Tees Quarterly Market Update

Published on July 2nd 2019

Kieran Follis, Head of Investment Management

INVESTMENT OUTLOOK

With the rapid ups and downs seen in markets over the past twelve months, clients may be forgiven for thinking they have somehow wandered into a parallel land of ‘Shocks and Scares’, rather than the usual variety we normally put into portfolios! Despite this volatility, the FTSE 100 index still sits at the same level it was almost a year ago, although underlying investor sentiment does seem to be waning. As mentioned in our previous commentaries, we have a strong suspicion that markets are now heading into the final up-leg of the current investment cycle, with an endgame of a generally slowing global economic growth now in sight. So it’s no surprise that the monetary policies of both the US Federal Reserve and the ECB have turned almost on a sixpence, with expected reductions in interest rates and further QE manoeuvring now back on the table.

Certainly, the length of the current US economic expansion has now broken all historical records, but despite the stretched valuations on that side of the pond, it has proved to be the right call for us to have maintained full weightings to such a powerhouse economy within our portfolios. From here on in, though, things may be looking a little trickier, as with most of the bad news to do with trade wars and tariffs already out there, but with potential political upheaval threatening the market’s outlook, it’s now more a case of “what happens next?” Ahead of a US presidential election next year, the Fed is under huge pressure to cut rates to keep things rolling domestically, but with the previous effects of tax cuts now fading, we feel this may only be a quick fix to support activity short term and so is just as likely to blow itself out, as earnings continue to slow. China, on the other hand, seems to have its foot firmly back on the accelerator once again and trade wars or not, it is now a case of how quickly their policy measures will boost their own economy and for the benefits to then begin to trickle down globally. Whilst we hope that the various trade tensions will resolve themselves positively in the months ahead, pushing up stock markets around the world, pragmatism suggests that this standoff may be with us for a while yet. Unfortunately, though, it is the European markets that continue to be caught in the crossfire and look increasingly vulnerable to the repercussions of a global trade war. Real or not, it is the uncertainty that is killing investment corporate decisions being made, along with fears that the European auto industry is likely to be next on the Trump hit list.

Summing up, we think that in any normal end-of-cycle scenario, investors might usually tend to start de-risking their portfolios and with a step sideways into holding higher exposures to fixed interest investments generally. However, with central banks having failed to normalise interest rates thus far and with economic growth still reasonably OK, albeit slowing, it’s really not clear that bonds will do their usual ‘safe haven’ thing this time around. Indeed, many canny investors are already heading towards the lure of gold and which has currently spiked to a five-year high on the bullion markets. From an equities point of view, though, we are almost ready to begin building more defensive allocations within our portfolios, but feel there is just one last leg-up left in markets to help us decide.

MARKETS

UK - The UK market may have moved modestly higher over the quarter, but the further decline in sterling perhaps demonstrates the impact of the high levels of ongoing Brexit uncertainty on investor sentiment towards UK assets and its markets. There is no certainty that any new Prime Minister will do anything different from the last, even deliver Brexit as envisaged, so markets may just tread water for now and against the background of a hugely polarised population regarding “Leave or Remain”.

A ‘no deal’ would potentially send sterling even lower, but would allow UK government bonds (gilts) and more internationally-exposed FTSE 100 stocks to move higher, as repatriated earnings would benefit from the weaker exchange rate. Then again, any General Election would risk a change of government to the Labour party, who historically have focussed on less market-friendly policies, higher government spending and the potential renationalisation of utility and transport stocks, for example. Such a move may send gilts and FTSE 100 stocks lower and given the very real possibility of this scenario playing out, it would be prudent for us to begin to bias UK portfolios away from small and medium-sized companies, both of which tend to be much more domestically focussed but have done so well for us in recent years. This de-risking would also help build some resilience into portfolios were a more global recession to emerge, so we are keeping a close eye on the temperature of markets.

EUROPE - European markets remain a conundrum for investors, with most indices generally moving higher over the quarter, despite many underlying European economies still remaining highly dependent on global trade and capital expenditure, exactly the two components of global growth that are faltering. Unfortunately, there are few domestic policy levers that can be pulled to try and support activity in many of its economies, with countries such as Italy (which is actually willing to use any sort of fiscal stimulus to boost demand) already hugely in debt. It’s just the opposite in Germany, where there is little political appetite for government spending or tax cuts, despite there being plenty of room to do so, with the interest rate on German government debt now negative for the next 15 years! Clearly, Germany has no wish to take any lead in dealing with the key problem facing Europe – that of deficient and declining demand – with even the ECB having very little petrol left in the tank. With interest rates already in negative territory, further cuts would weigh particularly heavily on European financial stocks and which make up over 20% of their benchmark indices. Yes, a conundrum indeed; but while markets continue to rise, our stance is to remain fully invested within them for now.

