Shaken and Stirred: 2016 was tricky for Bonds and Equities
Donald John Trump is to be inaugurated as the 45th President of the United States on 20th January 2017 and the world feels a very different place from a year ago.
Chief Investment Officer
With Brexit and the US Presidential Election, history may record 2016 as a year of peculiarly ‘left field’ events’.
Despite this, our view at the end of 2015 that 2016 should be expected to be ‘a year of two halves’ was broadly what transpired, with the date of the United Kingdom’s EU Referendum, not revealed by David Cameron until late-February, marking the midpoint in late-June 2016.
After the usual round of heavily-couched but generally optimistic financial sector forecasts for the markets in 2016, a reality check came in the form of short, sharp, equity market sell-offs in the first few weeks of the year. In terms of the FTSE 100 Index (see chart below), these came in both mid-January (-10%) and mid-February (-12%) on the back of a 25% drop in the price of crude oil to the $27 per barrel level.
In the event, this was the cathartic end to the downtrend in the oil price since June 2014. While these sell-offs undermined start-to-end year forecasts for 2016, they provided ideal conditions for timed investments.
The year-to-date change of the FTSE 100 index has been around 11% but the low-to-high has been almost 30% and the moves in several of the constituent stocks have been even greater.
The year-to-date performance range of the FTSE 100 Index stocks has been plus 294% (miner Anglo American) to minus 62% (services provider Capita) while that for FTSE 350 Index constituents has been plus 398% (Peruvian gold and silver miner Hochschild) to minus 56% (technology solutions provider Laird).
‘the year’s most significant challenge to those actively managing money was the sharp drop in the value of Sterling’
The year’s most significant challenge was the sharp drop in the value of Sterling on the 24th June; against the US$, the pound fell 11% from $1.49 to the $1.32 level and now stands 16% lower at $1.25.
Perversely, after its initial 9% ‘shock reaction’ drop, the FTSE 100 Index rallied strongly, fuelled by the fact that around 70% of the index revenues are derived from non-Sterling sources – a classic example of ‘bad’ news being ‘good’ news – depending, on the currency of your investment exposure.
The following table provides specific data on a selection of significant market moves during the year.
Bonds have had a roller coaster year; yields on the 10-year US and UK Government Treasury Bonds bottomed, respectively, in July and August.
US bond prices began to fall from July on the prospect of higher interest rates from the Federal Reserve later in the year, subsequently compounded since Trump’s election victory as fears of inflation increased.
The sharp fall in Sterling in June will lead to a rise in import costs and higher UK inflation in the coming months; BofE forecast for CPI was a rise from an estimated 1.3% at end-2016 to 2.7% by end-2017. This has had some impact on UK Bond prices but a rise in UK interest rates is not generally regarded as likely during 2017.
‘a rise in UK interest rates is not generally regarded as likely during 2017’
The lower trend in bond prices has caused adjustment in traditionally higher-yielding equities such as utility shares; ‘High yield’ equity portfolios, favoured by longer term investors in turbulent times, have seen some price deterioration, but as long as the dividends can be maintained, investors can afford to be patient for share prices to recover.
As interest rates rise in response to inflation, bond prices will generally trend lower; in contrast, equities usually match rises in inflation through the businesses to which they relate being able to raise prices and maintain or increase dividends.
With interest rates being kept low, the search for investment income has become more complicated in 2016 as investors have had to take greater care to satisfy themselves that corporate earnings can support sometimes quite generous pay-out levels, particularly in the oil and gas sector.
Companies with large pension liabilities have had to adjust their dividend policy to address funding gaps.
‘investors can afford to be patient for share prices to recover’
In the commodities, iron ore prices are up 87% reflecting continuing steady demand from China; oil prices have been buffeted by endless speculation in 2016 about OPEC’s production intentions but after achieving much of the recovery in the first half of the year, the price for Brent crude is closing the year a net 46% higher at $54 a barrel having hit $27 in January.
Copper is closing the year 22% higher after a boost from growing anticipated global demand since mid-October; gold gained around 25% by mid-year on growing fears about inflation, but slipped back to a 10% net gain for the year ahead of the expected interest rate rises by the Fed.
The mining sector produced the biggest risers, including FTSE’s Anglo American (+300%) and Glencore (+200%) which recovered strongly after being on the brink of insolvency at the end of 2015. Oil & Gas shares were also among the best gainers with FTSE 350 Index stock Tullow (+93%).
