Global equities posted robust gains over the first quarter of the year, driven by continued positive economic growth in many parts of the world. Asia Pacific and Europe were among the top performing equity regions, while US markets continued to advance to fresh all-time highs. In fixed income markets, government bonds saw mixed results, with credit generally outperforming.
In a widely-anticipated move, the Federal Reserve (Fed) once again hiked interest rates in March, with the Federal Open Market Committee (FOMC) voting 9-1 to raise interest rates for the second time in three months. Also, the UK government formally invoked Article 50 towards the end of March, nine months after the surprise vote to leave the European Union (EU). This has set in motion a two-year period of negotiation with EU counterparts.
The UK faces some cross currents in 2017. Article 50 has been served and domestic demand could flag in the face of Brexit. Business investment will likely be reined in and the Chancellor will keep a tight grip on spending. Consumption should be solid on the UK public’s unflagging optimism, but will be restrained by the inflation pick-up, which will keep real incomes flat. However, a modest slowdown should not have too much effect on the UK economy, although it may feel gloomier. On the positive side, surveys of production indicate positive prospects for manufacturing, services and exports are good. In practice, this is a rebalancing following last year’s 14% drop in sterling. Overall, we expect growth to be about 2% in 2017, which is at the higher end of forecasts.
Inflation has been attracting attention, with CPI rate rising from 0.3% in February 2016 to 2.3% in February 2017. The core rate went from 1.2% to 2%. Some forecasts are for the headline rate to get to 4%, but the underlying data does not warrant this sort of acceleration. The headline rate is expected to peak at about 2.75% in April, and then level off. This level is unlikely to create problems for the Monetary Policy Committee, which sees growth as fragile in the run-up to Brexit.
As for UK government bonds, the 10-year gilt is currently yielding 1.2%. This is down from year end, ensuring the UK was one of the best performing major global government bond markets in the first quarter. Nevertheless, the overall direction of policymaking in the West is for slow tightening. We expect yields on the 10-year gilt to rise modestly, finishing the year at 1.75%.
UK Corporate Bonds
Despite shorter duration, sterling corporate bonds performed slightly ahead of gilts in the first quarter, mainly due to the tightening in financials. After a historically low year for sterling corporate issuance in 2016, volumes so far in 2017 look healthier, as sterling has settled down and the UK economy has proved more resilient than feared. However, we note much of the issuance has been at the shorter end of the curve, where the cross currency basis is more favourable. After the jump in defaults in the energy sector seen in late 2015 and in 2016, global default rates are now predicted to return to low levels of about 2-3%. Despite some rate rises in the US, low interest rates and debt servicing costs continue to keep default rates contained.
With European Central Bank (ECB) quantitative easing (QE) to continue for the remainder of 2017 and the policy stance in Europe – including the UK – more geared towards supporting growth, we continue to see outperformance of corporates over gilts. In non-financials, we have a bias towards trading up in quality, as spreads have been compressed by QE. In financials, we retain our long position in insurers, which still appear cheap against banks.
The first quarter of 2017 was marked by politics superseding central bank policies as the main driver of performance in global bond markets. Some of the key themes influencing market returns included uncertainties over the Trump administration’s economic agenda, the upcoming elections in France, the UK’s triggering of Article 50, ongoing Greek debt relief discussions, as well as a change of rhetoric from the Fed. Overall, government bond yields rose during Q1 across Europe and Japan, while declining modestly in the US. Corporates outperformed government bonds, supported in Europe by the ongoing QE by the ECB and the search by investors for positive-yielding assets.
We expect to remain in an environment featuring improvements in the underlying economic data, with the recovery being supported by expansionary fiscal policies in the US and, to some extent, in Europe. Inflation should also move gradually higher on the back of these reflationary policies and a recovery in commodity prices, which should prompt the Fed to hike twice more by year-end. However, uncertainty has increased – with a general move towards less globalisation threatening trade, the rise of populist movements in Europe in the run-up to key elections, as well as the potential for disappointment from lower fiscal easing in the US following the failed vote on the repeal of the Affordable Care Act. The reflationary trends support renewed short duration positioning.
After a softer start to the year, UK equity markets performed well during the latter part of the quarter, ending Q1 firmly in positive territory. At UK economic level, the Government released its final spring Budget in March, with the Office for Budget Responsibility (OBR) upgrading its forecast for 2017 growth from 1.4% to 2%. This has resulted in lower-than-expected borrowing figures for the current year. However, the OBR revealed growth is forecast to slow to 1.6% in 2018.
The UK government formally invoked Article 50 towards the end of March, nine months after the surprise vote to leave the EU. This has set in motion a two-year period of negotiation with EU counterparts. For equity markets, this process will undoubtedly create volatility and we expect some corporates to defer decisions on major UK investments until there is greater clarity. This is unhelpful at the margin. Despite this, UK equities continue to be an attractive destination for investors, particularly relative to bonds.
