The pound is driving markets
Source: Thomson Reuters Datastream, 5.6.18
Past performance is not a reliable indicator of future returns.
The UK stock market has experienced quite a round trip so far in 2018. After a strong January, the volatility in February and March hit domestic shares hard and the market lost more than 10%, the usual definition of a correction. That put a definitive end to the benign conditions that had prevailed throughout 2017. Since then, however, there has been a spectacular recovery, with the All Share up by about 15% from its low.
It’s worth looking at what’s driven that. Principally, it is the oil price and the depreciation of sterling. Neither of these are within the control of companies and none of the rally can really be attributed to better corporate fundamentals. It suggests that in the short term the market may be rather stretched and it probably shouldn’t be chased too hard at today’s level.
That said, I’m loath to go too defensive on UK shares for a few reasons. First, the economy is not in bad shape when you consider the high degree of uncertainty around Brexit. Unemployment is low and wage growth is starting to come through. There is some inflation, which is helpful because it persuades consumers to spend. Monetary policy is also still easy and likely to remain so. Bond yields, which determine the cost of borrowing for both companies and individuals, may have troughed but they remain low.
When it comes to valuations, there is also no really compelling reason to turn your back on the domestic market. At 16 times expected earnings, the market is neither cheap nor expensive. That multiple can be maintained which means that total returns won’t be far off the combination of earnings growth of about 8% and the UK’s attractive dividend yield of 3-4%. A low double-digit return would be more than acceptable at this stage in the cycle.
The real challenge for investors is deciding where in the market to be invested. There has been quite a cyclical rally, which makes value stocks look less obviously interesting than the staples and other defensives they have outperformed over the past couple of years. I would, therefore, look to have a good balance between value and growth, which fortunately the Select 50’s UK funds provide.
Select 50 picks: We have deliberately provided a range of styles in the Select 50’s UK category. The funds here are designed to work well with each other so I would caution against picking just one fund but rather investing in a selection to benefit from the smoothing effect of a more diversified approach. For example, the LF Lindsell Train UK Equity Fund is a quality and growth play that will perform if the defensive style prevails. By contrast, the Fidelity Special Situations Fund is a more value-orientated, cyclical fund. There are two funds designed to capture the UK’s yield attractions: the JOHCM UK Equity Fund and the Fidelity Enhanced Income Fund, which boosts the natural yield of the market’s highest dividend payers by selling to other investors the right to buy shares at a discount to their prevailing price in the future. The fund receives a premium for this opportunity which increases income (at the cost of some capital appreciation). The Select 50 also covers the size range with the Franklin UK Smaller Companies Fund and the Threadneedle UK Mid 250 Fund providing access to companies outside the blue-chips.
Back to full employment
Source: Thomson Reuters Datastream, 5.6.18
Past performance is not a reliable indicator of future returns.
We’ve been neutral on the US for some time now, torn between punchy valuations on the one hand and the obvious cyclical and structural attractions of the American equity market. That stance has been justified by the performance of Wall Street in the first half of 2018 - pretty volatile and ultimately going sideways over the past six months.
In the short term there is clearly support for the US economy. Tax cuts and other fiscal stimulus may be storing up problems for the future but for now they are doing what they were designed to. Unemployment is as low as it was at the height of the technology boom in the late 1990s and, that period aside, has not been lower since the 1970s. Recent industrial surveys have also been remarkably strong. The silver lining of a higher oil price is the encouragement it gives to Shale producers who have been a significant contributor to US growth in the past few years.
That is the good news. The flip side of US economic resilience is that it increases pressure on both interest rates and the dollar. We have already seen the first signs of stress in emerging markets from a higher US currency. What we have not seen yet is the impact it might have on US exporters. The most recent results season saw an earnings growth bonanza, with US companies growing their profits on average by more than 20%. If the dollar remains at today’s levels that may well be as good as it gets.
