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April 01, 2019

Investment Outlook

Tom Elliott

Market sentiment: Less firm, after a period of volatility for risk assets in late March. But declining yields on core bond markets help support stock market valuations and will limit outflows, until a pick-up in news flow.


Hurrah for the long-term investment approach. The bull market for risk assets that marked the first quarter of 2019 resulted in very strong gains for stock markets. The January U-turn in Fed policy, large share buy-back programs, and hope that China and the U.S will come to an agreement on their trade dispute, all helped support the rally. The MSCI World index rose 10.7% in USD terms over the period, while the MSCI Emerging Markets index was up 9.9%.


This demonstrates the wisdom of buying and holding stocks for the long term, rather than selling in moments of market panic, such as we saw in December. Over the 12 months to the end of March, the MSCI World Index is up 4.0% in USD terms, a reasonable return that comfortably beats inflation and the returns available on risk-free assets such as bank account cash or G7 government bonds.


Why the new uncertainty? But the final weeks of the quarter saw a return of nerves on many stock markets. Fears grew of over-extended stock prices following the Q1 rally, and nervousness over the health of the U.S and Chinese and European economies. The U.S Treasury yield curve has flattened as medium and long-dated Treasuries have rallied, with slight inversions happening in recent weeks. This has been taken to be a warning of a coming recession by some commentators, many of whom have now begun to question whether the Fed’s January U-turn on monetary policy came too late. German manufacturing data, which is often seen as a proxy for global demand of high-end consumer and capital investment goods, has weakened significantly.


Factset, in their end-March survey of analysts’ corporate earnings estimates, report first-quarter consensus earnings growth on the S&P500 of -3.9% year-on-year, the first decline since Q2 2016. The VIX index of implied volatility on the S&P 500 rose to 16.6 on the 22nd March but ended last week at 13.7.


The joy of multi-asset investing. And yet, while nervousness on stock markets crept back, a strong rally in G7 government bond markets benefited those investors who have fixed income exposure. Government bonds might well be boring, but in times of market uncertainty, their (often) negative correlation with stock markets is extremely useful, helping to limit the extent of losses in an investment portfolio. This is why multi-asset funds tend to offer better risk-adjusted returns over the long term than pure equity funds, which may outperform multi-asset funds but with greater volatility along the way.


What should the Fed do now? As at the end of Friday, the U.S 10 year Treasury yielded 2.42% while the three month Treasury note stood at 2.38% (having temporarily been lower than the 10 years a week earlier). This surely signals a need for the Fed to be cutting interest rates, to avoid -or at least to minimise- a recession, which financial history suggests may come approximately 18 months after yield curve inversion first happens. Inflation is modest by any chosen measure, suggesting there is room to cut rates, yet to do so while wage growth continues to rise (3.4% y/y growth in February, a 10-year high), in the context of a tight labour market, risks unleashing inflation. Unless the old rules of macroeconomics are dead? It is a difficult position for the Fed to find itself in.


Brexit…towards Turkey? Last week’s indicative votes in the House of Commons demonstrates that MPs cannot agree on any one type of Brexit. Therefore it may be that a second public referendum, on the option that is least-disliked by MPs, is the path forward. A second indicative vote scheduled for today is likely to show this to be for the U.K remaining in the customs union, but not the single market, in a position perhaps similar to that of Turkey. Sterling would rally on such an outcome. But the road to such a deal is long and winding.


Prime Minister Theresa May is determined to fight anything but her deal. Besides, membership of the customs union would stop the U.K from making trade agreements with other countries, and so would be unpalatably ‘soft’ for many Brexiters in the cabinet and for most Conservative party members (who number a surprisingly small 120,000). But she is also resisting a no-deal Brexit on 12 April, which is favoured by many Brexiters in cabinet, and the vast majority of the Conservative Party membership, on account of the likely chaos for the economy. Hence she may well bring her deal back to the House of Commons for another vote this week, or next, presenting it as the only Brexit solution available and resigning if it passes.


But a fourth attempt, with or without the political declaration attached to the Withdrawal Agreement, is likely to fail. This is because the Ulster Democrat Party (UDP), partners in May’s government, see the Irish backstop as undermining Northern Ireland’s ties to the U.K. For these to be maintained at the current level, no Brexit is felt to be preferable to any outcome except a hard Brexit without the Irish backstop, or no-deal.


The road to a Turkey-like relationship, therefore, requires a change of Prime Minister. It would also require Labour to drop demands for ‘a’ customs union (details of which are vague), and support ‘the’ current one instead. But Labour does not want to help solve the Brexit crisis, which is splitting the Conservative party for them. It would also require the next Prime Minister re-negotiating the political declaration, meaning Britain will have to seek a further extension on Article 50 and hold European Parliamentary elections in May. A general election might help deliver a parliamentary majority to deliver such a deal in the House of Commons, but it risks returning another hung Parliament.


Hence a second referendum, perhaps later this year or in 2020 is an increasingly likely scenario, in which voters will decide on a Turkey-like relationship with the E.U, or continuing full membership. If it comes to such a choice, my money is on the latter and for a strong rally in sterling.


A multi-asset portfolio for the long term. We favour a long-term run approach to investing, whereby investors choose a suitable combination of global equities and bonds (depending on their risk profile and investment horizon) and leave the portfolio unchanged. Regular re-balancing ensures winners are sold and losers are bought – which financial history, and common sense, supports. The chart below shows a typical long-term balanced portfolio based around 60% global equities and 40% global bonds. Financial history shows this combination to offer good returns relative to risk (ie, volatility). Investors should try to be as diversified as possible, perhaps using the 60/40 model as their guide. Multi-asset funds based on this principle are available, often with different ratios of bonds and equities depending on the level of risk suitable for an investor. Note that the chart shows neutral weightings for the long-term investor, it does not incorporate any near-term weighting suggestions made in previous paragraphs.

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