A view on the market, half way through 2019

Monday, 1st July 2019 08:58 - by David Harbage

This blog has regularly provided an update on what has been occurring in financial markets and, as we reach the half-way point in 2019, it may be helpful to follow up the previous article dated 3 April 2019 by sharing the author’s current thinking. In particular, on the prime issues or concerns that long term investors in stock exchange assets face, brief feedback on the performance of previously mentioned investments in 2019 to date and comment on the outlook.  

This report can be summarised by saying that, disappointingly but not surprisingly, there has been no real progress made on the major macro issues which are dominating the investment landscape. Uncertainty can be a greater negative headwind than actual bad news, and the unhelpful protracted tariff negotiations between the United States and its trading partners (notably China) has led to a slowdown in global economic activity, as the world’s biggest multinational businesses understandably defer investment plans. Closer to home, the immediate outlook for the UK’s currency, its bond and equity markets remains clouded by the key Brexit - with the consequent economic impact – issue. The results of the EU referendum showed that a market-friendly resolution is unlikely in the absence of a second referendum or a general election.

Light at the end of tunnel can be seen in the form of next year’s US elections and a change in direction by the US central bank. Seeking re-election, president Trump will want to point to achievements rather than posturing in his ‘America first’ campaign and to see closure on the China trade talks before 3 November 2020. In the meantime, faced with a slowing global economy and benign domestic indicators, the Federal Reserve is set to abandon its programme of monetary normalisation (via interest rate hikes) and Wall Street is anticipating a rate cut in July, with further easing likely in both September and December 2019. This will enhance the relative valuation of fixed interest and company stocks, as well as almost certainly prompt depreciation in the US dollar.

Making a call on how domestic politics, dominated by Brexit, will ‘pan out’ remains as difficult as ever. The EU referendum pointed to a polarisation of opinion – as the newly formed Brexit party and the ‘remain’ supporting Liberal Democrats thrashed the unclear dominant parties. The subsequent Peterborough by-election, producing a narrow win for the Labour candidate, reminded investors that the current state of political flux could deliver a general election outcome with the prospect of seriously negative news for business (a left wing Jeremy Corbyn-led government has threatened re-nationalisation along, with higher corporate and personal taxation).

History shows that markets ‘fall on negative rumour, rally on fact even if adverse’ and attempting to correctly time entry or exit points in the stock market is nigh on impossible. Bounce-backs occur so quickly that only a lucky few benefit from what are often double-digit share price jumps via such an aggressive trading strategy.  Owners of stock market listed companies should always be taking the longer term view – with a minimum retention period of five years or ten years, but perhaps more probably ‘an indefinite, foreseeable future’ should be considered as an appropriate time horizon. The 2019 version of the Barclays Equity Gilt Study, which reviewed returns from 1899 to the end of 2018, found that over every 5 year period UK company shares beat a higher rate deposit bank account in 76% of occasions. The probability that shares outperformed cash rose to 91% when assessing the respective total (income, plus or minus any capital movement) over every 10 year time period.

We acknowledge that most UK private clients will focus on the local landscape, rather than on global prospects – notwithstanding the fact that as much as three quarters of the revenue and profit earned by the constituent firms of the FTSE100 index arise overseas. Although it is to be hoped that investors are taking the long term view and are likely to retain their stock exchange investments for a decade or more (to ride out economic cycles, as well as unexpected natural disasters or dramatic geo-political events), to have concerns about the immediate future is natural. The potential investor has to ask him or herself if the prospects are under or over ‘priced in’ by the market, by assessing the likely future performance from different kinds of asset and the magnitude of the threat to those returns. One should look at the relative attraction of the various investible assets – from cash (sterling versus other currencies) to bonds (longer term interest rates or loans), through to equity (company shares, listed on the London and overseas stock exchanges, as well as well as private, unquoted equity) – in terms of potential returns over the next year or so.

In our previous quarterly update, we flagged the following issues as being most influential in affecting investor sentiment and, as previously intimated, little seems to have changed from:

1. United States-instigated action to address imbalances with its trading partners and China in particular, has prompted a slowdown in global economic activity.

2. The rise in populist politics, reversing a trend for greater globalisation in trade, is acting as a drag on business and consumer confidence - as well as raising unhelpful tensions between and intra nations.

3. Speaking of tensions, any resolution on the obvious domestic issue, Brexit – to say nothing of making any meaningful judgements on its likely impact – seems as distant as ever. Teresa May’s successor is almost certain to be more determined to exit, without a deal with the European Union – if Parliament allows. In the absence of that, the prospect of a general election looms; the recent EU elections, which featured strong showings for the Brexit and the Liberal Democrat parties, flags the difficulty in calling a winner.