That is certainly a key consideration for stock market investors and goes some way to explaining the disconnect between the headline newsflow and the trajectory of the S&P 500. Any CEO warning that growth may be topping out has seen a savaging of his share price this spring. It is no surprise in this environment that smaller US companies, more domestically-focused and less concerned about the level of the dollar or trade war fears, have been outperforming.
As for interest rates, there seems little reason for the divergence between the US and the rest of the world not to continue. Whether the Fed raises rates three or four times this year is not really the point. The fact is that US rates are heading higher and in the rest of the world they are not.
Another interesting aspect of the US market’s performance this year has been the sectoral split. Technology continues to find support and the FAANGs have recently hit new highs while defensive staples have retreated. This may, however, be investors sticking with what they know in the face of growing geo-political uncertainty and the perception that tech will be less affected by a trade war. On the one hand this looks like a move away from defensiveness but it may simply be a different attempt to protect against a downturn.
On the valuation front, the US still looks to be the world’s priciest market although the surge in earnings in the first quarter has certainly brought the average multiple down to manageable levels. The pressure is still on earnings to justify high teens price to earnings ratios but the hike in profits has probably bought a bit more time for this long-in-the-tooth cycle.
Select 50 picks: How well your US investments have done in the past couple of years has been very largely a consequence of your exposure to the technology sector. It’s dominance of returns has been the key differentiator between different fund managers. However good a stock-picker they are, missing out on the FAANGs has been a path to underperformance. The JPM US Select Fund, for example has Microsoft, Apple, Amazon and Alphabet in its top five holdings. The Fidelity American Special Situations Fund has none of them in its top ten, a painful omission but, who knows, maybe the right call now with tech valuations so stretched.
Tokyo market: pause for breath
Source: Thomson Reuters Datastream, 5.6.18, total returns in local currency
Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may also affect the value of an investment.
The Nikkei suffered a wobble in the first quarter. That has taken the shine off a good couple of years for the Tokyo market, which has served us well. For a number of reasons, I think the past few months are a pause not a reversal and I am sticking with the positive view on Japan.
The principal issue this year has been the first negative growth reading in nine quarters. Partly that’s just payback after eight strong periods of growth. Weather was a factor too, with a lot of snow this year. Sentiment also took a hit thanks to the increase in trade tensions. Japan is particularly sensitive to the global economic cycle. This is compounded when there is uncertainty by the yen’s status as a safe haven currency which makes Japanese exports less competitive.
It's by no means all bad news on the economic front, however. Japanese wages are growing at the fastest pace in 15 years. That’s a positive in a country where incomes have stagnated for a generation. Tourism is also growing strongly, with the number of inbound holidaymakers growing at the fastest rate ever. The Tankan survey of business sentiment has also turned positive again. Crucially, the Bank of Japan remains highly accommodative, contrary to worries in the first quarter that it was reining in its stimulus.
When it comes to valuations, the Japanese market is still one of the most attractive in the world. The Topix index trades on around 13 times earnings, which is the same multiple as back in 2012. There is quite a range, with banks, autos, trading companies and utilities priced at roughly half the level of pharmaceuticals, retail and services businesses but there are still plenty of opportunities for stock-picking.
There are risks, of course, investing in Japan. The biggest is a significant trade slowdown, so it is worth keeping an eye on the ongoing negotiations between China and the US. The second is the level of the yen. If it stays at 110 yen to the dollar then there could be some upside to current single-digit earnings growth forecasts. If the yen appreciates closer to 100 then exporters will suffer. The third risk is a leg up for the oil price - Japan is a big importer. Finally, the Abe government looks a lot less secure than it did, with allegations that the Prime Minister may have misled parliament.
All in all, however, the concerns are probably priced in to this out-of-favour market. If shares can break through the strong resistance at about the current level then investors can hope for further gains to come as the long deflationary slump is finally laid to rest.
