In our December budget Newsletter we touched on the ongoing impacts of the 2009 financial crisis and of the Brexit situation. We now comment further on both, but the enduring global hangover from the financial crisis of ten years ago is worthy of particular mention.
Those who have been readers of our Newsletters will recall our earlier observations on quantitative easing and on the ‘lower for longer’ interest rate outlook. One of the key impacts of both QE and low interest rates has been the support that they have provided to financial markets and, from there, to confidence in the economies of the USA, of EU countries (including the UK) and of Japan. Asset prices, and equities in particular, have been clear and significant beneficiaries of this process which has, in terms of confidence restoration, worked well.
As we moved through 2017, we saw initial steps taken towards higher interest rates and tighter monetary conditions particularly in the USA but also in the UK, while the remaining QE in Europe is being reduced. We are, finally, moving away from the period of rock bottom interest rates and of easy credit, although we are clearly well away from large scale monetary tightening. Nonetheless, the picture is beginning to change and we expect further moves in 2018 as the next stage in the post-crash monetary experiment begins to take effect. The impact of this on stock markets is hard to predict, and much depends on how skilfully central banks manage the process, including possible steps which they might take to begin to reduce their now highly overextended balance sheets.
In the UK, the subject of Brexit has attracted a huge volume of comment and for us, the most telling outcome so far is that growth in the UK’s gross domestic product since the referendum has slipped from being in top position among leading economies, to one that is close to the bottom of that particular league. We do not believe this is a coincidence.
2017 for Investors
Investors had a generally good year in 2017 with the FTSE 100 Share Index up approximately 8%, Germany’s DAX up 13%, the FTSE 250 up 15% while leading indices in the USA and Japan have risen by approximately 19%.
In the UK, the 10 year gilt yield ended the year at levels much the same as at the beginning, despite some volatility throughout. UK fixed interest investors have generally achieved a steady, if unexciting, capital return together with income levels that are reasonable by current standards. Steady and unexciting are of course key expectations among those fixed interest investors who withdraw the interest received and who are not in the sector for growth of capital. The fact that such growth has occurred in previous years has been entirely down to the previous falling interest rate environment which has now begun to reverse.
Sterling continued to depreciate against the Euro last year, by around 4%. This has negative consequences for the cost of goods and services supplied to the UK from within the Eurozone but there is some better news as Sterling has increased against the Dollar by 9%, very much as a result of the Dollar’s general weakness. This has helped to alleviate the negative effect of rising raw material prices, which are of course priced in Dollars.
I summary, markets continued to benefit from decent levels of growth in many economies from China through to the USA and much of Europe. This has served to underpin corporate profits and generally good returns for investors without excess volatility, comfortably outpacing the rise in inflation over the year.
The outlook for 2018
While there are risks in the global economy, the broad outlook continues to remain reasonably favourable in a number of respects. These include, perhaps most significantly, a continuation of economic growth in the US, in Europe, in China and elsewhere in Asia. This is underpinned by the benefits for now of low interest rates and low inflation, enabling companies to improve profitability at least in part due to easy access to inexpensive finance and to still relatively inexpensive raw materials.
We do however expect that the trend towards slightly higher interest rates, particularly in the USA, will continue as 2018 develops. Indeed, we see monetary policy development in the USA as one of 2018’s key global drivers, given the huge US influence on the global economy. If US inflation continues to undershoot, the new chairman of the US Federal Reserve, Jerome Powell (who takes over in February) looks set to make haste slowly with further interest rate rises, rather than risk the disruption that might otherwise be caused. This in turn will have a significant influence on the value of the US Dollar which has depreciated over the last year, a trend that we believe may now be drawing towards a conclusion, particularly if USA growth (which has surprised on the upside) and inflation turn out to be strong.
Turning now to the outlook for investment in US stock markets, by some standards equities look fully valued rather than overvalued. Mr Trump’s major corporation tax reforms will have a significant and positive impact on company profits and their ability to provide sound returns to shareholders. It appears that the President’s expectation is that this will lead to a stronger US economy (either through cash flows as a result of increased dividend payments or via additional investment in US plant and machinery, i.e. in ways that will encourage economic growth to offset the loss of tax revenue) while there is also an expectation that US companies will repatriate significant funds held overseas now that the potential tax burden on them will be very much reduced.
Generally, we continue to see US equity markets as an attractive medium to long term investment for which there is a clear place in portfolios either directly or via global funds.
In the Eurozone, the recent currency strength has been supported by increasingly strong levels of economic activity. There are of course political questions to be resolved, as at the time of writing the make-up of the German government is subject to negotiation while there are potentially significant elections in Italy early in March. However, Eurozone business activity ended 2017 at the strongest level for some 6 years and it would come as no surprise to see the ECB’s bond buying programme subject to further tapering earlier than previously thought. Generally, we believe that there are sound opportunities within Europe for equity investors taking a medium and longer term view point.
