Economic Commentary: Escalating Mind Games

12 October 2017

Investment Managers Nigel Skelton and Chris Murphy give their views on market movements over the past quarter. 

Following previous commentaries and due to gargantuan Quantitative Easing (QE), economic data continues to point to robust and generally synchronised global growth. The last time we saw a combination of synchronised global growth, loose financial conditions and low financial market volatility was in 2006. Whilst we do not necessarily believe that another global financial crisis is on the horizon, we are nevertheless slightly wary as the macroeconomic backdrop as well as financial market valuations appear to be relatively frothy. The UK’s benchmark equity Index, the FTSE 100, continued to trade virtually sideward over the third quarter of the calendar year, rising just 60 points (or 0.8%) to 7372. This followed a mere 10 point drop over the second quarter of the calendar year. In previous commentary, I referred to the extremely low level of the VIX (Volatility Index or ‘fear gauge’) and questioned whether its almost historically low level of 11.18 (down 9.6% over the second quarter) represented the calm before the storm. I am even more minded to reference the eerie tranquillity of the Index following its fall of 14.9% to 9.51 over the third quarter.

Indeed, despite the apparent rosiness, beneath the surface there may still be question marks regarding the continuity of this elongated recovery phase of the current economic cycle. The above comment may be particularly pertinent to the UK where faltering car sales, scepticism regarding the longevity of prevailing low rates of interest and general perceptions regarding moderate consumer malaise are posing serious question marks for institutional and retail investors alike. For example in the UK and largely due to our weak Sterling, inflation remains stubbornly above target and many believe that Governor Mark Carney has little option but to follow Janet Yellen and the US Fed by raising rates. Nevertheless, due to several of the aforementioned points, the outlook remains distinctly opaque - especially when a protracted Brexit is factored into the equation. Many economists now expect the Bank of England’s rate-setting Monetary Policy Committee (MPC) to raise base interest rates by 0.25% (to 0.5%) at their November meeting or shortly thereafter (early 2018) – thereby offsetting the post-Brexit rate cut from August 2016.

There are contradictory signals from the gentle, but relentless, advance in price of crude oil (the price of the Brent variety increased by 15.5% over the quarter to $56.53 per barrel), whereas UK wage growth remains relatively benign, despite pressures from the Public and Private sectors alike. With the unemployment rate having fallen to its lowest rate since 1975 at 4.3%, is it therefore time that Mark Carney and the MPC members vote for an increase in the Bank of England’s base lending rate before the calendar year end? For my part I believe it would be both prudent and sensible to ensure that a much greater proportion of consumer spending is effectively from earned income rather than ‘created’/pseudo wealth from additional borrowed money at extremely low and almost incredible rates of interest. For example, on an interest only basis it is presently possible to borrow £100,000 for approximately £125 per month which seems ludicrously low.  

Government Bond (‘Gilt’) markets are certainly pricing in the ever growing likelihood of an increase in base interest rates – the benchmark 10-year Gilt yield rose by 9.7% over the quarter from approximately 1.254% to 1.376%.  Whilst still incredibly low from an historic perspective, it is clear that borrowing costs are rising (noting that the benchmark yield was as low as approximately 0.5% just last year in August 2016).

Amidst quieter (I don’t get many) moments I have often thought over the years that a two tier lending system would assist the UK greatly such that so called SME’s (small /medium enterprises) should be afforded some tax breaks or reduced lending rates to commence entrepreneurial projects, whereas the ‘man in the street’ should perhaps pay an additional 1-2% to maintain realistic yet affordable borrowing costs.

At the time of writing, the fifth round of Brexit negotiations between the UK and the EU has just begun. Despite the glimmers of progress thus far in previous negotiating rounds, Theresa May’s Government are now planning for “every eventuality”, which includes the possibility of no deal. What is clear is that there is still a lot of negotiating to do between now and 2019 and with seemingly every word from each side of the negotiating table being scrutinised by the press, the issue is likely to dominate newspaper headlines for some while yet.

Across the pond in the US, as expected, on 20 September, the US FOMC (Federal Open Market Committee) announced that it will begin unwinding its $4.5 trillion bond portfolio from October 2017. The unwinding process will be done gradually and will take several years to complete. Interest rates were kept on hold at a range of 1.0-1.25%. However, the quarterly FOMC forecasts continue to point to one more interest rate hike this year, which would mark the third rise of 2017. GDP growth is expected to slow in the coming months and with Democrats and Republicans seen as too far apart on tax issues, it is unlikely that any of Donald Trump’s much-vaunted major tax reforms will come to fruition. This all points to a likely gradual slowdown of economic momentum in the US in the short term at least.

In terms of Geopolitics, the escalating mind games (as per the title) have, fortunately, reached a quiet moment at the time of dictation following various bouts of rhetoric and verbal sparring which we hope will remain merely as oral jousting rather than the onset of nuclear war! Despite the posturing and general bluster between Donald Trump and Kim Jong-un, we do not believe that either side truly covets a military conflict, especially the latter. Financial markets also appear to be taking all of the rhetoric with a pinch of salt, judging by their relatively muted reaction to the headline grabbing war of words.

In conclusion and to repeat my sentiments from my last commentary, protracted Brexit negotiations are ongoing and the huge potential range of outcomes means that it remains extremely difficult to make accurate forecasts for the future with any degree of certainty. In terms of the elongated recovery phase and with regard to Stock markets I detect certain good performing sectors which are more associated with the growth phase of economic wellbeing, e.g. the Bank and Oil sectors which have generally performed strongly over the past 3-4 months. On the flip side, there have been several company or industry specific adverse/surprising news announcements which have caused relatively large and sudden share price falls – examples include Provident Financial, British American Tobacco and AstraZeneca. Whilst the latter named company’s shares have since recovered most or all of the sudden fall, I am more cognisant than ever of the potential risk to capital that equity investing entails. However, my long-held belief in careful stock selection and above all careful constructed portfolio diversification will always be at the core of my investment process in order to help mitigate any adverse effect from a company-specific shock.

As aforementioned, the leading FTSE 100 Index as a whole continues to trade in a narrow sideward range and I would expect this to continue for the time being in the absence of any major moves in the value of £ Sterling and/or an unexpectedly drastic move from the MPC with regards to base interest rates. Amidst a somewhat difficult backdrop, I am therefore minded to take a cautionary stance and will continue to diversify client portfolios across asset classes in order to secure what we believe to be relatively good long-term returns including the ever important income returns.

As ever your usual adviser will be happy to offer assistance with portfolio planning and asset allocation or other specific investment queries.