Outlook for 2017
With the International Energy Agency predicting a production deficit of around 600,000 barrels per day to emerge in the first half of 2017 which could see a further recovery to $65/70 in the coming months.
The Fed expected to raise interest rates by four quarter-percentage point increments during 2016, but due to economic uncertainties, made just one rise from 0.5% to 0.75% in December; further rises are expected in 2017, particularly as President Trump’s economic policies are expected to be inflationary.
UK interest rates are expected to remain flat throughout 2017 despite inflation caused by the drop in Sterling; Governor of the Bank of England, Mark Carney, has indicated he will continue in his role until June 2019 and he wants monetary conditions to bolster confidence in the economy during the period of the Brexit negotiations even if the rate of CPI inflation – 1.2% in November – eventually exceeds the Bank’s target rate of 2%.
‘President Trump’s economic policies are expected to be inflationary’
Mr Trump has vowed to abandon the Trans-Pacific Partnership (TPP) trade agreement on his first day in office to the a disappointment of the remaining eleven participating countries mainly in Asia although China is is expected to exert further influence in the region.
The European Union has faced significant challenges in 2016 including huge inflows of refugees and economic migrants which have brought with them mixed political and economic implications and the perceived threat from Russia.
Brexit creates the prospect of fundamental change, not just for the UK.
The resignation of Italian Prime Minister Matteo Renzi has impacted Italy’s banking sector and Monte dei Paschi de Siena, reputedly the world’s oldest surviving bank, could now be nationalised.
‘Brexit creates the prospect of fundamental change, not just for the UK’
With an estimated total of 360 billion euros of bad loans in the Italian banking system, the need for wider resolution is critical if the euro and whole Eurozone are not to face existential risks.
The Fed should keep US interest rates rising to offset ‘Trumpflation’, keeping the dollar firm and keep the euro in a range between parity to the dollar and $1.08; however, if concerns grow about the very future of the Eurozone, intervention by central banks may be required to counter wilder swings.
IMF forecasts had been for a slight improvement to 3.1% in 2017, but that may be adjusted post the US Election.
In the FTSE 350 sectors, trends suggest that Mining looks likely to make a little more progress, whereas beverages (main component Diageo) and Chemicals (Johnson Matthey and Croda) and General Industrials (RPC, DS Smith) may be expensive.
Oil & Gas group (Royal Shell and BP) could have more upside potential while Weir Group in Industrial Engineering should have further to go while the oil price consolidates recent gains at around $55 per barrel.
Banks (HSBC and Barclays) appear to have some further long term upside but may be erratic in the short term; the index sector group with the best bottoming profile in the short term is Fixed Line Telecoms, dominated by BT Group although timing could be crucial.
Summary and Conclusions
The trend in commodity prices in 2016 has had a profound effect at many levels globally – corporate, national – and this influence is unlikely to be diminished in 2017.
The world economy must now deal with the prospect of a recovering oil price even if not back to the $100 a barrel in the short term.
Precious metals, particularly gold and silver, may have a good year if the perception grows that inflation is accelerating and that Central Banks are behind the curve with their interest rate policies.
‘Investors will have to follow economic and political developments especially closely in the coming months’
The London equity market will not be immune from Wall Street but it will also need to deal with uncertainties around Brexit; there could be short term trading opportunities but, as in 2016, the longer term picture may not be clear for several months.
The investment emphasis is likely to remain on seeking out reliable higher yielding equities as rising interest rates weigh on bond markets.
Given recent events, politics has become a more significant factor in assessing the prospects for markets and the election as President of Donald Trump – a self-confessed political ‘outsider’ – carries its own challenge to gauging the outlook for 2017.
Purely in terms of threats or opportunities for investors, the ‘Trump Effect’ could either see the emergence of a reinvigorated economy and a rise in US national self-esteem, or the project could stall as vested interests feel unable to embrace the Trump initiatives.
Investors will have to follow economic and political developments especially closely in the coming months.
The potential for misunderstandings is likely to give rise to heightened volatility in markets, leading to a ‘right royal’ casino atmosphere at times.
However, if the conspiracy theorists are to be believed about possible Russian links, perhaps all investments should be placed on red.