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The second quarter of 2016 continued the pattern of notable events with exceptional market movements, dominated in the period by the UK’s European Union referendum, the full consequences of which will take time to become clear. Political or economic considerations and challenges remain, although a sense of relief and continued cheap money from central banks has provided a boost to risk assets.
Markets in April had assumed a degree of stability after the fluctuations in the first quarter of the year. There was a further improvement in commodity prices, more reassuring news from China and every indication from central banks that they would continue to do what they could to stimulate sluggish global economic growth. In May the relative stability continued even if it did perhaps reflect more a degree of confusion over the future course of events rather than any particular confidence in the outlook. In June markets again saw considerable volatility when the outcome of the referendum confounded most expectations and compounded broader uncertainties, although there was a significant recovery soon after the initial shake-out.
Over the quarter economic news was still varied. In the US the job market numbers were disappointing in May and then remarkably strong in June. In China the authorities have looked to smooth a slowing economy that remains in transition. In Japan the economic outlook has been impacted by the strength of the currency in spite of the move to negative interest rates. On the Continent there has been an improvement in levels of economic growth even if an easing of austerity has left government deficits higher than target. In the UK the rate of growth has softened given the uncertainty ahead of the referendum and that is likely to persist, which may lead to a dip towards recession which will also have implications elsewhere in Europe.
Political factors include the role of the UK in Europe and within itself, if it does not stay a United Kingdom, as well as the referendum in Italy due in the Autumn on constitutional reform and the US presidential election in November. The vote on the UK’s membership of the European Union has created a remarkable series of political changes and may yet have significant longer-term implications as well as shorter-term economic ones, although the fastchanging political landscape may soon settle back into a familiar pattern.
Subdued economic growth worldwide and political uncertainty has been reflected in everlower interest rates and an emphasis on defensive assets with some growth potential. We have retained a cautious approach as we believe that returns will be hard to achieve and volatility may well return, which will present opportunities, and we are making some adjustments. We still have a core of assets that can serve portfolios well over time and a diversified range of holdings with defensive elements that should offer some continued resilience.
The total return from the FTSE UK Gilts All-Stocks Index was 6.2% in the quarter which came primarily from a rise in June given their safe haven appeal. Ten-year gilt yields fell sharply in the three months moving from 1.42% to 0.87% while in the US they dropped from 1.77% to 1.47% and in Germany from 0.15% to a negative 0.13%, which is striking; some shorter-dated UK gilts also traded with a negative yield in the period.
Equity markets were mixed. Over the three months the FTSE 100 index managed a rise of 5.3% to 6504 (and in July to date it has moved further ahead, making a sharp recovery from the low point of 5537 in February). The FTSE 250 Index of mid-sized companies was down by 3.9% in the quarter as it was hit harder by concerns over the EU vote which led to sharp falls in shares in property, house-builders and challenger banks as well as a widening of investment trust discounts. The FTSE SmallCap Index was also impacted by its more domestic orientation with a decline of 1.6%, with limited liquidity perhaps providing some protection in the short-term. In the US the S&P 500 index rose 1.9% although the return was materially higher for investors in Sterling; the NASDAQ index, which is technology-oriented, was down 0.6% in US$. In Europe the EURO STOXX 50 fell by a further 4.7% in the period, although again the return was better for investors in Sterling. In Japan the Nikkei 225 was also sharply down with a drop of 7.1% as the Yen strengthened given its own safe haven appeal, again thus providing a positive return in Sterling terms (hedging the Yen, or not, has been a primary factor in returns). The MSCI Emerging Markets index in US$ was little changed over the quarter with a small decline of 0.3%.
Sterling weakened materially against other currencies after the EU vote, such that against the US Dollar it fell by 7.3% over the quarter to close at a rate of $1.1.33:£ while against the euro it was 5%weaker at €1.26:£. The euro was a little weaker against the US Dollar over the period while the Japanese Yen was a notable 8.3% stronger.
The price of a barrel of Brent oil continued a recovery from the low point early in the year and was 25% higher over the quarter to close at $48.50 while the gas price rose sharply in June. The price of gold continued to run up and rose by a further 7.3% over the quarter to end at $1322 per troy ounce. Many other metal prices also rose over the period although the bellwether copper price was flat while agricultural commodities were mixed, as often.
The Vix index of volatility rose by some 12% in the quarter, mostly in June, and moved back to a level a fifth off its one-year high.
The UK’s vote to leave the EU by 52% to 48% had been predicted in a number of polls if not by bookmakers nor a political elite that is not used to such rebuffs. The fall-out in political circles has been extensive although the instinct for self-preservation in the Conservative party (the internal divisions in which over Europe had brought on the referendum in the first place) has seen a reassuringly prompt move to establish a new government and to provide the form of internal coalition of differing factions that has more chance of success than an external one, especially when there is no coherent opposition from a Labour party in disarray.
