In v estm en t Views January 2018
Global strategy Global economic prospects for 2018 Predicting economic outcomes at a country or global level is an exercise that can be charitably described as an inexact science. Here at Butterfield, at the end of every year, we make predictions about the direction and strength of the global economy with a focus on the US economy. In general, we are much more concerned with getting the direction of travel correct, rather than strictly looking at the numerical figures and judging them right or wrong. The underlying trends in growth and inflation, we believe, are instructive to investors. They form the basis of our recommended asset allocation decisions amongst the broad asset classes in which we invest: Equities, Fixed Income, Non- Traditional Assets, and Cash. In the US, we predicted the following for 2017: 2.3% GDP Growth 4.4% Unemployment Rate 2.2% Core Inflation 1.5% US Federal Funds Base Rate Overall growth in the US is likely to be reported as stronger than 2.3% for 2017 (perhaps 2.5%), as the second half of the year was very strong across the board and featured good corporate profitability. Since 2016 GDP growth was 1.5%, our forecast captured the essence of the strong directionally positive cyclical picture in the US, although we underestimated the strength slightly. Our prediction for 2018 is for 2.8% GDP growth, stronger again in 2018 than it was in 2017 and far above what we would consider a sustainable trend growth rate for the US. Similarly, the unemployment rate in the US is likely to eclipse our prediction of 4.4%, having reported a 4.1% rate in November. The rate at the end of 2016 was 4.7%, so again, we have been directionally correct, but the job market has been even stronger than our prediction. We expect the rate to drop further in 2018, potentially to 3.8%. This type of employment growth has, in the past, been associated with better wage results and higher inflation. The last forecast we got mostly right was for US base rates, as we had expected 3 and possibly 4 rate increases in the US and we did see 3 increases. We expect a further 3 to 4 base rate increases in 2018 as the economy continues to be strong.
Global strategy Global economic prospects for 2018 (continued) On inflation, however, our predictive power was a bit lacking. Our forecast for core inflation to rise due to strong economic growth in 2017 did not come to pass. The Federal Reserve s preferred measure of core inflation the Core Personal Consumption deflator (Core PCE), currently sits at 1.5%, after ending 2016 at 1.3%. Inflation has remained stubbornly low, in part due to a lack of wage gains and poor measured productivity. Based on our relatively rosy GDP and employment forecasts, we do expect inflation to return in 2018, with a forecast of 2.3% Core PCE. This forecast is notably higher than most analysts expectations and represents our largest deviation from consensus expectations for 2018.
Equities Stock markets complete strong quarter Global equities continued to perform well in the final quarter of 2017, returning 5.5% in US dollar terms. This marks the seventh consecutive quarterly gain, dating back to the second quarter of 2016. On an annual basis, global equities returned 22.4% in US dollar terms, the largest gain since 2013. The quarter was reminiscent of the third quarter of 2017, with broad-based synchronized gains coming from all major regions and 10 of 11 global sectors. Despite the numerous geopolitical risks heading into the year, market gains were driven by the fundamental strength of company earnings. In each of the first three quarters of the year, earnings for S&P 500 constituents increased 11%, 9%, and 7% relative to the same quarter of 2016; fourth quarter earnings are expected to grow in the low double digits. The S&P 500 returned 6.5% for the quarter and 21.8% for 2017. That annual return would have been the highest amongst the major regions since 2014, however North American equity returns were eclipsed by all other regions during 2017. Emerging Markets continued their strong performance, returning 7.4% during the quarter and 37.3% for the year. Many Emerging Markets shook off potentially damaging events such as North Korea s nuclear tests, new charges brought against Brazilian President Michel Temer, Saudi Arabia s anti-corruption campaign, together with three interest rate increases in the US. The Euro Stoxx 50 increased 25.1% in US dollar terms, with the majority of gains stemming from the near 15% gain in the Euro relative to the US dollar. Japanese equities in local currency terms have historically required support from a weaker Yen in order to perform well, however this relationship broke down last year. This reflects inflows from global investors recognising the positive changes brought about by Abenomics.
