Review of the first quarter:
The first quarter of 2016 started with a bang as Chinese equity markets brought on renewed instability to global markets. More weakness in the oil price also added to growing investor fears, who instead sought safe havens such as Treasuries, Gilts and Bonds. Following the decision by the Federal Reserve to raise interest rates in the previous quarter, expectations for further hikes in the cost of borrowing were pushed back as heightened volatility in global financial markets gave way to a dovish outlook.
Closer to home, the European Central Bank continued with its stance of ultra-loose monetary policy, as investors expressed concerns over the ability of central bankers to stave off deflation. The feeling that the ECB has exhausted all of its options resonated strongly with investors, as growth and inflation data remained persistently low, while unemployment stays the polar opposite. Meanwhile, British Prime Minister David Cameron announced a sooner than expected date for the EU referendum, causing sterling to weaken considerably against the dollar. In Asia, the Bank of Japan spooked markets by implementing negative interest rates, while Japanese equities continued to suffer as the economy contracted over doubts regarding the credibility of the government’s Abenomics programme. Emerging markets had a rocky start to the year as the Chinese government lifted selling restrictions on mainland stocks in January, while other headwinds included poor economic data and sustained weakness in the Yuan.The actuarial view:
Back in December we saw the Fed raise rates for the first time since 2006, anyone expecting this to signal a return to normality however will have been disappointed. If anything the future appears murky, with an outlook of mixed to gloomy at best. Interest rates remain below where they were this time last year and equity markets have not recovered since their collapse in August. We remain stuck in a situation of lower prices and weak growth, despite strong employment figures. The question is will wages start growing, or are we perhaps heading towards another financial crisis? Alternatively could it be that most economies are just 10 years behind Japan, where rates have been falling since 1990 and 1989 remains the market peak.
Looking at the US and the UK, supposedly the most robust of economies, we are receiving mixed signals. Japan and Europe meanwhile seem to be improving, albeit from a very low base, with growth now coming into line with the US and UK. Generally we are seeing an easing of the negative outlook for bonds versus cash and the outlook for developed countries has improved relative to that of emerging economies.What to look for in Q2:
Asset class scenarios:
- BoE Monetary Policy Committee Meetings: The next announcements are due on the 14 April, 12 May and 16 June. The bank has remained dovish so far in 2016, with the MPC voting unanimously to keep interest rates on hold at their current level of 0.5 per cent. Inflation is picking up slowly but is likely to remain low enough to allow the bank not to increase rates this year at least, while wage growth continues to disappoint.
- Fed Meetings: The next meetings are scheduled for the 26-27 April and 14-15 June. After the decision by policymakers to finally increase interest rates in December, the turbulence which followed in global markets has casted doubt over when the next rate hike will occur. The US labour market continues to tighten and the economy looks very robust, so it will be interesting to see if the Fed delivers on its intentions to raise rates four times this year.
- Governing Council of the ECB: The next meetings are scheduled for the 21 April and 2 June, with press conferences to follow on the same day. The ECB continues to deploy its monetary easing policy while both the Fed and the BoE are looking to tighten. As we mentioned earlier, investors were spooked at the prospect of another interest rate cut in March, with a loosening policy having the opposite effect tan desired for European bourses.
- EU Referendum: After much speculation, the date for the when Britain decides on its membership of the European Union has been set for 23 June. Whether Prime Minister David Cameron’s attempts to grant the UK “special status” will resonate with voters remains to be seen, following negotiations in February.
Most Likely: The next quarter is going to be dominated by the ebb and flow of opinion polls regarding June’s EU referendum. It’s the uncertainty rather than the outcome that equity investors are worried about. Nevertheless the correction since last year’s high means valuations are reasonable.
Worst Case: Volatility is likely to rise ahead of the membership referendum in June, especially if polls don’t give clear indication. We note that earnings growth forecasts in the UK are the worst of the key global markets. The UK market has heightened exposure to commodity and Emerging Markets sectors, which continue to come under pressure given the continued downward pressure on oil prices.
Best Case: After a disappointing quarter for the UK equity market, its exposure to the commodity and energy markets, as well as its strong dividend attraction, makes it one of the more favoured destinations for contrarian investors this spring. The rotation from growth to value, defensives to cyclicals will favour more contrarian investors willing to be a bit early into the new market phase.