US - Pleasingly, the quarter saw the S&P 500 Index reach an (albeit short lived!) all-time high before the wheels finally came off in the trade negotiations between the US and China. With both sides pressing ahead with various tariffs against each other, the impact has been most keenly felt in economic forecasts. Equity markets are now pricing in weakening economic growth and softer levels of inflation, as well as a potentially over-estimated three Fed rate cuts by the end of this year, a complete U-turn from January. At face value, it looks like the US bond and equity markets are completely out of sync, as assets across the entire risk spectrum have rallied strongly, whilst the US bond market paints a considerably bleaker picture as to economic outlook. The underlying thread is, of course, that investors are hoping the Fed will come in to pick up the pieces and do whatever is necessary to sustain the US expansion. Indeed, ‘normal’ levels of interest rates are clearly not coming back any time soon and the Fed seems amenable in tolerating higher levels of inflation for now. Despite increased levels of market volatility continuing to feature, we will remain invested within the larger, high quality company end of the market, with strong balance sheets and with a focus on long-term themes such as Technology and Healthcare, both of which remain our favoured sectors.

JAPAN - Japanese markets have seen modest returns in the quarter, with renewed concern over fallout from the US-China trade issues and a gradual appreciation of the Yen in turn weakening market sentiment. Whilst signs that global growth is easing and analysts downgrading domestic earnings expectations, the continuing stability of Mr Abe’s government suggests we may now be expecting a slowdown rather than a recession. However, we remain positive as to improving news towards corporate governance, internal controls and shareholder disclosure levels within Japanese companies (which looks to be increasingly structural) with share buybacks now at an all-time high. We remain neutral for now.

ASIA & EMERGING MARKETS - Overall, Asia and Emerging Markets had a reasonable quarter, with Latin America, India and Russia putting in some positive performances. However, the continuing concern regarding the ongoing US/China trade tariff talks has certainly been a drag on Asian markets, although it is also becoming increasingly apparent that China’s domestic economy might be on the launch pad again, leading to increased demand for global commodities such as iron ore and copper.

FIXED INTEREST - Fixed interest stocks across the globe enjoyed another strong quarter, as the major central banks held interest rates steady, allowing markets to rise by an average of 4% over the period. Talk has now turned to potential rate cuts in the UK and US and further stimulus in Europe and Japan, which is also positive for bond markets. Indeed, whilst some government debt is now so expensive that it is producing negative returns, there is still remains plenty of good value in the Corporate and Emerging Market sectors, and yielding very acceptable real returns.

PROPERTY - Global property markets continued to grow through the quarter as in many ways like the fixed interest markets, property investors were relieved at the prospect of lower interest rates and benign employment and inflation forecasts. However, UK property continues to be held back by Brexit fears, with the index falling by 2.4% whilst global property rose in value by some 2.2%.

SPECIALIST - Investment within our Specialist asset class has seen a generally mixed return over the quarter, although all sub-sectors have produced positive returns for us. Our Infrastructure holdings continue to perform strongly, with investors increasingly concerned about slowing global growth generally. Investing in assets that have the potential to offer steady dividend growth, protection from inflation and long-term capital growth from areas such as roads, railways, ports, airports and energy pipelines remains extremely attractive and, in our view, still undervalued. With significant structural drivers in place such as urbanisation, climate change, globalisation and the digital revolution behind much of our infrastructure exposure and where positives such as high barriers to entry and significant pricing power still exist, we remain extremely positive about the sector.

Technology shares have also regained some poise and once again continue to climb their long-term growth trends, as the sector creates new markets whilst also transforming older ones, rather than just tracking GDP growth globally. With wave upon wave of innovation, particularly within the Cloud Computing and Artificial Intelligence spaces (where we retain significant exposure), we remain long-term supporters of these high growth markets. Similarly, the Healthcare sector continues to rise slightly ahead of the wider market, as increasingly limited government budgets means innovation within the pharmaceutical and biotechnology is key and remains the focus of our investment in this specialist sector. So, as we see continuing structural growth in the demand for healthcare provision and medical treatment – and supported by positive demographic trends, improving standards of living and technological advancements – our stance as long-term, patient investors should be rewarded.

For Commodities, worries over a global slowdown, ongoing US/China trade tensions and renewed expectations of an imminent US interest rate cut has impacted investor sentiment and sparked a flight to safety towards gold. With the precious metal now trading at a five-year high, but against a weakening US Dollar following the Fed’s recent policy change on interest rate hikes, gold bugs should continue to be rewarded. It’s a similar story in the oil markets, where the ongoing dispute between the US and Iran as well as threats to disrupt supply has generally squeezed prices higher. Indeed, this price spike may hold steady for now, as Russia and Saudi Arabia indicate their agreement with OPEC to extend reductions in oil supply for a further six to nine months. As mentioned above, the green shoots of resurgence in the Chinese economy may provide some uplift for copper and aluminium, where prices have been under pressure following lower cyclical demand, but a stand-out has been the increasing levels of Chinese demand for iron ore, which has driven prices above $100/tonne for the first time in five years.

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