Macro Overview – commentary 2017
The global economy continued to grow at a brisk pace in the quarter with, Europe, Asia and the US all contributing to faster growth than that experienced in any of the prior three years. The UK continued to lag but Q3 GDP growth was a touch faster than Q2 (+0.4% v +0.3%) and Q4 is expected to be at least as good as Q3, despite some consumer numbers coming off the boil somewhat.
It has been a strong quarter for financial assets, as the table below shows (29th September to 29Th December):
Sterling up, albeit modestly, against each of the US Dollar and the Yen was a welcome relief for those worried about imported inflation, whilst UK equities provided decent returns after a strong December rally. The strength of the Euro impacted European shares somewhat as the currency was surprisingly unfazed by events in either Catalonia or Germany.
Huge flows into passives and ETFs/’Smart Beta’ products mean trend following punctuated by abrupt reversals will probably continue to be the way markets behave in the short to intermediate term. This is likely to result in extremes in valuations arising from time to time at both ends of the spectrum as favoured assets are bid up feverishly whilst out of favour assets are shunned at all costs (until the trend reverses, as it inevitably does). The concept of investor ‘herding’ has cropped up more frequently of late and will remain a theme in 2018, in my opinion.
The chart below shows how inflows into ETFs (Exchange Traded Funds) are responsible for all of the net inflows into equities since the end of 2013 (active funds have seen outflows in aggregate):
Indeed one of the surprises this year is that bond funds globally have enjoyed far stronger inflows than equity funds despite a widespread acceleration in GDP growth and corresponding rebound in corporate profitability. Jeffries estimates that in the US through to the end of November US$23 billion had been invested into US equities in 2017, whereas US$197 billion had flowed into bonds. In Europe, Investment Europe reported that in November €18 billion found its way into bond funds as against €7 billion for equities.
One viable reason for this is that inflationary expectations, particularly in the US, but also in the Eurozone, ebbed from the elevated expectations reached at the beginning of the year. Consensus is forming (but not complete) that inflation will stay low due to globalisation and technological change. However, with unemployment now at low levels, indeed at levels historically associated with full employment, in each of UK, US and Japan and with the oil price having just rallied again I think this call is premature. One should ask oneself why interest rates today are, on average, no higher than during the Great Depression when severe deflation was entrenched and unemployment was above 20%.
Despite profit growth and upward revisions to profit estimates being widespread in 2017, investors embraced shares exhibiting revenue growth characteristics (primarily technology but also some consumer and healthcare sectors in Asia) and eschewed more cyclical sectors of the market along with higher dividend paying sectors.
This latter phenomenon was a slight issue for most of our portfolios but a meaningful one for our Income Strategy. We moved a while ago from pure dividend funds to ones our analysis concluded could grow dividends over time. This strategy is a rational one and will continue, as it is just as likely to bear fruit over time from here as it has historically. Indeed we are adding to some funds where good long term managers have had a rough patch of late.
Positioning & Outlook
Strong economic growth for 2018 is now the consensus with investors expecting above (recent) trend growth from all of Europe, US, Asia ex China (the latter is expected to slow only slightly despite the removal of fiscal stimulus and enactment of monetary tightening) and other Emerging Markets. Like 2017 we in the UK are expected to bring up the rear despite real wage growth improving to flat from negative as the year progresses. To anyone who thinks 2018 predictions seem a lot like simple extrapolation of what has happened in 2017, you have a like minded thinker in me.
Tax cuts in the US should bolster near term activity but I am convinced there will be at least a scare re Chinese growth, given all the policy changes we have witnessed in the last twelve months (as mentioned above).
Wage inflation will be another issue in 2018 as the UK, US and Japan have each reached employment levels that imply staff shortages in some sectors. Deutsche Bank have concluded a piece of research which shows the relationship between employment levels and wage inflation is non linear and we have (at least in the US) reached a point where wages should accelerate for each incremental increase in employment. This would jive with the routine habit of investors giving up on something just as it is about to come through (the Euro at end 2016 springs to mind, as does oil at the end of 2015).
The other broad consensus is that the transition from Quantitative Easing (QE) to Quantitative Tightening (QT) will be smooth and serene (N.B. QT really begins in 2019, this coming year merely sees a significant reduction in QE). Again my concern is that at some point investors will have a worry about this profound shift in structure of financial markets. Central Banks will indeed be cautious in removal of QE and are already very sensitive about avoiding panic but the numbers involved are so large ($15 trillion injected globally over the last 10 years) it almost beggars belief that the policy reversal won’t upset some apple carts. Logically, bond markets should be most affected as they have benefitted most from inflows but we will have to be mindful across asset classes due to the ‘fountain effect’ discussed in my Q4 2017 Commentary.
No contemporary investment commentary is complete without a comment on volatility, or more precisely, lack thereof, across financial markets. 2017 goes down in history as the first year in which the S&P 500 delivered a positive return in each of the twelve months. Volatility across other markets, encompassing both equities and bonds, was also close to all time lows. We wrote (during the highly volatile markets which followed the Sovereign debt crises of 2010-13) that volatility was likely to fall in the ensuing years as it does, in our observations, mean revert over time. So now we are going to write that it is highly likely to rise substantially over the next two years as financial conditions tighten and inflation and growth scares each have their chance to buttress increasingly complacent investors.
We will also add that this is normal; drawdowns are commonplace and need not to be compared with a 2008 global financial crises (which thankfully are very rare). We would also note that volatility works both ways and some asset classes, or sub components thereof, enjoy appreciation at a rate which is difficult to fathom and is unlikely to be enduring.
Indeed bull markets and economic expansions don’t usually die natural deaths. They are either killed off by Central Banks who become over eager to choke off rapidly rising inflation (we are not quite there yet) or because an exogenous shock occurs, which by definition is unpredictable.
So risks have risen considerably and will continue to do so into 2019 as Central Banks become net sellers of bonds, Chinese largesse is further unwound and the highs of the US tax cuts are anniversaried. However, with economic momentum still good and the global industrial economy just one year into a recovery after a two year downturn, going very defensive could be very painful short term. Especially as Central Banks are mostly craving a bit more inflation as it helps reduce the debt to GDP ratio.
Thus it will be a year for staying focussed on our quest for decent risk adjusted returns whilst tempering the extremes of any drawdowns by being on the constant lookout for anomalies between valuation and fundamentals.
Important Information/Risk Factors:
Past performance is not a guide to future performance and investment markets and conditions can change rapidly. Investments in equity markets will be more volatile than an investment in cash or fixed deposits. The value of your investment may go down as well as up. There is no guarantee you will get back the amount invested. If you fund invests in overseas markets, currents movements may affect both the income received and the capital value of your investment. If it invests in the shares of small companies, in emerging markets, or in a single country or sector, it may be less liquid and more volatile than a broadly diversified fund investing in developed equity markets.
The views expressed herein should not be relied upon when making investment decisions. The article is not intended as individual advice and if you require advice or further information you should contact us.
Copyright ©Harpsden 2018 (unless otherwise indicated). All rights reserved.