At economic level, PMI data continues to improve and consensus GDP forecasts are back to pre-Brexit levels. Most regions appear to be improving, although there are some laggards – notably Italy. It is an important year for European politics – notably the upcoming French and German elections. The first round of the French election is in April, with the second round in May. The probability of victory for far-right candidate Marine Le Pen has fallen, with Emmanuel Macron the favourite. The German election is in September, with a recent state election positive for Angela Merkel’s CDU.
As for equities, the first quarter started sluggishly for Europe, but markets picked up strong momentum as the quarter progressed. Earnings growth is expected to be strong in 2017, with revisions on the upside. With markets continuing to be cheap, we think the region is a buy.
US GDP growth for 2017 is estimated to come in at 2.2%, with 2.3% forecast for 2018. Economic data continues to be positive, with strong manufacturing PMI and robust labour markets. The Fed once again hiked interest rates in March and retained expectations of three rate increases for 2017. Aside from monetary policy, politics again took centre stage, with the Republican Party’s abandonment of its American Health Care Act. The failure has heightened concerns on President Trump’s ability to easily and swiftly pass his other planned agenda, such as tax reform.
As for US equity markets, valuations keep rising. The price-to-book is the highest since 2004 and 28% above the 10-year average, while historic price-to-earnings is also 28% above the 10-year average. The Shiller P/E is also extremely elevated, with a level above 30x historically suggesting a subsequent real return of -0.3% per annum over 10 years. Does this mean we could see a correction or something worse? We anticipate a mild to moderate correction of 5-10% ahead.
It was a quarter of consolidation for Japanese equities in Q1, after a large rally the previous quarter. Business confidence has improved on the weaker yen currency and a stronger stock market. The composite PMI is at a solid 52.9 and consumer confidence is also at reasonable level. Employment has been increasing, helped by higher levels of female workers and older retirement.
We are continuing to see upgrades to GDP and earnings growth forecasts. GDP growth of 1.1% is expected in 2017, with 1% in 2018. Earnings growth of 15% is forecast – which could result in a record high for earnings. Earnings growth is dependent on the yen over the short term, but fundamental improvements have been seen. On both price-to-sales and price-to-book, Japan remains the cheapest large market in the world. Price-to-earnings is also reasonable. There is the potential to improve profitability with labour market and governance reforms. A weaker yen is also good for margins and profits.
Asia Pacific ex-Japan
Asia Pacific equities rebounded from a sluggish final quarter of 2016 in the first quarter of this year, buoyed by robust political results and economic data. Despite the Fed raising rates during the quarter, most Asian equity markets were resilient, largely due to the Fed retaining its expectations for just two more rate hikes over the course of 2017.
During the quarter, Chinese Premier Li Keqiang revealed China’s growth target for 2017 was 6.5%, in line with the figure President Xi Jinping outlined the country would target annually over the 13th Five Year Plan. We expect fixed-asset investment (FAI) to drive growth in China. The authorities have been cutting capex since 2012, in line with the fall in nominal GDP. However, manufacturing FAI has rebounded to 10.3% in December 2016, from 3% in October 2016. Private investment accounts for 87% of total manufacturing FAI. Monetary easing since November 2014 and fiscal spending has helped the cycle. During the Central Economic Leadership Unit conference, President Xi emphasised revitalisation of manufacturing industry and said it was a key policy focus. India performed well over the quarter, buoyed by strong state election results for the ruling Bharatiya Janata Party (BJP). The results from five Indian states showed overwhelming support for Prime Minister Narendra Modi’s BJP, indicating Modi’s recent reform gamble in regards to demonetisation has paid off.
After a strong Q1, Asian earnings upgrades are likely to continue, but expectations could well be in the price. This means we could witness a subdued second quarter of the year.
UK Commercial Property
A moderate economy, with weak sterling and low interest rates, has supported the commercial property market. The impact of Brexit on UK property values has been limited so far, although much of the detail about the negotiations with the EU is still unknown. Property values have stabilised or seen modest increases since the final quarter of 2016. Rental value growth has been driving property market performance until now, but rents are starting to plateau and soften in some regions and sectors, including Central London offices and standard shops in the regions. This is as a result of continued occupier caution due to the uncertainty surrounding Brexit.
More resilient, defensive sectors are expected to outperform the average, especially industrials and ‘alternative’ real estate sectors. There is an increasing synergy between property and infrastructure assets, with the latter witnessing growing demand from investors looking to diversify portfolios. The distribution and logistics sectors continue to attract strong levels of investor demand. Investors remain attracted by the sector’s defensive, resilient income and long lease structure characteristics. Occupier demand has remained buoyant, especially among online retailers and major supermarket and mixed goods retailers requiring major high quality distribution centres.
A major draw for investors to property continues to be its attractive yield pick-up over UK government bonds.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. Currency fluctuations can also affect performance.
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CLI 00738 Expiry July 2017