4. Risk assets, such as equity, which sold-off in the last three months of 2018 - as investors succumbed to fear – recovered from their oversold valuation and consolidated the last quarter period’s bounce-back.

5. A risk-averse environ remains evident with negative real (after taking account of inflation) interest rates – in overnight money, but also across government and investment grade (BBB or higher credit rated corporate) debt issues.

6. As global economic growth appears to have peaked last year, the prospect of interest rate hikes abated – in turn reinforcing the relative value (compared to other asset types) of credit and equity.

7. Corporate earnings growth, aided by lower rates of taxation, was exceptional in 2018 – but, while profit and dividend progression ahead of inflation is forecast for the current year, the prospect of slowing economic activity in 2020 is likely to mean that company earnings will weaken. Analysts will be making downward revisions, beginning with the most economically sensitive sectors, with highly rated listed businesses being most susceptible to investor disappointment.

8. While the pace of top-line revenue growth may be slowing, company balance sheets appear robust (in the absence of any rise in the cost of servicing debt) and, for the most part, dividend cover appears robust. In such an environment, financially strong firms will seek to grow their businesses via acquisitions and re-engineer their balance sheets (bringing down the cost of capital by low coupon bond issuance) and also consider boosting earnings by buying back their own shares.

9. Disappointingly, the bounce-back in investors’ appetite for risk has been half-hearted as the current sources of uncertainty (notably US-China trade talks and Brexit, which optimists expect to be resolved in the second half of 2019) remain a drag on sentiment.

10. Finally, a catalyst for sparking corporate merger and acquisition activity – which could come to the rescue of mispriced assets (often at times of heightened volatility, uncertainty or emotion) - has yet to make an appearance. We expect the de-rating of domestic stock exchange listed companies to rebound upon any resolution of Brexit; even being forced out on 31 October, without a trading deal with the EU, is likely to be a low water mark for this unloved segment. Surely overseas, especially dollar-denominated, buyers must be viewing the universe of investor-neglected UK company investments as an opportunity to acquire assets cheaply.

The consensual view is that global economic growth will still be reasonably robust this year - forecasting real GDP growth for 2019 at 2.7% - but notably lower than the 3.1% predicted at the beginning of the year. Essentially, that means experts expect gross domestic product to rise 2.7%, after inflation, compared to 2018’s higher pace of 3.2%. Looking forward, the previously referred to trade tariffs remain at best a significant unknown, but most commentators anticipate unchanged levels of economic activity in both 2020 and 2021 forecasting global GDP growing at a rate of 2.7%. Anticipating such an environ, over the next twelve months interest rates hikes will become a rarity - with inflation typically exceeding local rates to deliver negative returns to holders of cash.

For instance in the UK, cash rates of say 0.75% lags inflation which is closer to 2.0%. The same scenario applies in the US, Japan and in the Euro zone. In such an environment, to hold large sums of one’s liquid, long term savings in Cash is unappealing and conventional government bonds struggle to offer real (inflation beating) returns, especially after deduction of income tax. The current gross of tax yield to redemption of a ten year conventional British Government stock is just 0.85%. By contrast, inflation-linked bonds provide some relief, as they offer the prospect of appreciation in capital - and growth in income. No longer expecting a hike in US interest rates over the next year (Federal Funds rate is likely to be cut from 2.5% to 2.0%) and slower, below-trend economic growth in the UK and the Eurozone will not prompt central banks to hike. UK Bank rate and Eurozone rates are unlikely to change from their current respective 0.75% and 0.0%, but there is an outlier prospect: of a soft Brexit resolution which could see our base rate rise to 1.0%. By contrast a ‘no deal’ exit would almost certainly prompt the Bank of England to stimulate the domestic economy by cutting interest rates to 0.25%, prompting further weakness in sterling.

The prognosis for equity performance is unchanged from that espoused in April’s blog that, after the first quarter’s significant rebound, one can expect to see equities make further progress over the remainder of 2019 – with an approximate 5% uplift in capital terms, enhanced by income distributions. This is based on the current macro factors (notably international trade disputes and Brexit uncertainty) continuing, close to their current ‘state of play’. Any major positive breakthrough on the US-China talks (currently occurring in Japan) could see markets achieve that 5% advance overnight, and then progress further. While a positive outcome on Brexit would benefit domestic businesses most, the FTSE100 index’s multinationals would be less affected (as anticipated foreign exchange translation benefits end upon a recovery in sterling). It probably does not need to be reiterated, but new negative ‘news’ or protracted uncertainty on the political or trade front, (for example the announcement of a general election), would not be well received by financial markets.

