Equity markets were generally strong in July, as investors appeared to shrug off fears of a global trade war. US and Eurozone equities were particularly strong, Asia and EM in the middle of the pack, and the UK bringing up the rear. Although sterling has not been that much weaker against the dollar than the euro in recent weeks, it may be that Brexit concerns are starting to impact the UK equity market.
"Trump is attempting to rewrite rulebooks on so many fronts"
As for bond markets, yields across the developed world rose during July. This was more about higher real interest rates than higher inflation expectations, suggesting that the rise related to investors anticipating tighter monetary policy ahead. That said, although longer term inflation expectations in general have been stable for the last few months, they appear to be in an uptrend that began in 2016. Furthermore, the University of Michigan monthly survey now has 1 year and 5-10 year inflation expectations at 2.9% and 2.4% compared with 2.2% and 2.3% at the end of 2016.
Expectations of interest rate hikes in the coming two months in the US and the UK increased in July. The implied probability of a rise in the Fed Fund Rate at the September meeting rose from below 80% at the end of June to 92% at the end of July. A similar pattern was seen in the UK, with the chances of the Bank of England increasing the Base Rate at the 2 August meeting rising from 70% to 90%.
The respective central banks had guided these expectations higher over the month but so too did the macro data. In the US, second quarter GDP came in at 4.1% quarter-on-quarter annualised, with the first quarter revised up from 2.0% to 2.2%. In the UK, employment change, construction output, unit labour costs and the composite purchasing manager index were all higher than expected or the previously announced figure. Late in the month, consumer credit data was announced, showing that credit card growth reached 9.5% YoY in June. This compares with mid-single digit growth back in 2014 and 2015.
It is a somewhat different story in the Eurozone and in Japan where the possibility of interest rate hikes this year remains remote. That said, there is now evidence of inflation pressures building in both jurisdictions. Monthly cash earnings in Japan are now rising by 2.1% YoY compared with zero for much of 2016 and 2017. In Europe, wages and salaries are rising by 1.8%, showing a clear acceleration in the last five or so years.
Another potential source of inflation down the road is the oil price, which has been rising sharply this year.
In the emerging world, perhaps the most important development relates to the Chinese currency, which has depreciated significantly in the last two months both against the dollar and on a trade weighted basis. This is clearly a response to the US trade tariffs imposed on Chinese goods thus far as well as fears of further tariff hikes. An even cheaper Chinese currency is certainly not what US president Trump intended so this issue still has the potential to spiral out of control. Indeed, Trump is attempting to rewrite rulebooks on so many fronts, whether internationally with respect to North Korea, trade, Iran, or domestically in relation to such issues as immigration and taxation, and it is unclear what the longer term implications of such an approach will be.
Of course, trade tariffs themselves are inflationary in that they feed straight through to consumer prices. They may also hurt growth so the prospect of some sort of “stagflationary” environment looms large.
As for fund activity, we reduced equity targets across all five Sequel funds in July, as well as for all other funds under our management. This was a scheduled reduction, as per the road map we have laid out for asset allocation changes as we move ever closer to the end of the cycle. The reduction came out of the UK, where we think inflation is becoming more pronounced and thus where we expect more hawkish language from the central bank. Specifically, we took the opportunity to exit one of our UK holdings that has become very expensive as a result of strong share price performance. Sales are ongoing so it would not be appropriate to broadcast the name at this stage.
In terms of use of proceeds, we added to holdings in our two short duration high yield funds. Spreads had risen in recent weeks so on a short-term basis the timing seemed reasonable. The asset class allows us to avoid duration risk (the risk relation both to rising inflation and rising real interest rates) while maintaining exposure to credit risk which we think can continue to generate decent returns for the foreseeable future.
Looking ahead, there has been no reason to change our expectations, namely that the global economy is now in expansion phase and will continue to move in a forward direction towards peak phase. In the expansion phase, we expect equity returns to fall but remain positive and bond returns to be negative. Commodity prices in this phase tend to be good, as evidenced by the rising oil price in recent months, but they can also be impacted by events such as the recent rise in trade tensions (note the poor performance of late of some industrial metals).
Published in Investment Letter, August 2018
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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