Monthly Market Update, June: Volatile Europe

Read our full Monthly Market Update June 2018

May, a month of European volatility

Global stocks were mixed last month. A combination of slower global growth, negative trade news and political volatility in Italy and Spain weighed with investors, many of whom chose to reduce their risk levels from more volatile regions. Performance was greatly affected by currencies, as the US Dollar gained more than 3% versus the GBP and the Euro, boosting  assets denominated in that currency, such as global stock and emerging market indices. The Yen also rallied, causing Japanese stocks to fall. The result was tighter bond yields and wide dispersion in the equity markets. UK stocks gained 2.8%, with industrials leading the way, as manufacturing continues to benefit from the overall weaker Pound and becomes the biggest driver for a UK economy now growing at a mere 1.2% per annum. In Sterling terms, global stocks gained 4.2% (0.6% in USD), US stocks gained 6% (2.4% in USD), European stocks lost 1%, EM stocks lost 0.1% (-3.5% in USD) and Japanese stocks gained 2.2% (-1.7% in Yen). Following April’s rally, oil performance was thwarted, losing 2.2% last month. The UK 10 year bond yield fell from 1.42% to 1.23% during May, along with its US and European counterparts, as investors rushed into safer asset classes following political upheaval in Italy, when the President rejected the new government’s appointment of Finance Minister, almost driving the country into another election. In economic terms, global data suggest that Europe, which had been leading global growth at the end of last year, is now slowing down, mostly due to capacity constraints, but also due to consumer apprehension. Global trading patterns suggest that the slowdown in the global economy is not due to bad weather, as some commentators suggested. The silver lining came from an improvement in US manufacturing data, with internal demand driving the country’s industries. Global inflationary pressures intensified, partly due to higher energy prices and partly due to wage growth pressures, especially in the US. Central banks remained largely silent, with the US Federal Reserve still en route to deliver 3-4 rate hikes this year.

Portfolios and Outlook

May confirmed data indicating that the global economy has been slowing down, compared to the rates it was growing at last year. Europe, last’s year’s economic champion, saw a weaker pace of growth, while the US experienced acceleration. Higher oil prices and capacity constraints have resulted in an inflation build up in most of the developed markets. Meanwhile employment conditions continued to improve across most developed economies.

Volatility continued in May, as European politics and a few more trade salvos from the White House upset traders. Return dispersion persisted, with the US outperforming after a very good earnings season and Europe weaker on heightened risks after the Italian election.

Global equity valuations continue to hover slightly above historical averages but shorter term metrics do not signal heightened valuation risks. Investors are aware of the potential impact of political gridlock, especially as the US mid-term elections draw nearer, as well as a growing trend of protectionist and isolationist policies which could further hamstring global growth.

Given the extent of uncertainty surrounding Brexit we remain cautious on the UK, despite attractive valuations, as the overall economic picture continues to deteriorate. Aside from an underweight UK position, we have no strong geographic preferences, favouring large-caps.

In our portfolios, lost performance was due to an underweight in US small caps and an overweight in European stocks. Conversely, gains were made from an overweight to US stocks and global bonds. At the January 2018 investment committee we decided to take some profits and reduce our equity overweight to “neutral”, acknowledging early that high valuations could lead to a correction, and increase our cash holding. In April, we decided to use half the exposure in cash to buy gold as a hedge against more volatility. We still believe that the cycle, for the time being, remains intact but it is showing signs of maturity.

Risks ahead

Global economic performance has slowed, while inflation pressures have intensified. We are already seeing some of the risks that we highlighted at the beginning of the year play out. Markets are now mostly focused on risks stemming form protectionism and volatile European politics. Global debt levels continue to be alarming in the world’s biggest economies. Supply chain constraints, which have not been met with an increase in output and capacity also threaten growth. Central banks continue to tighten to tighten monetary conditions, ending the “Whatever It Takes” era, as inflationary pressures increase. Fed Chair Jay Powell appears less inclined to confirm the “Fed Put”, while central banks in the UK and Europe are using more hawkish rhetoric. There is also the risk that falling sentiment due to the market sell-off and concerns about future regulation of tech companies could lead to a de-rating of equity valuations.

In the US the main risk is a policy mistake, especially if rates increase and inflation fails to keep up. Additionally, investors have yet to discover the true depth of recent tax reforms, which could put additional strains on the budget, with debt issuance expected to rise.

In the UK we have seen some of the impacts of Brexit in the form of slower growth, dented consumption and a slowdown in house prices. Inflation has stabilised but is still outpacing wage growth and thus is lowering disposable incomes. This trend could accelerate should businesses decide to bring forward their Brexit contingency plans.

In Europe, there is renewed fears over the political fate of the EMU, after new governments in Italy and Spain seem set to challenge the dictums of EU institutions.

We feel that short-term systemic risks are mostly manageable and liquidity is still ample. However, there is now less probability of a pick up in private investment and capital expenditure supporting growth acceleration over the medium term.