Quarterly investment outlook. Five key issues shaping current investment strategy Second quarter 2018

Transcription

1 Quarterly investment outlook Five key issues shaping current investment strategy Second quarter 2018

2 Five key issues shaping current investment strategy Second quarter 2018 Page 2 Five key issues shaping current investment strategy 1. Looking up How will equities react to rising bond yields? 3 2. Inflated expectations Are inflation concerns justified? 4 3. The problem with protectionism Biting the hand that feeds the consumer 5 4. Portfolio protectionism Steady through the ups and downs 6 5. Good value or value trap? UK equities look attractive across various measures 7

3 Five key issues shaping current investment strategy Second quarter 2018 Page 3 1. Looking up How will equities react to rising bond yields? we have done a lot of work on assessing the likely path of US bond yields, which has important implications for equity returns. We estimate an equilibrium yield of 3.25% for 10-year Treasuries, not far above the current level of 2.75% (at the time of writing). this estimate takes into consideration the outlook for GDP growth, inflation and interest rate expectations and the typical premium of US Treasury yields over inflation. market expectations for a neutral real interest rate (interest rates less inflation) of r0ughly zero is in line with our own analysis and also suggests yields are unlikely to stray too far above 3.25% (figure 1). it s possible that bond yields could stray beyond this equilibrium level in the short term, with the 10-year Treasury already near this level. we believe the US economy will be strong enough to support equity markets through rising bond yields this year. But we are cautious given US firms may have become more sensitive to high interest rates following a dramatic rise in corporate borrowing (figure 2). Market-implied equilibrium real interest rates US EU Leverage (borrowing) in the S&P 500 Index S&P 500: leverage - Median S&P 500: leverage - Median ex tech Figure 1 Market expectations, which we can derive from interest rate and inflation swaps, suggest a neutral real rate of 0%, and an equilibrium bond yield of around 3.25%. Figure 2 US firms may have become more sensitive to high interest rates following a dramatic rise in corporate borrowing over the past few years.

4 Five key issues shaping current investment strategy Second quarter 2018 Page 4 2. Inflated expectations Are inflation concerns justified? with sterling off its Brexit-related lows, inflation has been hovering at around 3% recently. As the sterling effect fades from annual calculations, we believe it will drop to around 2.5% in the coming months. inflation has remained subdued across the rest of the world, with prices rising at an annual rate of more than 2% in just 30% of 35 countries tracked by the Organisation for Economic Co-operation and Development (figure 3). stronger US wages and Donald Trump s tariffs have raised fears that inflation could accelerate. However, excluding food, energy and housing, US inflation is still low and we believe the market has overreacted to recent wage data (figure 4). the cost of oil can have a big impact on global inflation rates; we don t see it going much higher as supplies of shale oil from the US are likely to offset any production cuts from OPEC. some of the structural forces acting on inflation, such as technological and demographic shifts, are changing, but we do not expect a sharp rise or fall in the coming year. Core inflation in 35 advanced economies (%) Max/min Median A weak relationship (%) Core CPI excluding Shelter Average hourly earnings, yoy %ch Figure 3 Global economic growth is still strong and inflation remains subdued. Figure 4 The correlation between wages and inflation in the US is very weak, which is unusual but not unprecedented. Source: Datastream, Bank of England, Rathbones

5 Five key issues shaping current investment strategy Second quarter 2018 Page 5 3. The problem with protectionism Biting the hand that feeds the consumer although we think it s too soon to declare a trade war, Donald Trump s recent spate of tariffs indicate that his anti-trade talk wasn t just for show. trade featured heavily in the President s rally speeches and once elected he appointed Wilbur Ross and Robert Lighthizer, who have both lobbied for protectionist measures, to key roles. Under Trump, policy has moved in favour of US companies. The Trade Partnership, an independent think tank, estimated that steel and aluminium tariffs would add 33,464 jobs in the US metals industry, but cost 179,334 jobs across the rest of the economy. This would result in a net loss of about 146,000 jobs (figure 5). while some past US tariffs have been met with appeasement, trading partners took a tactical defeat for the sake of the strategic aim of globalisation. Now that globalisation has been achieved, appeasement may be less likely. US demand is also less important than it once was as a bargaining chip (figure 6). an isolationist approach risks undermining investment and productivity, while also losing out over the long term as integration goes on elsewhere. Job creation and destruction Sector Jobs Primary agriculture -285 Primary energy -669 Services -142,305 Manufacturing: iron and steel +29,998 Manufacturing: non-ferrous metals +3,466 Other manufacturing -36,076 Total -145,871 China s steel exports to the US in 2016 (%) Myanmar Hong Kong Pakistan USA Malaysia India Indonesia Philippines Thailand Vietnam Korea Figure 5 The independent think tank The Trade Partnership has estimated the impact of Trump s tariffs on jobs across the economy. Source: The Trade Partnership, Rathbones Figure 6 Trump s tariffs on steel imports would probably have a limited impact on China because of the small proportion it exports to the US. Source: comtrade.un.org

