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2018 Spring Investment Update

Posted on May 30th, 2018


Volatility is back!
After a strong year for equities in 2017, most stock markets were fast out of the blocks in 2018 only to stumble at the first hurdle into February. We wrote about February‘s sell-off early in that month. Higher inflation expectations based on strong growth, a weaker dollar, low unemployment and higher wages prompted a decline in bonds pushing 10 year US Treasury yields to 3% and prompting equities to fall around 10%.

Since then, a flurry of US companies beating earnings expectations led a recovery in share prices. Trump’s tax cuts have been most effective in this regard, at least in the short term, with evidence suggesting around a third of the increased profits were attributable to new lower tax rates.

Until recent weeks, the dollar had also been feeling the effects of the tax cuts but not in a positive capacity, weakening through the start of 2018, as investors rightly focused on the fact the tax cuts would push the US budget deficit to $1 trillion! That pattern has since reversed with the dollar regaining all ground lost year to date as the focus turns once again to higher interest rates in a buoyant economy.

Trade Wars
Geopolitical headlines had been less well received, the prospect of a trade war between the US and China and escalating tensions between the US and Russia over the situation in Syria unnerved investors. However, markets regained that ground when the US administration reversed their stance, putting tariffs on hold when China agreed to assist in reducing the US trade deficit by buying more US goods.

Not content with trade wars, Trump stoked the fires for real wars after pulling out of the Iranian nuclear deal and re-instating sanctions. Other than upsetting Allies, the biggest consequence so far has been a rising oil price. In a world sensitive to inflation shocks, as witnessed by the recent correction, this is very relevant. A rising oil price damages everyone’s disposable income and damages growth. Despite recent Middle East tensions, oil has been moving higher for over a year now anyway, as co-ordinated efforts from OPEC to restrict supply have whittled reserves down, making higher oil prices a real threat.

In Europe
Outside of the US, stock markets have also rebounded since February’s wobble. Eurozone unemployment fell to 8.5% and consumer confidence picked up. Unlike in the US, EU interest rates remain low and appear likely to stay that way for the remainder of the year as President of the European Central Bank (ECB), Mario Draghi emphasises ‘patience and persistence’ once again. We are not expecting any radical change from the ECB, certainly not before Draghi steps down next year, which is supportive of our positive view on European equities.

In the UK, wages grew at their fastest rate for three years and faster than inflation, easing some pressure on the consumer. However, February’s cold weather and Brexit woes hindered economic activity with UK first quarter GDP falling short of expectations at just 0.1% quarter on quarter. Stocks shrugged off the low growth numbers as ultimately it meant the planned interest rate rise for May was pushed back. This short-sighted behaviour being a reminder of how dependent markets are on central bank policy, rather than company fundamentals.

But fundamentals are still sound
We are not alone in the belief markets are in the later stage of the economic cycle and it is not unusual during such period, where monetary policy is tightening, for volatility to pick-up, as we saw earlier this year. The US Federal Reserve appear confident travelling further up the rate rising road, which we believe will bring further volatility. Withdrawing QE and hence liquidity from the system at the same time as raising interest rates is pushing borrowing costs higher. This is all happening at a time when global debt is at an alltime high, company valuations in the US are at a 19 year high and company input costs are rising.

We acknowledge economic fundamentals are currently sound, unemployment is low, earnings are growing well and consumer confidence is strong. In addition, not all countries share prices are as high as Americas. These are all true but historical rather than forward looking observations. If we were to add our own observation, we would merely tell you these are not signals that appear at the start of market cycle.

Cracks beneath the surface
On the surface, all appears well but cracks are appearing. You can see these in numbers released by the National Association of Credit Management, which looks at ‘dollar collections’, a category which just fell to a level not seen since the height of the 2009 crisis! This may turn out to be an anomaly or a potential early warning. Credit is the lifeblood of the economy and as such we place importance on analysing such trends, which tend to lead those in equity markets. If it is taking longer for companies to collect money owed to them or worse if dues are simply not being collected, this may be an initial indication of financial stress in the system.

It is not new news that government and corporate leverage has been rising, as have US interest rates, with firms being more sensitive to short term rates. This is of some concern in relation to another phenomenon which is occurring; that being a dollar liquidity squeeze, which also has similarities to the credit crisis. The dollar LIBOR-OIS spread has recently spiked raising the cost and reducing the availability of dollar denominated loans for non-US companies. LIBOR is the average rate at which banks lend money to one another. The spread is at a six year high and made worse by US firms currently repatriating large cash piles back home to take advantage of a onetime tax break, which in-turn reduces the availability of dollars in non-US countries. This may particularly affect European and Japanese banks if the shortage means banks need to turn to central bank funding lines which have become more costly.

High stakes and interest rates
We still see tighter monetary policy (led by the US) as the biggest risk for the economy, particularly if this now brings with it a stronger dollar, which will further raise the cost of debt repayments for emerging economies. With increasing inflation pressure and a confident US central bank, combined with attractive US yields relative to the rest of the world, these risks are more real than ever.

We may not be at the point, yet, where the gravitational pull of the Federal Reserve is strong enough to derail the current bull market but we do not feel this is far off. Depending on who you speak to commentators are pointing to a range of years between 2019-2021, at which they see a serious impact coming for the economy. Our concern is that it comes sooner, as markets tend to price in expectations one to two years out.

Our cautious tone is unchanged, which we hope is reassuring now the market cycle is maturing. We are entering a high stakes game, where going ‘all-in’ now would severely risk getting burnt. This is reflected in our portfolio positioning, having reduced our equity weightings in recent times but simultaneously tilting toward funds, regions and specialist all weather strategies that we believe have the potential to outperform in rising or falling markets. A big part of this is favouring unloved stocks or following a ‘value’ strategy.

The details, views and opinions expressed above are KMD's, can change at any time and are not intended to be advice or a solicitation to make an investment. Professional advice should be sought before acting on any information contained in this document. The value of investments can fall as well as rise and your capital is not guaranteed. Past performance is not a reliable indicator of future performance.

Copyright © 2018 KMD Private Wealth Management, All rights reserved.

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