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Monthly Viewpoint – Review of September 2018 and Q3 2018

Date:
Author:
Gill Hutchison
IA Sector:
N/A
Asset Manager:
N/A
  • Equity markets were mixed, with Asia and emerging markets underperforming again.  US markets crept up to record highs, despite continued nervousness about trade and higher US rates. 
  • Rises in government bond yields resulted in negative returns.  High yield markets outperformed.
  • The oil price moved up in response to supply issues.  The gold price fell back.

Backdrop

September was a choppy month for risk assets, with the worries of trade tariffs, emerging market challenges and rising yields continuing to occupy investors’ minds.

The ongoing economic and political traumas in Turkey and Argentina remained in the headlines.  As investors scrutinised their exposures to emerging markets, weaker economies with the characteristics of current account deficits, external funding needs and high inflation also found themselves in the firing line.   According to Bloomberg, this year is seeing the longest rout in emerging market equities since 2008.

Trade tensions continued to bubble away as President Trump threatened and then implemented an additional $200bn of tariffs on Chinese goods and, inevitably, China threatened retaliation.  In unwelcome news for the President, data showed that Chinese exports to the US were higher than ever, as activity was front-loaded ahead of tariff implementation.

After the summer break, Brexit news returned to the fore and the Tory party continued to squabble about the so-called “Chequers” plan.  More positively, the UK and the EU softened their approach to some of the key demands, bolstering hopes of a breakthrough.  Later, however, an informal EU summit in Salzburg reinforced the intractability around the Irish border problem.  As usual, sterling moves tracked the flow of Brexit news; in September, sterling climbed slightly against other currencies as some optimism for a deal emerged.  Economically, GDP data showed that growth was pepped up by the hot summer weather, the Royal Wedding and the World Cup; data also showed an improvement in wage growth and stronger-than-expected retail sales.  This also supported the pound.  Nevertheless, the Bank of England held firm on interest rates, citing the uncertainty surrounding Brexit.  Indeed, Mark Carney issued a stark warning about the potential dangers to the currency and the housing market in the event of a “no deal”.

The parlous state of Italian finances returned to the spotlight, putting pressure on bond and equity markets.  The coalition government’s spending plans mean that it will fail to meet its budget deficit target, a level previously promised to the European Commission.  With the second highest public stock of debt in the EU (after Greece), financial markets remain nervous about the trajectory of the country under populist rule.  More broadly, disappointing economic data was released from Germany and France.

As expected, the US Federal Reserve raised rates by 0.25% at the end of the month, the eighth hike since 2015.  The committee kept to its plans for steady interest rate rises, forecasting another hike in December and three more next year.  The immediate market response from this well-flagged policy change was muted, with more dramatic market moves transpiring in October.

Equity markets

Sentiment towards equities was mixed, but broadly improved over the course of the month on hopes that trade tensions would ease.  Indeed, US indices crept up to record highs, delivering a modestly positive return over the month.  Notably, the technology sectors were not in the vanguard of performers.

In the UK, the broad market chalked up a positive result, with large caps outperforming mid and small caps significantly.  At the sector level, there were large variations in performance; style-wise, value outperformed growth.  The strength of the oil price was helpful for the oil majors and related companies.  As in other markets, financials fell away at the end of the month as concerns about the Italian budget intensified.  The broad European index failed to make headway and, similar to the UK market, there was plenty of sector dispersion, with value as a style ahead of growth.  Japan was a bright spot and one of the best performing global equity markets over the month.  With better economic data and Prime Minister Abe winning his party’s leadership election, foreign buyers returned to the market.

After a long period of weakness, Asian markets finally caught a (short-lived) bid during September, although this did not prevent the broad index from registering another negative month.  Similarly, emerging markets declined.  Of note, Turkey saw a relief rally after this year’s deep losses.  Interest rates were raised to 24% (+6.25% rise in one move!) in order to support the lira.  Meanwhile, India was a negative outlier, with the market finally succumbing to external pressures (higher oil price, weakening currency, rising rates).

Bond markets

With sovereign bond yields on the rise, bond markets were under pressure in September.  UK gilts delivered a negative return, with longer maturities suffering to a greater extent due to the effects of duration.  Corporate bonds were also in negative territory, but to a lesser extent than government bonds.  Lower-rated credits eked out a positive return overall, benefiting from their lower sensitivity to interest rates.  The US 10-year yield breached the psychologically-important 3% level, while the UK 10-year yield moved up through 1.5%.  German bunds also succumbed to upward pressure on yields.

Commodity markets

The oil price moved higher as traders focused upon supply issues, notably, the slump in Iranian exports and the effect of the ongoing turmoil in Venezuela.  Furthermore, Saudi Arabia signalled that it is content with a price above $80 per barrel (President Trump, less so…).  The performances of other commodities were mixed.  The gold price fell away at the end of the month; its traditional safe-haven status remains elusive for now.

The third quarter of 2018 in review

Geopolitical stories continued to occupy investors’ minds during the third quarter, namely, the escalating trade war rhetoric and actions, emerging market weakness (notably Turkey and Argentina), Brexit and political and budgetary stress in Italy.  The influence of these stories has ebbed and flowed, but eased towards the end of the quarter, with the result that US treasury yields rose, the dollar softened and emerging markets (temporarily) arrested their declines.

Bonds treaded water for much of the quarter, but the rise in yields at the end of September took the quarterly return into negative territory.  For the period as a whole, higher yielding credits fared better than sovereign bonds.

The global equities delivered a robust positive return for the quarter, thanks in large part to the contribution from US equities given its dominant size in indices.  Japan was also helpful, following the rally in September.  The performances delivered by other equity markets were far less compelling.  European markets generated a modest positive return, but the UK was marginally under water.  Asian and emerging markets were once again the laggards.  With sterling weakening over the period, unhedged overseas allocations were helpful for UK-based investors.

Market thoughts

We have been pointing to the risk of continued strength from US assets, if only because of the important dynamic of investor positioning.  US equities (and until recently, technology equities specifically) have been the last refuge in a fraught world.  While the US economy and earnings roll on, there is little to shake its relative attraction and fund flows simply complete the virtuous circle.  We can worry about valuations and, ultimately of course, they matter; however, valuation metrics have never been a good timing tool, as we are currently being reminded.  However, we should consider our future return expectations when we think about today’s prices.

By contrast, the UK market is still in the dog-house, overshadowed by the Brexit muddle.  As one fund manager described it, stock and sector performance is akin to, “jelly wobbling on a plate, with sterling providing the tremors”, (Adrian Frost, Artemis).  The occasional flurry of M&A is a reminder that relative valuations have appeal, but until we have some visibility about the likely shape of things after 29th March 2019, it seems unlikely that the UK market will attract a broader audience.

So far, 2018 has been a much more difficult year for a host of reasons.  As interest rates rise and the cost of capital increases, the tide will continue to go out on the most fragile investments.  With this in mind, equity fund managers are increasingly focused upon corporate leverage.  Margins are also in the spotlight as cost pressures increase; in an internet-powered world of elevated competition and pricing visibility, passing costs onto consumers is no mean feat and some companies will simply have to take the pain.

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