Investment Review Quarter 2 2017

Market Review of Quarter Two

After a strong start to the year, global stock market momentum faltered through Q2. Without substance, initially the rally continued, however, economically things weren’t looking that good. 

We’d had a series of poor data releases both in the UK and abroad, a lack of action by the infamous Mr Trump and election uncertainty to deal with here at home. Despite this, the FTSE 100 had returned 4% between 1^st April and 1^st June, before falling back significantly to finish the quarter just above flat.

Staying in the UK for now, it would be remiss of us not to comment on the election outcome. The result put us in a less powerful position to start Brexit negotiations. At the same time, inflation was peaking, hitting 2.9% in the 12 months to the end of May. Consumers have been hit by rising prices, with retail sales data showing a strong slowdown in the last few months. Despite the difficult economic balance, the Bank of England seems to have moved closer to hiking interest rates.

As political uncertainty rose in the UK, it simultaneously fell in Europe, as Emmanuel Macron was convincingly elected as the next French President. He is an “independent” by nature, the first time in decades that one of the main two parties hasn’t ruled the roost. The chance of Frexit abated and European equities outperformed to finish 4.5% up over the quarter. France, and Europe for that matter, are by no means home and dry; we still have German and Italian political situations to develop before the year end. However, with data still strong, prospects remain good on the continent.

Heading to the US and the Trump saga continued. As we detailed in Q1, he was more likely to climb his own Mexican wall than pass all the policies he promised. A further three months on and not much has changed. The US Central Bank continue to raise interest rates, and the US economy looks fine from most angles, but the buoyant growth promised last year is unlikely from here.

Those of you who are avid readers of these updates will recall various references to the effects of Central Bank support. Equities and bond markets have been bolstered for more than 7 years now, but late this quarter, the commentary from key policymakers changed from being ultra-supportive, to neutral. This caused a small wobble in both markets, as they fell 3%-5% in a matter of days. Policymakers cite better economic prospects as the reason for less support, however, investment markets are uncertain of continued growth and grow nervous with this type of talk.

To summarise, it was a mixed quarter for most markets as they rallied into June before falling back to end the quarter. European equities delivered the best returns, and UK Commercial Property also stayed solid throughout. The pound weakened on the back of election/Brexit concerns, boosting overseas positions, and fixed interest markets struggled on the back of reducing Central Bank support. Overall, we have still had a positive return environment since the start of the year, but this was skewed Q1 with an up and down journey delivered in Q2.

Portfolio Review

Despite mixed markets, the portfolios delivered another strong quarter, returning between 0.79% and 1.71% across the range. This type of environment usually suits our philosophy; focus on protecting the downside to generate sustainable, long term returns.

Going into the election, as a team we had already completed a lot of work to stress test the portfolios against each possible scenario, concluding that we were well positioned whatever the outcome. As the pound fell, our overseas positions got an immediate boost, in particular, our decision to increase European equity exposure on the back of an opportunistic outlook in Q1 drove the portfolios higher.

The second key decision that generated superior performance was our move to reduce equity exposure in mid-June. As a committee, we meet every Monday morning, with part of the discussion focusing on pre-determined trigger points on the main asset classes. They are essentially levels at which we would automatically review our exposures, with a likely prescribed action e.g. to reduce or increase a certain sector.

Equity markets have had a buoyant 12-18 months now, and despite the recent poor data they hit our trigger point in June. With equities overvalued in our view, and volatility at all-time lows, we felt the risks were skewed to the downside and on that basis decided to take a more cautious stance.  

It’s at times like these where our thinking differs from everyone else’s; we are not in the business of achieving returns at any cost, but moreover our clients’ financial planning and wealth preservation requirements are always central. Risk is the first metric, with returns second. We don’t aim to beat benchmarks, but instead focus on achieving our clients’ return targets with the appropriate level of risk.

Market Outlook

Volatility in investment markets remains low and our outlook similar to last quarter. We have improved political stability in France, and with the UK Conservative Party operating with a reduced majority, we expect Brexit negotiations to be softer, and austerity levels to be lower by way of increased public sector spending. This is generally positive for risk assets and inflation.

There are, however, several conundrums to consider when constructing our clients’ portfolios. Perhaps the most obvious remains; stock markets globally are trading near record highs. In contrast, fixed income markets suggest deteriorating economic conditions. This disconnect is alarming and continues to challenge our objective to grow our portfolios whilst keeping the back door shut against possible corrections. There is no room for complacency.

Inflation is still this years buzzword, as expectations for rising costs continue to headline the news. However, the optimism that emerged when Trump was elected in Q4 2016 has reversed throughout 2017 – the dollar has weakened as a result and US inflation remains subdued.  So, whilst inflation is rising, we question it’s sustainability. For it to be so, we need to see some evidence of wage growth, and globally there is very little. The UK and the US are both close to full employment, a point at which we would normally expect to see a pickup in wages, although there is no evidence to support this. Incomes adjusted for inflation are in fact falling, and not just in the public sector. We are of the view that the developed world will run with low inflation and low interest rates for the foreseeable future. This creates challenges in the fixed interest environment, but there are opportunities, particularly in US companies and Emerging Markets that can benefit from interest rate rises.

Staying over the pond; our view remains that economic numbers will remain largely stagnant in the US and might be too low to support increases to US interest rates at the speed that the US Federal Reserve might have hoped. The US is at a later stage in the current global economic cycle, and we believe better value remains elsewhere.

In the UK, companies whose earnings are produced globally might struggle if the UK were to increase interest rates. If you were to take the fall in the value of the pound out of the FTSE 100 index over the last 12 months, you would end with a muchlower return figure. Therefore, care is needed if sterling were to strengthen as this would impact on the FTSE 100 in the opposite direction (down). We have invested in what we believe are some compelling opportunities in the UK, although they are selective, thus requiring careful ongoing analysis. Our UK equity performance in June outperformed the FTSE 100 by over 2.7% (June 9th to July 9th 2017, Financial Analytics), showing the importance of sector selection and research. We have a continued preference for healthcare and financials.

It is in Europe where we feel greatest conviction. Macron’s election win was robust and has provided stability to the area. Unemployment continues to fall from quite high levels, particularly in Southern Europe, with strong Spanish data continuing… even Greece has shown signs of growth! The Eurozone is expected to grow at an increasing rate in comparison to the US and UK, and company valuations are cheaper on a relative basis.

Certain Emerging Markets and Japanese equities also look to have some excellent selective opportunities, although increased volatility restricts them to being short-term additions rather than staples or core assets.

We remain happy with our property exposure. We recently undertook a review of the tenants within our portfolios to assess the risk of leases not being renewed due to tenants relocating back to Europe. We concluded that as over 90% of our leases were held with British companies, this threat was low, and we continue to expect predictable returns from this asset of around 4% per annum after costs.

In summary, these are challenging but exciting times to manage money. There are many risks that threaten investment markets, however we remain committed to understanding those risks, whilst uncovering opportunity. We run our portfolios on an infinite and not a finite basis. Of key importance is the manner of our journey, in that we make sure the portfolios work hardest for you when things are difficult, making progressive and sustainable returns over the longer term.