Are there reasons for further optimism after a strong 2017 for global equity markets?
We are concerned that valuations of markets overall are a little extended, but this has been skewed by very strong performance from the technology sector. This has also had the effect of pulling the gap between US and European valuations to a new wide. However, the top five stocks on the S&P 500 index currently total a similar combined market cap to the smallest 250 names in that index, once again demonstrating the value ascribed by investors to the growth prospects of technology companies and the view that they will continue to be able to grow against a backdrop of secularly sluggish economies. We are comfortable with the view that the returns available on equities are still likely to be superior to those on cash or fixed income as we write, although if bond yields continue their march upwards and begin to offer significantly better real yields this situation could change.
How concerned are you about the prospects of coordinated tightening by central banks around the world?
Tightening has been much trailed, not least by the Federal Reserve (the Fed) and the European Central Bank, in an attempt to prepare markets for possible action. While there may be scope for ‘taper tantrums’ here and there, we are not overly concerned that the quantum or pace of these actions alone will be sufficient to derail markets, especially as we believe inflationary pressures to be structurally subdued. At the time of writing, market expectations of inflation have risen, but we view this more as a late-cycle situation and certainly not representative of any form of inflationary problem. What could prove more troublesome would be a sharper – and more sustained – inflationary impulse, which could oblige central banks to be more aggressive in tightening policy and begin to affect the large stock of both public and private debt written at ultra-low interest rates.
We do not expect this to happen on a widespread basis, but some pockets of pressure are appearing. Low-end wages are rising meaningfully in Japan, for example, for the first time in some years. In our view, the Bank of Japan is the major central bank least likely to tighten policy to any great extent or sustainably as this effect has not been felt consistently across that economy. Notwithstanding this, any small rise in Japanese government bond yields would be viewed as significant in the context of a zero-interest-rate environment; and we are alive to the market impacts this could have, not least a potential (and perhaps temporary) strengthening of the yen.
What are the primary political risks facing Europe?
Nationalistic tensions continue to be witnessed across Europe: interestingly, the peripheral nations of Hungary and Poland have shown their own resistance to immigration in recent months. However, it seems that, for now, the high point of nationalist feeling represented by Brexit, the Trump election victory and the strong early electoral performances of both Geert Wilders in the Netherlands and Marine Le Pen in France in the first half of 2017 has receded.
Catalonia is something of a different story: a wealthy region of Spain, which has long felt different to the rest of Iberia, has seen its local political leadership use the nationalist backdrop as a ‘Trojan Horse’ to launch its bid for independence; but this is more a question of intra-country economics than immigration. Indeed, the Catalonian nation, were it to exist independently, would be a strongly pro-European Union state and very keen to assert its European credentials, in contrast to the UK which has never been wholly comfortable with the idea, let alone the construct, of the European Union (EU).
Despite the occasional bungle, the UK political outlook has stabilised a little. The chaotic recent Cabinet reshuffle following the resignation of Theresa May’s deputy Damian Green over a personal behavioural issue served to highlight her underlying vulnerability. However, it does seem that her personal standing has improved somewhat and her minority government has consolidated into a ‘weak and stable’ existence.
The conclusion of the first phase of Brexit negotiations came as a relief to both the administration and the UK currency: sterling has been resilient in recent weeks (aided by a Bank of England rate increase). There are signs, however, that corporate investment is slowing as consumer credit is growing – a potentially toxic combination – and the strong overall employment data masks the fact that wages are struggling to keep pace with accelerated inflation. The second phase of Brexit talks may see the EU struggle to maintain the unity exhibited in the opening round, especially as trade arrangements, an area of consistent bickering within the EU, are to be discussed: this could prove to be useful to the UK at the negotiating table. All we know for sure is that there will be many more twists and turns before the Brexit saga is finally resolved.
