheap valuations. On the other, political changes could single handedly determine whether European Equitiesend 2017 10% up, or 10% down. A so-called “Frexit” remains the biggest risk to the region, and although we don’t believe the probability is high, the risk’s rife.

It has been some time since we cited China as a core risk to the world economy, but its problems haven’t gone away. As time goes on, and growth slows, their debt-laden financial system will continue to struggle to refinance bad loans. Thankfully, we believe the issue is well contained within China, so whilst it’s an issue to be aware of, it’s one that can be easily mitigated by removing exposure to this region.

Then we have the chance of a US recession. The conversion rate of Donald Trump’s policy agenda will be of increased importance, and early signs are not good, given his failure to implement any changes to Obamacare last week in Congress. Nonetheless, we do expect him to pass significant corporate tax cuts, which should limit isolated company issues and ensure the economic recovery continues, for now (see our blog; Jaegerbomb moment).

Despite limited risks, we find ourselves at a juncture with our strategy, primarily because many assets are widely overvalued. US equities look expensive and government bond yields remain near all-time lows.

Emerging markets remain an area we like, alongside good-quality UK companies. Did you know that out of the 7 billion people in the world, 6 billion live in emerging markets? As they develop and stabilise politically, there could be a huge long-term investment opportunity. In the UK, we have some strategies that can take advantage of global trends, such as an increasing demand for healthcare, and an evolving financial system.

Outside of these areas we continue to like good quality corporate bonds, but expect to slowly reduce our inflation-linked exposures after recent strong performance. Property remains an attractive investment opportunity from various angles. If you took the yield alone you would sit with 3.5%-4% at year end, and tenant demand should remain robust given Brexit clarity is still a long way away. 

So whilst we can’t get too carried away with the outlook, we have identified areas we think will be rewarding long term investments. As always, we will continue to hold a blend of assets that do well at different times to ensure client goals will be achieved whichever way things play out. A good gauge of our optimism is our willingness to add to equity markets if they pullback, and at this point we would carefully be doing that to gain exposure to the right areas.