6 Five key issues shaping current investment strategy Second quarter 2018 Page 6 4. Portfolio protectionism Steady through the ups and downs we have long held the view that with yields so low, gilts offered little advantage over cash. But with 10- year gilt yields now at levels not seen since late 2016, the extra income is looking attractive again (figure 7). we believe portfolios should also include securities we call diversifiers, which aim to maximise long-term risk-adjusted returns by adding assets whose returns don t track equities and bonds. Among them: long short equity is one of the most popular diversifying strategies (figure 8), where managers can make a profit when share prices rise and fall. However, we don t consider all funds in this category as diversifiers, as some tend to track equity returns. event-driven funds seek to exploit pricing inefficiencies that may occur before or after a corporate event, such as a merger. global macro managers invest according to economic and political conditions in various countries, but returns have been disappointing recently due to a lack of volatility in currency markets. commodity trading advisers (CTAs) use derivative contracts across all asset classes to generate returns from market trends. 10-year UK gilt yields (%) Allocations to diversifying strategies (%) Active managed fixed income 6 Discretionary macro Targeted return strategies Equity long short and event driven 38 CTAs 31 Precious metals Property Figure 7 Yields have returned to levels where gilts can once again be considered a viable alternative to holding cash. Figure 8 Allocations to diversifiers in a typical Rathbones balanced portfolio, as of 31 December 2017.

7 Five key issues shaping current investment strategy Second quarter 2018 Page 7 5. Good value or value trap? UK equities look attractive across various measures we think investors are pricing in a fairly negative Brexit scenario; UK shares offer fundamental value and opportunities for differing economic outlooks. before the Brexit vote, the FTSE 100 s price relative to earnings for the year ahead (the forward PE ) was at 14.4 compared with 17.8 for the S&P 500. The FTSE 100 s forward PE has since fallen to 13.4, and the S&P 500 s has been fairly steady, recently at 17.4, widening the discount to 22% (figure 9). on another good valuation measure, the FTSE 100 has also become more attractive: free cash flow as a percentage of the value of all shares. This has risen from 4.8% at the time of the EU referendum to 6.6% today better than the S&P 500 (figure 10). if the UK exits the EU without a trade deal, sterling weakness is likely to resume, boosting the value of overseas revenues 76% of the FTSE 100 total. overseas investors may also be put off by the prospect of a hard-left UK government with Labour leader Jeremy Corbyn climbing in the polls. But we believe sterling is undervalued and will eventually normalise. This will boost returns for global investors, while the internationally focused FTSE 100 should also deliver long-term earnings growth. FTSE 100 forward PE relative to S&P Mar 16 Jun 16 Sep 16 Dec 16 Mar 17 Jun 17 Sep 17 Dec 17 Mar 18 FTSE 100 free cash flow yield relative to S&P Mar 16 Jun 16 Sep 16 Dec 16 Mar 17 Jun 17 Sep 17 Dec 17 Mar 18 Figure 9 The FTSE 100 s forward PE has fallen to relatively attractive levels compared with the S&P 500. Figure 10 The FTSE 100 has become more attractive in terms of projected free cash flow yield.

8 Five key issues shaping current investment strategy Second quarter 2018 Page 8 Important information The value of investments and the income from them may go down as well as up and you may not get back your original investment. Past performance should not be seen as an indication of future performance. Changes in rates of exchange between currencies may cause the value of investments to decrease or increase. Information valid at 31 March Tax regimes, bases and reliefs may change in the future. Rathbone Brothers Plc is independently owned, is the sole shareholder in each of its subsidiary businesses and is listed on the London Stock Exchange. Rathbone Investment Management Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Registered office: Port of Liverpool Building, Pier Head, Liverpool, L3 1NW, Registered in England No Rathbones and Rathbone Greenbank Investments are trading names of Rathbone Investment Management Limited. Rathbone Unit Trust Management Limited is authorised and regulated by the Financial Conduct Authority. Registered office: 8 Finsbury Circus, London EC2M 7AZ. Registered in England No Rathbone Trust Legal Services Limited is authorised and regulated by the Solicitors Regulation Authority. Rathbone Investment Management International is the registered business name of Rathbone Investment Management International Limited which is regulated by the Jersey Financial Services Commission. Registered Office: 26 Esplanade, St Helier, Jersey JE1 2RB. Company Registration No Rathbone Investment Management International Limited is not authorised or regulated by the Financial Conduct Authority or the Prudential Regulation Authority in the UK. Rathbone Investment Management International Limited is not subject to the provisions of the UK Financial Services and Markets Act 2000 and the Financial Services Act 2012; and, investors entering into investment agreements with Rathbone Investment Management International Limited will not have the protections afforded by those Acts or the rules and regulations made under them, including the UK Financial Services Compensation Scheme. This document is not intended as an offer or solicitation for the purchase or sale of any financial instrument by Rathbone Investment Management International Limited. No part of this document may be reproduced in any manner without prior permission Rathbone Brothers Plc. All rights reserved.