25 Jan Groundhog Day (Year)
In preparing these commentaries we always review our previous year’s reports and in that respect the January 2017 makes for interesting reading. In it we reflected on 2016 as a year of unexpected events and political turmoil but ultimately a positive year for most asset prices. Had we been of a lazy disposition at CDC we could simply have regurgitated those reports here, replacing references to 2016 with 2017. Gladly we are not.
2017 has also been a year of political upheaval with the added thrill of Nuclear brinkmanship between two of the world’s most unstable leaders, but even that has done nothing to spoil the party with markets characterised by strong performance and surprisingly low volatility.
The FTSE 100, the UK’s largest 100 companies, returned 11.95% over 2017 on a total return basis, meaning approximately 4% income and 8% capital appreciation. The wider market as measured by the FTSE All Share did slightly better with a stronger performance from mid-cap and smaller companies. This has been somewhat of a reversal from the post Brexit position, when larger companies did well on the back of their global exposure and weaker sterling, at the expense of smaller domestically focussed companies.
The final month and particularly the final few days of 2017, were particularly strong, with once again the “Santa Rally” helping to push the UK market to fresh highs, albeit on very thin volumes, although a return to normal volumes has seen this continue into the New Year.
US equity markets performed at a very similar level in Dollar terms, whilst global equity markets fared slightly better at 13.45%. Emerging markets produced a very strong return of over 27%.
Bond markets, particularly UK Government bonds, continued as laggards. In an environment of rising inflation and higher interest rates one would expect this to continue and our portfolios are positioned accordingly.
Property made somewhat of a comeback in 2017, as post Brexit concerns moderated, the UK all property market returned almost 7%, which could certainly be considered a reasonable return for that particular asset class.
So what lay behind those numbers………… ?
2017 was not a good year for Theresa May. Despite riding high in the polls having triggered Article 50, the added uncertainty brought about by the ill-fated snap election was less welcome, but perversely, it did bolster the market through the perceived diminution of a hard Brexit. This was followed by a Party Conference which may have done something to restore the view that she is human after all, though one suspects nothing to reinforce the ‘strong and stable’ position she had promoted as part of her election campaign.
In our budget commentary we suggested the Chancellor had appeared to shift from economist to stand-up comedian. If the jokes were good, the key messages were not. Whilst the UK economy continues to grow and has performed reasonably well, the budget came with a raft of downgrades as the impact of the leave vote starts to bite. Clearly more clarity is needed on the future relationship between the UK and EU to determine the longer term economic impact.
In many areas of the UK market, valuations remain stretched and we are acutely aware that when this happens, they can often snap, resulting in a correction. It could be argued that some form of correction would be welcome as a way of blowing away the froth in the UK equity market, returning valuations to sensible levels and offering investors the opportunity to deploy cash they currently seem reluctant to commit at these levels. Corrections are of course not uncommon but we are confident in the ability of our portfolios to insulate investors against such an event when it does occur.
We would expect to see a continuation of normalising monetary policy as the Bank of England considers further tightening through increased interest rates following the rise seen in 2017. It is not that growth and inflationary pressures are demanding action, in fact we would expect inflation to moderate as the currency impact we have witnessed begins to fall out of the calculations, but rather the slow process of normalising rates has to begin and we feel small measured increases would be unlikely to hamper growth unduly.
Turning to the US, the escalating tensions with North Korea, largely played out via Twitter, did little to unsettle the US economy or indeed investment markets, which also rose to fresh highs. We discussed the Trump Reflation trade in previous commentaries, but also touched on the difficulties he might have in bringing some of those policies to bear. He may take a huge amount of credit for the fortunes of the US investment markets last year, but it is only now that some of the measures he proposed are coming into play. The landmark reform of its tax code, which provides material tax cuts for businesses, may be the beginning of the pro-business agenda much promoted by Trump and welcomed by his supporters.
The Federal Reserve has also begun its policy normalisation, with tapering of stimulus and increases in interest rates during 2017. Inflation in the States is still low, but is certainly rising and therefore it is likely that we will see continued rate rises, some suggesting three this year. Rising interest rates and higher inflation should give cause for concern, but it is difficult to see this threatening equity markets and the momentum trade that is currently pushing prices higher. An inflationary environment should favour equities over bonds, which is a view reflected in our portfolios.
In Europe, the elections throughout 2017 failed to provide any further concern regarding the rise of populism, with results perhaps not being as clear cut as one may have hoped, but certainly a definite vote for the status quo. Markets sighed with relief that this had served to dampened political risk. The only blot on the landscape was the Catalonian independence referendum weighing on the relative performance of Spanish equities since August. European Markets outperformed the UK but struggled against the US and other markets worldwide on a relative basis. However, it is fair to say they had a good year overall with the MSCI Europe Ex UK Index returning 14.5% in 2017. The Euro has been strong which has weighed on those companies with foreign earnings.
Concerns on China dominated markets and our reports in 2016, but largely have been ignored since. This is in part due to the focus switching to events in the world’s biggest economy, the US, but also some recognition that the Chinese Government has a reasonable grasp of the necessary levers to enable a control of the economy not seen elsewhere. China did raise interest rates in 2017 reflecting a widely held view that policy tightening is required, but this did little to affect consumer and business confidence, which suggests demand remains strong.
One aspect of the continued Westernisation of the Chinese economy that does deserve some caution is growing debt levels. Chinese corporate debt rose from $6 trillion during the financial crisis to around $28 trillion at the end of last year. That takes its debt from 140% of GDP to 260% over the period, which makes their companies the most highly leveraged in the world.
We have seen how a debt led crisis can have very serious long term implications and therefore one hopes that the Chinese authorities are able to arrest this debt growth without any serious global impact.
Elsewhere, the best performing equity markets last year were Asia and the Emerging Markets. A weak dollar has historically been supportive of the relative performance of emerging market equities and this proved to be the case in 2017. EM equities have also benefited from a rebound in earnings, albeit from a low base. The rally in technology related stocks in 2017 has benefited EM equities. The recovery in some commodity prices and the strength of technology related stocks has helped propel EM stock markets.
In summary, investors have enjoyed a positive year with good returns and low volatility without the significant sell offs we have seen in previous years. The outlook for 2018 remains fairly benign, but there are still potential clouds on the horizon. Inflation expectations have moderated and it may be that long term deflationary pressures end up not being quite so fanciful. Monetary policy (and more precisely getting this right) perhaps remains the key determinant going forward. If inflation does prove problematical in the short term and central banks are too heavy handed on the tiller, growth would suffer, with inevitable market fall-out.
With valuations high and volatility low, the biggest danger is perhaps complacency. Whilst we favour an overweight equity versus bond position within all CDC portfolios, we are actively looking at ways in which we can moderate the risk within portfolios whilst maintaining our longer term commitment.