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Market Review – July 2016
July was Brexit bounce-back month which saw risk assets firmly in favour.
By the end of the month, most equity markets were back to, or above pre-Brexit levels. In general terms, this recovery can be attributed to the anticipation of additional methadone shots, in the form of further monetary stimulus. The Bank of England held fire in July as it awaited data and further analysis and but announced a package of measures at its meeting on 4th August 2016, including a base rate cut from 0.50% to 0.25%. In spite of investors’ consternation about the effectiveness of the measures, asset prices responded positively to the news.
For July, the UK market was firmly in positive territory, with the mid-cap index continuing to recover ground from its short-term, but nonetheless brutal, post-Brexit sell-off. With sterling stabilising over the month, currency effects were minimal after last month’s traumas. European markets were also strong, led by the German Dax. In particular, European banks showed share price strength ahead of the EU bank stress tests at the end of the month, although the European banks index remains deeply in negative territory for the year to date. The US markets also moved ahead, with mixed economic data, including a weak GDP number, unable to knock the market back. In a change of trend, the Japanese market moved ahead strongly, bolstered by the yen arresting its recent run of strength. Emerging market equities were also fruitful investments for the month, with the Brazilian index leading the charge.
In fixed income, the risk-on tone extended to credit markets in the month of July. Generally speaking, higher yielding bonds outperformed investment grade credit, with all in positive territory. However, in the sterling credit market, investment grade bonds and subordinated financials were the winners, thanks to a rally in gilts, post-Brexit bargain hunting and the prospect of corporate bond-buying by the Bank of England. Government bonds were generally more subdued, although again, UK gilts outperformed other markets.
Unusually, this positive month for risk assets was set against the backdrop of a significant slide in the oil price. Indeed, generally speaking, it was a weak month for commodities. However, gold was modestly positive while silver continued its winning streak.
Market Thoughts
The excitement of the EU referendum was a distraction from the most important question of the day, which is how we break out of the cycle of monetary intervention and asset price pumping. Markets have settled down for now as the immediate Brexit shock has passed, but we all know that the real impact of this event will only become apparent in the months and years to come.
Mark Carney is aware that monetary policy is reaching its natural limits and yet, given the current circumstances, he had no real choice in August but to reinforce the myth that cutting interest rates and quantitative easing measures are effective policies for the real economy. Asset markets may cheer, but savers are squealing, while borrowers are barely better off, if at all, as banks struggle to retain some margin.
Over past months, we have pointed to the fact that our cautious view may be challenged by the rise of asset prices against a highly supportive monetary backdrop. Markets were shocked out of a pretty directionless second quarter by Brexit and then the prospect and reality of more stimulus. None of this is very heart-warming for investors who base their decisions upon fundamentals, rather than the next utterance of a central banker, and most are innately uncomfortable about the fact that rich valuations depend upon risk-free rates remaining at emergency levels.
This explains why many fund managers remain nervous and markets are rotational, as investors ponder different paths out of the cul-de-sac of insipid growth and ultra-low interest rates. As we have said before, there is nothing normal about government bond yields at historic lows whilst the US equity market trades close to its all-time highs.
Strategies
For invested, directional portfolios, we suggest diversification and balance at the present time. Markets could move to price in anything from more-of-the-same (yield continues to re-rate and bond proxies march on), to a return of the real economy as governments loosen the purse strings and inject stimulus directly into the economy. Tilting investment portfolios with any degree of conviction at this juncture is therefore a challenge.
For those less convinced about market direction, we continue to favour absolute return-orientated mixed asset or equity long/short funds during this challenging phase. As we emphasise in our IA Sector Overview, the sector features funds that are appropriate for a wide range of different risk appetites, so careful selection is warranted. The last year has been tough and therefore it is a helpful time period to review and analyse the risk and return characteristics of different types of funds.
IA Sector Highlights
In the UK, it was a much improved month for mid and small caps as the trauma of referendum died down. This saw a recovery in the performances of some of the funds that had been hardest hit last month. Nonetheless, multi-cap funds continue to struggle relative to the main index on a year-to-date basis. Conversely, the largest cap, most defensive funds tended to underperform over the month. In a change of sector trend, the banking sector was relatively robust, while the oil & gas sector weakened sharply at the end of the month in response to the falling oil price.
In Europe, there was a less overt market cap effect compared to the UK. Performance patterns at the sector level were mixed but a bias to more cyclical areas tended to be helpful. Similarly, cyclicality and growth were generally rewarding in the North American and global sectors, while income-biased funds struggled to keep pace.
A change of trend in Japan, sparked by yen weakening, saw large caps outperform small caps and this was reflected clearly in the performances of different funds in the sector. In Asia and emerging markets, more cyclically-tilted funds tended to outperform.
In an extremely strong month for sterling bonds, funds exposed to interest rate risk and spread risk, particularly in the investment grade market, performed well. More defensively positioned funds underperformed.
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