A ‘strong and stable’ Germany is clearly important to the EU, and the drawn-out nature of coalition negotiations are not helpful. However, despite the politically damaging missteps regarding European immigration which she made in recent times, we see Angela Merkel as a canny politician with strong public support. Whether via a grand coalition or another set of elections, our basic assumption will be that she will remain in place and that markets will not ascribe huge importance to the day-to-day events in German politics – especially as the mainstream element of it does not represent any existential threat to the EU.
What are your views on Japan’s investment prospects?
A recent investment visit to Japan has confirmed our relatively constructive view on the country’s economy and stock market. After a scare, Prime Minister Shinzo Abe and his Liberal Democratic Party were recently re-elected comfortably: this means both that government policy will remain consistent, and that the leadership of the Bank of Japan is likely to continue to be provided by Governor Kuroda. Monetary policy will very probably remain extremely loose as a result. Moreover, the corporate governance policies encouraged by the authorities seem to be becoming gradually embedded into company managements’ behaviour, while disclosure and shareholder returns continue to improve slowly but surely. The Japanese market in its entirety may not be a significant outperformer on a consistent basis from here after a strong recent run, but we feel it offers compelling opportunities for the stock-picker.
Chinese internet companies were standout performers in 2017. What are their prospects over the next 12 months?
As stated already, technology has been a favoured area owing to secular changes in consumer behaviour, represented by the ‘internet of things’, the dominance of smart devices, the advent of electric vehicles and so on, convincing investors that it offers the best source of clear growth against a relatively subdued secular economic backdrop. Chinese e-commerce firms are also able to harness the unique once-in-a-generational opportunity offered by the domestic consumer in regard to these trends, and both their operational and stock performance were stellar in 2017. There is no doubt, however, that as these stocks represent increasingly large chunks of major indices (more than 10% of Hong Kong’s Hang Seng Index in one case), there is some forced purchasing. Such money flows invariably find their own balance eventually in the form of profit-taking by early investors. This can lead to volatility.
On a global level, do you expect to see managers shifting away from expensive growth stocks into cheaper value-oriented areas such as financials, industrials and energy companies?
There is a chance that investors will rotate into value stocks to some extent, echoing the shift from growth to value witnessed in 2016. The difference this time may be the pace of any monetary tightening pursued by central banks. Should rates rise in a more sustainable way than is priced in by fixed income markets (at the time of writing, the yield curve in the US Treasury market had been shifting upwards in parallel, indicating limited belief that rate hikes will continue for a prolonged period of time), this may benefit the banks much more than other value sectors such as commodities, utilities and industrials. Furthermore, the prospect of a consequently stronger US dollar would crimp the potential for outperformance from energy and commodities.
How do you view China’s overall prospects in 2018?
We have been cautious about the sustainability of the Chinese growth story for some time. However, despite seemingly unstoppable growth in private debt, signs that the government wishes to slow things down somewhat should be taken positively. An intentionally slower, more sustainable rate of Chinese growth can only be good for the rest of the world. The spectre of an ugly bust would be lessened, and companies and investors would be able to apply a longer timescale to their assumptions on (nonetheless weaker) Chinese economic expansion. Of course, growth elsewhere would be useful to take up the global slack; and sustainable sources of this are not straightforward to identify as Western economies struggle with demographics, the undesirable side-effects of technological development on pricing and employment, and spiralling welfare bills. It is also difficult to see a high number of emerging economies not being negatively affected by a slower Chinese growth trajectory.
What is the outlook of the US dollar over the next several years?
The US dollar has trodden water – indeed, weakened somewhat – in recent months. It certainly seems that the Fed would have to embark on a longer and more sustainable series of rate rises for the dollar to be able to regain its upward trajectory; and markets have not, until very recently, been convinced. At this stage, the Fed is most concerned with normalisation (and ‘fixing the roof while the sun shines’) as it wishes to give itself some interest-rate ammunition once the economy begins to slow. There is a chance that this sideways trend will continue until markets see some chance that the US rate cycle is appreciably different to that of other major economies (with the probable exception of the Bank of Japan which, as stated above, is very unlikely to tighten policy in any way other than perhaps to slightly relax its target yield for the 10-year Japanese government bond).
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