Equities Stock markets complete strong quarter (continued) Drilling down into the global sectors, cyclically based sectors continued their strong run and growth companies outperformed value yet again in the final quarter of the year. The technology sector was the top performer during the quarter and for the whole year, driven by strong top and bottom line growth. Energy had a year of two halves, falling double digits in the first half and snapping back double digits in the second half, to finish the year with a 5.0% gain, the lowest of any sector. Oil prices were buoyed in the second half of the year as OPEC countries agreed to extend production cuts through the end of 2018. Crude oil finished the year above $60 per barrel, a 12.5% gain. We are in the process of adjusting sector allocations, reducing Consumer Discretionary holdings in favour of Industrials. Several factors that negatively impact consumers, mainly higher interest rates and stronger commodity price inflation, were factors behind the decision. The capital expenditure cycle appears to be on the upswing, while consumer confidence looks to have peaked during 2017, with implications for consumption growth. Finally, tax reform in the US is supportive of earnings, but the changes are not expected to provide a huge boost to economic growth, and much of the earnings expectations are already priced into markets. It is natural to feel somewhat more cautious after such a strong period of gains, however with global growth and earnings both still supportive, it is not appropriate to reduce equity exposure below benchmark weight at this stage. We are aware that investor sentiment is high and realised volatility is low, which counterintuitively means that risk is higher as expectations are higher. We are watchful for any signs that the environment for risk assets is changing, but remain fully invested as we head into 2018.
Fixed income Still prefer underweight to bond markets Returns from international fixed income markets during the final quarter of 2017 have remained low, and in certain currencies negative. US Government bonds gave up a little ground during the final quarter as yields drifted higher, but finished the year just in positive territory. Conversely, UK bonds made a little progress during the final quarter, but the year as a whole saw the asset class fail to make any headway. However, the recent return profile of international bond markets should not come as a great surprise, given the low level of nominal bond yields and the measured pace at which Central Banks are removing excessive monetary accommodation. The most recent quarter has seen the Federal Reserve (Fed) continue with its third 0.25% interest rate increase of 2017, taking the current tightening cycle to five such moves. As we move through 2018, we anticipate that the economy will progress ahead of its sustainable trend growth rate. Recent proposals to adjust tax legislation will make a marginal improvement to growth projections, but underlying fundamentals in what is a fully employed US economy should see overall growth rates buoyant. Bond market pricing seems relatively benign in terms of future interest rate rises and inflation expectations. We fear that the growth likely to be experienced in the US over the next two years could become inflationary and markets may see long-term bond yields drift higher than currently expected. In the UK, the Bank of England s Monetary Policy Committee increased interest rates for the first time in 10 years. The 25 basis point increase has been described as a dovish hike, with the market anticipating just another two moves of similar size by 2020. Timing of the move appears questionable as we do not believe that it was fully justified by underlying economic fundamentals, with inflation forces rolling over and growth likely to remain below 2% per annum over the next two years. To this extent, we do not see the Bank of England following in the footsteps of each expected move by the Fed over the coming years, which should support bond prices. But the prospect of
Fixed income Still prefer underweight to bond markets (continued) further political turmoil in the UK through 2018 (ongoing Brexit negotiations or further difficulties for Prime Minister May) add an increased level of risk. The European economy performed better than anticipated through 2017. Despite a difficult political backdrop, employment growth is behind the economic upturn. Looking forward, the European Central Bank will scale back its quantitative easing programme through 2018, but the labour market recovery should continue, whilst banks are finally starting to increase lending. We anticipate that the European Central Bank (ECB) will be cautious in terms of adjusting interest rates from where they currently stand, but a policy error in terms of raising rates too quickly is the key risk for Euro denominated bond markets in 2018. In all, risks in international bond markets are skewed towards interest rates and bond yields shifting higher than markets are currently expecting. To this extent, core policy ensures that interest rate risk is maintained below benchmark duration at this time. Furthermore, inflation linked notes are held where appropriate to hedge against the possibility of inflation moving higher than consensus, especially within the US.