With limited appetite for bonds or cash (which  typically might be held in a professionally managed portfolio in order to be available to meet investment opportunities, as they arise) at their current low yielding valuation levels, company shares continue to represent more appeal for many personal investors as a long term investment. The ability of well-managed businesses to adapt and prosper, even in difficult or uncertain economic circumstances, encourages selective ownership within a diversified portfolio – especially in recognition of well-managed companies ability to increase dividend pay-outs.

For similar reasons surrounding the prospect of income growth from higher rent rolls, real asset ‘bricks & mortar’ in the form of commercial property retains its appeal for many. Geographically, the domestic market has limited space, especially in the south east of England; accordingly, well-located assets are likely to appreciate. Offering a rising rental stream over the appropriate longer term and the prospect of exceptional capital appreciation, as a result of landlord or management improvement, property merits a position in most portfolios. Some readers, owning one or more residential homes and perhaps their own business premises may be loath to commit more of their savings or retirement wealth to commercial property, but it is important to own differing kinds of asset to achieve optimum diversification and reduce the overall risk profile (in particular, not to own too much equity).

Turning to potential trading activity which the author has considered in the second quarter of 2019, it may have been tempted to book a profit on Legal & General shares, which had risen by 22% in the first three months of the year, to reinvest into its life assurance peer Prudential. The Pru is a similarly geared play on asset appreciation, but probably offers greater potential via its exposure to the world’s (and Asia in particular) higher growth economies. At the beginning of April L&G stock was priced on a price-to-earnings (PE) multiple of 8.9 times the consensus of London-based brokers’ profit forecast for the year to 31 December 2020, while Prudential was valued on the same analysts’ consensus PE ratio of 9.3x for its accounting year ending April 2021. A critical factor in deciding whether to switch is the relative valuation of these peers: normally Pru shares would be on a 15%+ premium to the rating accorded to L&G’s equity and City research analysts opinions reflected this. At the beginning of the quarter, L&G stock boasted 9 Buy, 5 Hold & 3 Sell recommendations versus Prudential's 10 Buys, 5 Holds and just 1 call to Sell.  

Another transaction that an active trader who was becoming more cautious on global growth might consider is to switch from the i share MSCI World index exchange traded fund (ETF) into the Vanguard Global High Dividend ETF. Although similar in owning company shares on most overseas bourses, the latter is considerably more defensive via its bias towards stocks that pay a higher level of dividend income (which are typically less economically sensitive and more resilient), thereby having a deliberate policy of ignoring highly valued firms which had yet to reach that level of business maturity.

A concern about a slowing Chinese economy – prompted by the US plans to apply higher tariffs on its trade partners – might lead an investor to a view that emerging stock markets had perhaps progressed far enough in the short term. Sometimes termed by fund managers as ‘being up with events’ this could prompt profit taking in the likes of JP Morgan Emerging markets investment trust, following its strong showing over the past year - in both absolute and discount to NAV terms. As regards the latter, this discount had come in to 7% from the 15% which prevailed in August 2018 - as the share price moved from 770p to £10.

Investors looking for a less economically-sensitive area to reinvest might consider an exposure to Ecofin Global Utilities & Infrastructure investment trust. This closed-ended collective investment fund aims to achieve a high, stable income, and long term growth - taking care to preserve capital – investing its £125m portfolio of assets, split geographically primarily between North America 41%, Europe 41% and the UK13%. Since listing on the London stock exchange in September 2016, the Ecofin Global Utilities & Infrastructure investment trust has outperformed both the MSCI World and the World Utilities indices. Offering exposure to earnings which are relatively resilient (although impacted by regulators and politicians), the shares yield 4.7% and are priced at an attractive 10% discount to net asset value (NAV).

Prudent investors should not ‘buy & forget’ but ‘watch, buy & watch’ each constituent of their portfolio of investments. This monitoring should extend beyond individual company shares to assess on-going suitability of both passive index tracking and actively managed collective investments - considering their relative attractions as compared to the respective peer group. This will take the form of watching short term performance of the underlying portfolio, versus its defined benchmark and the universe of similarly investing funds or trusts, as well deciding if the market’s valuation (comparing price to net asset value in the case of investment trusts) is fair. Such action might have prompted profit taking on Standard Life Smaller Companies investment trust, following the shares’ marked outperformance of the UK equity market and its small cap peers earlier in 2019. Besides the trust’s relative strength, active traders might also have made such a decision in recognition of rising domestic political tensions (notably a fall in support for the mainstream parties in the EU election, and a further power vacuum as the Prime Minister gave up her leadership).

