Three themes to draw from the start of 2017

The markets cannot always be right (not least as it would be impossible for advisers and clients to make money from them if all securities were always appropriately priced and valued) but their views must always be respected.

After all, the price on a screen offered about a specific stock, bond or commodity, or the net asset value of a fund, represent the combined wisdom of all participants concerning those assets at that given time. Given the number of hedge funds, pension funds, advisers and clients looking at those screens, it is fair to say those prices reflect many hours of research and much thought.

As such, it is worth pondering what lessons can be drawn from the price action witnessed in the first quarter of 2017, to see what the market is telling us. Such analysis may also help to highlight where the markets may have made a rick and got it wrong, presenting an opportunity to any advisers and clients who wish to take a pro-active approach to portfolio management.

Looking at the performance data across asset classes, sectors and geographies in total return, sterling-denominated terms three clear themes come to light:

  • First, the Trump ‘reflation trade’ retained its grip on the markets’ imagination. Stocks easily outperformed bonds and sentiment remained skewed to ‘risk on’, as evidenced by the outperformance of emerging markets within equities and long-dated, high-yield or emerging market debt within fixed income.
  • Second, the picture became more nuanced as the quarter wore on and President Trump became entangled in first a visa row and then ultimately unsuccessful negotiations to get his healthcare reform bill through the House of Representatives. Defensive sectors such as utilities began to do better and miners and financials began to do worse as Trump’s programme (and the dollar) lost a little momentum. In addition, US stocks underperformed the MSCI World equity index, perhaps finally reflecting how the American market looks expensive relative to its international peers as well as its own history.
  • Third, bonds generally did well in the UK, on a global basis, while domestic equities generally did relatively poorly. The markets appear to have their doubts over the underlying robustness of the British economy and seem to be of the opinion that the Bank of England will be in no rush to raise interest rates as a result, whether this is the result of excess debt, doubts over Brexit or other factors. The trend toward more defensive equity sectors became clear here, too, as the quarter wore on.
  • Moreover, the dismal performance of the energy stocks throughout the period, and loss of momentum by both financial and mining stocks were all unhelpful trends for the UK equity market, given their dominance of the analysts’ consensus forecasts for FTSE 100 earnings and dividend growth in 2017, and improvement is required if domestic plays are to offer better rewards for the rest of the year.

Scores on the doors: Asset classes

In the first quarter of 2017, equities, as benchmarked by the MSCI World Index, handily outperformed bonds of all flavours (and also commodities).

This appears to provide affirmation that the reflation trade that began after the UK’s referendum on EU membership and was turbo-charged by President Trump’s election remains intact:

Global stocks beat global bonds hands down in the first quarter of 2017

(Total returns, in sterling terms)
Source: Thomson Reuters Datastream. *To 3 April 2017.

Faith in President Trump’s ability to boost US (and global) growth with his tax-cutting, deregulating and infrastructure-spending clearly remains undimmed. Increases in inflation, ultra-loose monetary policy in the EU, UK and Japan and solid numbers from China also support hopes for a benign economic backdrop, especially as the US Federal Reserve continues to raise interest rates only slowly in America.

Scores on the doors: stock markets

However, the US was not the best performing stock market in the first quarter. By geography, Emerging Markets came out on top, with Latin America and Asia leading the way. Western Europe came third and the USA actually underperformed the MSCI World benchmark, when measured in sterling total return terms.

Emerging markets lead the way for equity investors in the first quarter of 2017

(Total returns, in sterling terms).
Source: Thomson Reuters Datastream. *To 3 April 2017.

This looks to provide yet another useful reminder of the old phrase that “you can have cheap stocks and good news, just not both at the same time.”

As discussed many times in this column, hopes are high for the Trump agenda and the valuation of US stocks is higher still, relative to history, using tried-and-tested methods such as the Shiller price/earnings ratio and market-cap-to-GDP.

Western Europe trades at a historically high discount to the US, while Latin America and Asia underperformed consistently during 2012-2015. Such a terrible run perhaps created some value and although both arenas did better in 2016 they have done well again so far this year, in the face of worries about the impact of weak commodity prices (Latin America) and spiralling debts (China).

Western Europe has meanwhile climbed a wall of (political) worry. The Dutch election went the ‘right’ way so far as the EU was concerned, although the French and German polls due in May and then the autumn still offer scope for further concern to those who believe in the European project.