Theresa May may not have campaigned to leave the EU but she has committed to manage the process if not yet to a timetable as it will take a while to establish how the UK best goes about invoking Article 50 of the Lisbon Treaty to leave, assuming as we should that it still does. There are a number of constitutional matters to resolve, in particular over what Scotland could do under the Sewel convention and how to handle the creation of a land border with the EU across Ireland. Even when the new government is fully established in the UK the response of the EU is not clear especially ahead of elections in France and Germany in 2017. Negotiations could founder over the EU’s inflexible policy on the free movement of people and there will be uncertainty about passporting in financial services as well as the timing of new trade treaties, given the shortage of experienced negotiators.
The pro-European team failed to make a convincing case and the anti-European players were beneficiaries of a growing sense of disenchantment especially in the regions of England, where the impact on jobs has come not just from immigration (which may even rise in the short-term) but also from a deficiency in education and skills that has been reflected in poor productivity growth and will deter investment, while the global impact of Chinese over-capacity in many industries continues. The new government will need not just to commit to a more equitable distribution of income but also to find the resources to do so. Businesses in the UK may reach a new higher level of resilience and risk-taking once released from the shackles of the EU, although bureaucracy will not evaporate. The country is pragmatic if problematic, and will find solutions to most challenges.
There will be some economic uncertainty from reduced consumer confidence, although there have been indications that retail demand remains robust (in spite of the shortage of a Summer) and on the level of future investment into the country, which had already slowed. This would lead to a drop in the level of economic growth and might trigger a short if not sharp recession, depending also on the impact on the various financial services in the City of London, which have made a significant contribution to recent economic growth if also to income disparity.
The sharp fall in Sterling on the currency markets has been the most significant response to the vote to leave. The pound had weakened in the first part of the year and rallied to a level of $1.50 ahead of the referendum as expectations increased of a vote to remain. It fell as far as $1.28, the lowest for 31 years, although it has rallied a little. The overall fall will provide a boost to exporters from extra competitiveness and will also make the UK a cheaper place in which to invest, which will help to offset the pressures on growth. Greater exports and a reduced level of imports, now more expensive, should also improve the current account deficit which has also weighed on Sterling, together with the budget deficit which George Osborne was quick to say after the vote would not be reversed by 2020 as he had previously forecast. The concern on deficits has not had an impact on gilt yields, and may yet do so.
The weaker currency would also lead to higher prices on imported goods and thus add to inflationary pressures, although the Governor of the Bank of England, Mark Carney, has indicated that interest rates are more likely to be cut, as part of his commitment that the central bank will take whatever action is needed to support growth. As we have indicated calling currencies is a considerable challenge and there is a risk in a mismatch between assets and liabilities.
The initial reaction in the UK stock market was a sharp fall although that was soon reversed in the FTSE 100 given the high proportion of overseas earnings and the appeal of defensive sectors such as consumer defensives including tobacco and healthcare, while lower interest rate expectations enhanced the appeal of utilities, seen also as bond proxies if with regulatory risk. The boost to earnings from weaker Sterling also improved the potential for companies to maintain dividend payments, one factor in the rally in the price of the oil majors. The market was discriminating to the extent that shares in property companies, housebuilders, retailers and banks bore the brunt of the sell-off given reduced expectations for the UK economy and the difficulty for banks to make profits when interest rates stay low (although they remain relatively well-capitalised). Even such sector differentiation can provide opportunities in individual companies that show greater flexibility. In particular a number of mid-sized and smaller companies also have overseas earnings as well as strategic strengths that might look more tempting for overseas purchasers after the currency drop.
We have moved to reduce portfolio exposure to the UK if only a little, and will concentrate even more on those companies and funds that have scope to provide resilience as well as the potential for growth, with cash flow yields an important consideration.
European stock markets fell even more sharply than that in the UK following its vote to leave given an expectation that the European project would collapse and that the eurozone would fragment, although they have also stabilised. There is certainly a greater risk of a split even if the initial reaction in countries such as Denmark and the Netherlands was to see an increase in support for the status quo. The EU is likely to be tough in its negotiations with the UK pour encourager les autres (and is also likely to wish English gone as the de facto language).
The second election in Spain on 26th June at least proved positive in the higher backing for the ruling Partido Popular, although the centre-right party is still short of an overall majority. The concerns have shifted to Italy where Matteo Renzi’s Democratic Party is losing ground to the Eurosceptic Five Stars movement such that if Renzi loses the proposed referendum on constitutional reform due in October or November he may also lose the election he would be expected to call. The problem lies in the country’s banks which have some €360bn of non-performing loans; Germany is supportive of moves by the Italian authorities to refinance the banks without breaching EU rules on public support, while with many retail bondholders there is perhaps little between individuals taking the hit or doing so as taxpayers. In 2017 there will also be elections in France and Germany which will add to the uncertainty.
The eurozone economy may see some benefit from a weaker currency although the IMF shaved its forecasts for the region as an early assessment of the impact of the UK vote; the European Central Bank is expected to continue its support, which has extended to the purchase of corporate as well as government bonds as part of its commitment of €80bn a month.
