Despite the recent sell off in the US, we continue to maintain our US exposure where we feel business will continue to be supported by deregulation, tax cuts and a pro-business tax reform.
The US has managed to shrug off a series of external shocks, political risks and enjoyed its fastest growth since 2005.
With confidence high, consumption and business investment have grown solidly despite a further correction in interest-sensitive residential investment.
The continued escalation of trade tensions between the US and China led to a further flight to the relative safety of the US dollar and depressed asset prices throughout the rest of the world. This was most apparent in declines of overseas currencies and investors punished those where there are large current account deficits and a reliance on overseas sources of funding. Investment returns have been mixed and the dispersion of returns in the second quarter an ongoing theme.
Europe has confirmed that it will end its Quantitative Easing program by the end of the year, although interest rates are not likely to climb until next year. UK interest rates were increased to 0.75%, the first hike of 2018, but no further move is expected until after Brexit. There are no signs that Japan is ready to end its Quantitative Easing program and it recently expanded the range of equities eligible for purchase.
Economic data have been mixed. The US has continued to outperform other regions. Whilst growth picked up in the UK and Japan, there remain some doubts about its sustainability in these countries. Leading indicators in China point towards lower GDP growth. There remains a risk of US tariffs rising to 25% on the full range of US – Chinese imports with the most pessimistic forecasts suggesting a 15% yuan devaluation and China’s current account going into deficit. Meanwhile in Europe, the economy remains relatively solid, although political issues still linger.
Equities
The US equity markets outperformed again. This came despite the US Federal Reserve raising interest rates again and the market is now becoming more confident in their outlook for higher rates over the next year.
UK markets posted negative total returns over the quarter and the FTSE 100 lost -0.7% with the more domestic based FTSE 250 down -1.8%. The US made the best overall returns in global equity markets, the S&P 500 making a total return of +8.9% when converted to sterling. Eurozone indices and broad based emerging market indices were roughly unchanged.
Fixed Income
Government bond markets struggled as investors priced in the prospects for additional rate hikes, particularly in the US. Conventional Gilts made a total return of -2.0% with Index Linked Gilts down -1.4%. The only gains to be had were in High Yield which gained +1.9% and Strategic Bonds up +0.4%. Corporate Bonds were little changed, down -0.2%.
Gold
Gold fell by -4.4% in dollar terms over the quarter. The precious metal tends to struggle in an environment of rising real interest rates, although it remains valuable as a hedge within portfolios.
A robust global economy, fuelled by improving US economic data, led developed markets broadly higher during Q2. Dispersion of returns across equity markets increased and there was weakness in emerging markets where growth prospects have been trimmed. European data has also cooled and political risk there has again come to the fore.
United States
Strength in the US dollar continues to be one of the defining features in markets. The US Federal Reserve increased interest rates by 25 basis points for the second time this year and it remains committed to two further hikes within the calendar year. It has resulted in weakness in other currencies, primarily in emerging markets where underperformance has been widespread, partly as a result of reliance on dollar-denominated debt and ensuing pressures on lending activity.
We expect foreign exchange rates to continue to play an important role in markets in the short term and remain positive on the US dollar, largely because of the progressive stance on monetary policy adopted in the US in comparison to other countries. Conditions do not appear ripe for a recession and an imminent equity bear market looks unlikely. The momentum in US assets looks set to continue for now although valuations, particularly in the technology sector, look expensive. Europe and emerging markets are at an earlier stage in the cycle and could outperform if fears regarding global trade wars and political risk in Europe subside.
Europe
Europe committed to ending its Quantitative Easing policy at the end of 2018, although there remains no clear exit for Japan. In the UK, interest rates continue to rise at a glacial pace; with the disappointing economic backdrop setting back the timetable for rate increases.
Equities
The majority of equity markets are still lower in 2018 with the US market a notable exception.
The US produced the best returns in global equity markets and the tech-heavy NASDAQ made a total return of 7.3%. Returns were more modest elsewhere. UK equity returns were augmented by weakness in the pound against the US dollar which has helped exporters. The oil price rallied sharply as the US stepped back from the Iran nuclear deal, meaning that global supply would be lowered as a result of the renewal of sanctions.
Fixed Income
There was little movement in fixed interest markets over the quarter. The sector remains an important source of income and offers diversification.
Gold
The gold price declined by -5.5% as investors moved into riskier investments such as equities. The Absolute Return sector was unchanged and in the current environment it remains difficult for managers within the sector to add value.
Positive momentum in equity markets continued into the new year but gave way to volatility in February as investors showed increasing concern about inflation. The pound strengthened modestly against the dollar and euro which depressed sterling-denominated returns.
Central banks remain on a tightening path on the grounds of controlling inflation and maintaining financial stability. The US Federal Reserve raised interest rates once and at least two more hikes are expected this year. The Bank of England is likely to follow to a lesser extent and even the European and Japanese central banks have guided to a more restrictive monetary policy, signaling a slowdown in Quantitative easing, if not outright rate increases at this stage.
Equities
Weakness was widespread across global equity markets.
In the US, the broad S&P 500 index declined by 4.4% in sterling terms while the tech-heavy NASDAQ index fell around 7% from its peak in early March.
Emerging Markets fared better with the MSCI index declining by 2.2% but our Core exposure weighted to India (a potential loser from trade tariffs) and infrastructure (susceptible to higher rates) failed to capture the more resilient sectors.
Fixed Income
Fixed interest markets were generally weaker but strong demand from pension funds generated some recovery towards the end of the quarter.
United States
Following the imposition of tariffs by the US on certain trading partners, fears arose about the potential for escalation into a broader trade war.
In the US, the technology sector, which up to now had been leading the market higher, was pressured following concerns over Facebook’s privacy issues. As a result, the high level of Valuations across the sector has been questioned.
Europe
There were several other developments for investors to digest. The Italian election demonstrated that populism in Europe remains strong as the mainstream Democratic party suffered a resounding defeat.
The FTSE 100 made a total return of -7.2% over the quarter. Our Core UK exposure is dominated by exposure to mid-caps and the property sector which held up better, supported by bid activity as companies responded to the value opportunities emerging.
Conclusion
The recent volatility highlights the importance of maintaining a well-diversified spread of assets. Some sectors that were previously trading at a premium to net-asset-value or fair-value, such as infrastructure and asset-backed income, have now seen those premiums eroded and this is likely to throw up attractive opportunities to deploy the cash recently realized over the coming weeks.