Global asset allocation The chart below details our 6-12 month tactical investment strategy Underweight + Overweight Inflation protection US mid-caps Non-traditional asset classes High yield debt Emerging markets Healthcare Investment grade corporate debt Asset allocation Fixed interest Equities Regional Equities Sector Fixed interest US$ interest rate risk Sterling interest rate risk Telecommunications Utilities Government debt
Disclaimer This document and the information contained herein has been prepared and issued by Butterfield Asset Management Limited, Butterfield Bank (Cayman) Limited and Butterfield Bank (Guernsey) Limited and is for illustrative purposes only. It neither constitutes investment advice nor is it an offer or an invitation to acquire or dispose of any securities and should not be relied upon as such. Prior to making any investment decision a financial adviser should be consulted. Products and services are available in the respective home jurisdictions and only in those other jurisdictions where they may be legally offered or obtained. The data source for this document is Bloomberg unless explicitly stated otherwise and is believed to be accurate as at the date of publication and may be subject to change without notice. Whilst every care has been taken in producing this commentary, neither the author nor Butterfield Asset Management Limited, Butterfield Bank (Cayman) Limited, nor Butterfield Bank (Guernsey) Limited shall be liable for any errors, misprints or misinterpretation of any of the matters set out in it. Past performance is not necessarily a guide to future performance. The value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment. Where an investment involves exposure to a foreign currency, changes in rates of exchange may cause the value of the investment, and the income from it, to go up or down. In the case of some investments, you should be aware that there is no recognised market for them and that it may therefore be difficult for you to deal in them or to obtain reliable information about their value or the extent of the risks to which they are exposed. Certain investments carry a higher degree of risk than others and are, therefore, unsuitable for some investors. Before contemplating any transaction, you should consider whether you require financial advice. Any copying, duplication or reproduction of part or all of this commentary and/or its content in any form without the express written consent of the copyright owner is prohibited and will constitute an infringement of copyright unless expressly agreed to by Butterfield Asset Management Limited, Butterfield Bank (Cayman) Limited, or Butterfield Bank (Guernsey) Limited, or as otherwise permitted by the Copyright (Bailiwick of Guernsey) Ordinance 2005. You may not, without our express written permission, distribute or commercially exploit this work. This commentary and/or its content is copyright of Butterfield Asset Management, Butterfield Bank (Cayman) Limited and Butterfield Bank (Guernsey) Limited. All rights reserved. Butterfield Asset Management Limited is licensed to conduct investment business by the Bermuda Monetary Authority. Registered Office Address: 65 Front Street, Hamilton HM12, Bermuda. Telephone: +(441) 299 3817. Website: www.bam.butterfieldgroup.com. Butterfield Bank (Cayman) Limited is licensed to conduct securities investment business by the Cayman Islands Monetary Authority. Registered Office Address: Butterfield Place, 12 Albert Panton Street, George Town, Grand Cayman KY1-1107, Cayman Islands. Telephone: +(345) 949 7055. Website: www.ky.butterfieldgroup.com. Butterfield Bank (Guernsey) Limited is licensed by the Guernsey Financial Services Commission under the Banking Supervision (Bailiwick of Guernsey) Law, 1994, The Protection of Investors (Bailiwick of Guernsey) Law, 1987 and the Regulation of Fiduciaries, Administration Businesses and Company Directors, etc. (Bailiwick of Guernsey) Law, 2000, each as amended from time to time. Registered Office Address: Regency Court, Glategny Esplanade, St Peter Port, Guernsey, GY1 3AP. Company registered in Guernsey No. 21061. Telephone: +44 (0)1481 711521. Fax: +44 (0)1481 714533. Website: www.gg.butterfieldgroup.com. Telephone calls are recorded for training, regulatory and security purposes. January 2018