Market Commentary for Q2 2017 and Future Outlook
Market Commentary for Q2 2017 and Future Outlook Liz Rees of Willis Owen looks at the key events and influences over the past quarter
Quarter 2 2017 performance
Markets have built on the momentum established in the first quarter with most making steady gains. Company results were a key driver, with Japan and the Eurozone among those exceeding expectations. Japan was the standout performer in local currency, assisted by a weak Yen, while China lagged behind on mixed economic data and worries over high levels of debt.
The UK proved relatively resilient to the unexpected Election outcome of a hung parliament and the commencement of Brexit negotiations. However, the FTSE 100 was held back somewhat by a stronger Pound and a weak oil price depressing the important oil sector.
Towards the end of the quarter, there were a few signs of the bull market running out of steam with investors starting to question President Trump’s lack of progress in implementing his policies. Furthermore, June’s increase in US interest rates, and hints of an end to monetary easing from several other Central Banks prompted a sell off in Government Bonds which had a knock on effect on equities.
Nevertheless, the first half of 2017 has proved to be one of the best for equities in a decade, driven by the US which represents over half of the world index. Growth orientated sectors such as Technology and Biotech led the way in developed markets while high growth Emerging Markets also shone.
Key events of the quarter
Politics took centre stage in June with Elections in France and the UK. In France, the polls got it right though the size of the victory by Emmanuel Macron took some by surprise. European markets rallied on hopes of business friendly policies.
The snap General Election in the UK was a gamble that did not pay off for Prime Minister Theresa May. In spite of gaining an improved share of the overall vote the loss of some key marginal seats resulted in a hung parliament. Eventually an arrangement with Northern Ireland’s Democratic Unionist Party scraped them to the required majority.
Brexit negotiations finally got underway on 19 June with Brexit secretary David Davis leading negotiations with his EU counterpart Michel Bernier. Initially, talks will focus on our exit bill and the status of EU citizens resident in the UK. Business leaders believe the chances of a hard Brexit, with Britain leaving the single market and customs union, may have reduced in light of the Governments weakened position.
The oil price slumped over the quarter, touching a low of $45 per barrel, as increased US shale production has outweighed the attempts by Middle East cartel OPEC to reduce output by its members. Other commodity prices were also marked down on fears that the clampdown in speculative trading could hit metals demand in China.
Economic trends and outlook around the globe
In its latest World Economic Outlook, published on 24 July, the IMF* maintained its 2017 global GDP growth forecast at 3.5%, while flagging that this masked a change in the contributions from leading economies. The estimate for 2018 remains at 3.6% and inflation is expected to remain subdued.
Overall, the broad based recovery in global growth appears to be continuing for the time being with an encouraging pick-up in world trade; goods and services volumes are expected to expand by 4% despite the threats of protectionism. The organisation sounded a note of caution around lofty market valuations against a background of policy uncertainty, pointing out that a market correction could undermine growth and confidence.
The IMF reduced its economic growth forecast to 1.7% for 2017, citing the first quarter weakness and Brexit uncertainty. Others have downgraded more harshly. For example, the Centre for Economic and Business Research now sees the UK economy expanding by just 1.3% in 2017.
Q1 growth was the slowest for a year, at 0.3%, as rising prices put consumer spending under pressure and Q2 looks set to be similar. Recent business and consumer data suggests that the UK faces further weakness with PMI** surveys for manufacturing, construction and services all showing declines in June.
Although growth in the manufacturing sector (which only accounts for 10% of GDP) hit a 3 year high in April, as the weak pound boosted exports, it has since deteriorated. Consumer spending has been funded by higher levels of personal debt but is also now suffering as real incomes fall. Services are the biggest component of the British economy and have recorded both weaker growth in new orders and a fall in business optimism.
Inflation remains a significant risk with the CPI index reaching 2.9% in May. If it continues to outstrip wage growth then consumers’ purchasing power, pivotal to growth, will erode further. While interest rates were left on hold over the period, the Bank of England lifted its inflation forecast for this year to 2.7% followed by 2.6% in 2018. Governor Carney warned in May that rates may have to rise sooner and faster than expected if wage growth picks up sharply next year.
All this amounts to an uncertain outlook for the UK. Brexit developments will be watched closely as a lack of progress will be interpreted as bad for jobs, investment and growth. This would increase the chances of the economy entering a period of recession.
The United States
Donald Trump’s failure to deliver the promised tax reforms and fiscal stimulus has led the IMF to cut its forecasts for the US to 2.1% for both 2017 and 2018. This stands well below the President’s own 3% target.