As further news of global economic slowdown – most recently from Germany – was being digested by market strategists, cautious investors might also have been inclined to reduce their exposure to Blackrock World Mining investment trust. Forward looking survey evidence points to a slowdown in consumption of industrial metals and minerals next year, which is likely to result in lower prices.  By contrast, the recent strength in Blackrock World Mining shares (rising by more than 10% in June) both by reference to inherent worth and a single digit discount to this asset’s value might prompt investors with a capital preservation priority to book a profit.

It might be helpful to indicate how the writer would currently allocate assets taking the appropriate longer term perspective – mindful that actual weightings would depend on an individual’s circumstances, appetite for risk and objectives:

1. Underweight bonds – owning government, risk-free inflation linked domestic and international bonds (but having no exposure to conventional gilts) across all maturities, along with investment grade (BBB rated or higher) sterling-denominated company bonds and global higher yield corporate bonds. The latter in expectation of the continuation of higher economic growth in emerging economies, allied to the prospect of falling delinquency rates in developed markets. Achieved by the use of relatively low-cost diversified ETFs in order to minimise default risk. Mindful that interest rates are low, as compared to history, and have limited scope to fall further - but that inflationary pressures are benign and likely to be peaking.

2. Underweight property – owning commercial and residential property funds, featuring active management and sector specialism (to overcome ‘flat spots’ like retail). Mindful that ‘bricks & mortar’ assets enjoys a scarcity, supply-demand benefit in the UK, but that demographic and cultural change casts uncertainty over the ability of landlords to raise rents (notably in retail, and away from central London) at the rates that historically applied in the short term.        

3. Overweight UK equity - in acknowledgement that UK company shares enjoy an unprecedented income yield advantage, relative to perceived ‘risk-free’ government bonds and cash. Brexit-recession fears have driven significant dispersion in industry valuations, with domestic industry sectors and especially smaller companies appearing particularly inexpensive.

4. Underweight overseas equity – preferring UK listed multinationals, which can provide the investor with exposure to the world’s higher growth economies and often represent better value. The prospect of a rebound in a seemingly oversold sterling also persuades for this position.

5. Overweight Flexible assets – essentially investing via undervalued investment trusts (by reference to share price at a discount to underlying asset value). One is entrusting these fund managers to select the appropriate, sometimes alternate, assets to deliver to their capital preservation perspective.

6. Underweight cash – given the low absolute return on offer compared to the other selected assets. Mindful, as mentioned previously, that retaining a cushion of liquidity can enable the diligent investor to take advantage of buying opportunities as they present themselves. In addition, the low yielding inflation-linked government bonds could also provide a further source of funds should an exceptional opportunity to add to another (probably equity) investment arise.  

Finally, the author takes a look at the shorter term capital performance of a typical portfolio’s constituents and proffers a few comments on the returns they produced in the second quarter of the year:

1. i shares UK Inflation-linked government bond ETF was steady, as the price moved from 18.8p to 18.9p.
2. i shares Global Inflation-linked government bond ETF progressed from 121.9p to 127.7p, as fears of further US rate increases in 2019 gave way to an expectation of an easing agenda.
3. i shares UK Corporate Bond ETF progressed from 144.5p to 148p, as an anticipation of domestic rate hikes are replaced by an expectation of a monetary stimulus in the event of a No-deal Brexit.
4. i shares Global High Yield Corporate Bond ETF progressed from 72.5p to 76.3p, aided by encouraging corporate health and forecasts of rate reductions in many regions (US) or of basement levels continuing in Europe and Japan.
5. Picton Property investment trust progressed from 90p to 98p, in response to another encouraging update and investor appetite for the shares of this active manager.
6. i shares UK Property ETF retreated from 590p to 568p, giving up half of the previous quarter year’s gains, as retail tenants’ difficulties dominated the industry’s headlines.
7. Tritax Big Box REIT progressed from 144p to 154.3p, as this niche warehouse operator benefits from the demographic shift towards online business.
8. Mercantile investment trust advanced from 201.6p to 205.4p, as its portfolio of medium sized UK companies (overwhelmingly FTSE250 index constituents) stabilised after its big rise in the first quarter of 2019.
9. Standard Life Smaller Companies investment trust progressed from 450p to 490p over the three months to the end of June, having reached a high of 517p.
10. Henderson Smaller Companies investment trust also enjoyed a recovery in sentiment towards domestic firms, rising from 842p to 862p.
11. Barclays struggled to make headway, slipping from 155p to 150p, albeit after paying its final dividend. Investor sentiment towards the banks remains weak but brokers are upgrading their profit projections for 2019 & 2020 and recommendations (only 3 Sell views amongst 22 research houses publishing a view on Barclays).
12. Bellway retreated from 3042p to 2785p, giving back almost half of the gain that the shares made in the first quarter of 2019. Domestic stocks remain unloved on Brexit cum recessionary fears, and Bellway appears significantly undervalued (at almost half the overall UK equity market PE rating), with no Sell recommendations amongst the 14 City analysts currently proffering an opinion.
13. GVC Holdings recovered from 563p to 652p, as a trading update pleased and investor attention moved from deliberating on the future of Ladbrokes’ shops in the UK to the liberalising US gaming market.
14. Legal & General marked time, as its shares slipped from 276p to 270p in the second quarter of 2019 – but having been as high as 290p earlier in the period.
15. Prudential rose from 1680p to 1716p – having traded in a 1575p to 1780p range in the second quarter of 2019.
16. Royal Dutch Shell advanced from 2448p to 2581p, despite a volatile oil price which was boosted in June by rising Middle East tensions surrounding Iran in particular.
17. i share FTSE100 ETF progressed from 722p to 733p, despite the disappointing lack of progress on US-China trade talks or, closer to home, Brexit.
18. Edinburgh investment trust fell from 648p to 581p, giving back the previous quarter’s gains, as investors chose to overlook its dividend hike, bias towards defensive businesses and the shares’ widening discount to NAV.
19. JP Morgan Global Growth & Income investment trust progressed from 315p to 333.5p, a return reflecting increasing appetite for risk assets and fears of higher rates receding.
20. JP Morgan Emerging Markets investment trust, aided by economists’ selective upgrades to country GDP and a tightening discount to NAV, also progressed from 920p to 1002p.
21. Blackrock World Mining investment trust, encouraged by measures to stimulate Chinese consumption, pushed forward from 365p to 375p.
22. i shares Core MSCI World ETF aided by a strong performance from US equities, advanced from 4296p to 4549p.
23. Vanguard All World High Dividend ETF also progressed well, given its income bias, progressing from 4195p to 4331p.
24. i shares MSCI Europe ex-UK ETF advanced from 2704p to 2868p, aided by sterling weakness, despite growing evidence of a slowdown in Germany the region’s biggest economy.
25. Vanguard Asia Pacific ex-Japan ETF capital return was static: the price was unchanged at 66.8p, after trading in a range of between 63.5p and 69p in the second quarter of 2019.
26. Caledonia investment trust advanced from 2975p to 3055p, with its returns typically being more pedestrian than a listed equity investment - as news flow on flexible or alternative asset types (such as unquoted) is slower, with lower visibility and less of requirement to provide a valuation.
27. Capital Gearing investment trust progressed from 4155p to 4240p, the same comment applies (per Caledonia), but its aim of beating 3 month LIBOR - if not UK equity returns – in search of preserving shareholders’ real wealth over the medium term was achieved.
28. Harbourvest Global Private Equity investment trust, another investment trust classified as ‘Flexible’, made the best progress of the alternative assets – jumping from 1430p to 1614p in the period under review.
29. Henderson Alternative Strategies investment trust made a respectable advance from 272p to 286p – delivering in accordance with the trust’s objective of achieving a total return of 8% per annum.
30. Ecofin Global Utilities & Infrastructure investment trust progressed from 130.5p to 141.5p in the second quarter of 2019.
31. Cash was unchanged (£1 = £1).

Previous blogs have commented on the higher risk inherent in individual company shares but, of the five above mentioned investments which recorded negative returns in the quarter just ended, the weakest capital performance came from a diversified pooled investment: Edinburgh investment trust which fell 10%. An overwhelming majority of the above mentioned investments produced positive capital returns, with the highest return (of +16%) coming from GVC which recovered from last March’s weakness, induced by senior management’s stock disposals. Finally, readers should also appreciate that the above returns take no account of income – which will be significant on the higher yielding assets, in particular the corporate bond ETF, the property and the UK equity investments.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.