The UK represents something of a conundrum. Inflation is increasing and we note that the latest reading of the Producer Price Index shows an increase of over 7%, more than twice the current inflation rate, this reflecting in no small part the increasing price of oil and of other raw materials. It is also our view that skilled labour, increasingly in short supply, may be able to successfully demand stronger wage increases, in which case the appearance of domestically driven inflationary pressures may begin to emerge for the first time for some years. We note that the minimum wage increases by over 4% in April, also ahead of inflation. Taken together, these factors make it not inconceivable that the rate of hiring of workers will slow, particularly where lower skilled tasks can more easily be mechanised. This may lead to an apparent increase in productivity (the same output achieved with less workers) but it does nothing for the skills base or for government finances. Overall, given the continuing great uncertainty for businesses posed by Brexit, which are unlikely to be fully resolved in many areas until we are well past March 2019, we remain very inclined to maintain what are by our standards underweight positions in UK equities.
We turn now to the Far East and, given its regional dominance, comment on China is clearly appropriate. The suggestion is that the Chinese economy will grow by a further 6% this year, i.e. at a somewhat slower rate than in 2017 but nonetheless an entirely attractive one by global standards. It is however difficult to understand what may be happening behind the scenes in China where not all of the massive investment in recent years may be as productive as was hoped and it is possible that inefficient or wasted development has hidden bad debt lying behind it. However, it would be unwise to dismiss China’s ongoing economic resilience from an investment prospective, this observation also applying to India’s huge and rapidly growing economy.
In Japan, growth forecasts look reasonably steady at around 2.5% and if the government is as successful in its aim to accelerate wage growth, and to boost inflation (still below 1%) the Bank of Japan might start to cut purchases of government bonds, i.e. introduce tapering as within the Eurozone. The Japanese government will soon commence offering an element of corporation tax relief to companies which raise wages by 3% plus and/or if those companies, currently facing corporation tax at a materially higher level than in the UK, invest in new technologies. Clearly the concept of cutting corporate tax in order to stimulate growth is not just a feature of US policy!
Elsewhere in Asia and in other emerging markets economic resilience, in a number of locations supported by rising commodity prices, suggests a solid outlook despite problems in certain individual countries. As a consequence, the MSCI Emerging Markets Currency Index is now not too far short of its 2011 highs. Thus equity investors in those areas are obliged to buy shares quoted in what are relatively expensive currencies: this does not make those shares poor value over the longer term but it does add to shorter term currency risk. Overall, we remain broadly confident in Asia’s growth potential.
In summary, we believe that the outlook for equity investment from a medium and longer term perspective remains sound with scope for rising dividends and, over time, improving capital values. Risks of course remain as ever but it is here that long term value can be added and equities continue as a core element within portfolios.
The easy money policy established after the crash is, if not ended, at least beginning a probably slow return to normality. Thus the case for fixed interest investment is not as strong as it was and we continue to underweight this sector, seeking alternative defensive options.
Much has been made in the press as to the ‘investment’ qualities of bitcoin and other “cryptocurrencies”.
In our view, one of the essential features of a currency is that it should be backed by a central bank, so that for example, Sterling is backed by the Bank of England and the US Dollar by the Federal Reserve. Cryptocurrencies are backed by nothing at all: they have no intrinsic value whatsoever. Even shares in South Sea Bubble related companies, in which huge fortunes were lost in the early 18th century, had an element of potential value (which happened to come to nothing) behind them. The risks with bitcoin are clear: private investors should keep clear.
As many readers will know, Old Mutual Wealth (a division of Old Mutual PLC) is one among a number of custodians that we use to hold investments on behalf of clients.
As part of reorganisation of Old Mutual PLC, Old Mutual Wealth is to become separately listed on the Stock Exchange later this year, at the earliest opportunity after Old Mutual PLC’s 2017 full year financial results, due to be announced on or about the 7th March.
Once separation has taken place, Old Mutual Wealth plans a name change, to Quilter plc, an old and respected City stockbroking name, although the present operation bears no relationship to that. The business will then be split into two segments, that relevant to P J Aiken clients being known as Quilter Wealth Solutions and a gradual rebranding process is set to be carried out over a period of approximately two years from March.
Based on assurances received, we believe that Old Mutual Wealth, becoming Quilter Wealth Solutions, is set to remain as an entirely appropriate provider of custodian services for those clients for which it has been recommended. In the unlikely event that this view changes we will of course make appropriate comment but in essence, the plan outlined above represents one element of a wider restructuring of its overall business by Old Mutual PLC into more effective operating units.
P J Aiken continues to manage investment portfolios on a bespoke basis, based on careful deliberation of client requirements and of investment considerations.
We take this opportunity to wish you all a prosperous 2018!