The US economy is not particularly robust although it appears to be strong relative to other regions of the world and retains greater potential to provide a positive surprise, even if the data can still be mixed. The level of job creation in May was disappointing but the report for June showed an impressive rise in non-farm payrolls of 287,000 even as the rate of unemployment edged up to 4.9% and wage inflation remains limited.
The Federal Reserve has been less mindful of global considerations, including the UK vote, but it has deferred raising interest rates given subdued levels of inflation. The yield on US Treasury stocks has reduced but again appears attractive relative to negative rates from other central banks, which in turn has boosted the appeal of steady US companies.
While the US stock market does not offer compelling value it does offer reasonable prospects and it is likely to be supported by the US Dollar, to justify an exposure through funds that can be resilient as well as selected individual holdings where appropriate.
Politics will become an ever more dominant issue as we approach the presidential elections in November, which will be a contest between Hilary Clinton and Donald Trump, neither of whom is very well-regarded. The stock market implications will reflect the potential impact in sectors such as healthcare, the country’s attitude to global trade and the result of the elections for Congress, as it is only really a president with the backing of the House that can take decisive action.
The outlook for the world’s second and third largest economies is similar to what it was before. In Japan the government’s target of 2% growth and 2% inflation remains elusive and growth has been held back by the strength of the Yen, which has been boosted by the safe haven appeal its liquidity brings at times of market volatility. The Bank of Japan has held off providing a further stimulus although the prime minister Shinzo Abe is more inclined to provide a fiscal boost following his party’s landslide success in the election in June, in which the Liberal Democrats won a ‘super-majority’ of two-thirds of the seats in Parliament.
This greater control may also allow Abe to realise an ambition of changing the constitution to enable Japan to take a more prominent military role, which will only increase tension in the region, already a little tense over disputed claims in the South China Sea.
In China the authorities have helped to smooth the adjustment in the economy, which is still expected to grow at around their 6.5% target. There are still challenges from over-capacity in a number of industries as well as the increase in debt levels, in particular in companies which have undertaken a high level of corporate activity; one estimate indicates that companies used 20% of their operating income to service debt in 2015 compared to 12% in 2008.
The second quarter of 2016 saw further stability in emerging markets given the outlook in China and the deferral of further US interest rate rises, as well as by changes in Brazil and in South Africa which had been in part self-inflicted. India has remained a key focus and there was disappointing news that Raghuram Rajan, the well-regarded Governor of the Reserve Bank, would not continue in his role beyond September, although the currency was relatively robust given the broader economic outlook. The wider Asian region has its advantages.
The oil price fell on the initial news of the UK’s vote to leave the UK and soon recovered, reflecting the limited impact on the global economy. The steadier price has provided some support for producers; while some such as Venezuela remain in a mess the outlook for Russia is better, if politically impalatable. The oil price has been less of a driver of markets than it was in the first quarter of the year.
The prices of many metals have stabilised following the end to the commodity super-cycle and the agricultural commodities market offers the potential for some interesting returns, subject as ever to the weather.
The gold price rose further in the period and provided a further boost to gold miners; the allure of the metal in difficult times remains, as does the difficulty of valuing it given the lack of yield, but that is less of a concern when interest rates stay low. The silver market is usually volatile and the price jumped in the quarter.
The pressures on large open-ended funds investing directly into UK property became all too apparent over the EU referendum, which led to a number of redemptions and the suspension of trading in most as their managers bought time to sell assets. While property can still generate an attractive yield and can still have a role in portfolios the sector is less attractive than before, even if prices might already reflect that changed position. Infrastructure assets and shares can provide a different option for portfolios, with steady demand and an attractive yield.
The second half of 2016 will continue to reflect political and economic issues following the EU referendum in the UK given the implications for the wider European project as well as the US presidential election, the transition in China, geopolitics in the South China Sea, the change in momentum in Japan and factors which have yet to come to the fore.
Economic growth in the world continues if at a subdued level with the US and Asia offering more scope for improvement. The UK and the rest of Europe may suffer a slow-down although that is by no means certain. Currencies are an important driver and earnings (in particular cash earnings) will be key. Political pressures abound.
The uncertainty has led to an extension of the central bank policies of quantitative easing and ultra-low interest rates, as a means to support economic growth even if they have failed to provide a lasting stimulus to bank lending and consumer demand. The authorities are now also ready to try some other options including providing a fiscal boost to spending. The potential distortion to asset prices is one of our concerns, along with the challenge of excessive debt levels and the drop in world trade and productivity growth.
We are wary rather than gloomy and just realistic that we live in uncertain times, while still able to find opportunities. We are adjusting portfolios to have a little more in the US and Asia with less in Europe including the UK; we have reduced property and preferred infrastructure. We will deploy cash as carefully as we can and be ready to re-build cash positions when we anticipate further volatility.
Julian Cooke – Investment Director 14th July 2016 Vintage Asset Management
All views are the authors own and do not represent those of SG Financial Services Limited.
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DISCLAIMER: Any forecasts, figures, opinions or investment techniques and strategies set out, unless otherwise stated, are Vintage Asset Management’s own. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. They may be subject to change without reference or notification to you. The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate and investors may not get back the full amount invested.