Most Likely: With the risk of further US rate rises receding, the period is likely to be focused on underlying economic developments and corporate profits. However there are several destabilisers on the horizon such as the US presidential race, and Brexit referendum; noise surrounding these topics should build over the coming months.
Worst Case: A repeat of August 2015 or January 2016 could see global equity markets suffer a bout of sharp losses despite few early signs of trouble. Triggers for this be a deteriorating US, European, or Chinese economy; the US is already being claimed by some fund managers and economists as entering a late stage of its economic cycle. Concerns over Chinese debt levels have dissipated recently, however a tightening of credit conditions and rise in loan defaults could easily spark fears of a financial crisis with global knock-on effects.
Best Case: Equity markets, undisturbed by macroeconomic events, continue to benefit from the increased supply of liquidity from the European and Japanese Central Banks, amongst others. Without any significant economic distress signal, a risk-on appetite could see global equities retrace more of the losses suffered during the last 18 months.
EMERGING MARKET EQUITY
Most Likely: There is a mild recovery of sentiment towards emerging markets as commodity price falls slow or reverse. A weakening dollar also reduces pressure, although any interest rate rises in the US are met with short term volatility. Equity market growth is best in consumer-oriented and technology areas. Returns are very variable among countries, depending on valuation and the political and economic context in each.
Worst Case: Chinese data is very poor, causing investors to worry about the emerging market countries dependent on China. The party cannot control a banking crisis in China which is felt in a large number of defaults, hitting business confidence and consumer spending. Commodity prices weaken further, hurting Latin America and other exporters, while political issues bedevil some countries and the US dollar surges again as investors seek a haven from a risky environment.
Best Case: Emerging market equities are pushed up by investors attracted by their cheap valuations. Politics leans in a pro-business direction while a weaker US dollar provides a boost to companies and governments with dollar debt. Chinese data is strong and confidence rebounds in the region. Commodity prices rise from their nadirs, boosting exporters and allowing supportive fiscal policy.
Most Likely: Cash returns continue to be significantly below appealing levels, sitting barely above the inflation rate. Nonetheless it would still provide safe haven appeal should investors have negative views on both equity and fixed income markets.
Worst Case: Signals from the Federal Bank indicate a low probability of another interest rate rise. Additionally OPEC might decide to reduce output to boost the oil price which could trigger a global rally in bond and equity markets, not only making the relative return on cash seem worse, but also boosting inflation to further erode the real return as well.
Best Case: A deteriorating global growth outlook combined with rising interest rates and falling commodity prices could create the situation whereby both equity markets and fixed income markets fall in tandem, meaning that in relative terms, the neutral positioning of cash would triumph.
Most Likely: Treasury and Gilt yields remain low. Inflationary pressures rise in the US and oil price falls fall out of the data. However, scepticism about medium and long-term growth tempers the effects of short term inflationary pressures. The Eurozone remains near or in deflation while demand from China slows. Markets worry about Brexit, which keeps demand for low-risk investments high.
Worst Case: US CPI is revised up sharply. Economic data is unambiguously good and investors sell Treasuries and high quality bonds to invest in equities and in the economy. Globally the news improves and the UK looks set to unambiguously vote to remain in the EU. Yields rise as globally investors seek risk assets.
Best Case: In the US data is ambiguous at best, while oil prices retest earlier lows. Deflationary fears prevail in the global economy, with longer term fears over Chinese growth depressing sentiment towards world growth. Yields continue to fall across the curve. Investment grade corporate spreads
tighten as investors prefer them to equities. High yield remains out of favour as investors believe the business cycle is heading to recession.
Most Likely: In the UK, most of the market performance will be driven by any Brexit-related announcement. The referendum will happen at the end of the quarter and a lot of noise is expected in the run-up, as the stability of the property market will depend on the deal agreed.
Worst Case: Foreign investors shy away over fears that the UK will leave the EU. This selloff or demand pullback will put pressure on prices and create volatility. The Bank of England follows the Fed’s footsteps and raises interest rates. While this could have a negative effect in the short term, this is likely to reflect a stronger UK economy and push rental growth further in the long term.
Best Case: Volatility creates opportunities for investors who can weather short-term disruptions. In the UK, portfolios holding less City offices should emerge in a better shape than less diversified ones. Elsewhere, low interest rates still make real estate an appealing proposition. Rental growth is helped by improving economic conditions, which would see corporates increasing their demand for space.
Lovewell Blake Financial Planning Limited is a firm of independent financial advisers authorised and regulated by the Financial Conduct Authority.