Markets took a downward turn in October as the impact of the global monetary tightening cycle, excessive valuations within some asset classes, political uncertainty and issues across emerging market currencies turned sentiment sour. However, we believe this was a sensible correction, not the first leg down in a long-term bear market. Fundamentally, it is the withdrawal of QE that will continue to put pressure on asset prices, following a decade of ultra-loose monetary policy. As the global economy remains sound, issues such as trade war rhetoric, Brexit uncertainty and Italian budget arguments are just general noise for now.
Global fixed income markets have been dealing with rising interest rate and inflation expectations for much of the year. This has been driven predominantly by the US, with strong economic growth, supply-side bottlenecks and fiscal spending resulting in a more hawkish US Federal Reserve. We expect the rate hiking cycle to continue – with 3 hikes in 2019 – as administrators try to keep inflation in check. US treasury yields have broken through the physiologically important 3% barrier in recent months and the yield curve remains incredibly flat. However, we are still finding value in US financials, with credits issued by world class businesses with strong balance sheets trading at levels which should be able to absorb further rate hikes and still deliver investors a positive return.
In Europe we are also seeing a build-up of price pressures, albeit much more gradually, whilst the European Central Bank further tapers its QE programme. Italy of course has been the main source of news, with Italian sovereign yields spiking following the failure of Salvini’s government to agree budget terms with the EU. Currently, we are comfortable with our Italian credit exposure as we believe the spreads on offer adequately compensate the slightly higher sovereign risk. More importantly, we have noted that EU debt has started accelerating once more at an aggregate level. This is a more pressing issue in our view.
The sterling credit market continues to be dominated by Brexit uncertainty, as does the wider domestic economy. Our view is that a deal is likely this side of Christmas, which would be positive for both sterling and risk assets more generally as GDP would likely be revised up. Looking at individual sector and stock selection, we are still finding pockets of value in certain areas. Although the broad index is currently trading at or close to post-crisis tights, sectors such as financials, insurance and collateralised bonds are still offering investors willing to undertake rigorous credit analysis attractive opportunities.
October saw a significant sell-off across all geographies. Globally, we had seen a 4% return from equity markets in the year-to-date to the end of September in local currency terms. In the year-to-date to the end of October, that return figure is now is now -4%. It has been the growth areas of the market – such as the well-known FAANG technology stocks – that have been the primary driver of equity returns in the low interest rate environment of the last decade. It was therefore these stocks that sold off the most in October as the prospect of further interest rate hikes spooked investors.
In addition, the prospect of a US-China trade war, deteriorating economic momentum in Europe and the potential contagion of the emerging market currency crisis have all boosted the attractiveness of ‘safe haven’ investments such as government bonds, whilst simultaneously causing many investors to reduce their equity exposure. We do not believe these issues will have a significant impact on market fundamentals in the short-term – which is why we continue to favour equities over bonds – but we do recognise that the future returns from equities are likely to be lower than they were earlier in the cycle. Markets such as the UK and Japan remain attractively valued for example and opportunities remain in the more value areas of the market that have underperformed for much of the last 10 years.
Whilst equities and bonds have struggled in 2018, UK commercial property has continued to hold up well. We have seen a solid income return, plus capital appreciation in selective areas such as industrials. Across the broad market, demand is largely in line with long-term averages, although sectors like retail have come under pressure. Retail represents some 40% of the benchmark and has been a poor performer in 2018 as there is simply too much retail space, particularly in less-than-prime locations. Following the well-known problems amongst casual dining operators, we are now seeing some distress in department stores and shopping centre locations, with further CVAs and restructurings likely.
However, the industrials sector has remained very strong, driven by the growth in e-commerce and online shopping. Office take-up has also been robust, with regional markets in particular an area where we have sourced a number of opportunities this year. Therefore, while capital upside in the next twelve months looks constrained, we are still able to generate an income return of c. 5% which highlights how important the asset class can be from a diversification perspective within a multi-asset portfolio.
The value of investments may fall as well as rise and investors may not get back the amount invested.
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