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February 14, 2019

Investment Outlook

Tom Elliott


Market sentiment: remains strong, as lower-than-expected USD interest rates over the coming year are priced into investor’s valuation spreadsheets. The risk of a U.S recession this year is substantially reduced. However, investors are a little mystified as to why the Fed announced a pause in its interest rate hikes in late January, so soon after it raised rates in mid-December and promised that there were more to come. Did it blink on account of December’s market volatility? Risk assets look set to rally further, with emerging market equity and debt in particular benefiting from relief over U.S interest rate forecasts. The VIX index of implied volatility on the S&P500 index stands at 16, down from a recent high on Christmas Eve of 36.


The so-called ‘Powell put’ continues to support risk asses. Much of January’s rally was in anticipation of a slower approach to interest rate rises than that suggested by the Fed’s ‘dot chart’ in December. This reflected Fed chair Jay Powell’s early January promise to be ‘patient’ on tightening monetary policy, which was reiterated throughout the month by Fed officials. However, few anticipated the declaration at the end of January by Powell that all further interest rate hikes will be put on hold. In addition, he declared that the $50bn a month shrinking of the Fed’s balance sheet was no longer on ‘auto-pilot’, but that the Fed will be flexible in its approach.


Why the turnaround? Powell cited slower U.S and global growth, tighter financial conditions, and geopolitical tensions. Yet little had changed in the preceding month. In fact, U.S January jobs data came in much better than expected, with 304,000 new jobs created. And geopolitical tensions do not appear worse than in December, whether considering the U.S/ China trade dispute or the risk of the U.K government driving the country into a chaotic no deal Brexit. But business and consumer confidence (such as the University of Michigan consumer confidence survey) had weakened sharply since the autumn. Perhaps the Fed became anxious that the fourth quarter’s fall in risk assets, particularly sharp in late December, was not so much a leading indicator of a coming recession but a potential driver of one as weaker stock prices held back confidence.


Santander’s decision not to make an early repayment of a EUR 1.5bn tier 1 capital bond (a so-called AT1 bond) will rattle investors in European bank debt. But a useful lesson is being taught. The Spanish bank’s decision probably reflects careful balance sheet management and a wish to preserve shareholder equity, rather than anything wrong in its (strong) balance sheet. It had the chance, but not the obligation, to call (ie, repay) the perpetual loan yesterday, and tradition dictates that this is done. This unstated obligation to repay makes the debt ambiguous – is the bond loss-absorbing capital, or not? The ambiguity suits both banks and investors, until there is market stress and investors claim the debt has a higher level of seniority than what the bank had told its regulator and shareholders.


However, as part of reforms made to euro zone banks after the financial crisis, the European Banking Authority (EBA) has made clear that it does not support this approach if it would mean the bank re-financing the debt at a higher cost. And it would prefer clarity over ambiguity. Santander are delivering this clarity to the bond market, potentially lowering the price of callable perpetual bank bonds throughout Europe as investors recognise a new reality. Those banks who have relied too much on the ambiguous nature of this type of bond, to hide fundamental weaknesses, may perhaps be afraid today of being shown up.




1)  Running down the clock. U.K Prime Minister Theresa May appears to have found a use for the Irish backstop. Her plan is to offer to re-negotiate the backstop with Brussels, despite E.U officials and heads of state making it clear that they will not make any meaningful changes. However, this ‘renegotiating’ ruse quite usefully kills time until the 29th March deadline, by blocking off demands from within her own government, as well as Parliament, for other options to be considered – such as a second referendum, or a Norway Plus arrangement.


2) Playing chicken with Parliament. May is probably expecting that, at a European Council of Ministers’ meeting on the 21st March, E.U heads of state will offer a very minor concession on the Irish backstop, to help her save face and her deal. She can return to Westminster boasting of as a significant concession, which she hopes Brexiters will now support. With this small alteration to the backstop provision, the same Brexit bill that failed in January will be again presented to the House of Commons for a ‘meaningful vote’ with just a few days to go before the U.K is due to leave the E.U. If it fails, ‘hard line’ Remain and Brexit-supporting M.Ps can then be blamed for allowing a no deal by default, and be blamed for any ensuing economic chaos.


But this is a high stakes game of chicken, given that many Brexit MPs appear to relish the idea of a no deal, as the best way of ensuring a ‘clean’ Brexit (May has herself said that ‘no deal is better than a bad deal’). It is also perfectly possible that the public blame her and the Conservative Party, rather than an assortment of M.Ps from different parties, if no deal occurs.


3) A complex triangulation is developing. Brexiters fear no Brexit over May’s deal. Therefore May is considered likely to triangulated her game of chicken, by at some time raising the possibility of delaying Brexit by extending Article 50. This will be to ensure the Brexiters vote for her deal, since the longer the process goes on, the greater the likelihood that Parliament will take control of Brexit and demand that the government consider the other, soft Brexit options or a second referendum. The danger of this approach, however, is that what might scare Brexiters will delight Remainers, who may vote against her deal in order to make use of the extended time period to give more power to Parliament.


4) Brexit and the markets. Sterling does not like the weaker economic data coming from the U.K, nor the game of chicken played by the U.K government. However, if the U.K does seek an extension to Article 50 we can expect a relief rally for the currency that will be sustained if Parliament then succeeds in forcing the government to consider other options, such as the Norway Plus (that would prevent the U.K from making its own trade deals, but would eliminate the Irish border problem). A soft Brexit will favour domestic-focused U.K small cap stocks over blue chip multinationals, which will see the sterling value of foreign earnings fall as the pound rallies.


5) The U.K economy grew at just 0.2% over the fourth quarter, and 1.4% overall in 2018 – the slowest rate of growth since 2009. Much of this has been blamed on sharp falls in industrial production, with autos, steel and construction activity down sharply. It is unclear how much of this is Brexit related. There is plenty of evidence that, as the Brexit deadline approaches, businesses are tending to put on hold investment plans and new hiring. However, the auto sector has ben hit by a sharp downturn in Chinese demand and weakness in the euro zone economies has also had a knock-on effect on the U.K economy.


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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