A miserable miracle

This has been one of the most begrudged share market rallies in modern times. Our chief investment officer, Julian Chillingworth, explains why political deadlock may help it continue. 

Only a brave investment manager would have told clients at the start of 2017 that the year would produce close to the best annual returns for global equites since 2009.

By year end, the FTSE World index was up 21% in dollar terms, having delivered 14 months of advances. Emerging markets surprised investors the most, rising 27% in dollar terms despite widespread predictions of a difficult 2017. Technology drove the S&P 500 higher, although it wasn’t the only sector to post strong gains. As for the UK, small and mid-cap companies left the FTSE 100 in their dust. Part of this would be due to sterling’s strength against the dollar, which would lower the sterling value of revenue earned in the US (likely to affect many FTSE 100 firms). However, at the same time the pound lost ground against the euro. That would have given an earnings boost to companies exporting to the Continent, while increasing costs for importers. Still, despite being a laggard compared with the world, the FTSE All-Share had a strong run in 2017. It posted a new record on the last day of trading: 4,221.8.

Almost wherever you look around the world, asset prices have been rising. And yet, investors have been awfully upset as it happened. For most of 2017, investors have been debating whether equity valuations – particularly in the US – are looking stretched. While prices are elevated, in the main it has been justified by strong earnings growth. With little evidence of recession on the horizon, we think shares will continue to outperform bonds this year.

Last year was marked by extremely low volatility; as we enter 2018, will this low volatility continue? The US Federal Reserve is expected to increase the pace of its interest rate hikes this year, especially now that the US tax cut is law. And the Fed is no longer the only major central bank that is expected to tighten monetary policy: upbeat European economic data may lead to a faster unwinding of the Continent’s ultra-loose interest rates and quantitative easing programme. Even Japan’s much-maligned economy has been looking much healthier lately, potentially paving the way for a reduction in its mind-boggling level of monetary stimulus. Tighter policy around the world would mean higher discount rates and therefore less valuable future cash flows. Still, central banks have been very cautious when raising rates since the financial crisis (except for that regrettable episode with the European Central Bank – under a different boss – in 2011). If this wariness continues, it seems likely tighter monetary policy will be accompanied by decent economic growth, which should feed corporate revenue growth. As more valuation components move in different directions, greater volatility could be in the pipe for both bond and equity markets. 

Index 1 month 3 months 6 months 1 year FTSE All-Share  4.8% 5.0% 7.2% 13.1% FTSE 100 5.0% 5.0% 6.9% 12.0% FTSE 250 4.0% 4.8% 8.5% 17.8% FTSE SmallCap 2.7% 4.2% 7.2% 18.2% S&P 500 1.1% 5.6% 6.7% 10.6% Euro Stoxx -0.2% 0.1% 5.1% 17.9% Topix 1.0% 7.7% 9.0% 15.6% Shanghai SE 1.3% -0.1% 3.6% 3.9% FTSE Emerging 4.2% 6.1% 10.9% 21.1%

Source: FE Analytics, data sterling total return to 31 December

Deadlock: the new progress

So, can equity markets post another year of double figure returns?

The economic backdrop looks pretty good. Last year, two-thirds of the 25 largest economies grew faster than their long-run averages and the IMF believes that should continue into 2018. Of course, the UK is an unfortunate exception. For the past 18 months, investors have wrestled with the implications of the Brexit vote and how the river of government policy constantly alters its course. Negotiations with the EU have been haphazard and jarring, but overall the first stage was a success. Now the two parties can move on to trade, a critical subject for businesses and therefore investors. Compromise on both sides will be crucial.

Contrary to her “strong and stable” pitch for the Conservative leadership, Theresa May is in probably the weakest position of any prime minister in decades. The power she has stems from the leader of the Opposition: her party is so terrified of Labour’s Jeremy Corbyn taking control in any tumult, that it has shown it will bend on Brexit points if necessary just to keep Mrs May in Downing Street.

Politics had very little direct influence on markets in 2017, with investors concentrating on rising earnings across major markets and generally ignoring everything from threats of nuclear apocalypse to the rise of far-right nationalism. US markets got excited about tax cuts, which were finally inked just before Christmas, but most of the year’s upward momentum came from company fundamentals.

Will this change in 2018? Italian bond markets have wobbled as a March election approaches and Angel Merkel is still trying to knit together a coalition government in Germany. US mid-term congressional elections will be held in November – expect plenty of electioneering to precede them.

If America voted today, the Democrats would likely take control of both chambers. If the Democrats controlled Congress, they could push to impeach the President. If they went down this path, things would get messy indeed. US politics is riven by tribal partisanship. Congressmen and women no longer seem to understand words spoken from the other side of the aisle. We expect this antipathy to continue; however, we believe the result would be deadlock, not exactly a radical change from the present. The Republican leadership only passed its tax-cut act by a whisker under favourable special procedures, despite controlling Congress and the White House. Almost all other legislation has fallen afoul of the courts or short of votes. But deadlock looks good on America: the S&P 500 is up by 25% since Barack Obama became a lame duck president in November 2016.

As we come off a strong year for share markets, many dream of another soaring uplift in 2018. Our fingers are definitely crossed. However, we feel it’s more prudent to prepare for a rockier investment landscape. Barring a sudden global downturn, equities should offer adequate returns – better than bonds, at least. But expectations should be tempered, lest irrational exuberance get the better of us.

Bond Yields

Sovereign 10-year Dec 31 Nov 30 UK  1.19% 1.33% US 2.41% 2.41% Germany 0.43% 0.37% Italy 2.02% 1.75% Japan 0.05% 0.04% Source: Bloomberg

Julian Chillingworth, Chief Investment Officer