However, the US Institute of Supply Management’s June report showed surprise acceleration in manufacturing growth as orders, production, employment and exports all expanded. Furthermore, the country is close to full employment with the jobless rate the lowest for 10 years.
Fed chair Janet Yellen had indicated that monetary stimulus was approaching an end and the 0.25% rate rise in June was expected. Yet inflation and retail sales figures have weakened although sentiment indices are still strong. CPI inflation peaked at 2.7% in February and has since fallen to 1.9%.
Corporate results have been very strong with Q1 beating consensus estimates. Moreover, most companies have a positive outlook on business conditions and the overall economy despite the lack of clarity on Government policies on healthcare, trade and immigration. Trump’s Budget plans were largely as expected, favouring defence and border security over welfare and government spending.
Ongoing economic strength in the world’s largest economy is positive for the wider global trade but shares in the US trade on demanding valuations and there may be better opportunities elsewhere.
The IMF upgraded its GDP growth estimates for the Euro area to 1.9% for 2017. The Eurozone has delivered 14 consecutive quarters of growth as business confidence remains resilient in the face of Brexit.
Emmanuel Macron, the independent centralist, won a clear victory in the runoff against Marine le Pen, the Far Right candidate, giving him a influential mandate to revitalise the French economy. He is a strong supporter of the EU and wants to see further integration.
First quarter GDP was a satisfactory 0.5% and corporate profits have been impressive with earnings on the Stoxx 600 up 20% on the previous year. The ECB president, Mario Draghi, has alluded to reducing the quantitative easing programme, describing the recovery as ‘solid and broad’. He noted that PMI indicators are healthy and the threat of deflation in the region has disappeared.
The Eurozone is further behind in the economic cycle then other developed economies and therefore there could be more recovery potential still to come.
The IMF has upgraded growth forecasts to 1.3% in 2017 after private consumption, investment and exports buoyed Q1 growth.
Japan’s economy grew by 0.3% in the first quarter, the 5th quarter of economic expansion, and a boost for the policies of Prime Minister Shinzo Abe. Monetary policy continues to be supportive and growth is forecast to accelerate.
Company profits rose by 27% and The Bank of Japan Tankan index, which measures confidence among large manufacturers, has continued to show improvement. It is hoped the tight labour market will exert upward pressure on wages and consumer prices, allowing the country to escape from 2 decades of on-off deflation.
Japan is modestly valued with a stable political position. The primary negatives are unfavourable demographics and the tendency of the market to track the Yen.
The IMF has upgraded Chinese growth slightly to 6.7% for 2017, following a better than expected Q2. India remains the other key to strong growth in developing markets with 7.2% predicted despite the disruption of the currency exchange initiative. The larger markets in Latin America are expected to pick up this year, albeit from depressed levels.
The MSCI Emerging Markets index has been the standout performer over both the quarter and the year to date, with some smaller Asian countries leading the way. India is officially the worlds fastest growing economy and remains on track to become the 3rd largest economy by 2030, overtaking Japan and Germany. Investors have recognised the impact of structural reforms and favourable demographics.
China has been unsettled by the authorities’ drive to end speculative trading. Economic growth of 1.3% in Q1 accelerated to 1.7% in Q2 although manufacturing contracted in May for first time in a year. Critics pointed out the extent of bank lending and a surge in new long term construction projects as growth reflected unexpected strength in the property market.
Latin America presents a mixed picture. In Brazil, President Temer has been implicated in a bribery scandal, putting much-needed pension reform at risk while oil producing countries have suffered from low oil prices. On the positive front, the outlook in Mexico and Chile is improving as the US administration has shown willingness to negotiate with trade partners.
Summary of the prospects for stock market investors
Strong corporate earnings have provided some justification for valuations of global equities being high by historic standards but there are a few potentially negative signs which we need to keep an eye on.
If Central Banks start to withdraw monetary easing and interest rates rise, it is likely that yields on Sovereign Bonds will follow meaning capital values will fall. Since the global financial crisis, both Bonds and Equities have made substantial gains and it is unclear as to whether they will start to disconnect and move to their traditional roles as portfolio diversifiers.
UK consumers are undoubtedly finding life tough with real wages under pressure as the weak Pound drives up the cost of imports. Brexit uncertainty may also hurt our domestic economy if international companies put investment plans on hold. Inflation is less of a problem elsewhere but stubbornly low productivity growth is keeping wage increases subdued in most developed economies.
Nevertheless, if global growth can maintain its momentum the prospects for Equities remain attractive. Equity Income, along with Property and Infrastructure, Funds remain sources of a steady and growing income which is particularly attractive if inflation exceeds returns available on cash. Our message as ever, is to ensure you diversify your portfolio rather than sticking to your home market.
Important Information: Willis Owen does not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.