By contrast, last year’s top performer, Eastern Europe, has collapsed to the bottom of the charts, where the UK has also continued to lurk.

Oil’s inability to rise consistently above $55 looks to be hurting Eastern Europe, where the crude-dependent Russian economy and stock market exert considerable influence, although galloping inflation and uncertainty over the implications of this month’s constitutional reform referendum in Turkey have slowed the rate of progress showed by the Istanbul exchange’s BIST-100 index.

Scores on the doors: sectors

Using the S&P 1200 Global indices as a benchmark, Energy has been the single worst sector performer during the first three months of this year, to confirm soggy oil prices as a potential source of Eastern Europe’s equity woes.

The performance figures otherwise are more nuanced when it comes to the reflation trade. Technology led the way (helped by a 24% rise in no less a stock than Apple) while Healthcare and Consumer Staples came next – both defensive sectors.

Cyclical sectors did not perform as well as might have been expected in the first quarter of 2017

(Based on S&P 1200 Global indices. Total returns, in sterling terms)
Source: Thomson Reuters Datastream.

More cyclical areas like Financials, Materials and Industrials did less well as they lost momentum during the quarter.

It would not pay to read too much into just three months’ data but gathering outperformance from Utilities and Consumer Staples is a potential warning sign for buoyant stock markets that are expecting a healthy acceleration in economic growth and corporate earnings.

This next table shows how the 11 global super-sectors ranked performance-wise by month during the quarter:

More defensive sectors came to the fore as the first quarter developed

(Based on S&P 1200 Global indices. Total returns, in sterling terms).
Source: Thomson Reuters Datastream. *To 3 April 2017.

These sector trends may help to explain why UK stocks did so poorly in the first quarter.

As emphasised in recent columns, banks, oils and miners are hugely important for the FTSE 100 (and by implication the whole UK market as the premier index represents around 85% of its total market capitalisation), as they dominate earnings and dividend – and earnings and dividend growth – forecasts for 2017 and 2018. If they perform poorly, all three could act as a drag on the UK’s headline indices.

The next table shows the 10 best and worst performing sectors in the FTSE All-Share this year so far:

The 10 best and worst performing equity sectors in the FTSE All-Share in 2017 to date

Source: Thomson Reuters Datastream. *To 3 April 2017.

The next table shows the sectors which made most progress up – and lost most ground by falling down – the performance rankings in February and March. The best performer is ranked one, the worst 39. As can be seen, Energy did consistently poorly (as above), while banks and miners lost momentum in the UK, just as they did globally.

The equity sectors showing the best and worst performing ranking momentum in the UK

Source: Thomson Reuters Datastream. *To 3 April 2017.

Advisers and clients with a domestic bias to their equity allocation will be looking for better from each of all three sectors in the rest of this year and beyond. If they fail to put in a better showing, UK stocks could again underperform their international peers.

Scores on the doors: fixed income.

Where UK assets did do well in the first quarter was in the field of fixed-income. 30-year Gilts, UK high yield debt, 10-year Gilts and UK corporate debt were four of the five best performing sub-sectors within the debt markets between January and March.

The UK was a source of good performance for fixed-income fans in the first quarter of 2017

(Total returns, in sterling terms.)
Source: Thomson Reuters Datastream.*To 3 April 2017.

This presumably reflects the Bank of England’s apparent disinclination to raise headline interest rates from their historic low of 0.10%, a policy which will place a premium on reliable income.

Ten-year Gilt yields have come back in to around 1.1%, a figure which in turn suggests the spike in inflation to 2.3% is seen as temporary, owing to oil, the effect of a rotten European winter on vegetable and salad prices and the weak pound.

The hunt for some yield that is seen as safe may also suggest that someone, somewhere has his or her doubts about the Trump/reflation trade – which takes us back to where we started.

There is no need to panic – after all stock and bond prices both remain near record highs and volatility is subdued. Yet it is exactly at such times, when making money looks easiest, that caution is warranted, as those who remember the peaks of 2000 and 2007 (or the volatility of 1987, 1994 and 1997-98) will attest, since this is when valuations are at their highest and therefore margins of safety in the event of a sudden shock at their lowest.

Keeping a balanced portfolio which satisfies the overall strategy, target returns, time horizon and appetite for risk of advisers and clients therefore feels like a sensible long-term plan, even if keeping a portion in fixed-income, and even cash or gold, may feel uncomfortable to many right now.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.