Select 50 picks: There are three Japanese funds in the Select 50. I particularly like two of them. The Baillie Gifford Japanese Fund has the best recent track record and has been a good way of playing Japan’s competitive advantage in certain key sectors like automation. Schroder Tokyo is managed by a very experienced manager, Andrew Rose, who has a long and consistent record and is well-supported by a big on the ground analyst presence in Japan.
Currency: less of a headwind
Source: Thomson Reuters Datastream, 5.6.18
Past performance is not a reliable indicator of what might happen in the future. When investing in overseas markets, changes in currency exchange rates may also affect the value of an investment.
Europe has been hogging the headlines recently, thanks to Italy’s political upheavals. The implied threat to the eurozone (and indeed the whole European project) of an avowedly anti-EU coalition was taken badly by the bond, equity and currency markets. At the time of writing, the pressure seemed to have eased somewhat but we have been reminded that 2017’s relative political calm in the region was a pause in the Euro-drama not a resolution of it.
Europe has also been out of favour this year because of a slowing in growth and fears about the strength of the euro. These are real issues but the outlook for the region is a lot better than newly-pessimistic investors seem to have concluded. A key positive is stronger credit growth as banks move on from rebuilding their balance sheets to focusing on their key lending function. Given that Europe is much more credit-driven than the US, this should be a strong tailwind for corporate earnings.
The currency issue is probably less of a problem than investors perceive it to be. For one thing, the widening gulf between Fed and ECB monetary policy should lead to a stronger dollar and weaker euro. The region anyway has a track record of outperforming during periods of euro strength such as in the years before the financial crisis.
Valuations in Europe are cheaper than in the US but not so cheap that the region is quite the obvious play that it seemed at the beginning of the year. The lack of technology and the exposure to global trade are headwinds. Because of this we will rein in the overweight recommendation to match the neutral positions for both the US and UK.
Select 50 picks: The Select 50 has a good range of ways to play the European investment opportunity. Income investors are well-served by the Invesco Perpetual European Equity Income Fund, managed by Stephanie Butcher. Fidelity European Growth holds a range of the continent’s biggest companies, including those listed in the UK. The FP CRUX European Special Situations and Jupiter European Special Situations funds give exposure to some smaller and less well-known names.
Asia and Emerging Markets
Asia and emerging markets enjoyed a fantastic year in 2017. This year has inevitably been a bit of a disappointment by comparison. Even if nothing had changed it would have been near impossible for the MSCI China to match the 70% or so gain from the start of last year to January’s peak. And, of course, things have changed this year.
First and foremost, the global trade outlook has deteriorated as the Trump White House has started to deliver on its America First campaign promises. Second, the dollar has strengthened, making life tougher for those developing countries with debts denominated in the US currency. Third, the oil price has soared, hard for countries that are big energy importers (like India). It has become clear this year that emerging markets are not in charge of their own destinies.
The good news is that emerging economies are nothing like as vulnerable as they were during the taper tantrum five years ago. Current accounts are under control and inflation is less of a worry. Meanwhile the long-term structural case for investing in the developing world remains intact. Asia has 60% of the world’s population, is responsible for 40% of GDP growth and probably accounts for less than 10% of our portfolios.
The opening up of the Chinese A-share market is a step in the right direction which will attract more foreign capital and encourage more institutionalised behaviour among investors. India is also making important structural advances, bringing more people into the formal economy via demonetisation and harmonising tax rates to make it easier to do business. GDP growth is now faster than in China.
The risks are higher than they were, though. Financial conditions have tightened for emerging markets thanks to rising US yields. Currency weakness is forcing central banks to raise interest rates faster than they would like to prevent imported inflation. Argentina and Turkey have been high profile examples but the story is similar from Brazil to Indonesia as well. After last year’s stellar run, this is certainly a time to be more cautious across emerging markets.
Select 50 picks: As the environment becomes more challenging for investors in Asia and emerging markets, it will pay to back quality. Two fund managers we particularly rate are Ian Heslop, manager of the Old Mutual Asia Pacific Fund and Nick Price, who manages the Fidelity Emerging Markets Fund.