Second quarter investment review and outlook
After a strong first quarter, equity markets paused for breath in the second quarter. A series of European elections dominated headlines but equity market volatility is still close to a record low.
For all the interesting political events over the past three months, the second quarter of 2017 proved to be relatively muted from an investment perspective. The MSCI All Country World Index, which includes emerging markets, was up just 0.5% in GBP terms.
In May, Emmanuel Macron was sensationally elected as the French President and the June Parliamentary elections cemented his power as his newly launched party La République En Marche! (REM) sealed a majority that should enable him to push through some of the economic reforms promised in his manifesto. Macron’s election has changed the narrative in the EU from that of a bloc in crisis due to the Brexit vote, to one that has a new confidence in developing a cohesive framework.
This perceived reduction in EU political risk saw some markets rally. Europe ex UK was up 4.5%, and the euro strengthened 3.4% against the pound.
Across the Atlantic, US President Donald Trump continues to tweet at a prodigious pace, amusing his supporters and enraging his opponents. Having hung on his every word, markets appear to have adjusted to the new normal. The S&P 500 was down just 0.6% in sterling terms, and equity market volatility hovers near all-time lows.
It would be remiss not to mention the disastrous, from the Conservative party perspective, UK election which saw Theresa May humiliated at the ballot box having had a twenty-point lead in the polls. The ‘strong and stable’ mantra has been cast aside, but, having made an agreement with Northern Ireland’s Democratic Unionist Party (DUP), the Queen’s Speech was passed giving the Conservatives some scope to govern on a slimmed-down mandate. Markets have been sanguine in their approach to political uncertainty. The overseas earnings-dominated FTSE 100 ended the quarter up by 1%, but perhaps the biggest surprise was the midcap index, the FTSE 250, which gained 3%. The latest economic data from the UK is quite robust, and the market is now factoring in a ‘softer’ Brexit which may help hold up confidence in the domestic economy.
Perhaps the most noteworthy event in this quarter was the spike in UK gilt yields in the last few days of June after Mark Carney, the governor of the Bank of England (BoE), surprised the market by speaking in more hawkish tones about UK interest rates. The ten-year gilt yield moved from 1.01% to 1.26% in short order with the market now factoring in a 55% chance of a rate hike by the end of the year, as opposed to a 20% chance just ten days earlier on 20 June.
Corporate bond yields have adjusted for the rise in government bond yields, but spreads (yield compensation for taking on credit risk) are still benign with the overall UK corporate bond spread hovering around 1.1%.
Market commentators make a good living out of trying to predict the top of the market and the end of economic cycles. Occasional readers of newspapers over the past five years would have a seen a variety of theories to cause them concern. Whether that be a collapse in Chinese growth, over indebtedness in developed market economies, the spectre of deflation, the spectre of inflation, the collapse in commodity prices, or the fact that this economic cycle has been longer than nearly any in the past 100 years. Anyone paying heed to these messages would have missed a near doubling of the MSCI All Country World Index over this timeframe.
Of course this economic cycle must, and will eventually, come to an end. However, with the cause and the extent of the next economic decline unknown, the downside that equity markets could face is similarly uncertain. The crash of 2008/09 is still fresh in most people’s memories, but the threat of wholesale meltdown of the financial system is generally agreed to be an outlier event, rather than a normal recession. It could be that the next recession disappoints those with cash on the sidelines in both its depth and length.
In a world of expensive asset classes, we continue to believe that long-term ownership of equities is the best way to grow your wealth over time and to avoid the corrosive effects of inflation on cash savings. IG Smart Portfolios offer five risk managed profiles, with robust asset allocations from BlackRock. They are currently positioned with a modest underweight to equities, sterling hedged positions (protecting against a rally in sterling) and with modest exposure to the yield curve (which will add value if interest rates rise).
One more thing: ETF ownership
There has been a lot of focus on the increasing exchange traded funds (ETFs) ownership of the equity markets, and what would happen if that was to reverse. Goldman Sachs produced a report in June showing that ETFs account for 6%, and growing, of ownership of the US equity market. However, a lot of this growth is at the expense of mutual funds, which in aggregate own the market in similar proportions but with a higher annual management charge.
Over the first quarter ETFs bought $98 billion of stock. This is still exceeded by corporate buybacks which amounted to $136 billion. We believe that corporate buybacks are a hugely important factor of market growth, and get less attention than they deserve. Indeed over the past five years, 10% of US market cap has been bought back and cancelled by companies.
With company shareholders still happy enough to see corporates issue very cheap debt to finance buybacks, and US economic conditions looking healthy, it would appear that either softening economic data or interest rate rises from the Federal Reserve will be required to end this trend.