Andrew Milligan, Head of Global Strategy at Aberdeen Standard Investments, explains how politics is only one factor affecting markets and suggests where investors can look for opportunities. He also discusses the US Federal Reserve’s (the Fed’s) latest announcement on interest rates and whether a recession is really looming.
Sterling waxes and wanes as Brexit confusion continues
The pound has bobbed around as political confusion over Brexit deepens. But at times like this it’s important to pay more attention to strong signals and less to market noise, especially if it comes from political issues.
Sterling has actually remained in a trading range against both the euro and dollar for some time. At present the dollar is trading at about $1.30 versus the pound, which is much the same as six months ago. It’s fallen as low as $1.25 and been as high as $1.33. But, unless you’re an active day trader in the currency markets, small movements such as these aren’t going to be the be all and end all of how and why your investments perform.
Europe – a barren land or hunting ground for investment opportunity?
European markets are suffering the longest withdrawal of money in a decade. Last year we saw international investors pull more than €50 billion out of European equities and, currently, investment in Europe is as low as it has been since the eurozone crisis.
Despite the many economic and political challenges Europe faces, we believe there are still reasons why investors should take another look at European equities.
Firstly, the relationship between European equity market performance and EU gross domestic product (GDP) growth is lower than might be expected. For example, the prospects of sectors in which Europe has many global leaders, such as healthcare, technology and consumer staples, have limited connection with European GDP. Instead, they have much closer ties to structural trends. These include digitalisation, an ageing global population and the rise of the emerging-market middle class.
Secondly, Europe’s apparent complexity as a market is actually a great advantage if you know what you’re doing and can identify undervalued and overlooked opportunities. A great example is Italy. We’ve found a number of fantastic investments in recent years, such as hearing aid retailer Amplifon. Despite all the economic and political challenges within the country, its business has enjoyed strong growth from an internationally diverse revenue base. Of course, past performance is not an indicator of future returns.
Thirdly, focussing on a small subset of the market, not the whole index, could deliver markedly different returns to the benchmark. A particular focus on those companies with robust business models, strong balance sheets and well-managed environmental, social and governance (ESG) risks will be important.
At Aberdeen Standard Investments, we believe Europe remains a rich hunting ground for companies that can prosper – partly because it is so unloved by many global investors.
Can performance outplay politics in emerging markets?
From new leadership in Brazil and Mexico to the upcoming general election in South Africa, politics is of course an important driver for some of the more fragile emerging market economies. If an emerging market suffers from a trade deficit – where it imports more goods, services, and capital than it exports – then it usually requires a regular stream of capital flowing in to fund this deficit. If that’s disrupted due to political uncertainty, then the currency will move sharply as we’ve seen happen in Turkey recently.
However, there are many other parts of the emerging market region for investors to focus on, whether large or small, a long-standing emerging market or a frontier market. At the time of writing, valuations for emerging market equities are generally better than for their developed market counterparts, for example.
We produce an emerging market heat map on a regular basis which analyses the relative fragility of the 25 or so largest emerging market economies. You can read more about our findings in our monthly Global Outlook.
Italy gets into bed with China
This month China succeeded in signing a note of understanding with Italy about their Belt and Road Initiative (BRI) – an ambitious effort to enhance connectivity on a trans-continental scale. The initiative aims to strengthen infrastructure, trade, and investment links between China and some 65 other countries.
The implications of the deal with China will take some time to become clear – after all, the devil will be in the detail and much still has to be sorted out. However, some political aspects are already quite clear. First of all, the Italian government is using a step forward with China as leverage in its future discussions with Brussels on how to manage its sizeable budget deficit. Secondly, the whole of the EU is debating how it should respond to the BRI.
Trade with China matters but there are security concerns in some countries, for example about Huawei and 5G. There’s also the issue of protecting key industries from Chinese competition.
Italy is just one small step along the road, but this development has certainly affected US-China trade negotiations. There’s strong pushback from some parts of the US government to any European countries using Chinese 5G technology. This situation will run and run as countries have to choose which of the two, the US or China, they wish to have as their strategic partner in the 21st century.
The Fed backtracks
The Fed met earlier this month and announced there would be no change to interest rates. They also released new forecasts showing there wouldn’t be any more interest rate hikes this year – that’s down from their previous forecast for two more.
Financial markets are sometimes surprised by statements from central bank governors, but on other occasions the markets are well ahead of what the governor actually says. This time it was a bit of a mixture. Investors had already noted the slowdown in the US and other major economies, so the statements from Fed Chairman, Powell, did have some effects.
More bearish investors were encouraged to move from expecting rate hikes to expecting rates to stay flat. On the other hand, the bond market has already looked ahead and expects that the next step for the Fed could be a rate cut.
This explains why some investors think there will eventually be a rate rise if economic growth falls and inflation rises. Others think there will be a cut for example if US-China trade talks collapse. Which is correct?
At Aberdeen Standard Investments, a key feature of our investment process is looking at what’s already in the price, and we don’t think that the US will actually cut interest rates by the end of the year. Central banks are stimulating economies in many countries, which we think should eventually lead through to better economic growth.
For now we remain positive about equities and to a lesser extent real estate and higher yielding debt, such as emerging markets or Australian bonds, in our multi-asset funds.
Tremors in the markets
Many commentators have argued that this business cycle must soon come to end. And we saw a preview at the end of the month, when a small earthquake shook the marketplace – Japanese equities fell 3% in a day for example. Very low bond yields and poor economic data worried investors.
This was caused by the yield curve (the gap between the yields on shorter and longer dated government bonds). The yield curve has been flattening for some months and at the end of March it inverted. Financial theory considers such an event to be quite important – a signal that slower economic growth or even recession lies ahead. But is it different this time? We think so.
One point to emphasise is that the US economy is still in quite good shape. Consumer spending is holding up on the back of robust employment and wages growth, and housing is starting to respond to lower mortgage rates.
Another point to note is that the trigger for the latest market tremor actually came from Europe. One of the business surveys for the eurozone showed the lowest level of confidence in the manufacturing sector since 2012. We’re seeing a minor manufacturing recession in parts of the world, but other sectors are holding up.
The shape of the yield curve is indeed a powerful signal, but it’s important to remember that there can be false positives from these signals. An obvious example is 1998 when the yield curve inverted during the latter stages of the Asian financial crisis, but no recession followed.
For now, we believe technical signals from bond market investors should be seen as a warning shot across the bows. If some major policy errors are made, say by Trump and Xi failing to settle their trade talks, then business and investor confidence might slide sharply. As long as policy makers are sensible, disaster can be avoided.
The information in this article should not be regarded as financial advice. Please remember that the value of your investment can go down as well as up and may be worth less than you paid in. Information is based on Aberdeen Standard Investment’s understanding in April 2019.