Current racing conditions: softer. Q1 asset allocation preferences (unhedged US dollar-based, updated at start of quarter): neutral equities vs. fixed income. Within equities overweight euro zone and Japan, underweight US, UK and emerging markets. Within fixed income, a preference for core government bonds over credit, no duration bias. Longer term outlook is to be pro-risk assets.
This week: Summary of Q1 and outlook, preparing for Brexit, mining stocks, and gold
Summary of Q1 and outlook
- The risk-on rally that lasted a month from mid-February, and that pushed up the price of equities and credit, has faded. This can be attributed to members of the US Fed, who over the last 10 days have been more hawkish in their comments on US growth, inflation risks and interest rates than we Fed Chair Janet Yellen was in her statement after the last Fed meeting, on 17 March.
- Thanks to the rally much of the market decline over the first six weeks of the year has now been reversed, with the MSCI World index now down only1.7% in USD since the beginning of January (as of 28 March). The MSCI Emerging Markets index is actually up 2.7% over the same period, led by the revival in commodity prices – particularly in energy and metals. This is the second large fall in stock markets to have been almost-reversed within a month or so since July of last year.
- On the bond markets, the Barclays Global Aggregate index of investment grade bonds is up 4.6% in USD, led by strong performance from core government bonds as the US Fed eased their forecast of future rate hikes for this year.
- The surprising strength of government bonds this year, and the sudden revival in energy and metals prices, demonstrates the need for investors to maintain a broadly-based portfolio that automatically includes out-of-favour asset classes.
- The USD was generally weak over the quarter, reflecting the reduced fear of multiple Fed rate hikes this year after a spell of weak economic data in late December and January.
- The outlook for the second quarter is equally uncertain. The biggest single risk for investors continues to be inappropriate monetary policy from the Fed when it is far from clear how strong growth and inflation pressures are (ie, will the Fed raise interest rates too fast, or too slow, for the safety of the underlying US economy and for the global economy?). Political risks are also rife, from the threat of a President Trump and Brexit, to over-reaction by the West to Islamic terrorism – creating exactly the Christian/ Sunni Islam conflict that ISIS seeks.
Preparing for Brexit
- The dollar, and US-based asset classes, appear to be the safest havens against fears of the UK leaving the European Union.
- Opinion polls still favour the UK remaining in the EU after the referendum on 23 June. However, the ‘Leave’ campaign has gained increasing support in recent weeks, and the terrorist incidents in Brussels last week is likely to have given it an additional boost.
- Sterling has already showed itself to be the most sensitive of financial assets, falling a few cents against the dollar whenever senior government ministers leaves the ‘Remain’ camp that is led by Prime Minister David Cameron. In February, when sterling stood at $1.40, Goldman Sachs suggested that sterling might fall by 20% should the ‘Leave’ campaign win the vote.
- How might fears of Brexit play in the stock market? I expect small and mid-cap stocks to underperform blue-chips during this period of uncertainty. At first glance, the liquidity and broad geographic shareholder of FTSE 100 stocks make them most vulnerable to a sell-off by investors looking to exit sterling-denominated assets. However, around 70% of FTSE 100 company earnings come from abroad, meaning that a devaluation will boost their profits when expressed in sterling. This gives a substantial amount of protection to the share price.
- Small and mid-cap UK stocks tend to be domestically focused, so will benefit less from sterling’s devaluation, and will be much more sensitive to any economic uncertainty arising from Brexit.
- Some market analysts suggest that the euro, and continental European stock markets, could also come under pressure if the likelihood of Brexit rises. This reflects fear of disruption to UK/ EU trade links as new trade deals are worked out, with the EU possibly dragging its heels in order to make the process as painful as possible and so dissuade other countries from following the UK’s path as a means of securing a more favourable relationship with the EU.
- This suggests that if investors wish to protect themselves against the risk of Brexit, a bias towards the dollar and the S&P500, and an underweight in sterling and euro-denominated assets may be a suitable route.
- The S+P/TSX Global mining index is up 13% since the start of January, in USD terms. Mining stocks have had a strong quarter, helped not only by the ‘risk-on’ sentiment amongst investors, that lasted for four weeks from mid-February, but also by industry-specific factors that have raised metal prices.
- These include an industry shake-out of high cost supplies over the last 18 months, which has reduced supply forecasts. The global demand picture has also improved, thanks in large part to a more dovish US Federal Reserve and assurances by the Chinese government that a looser fiscal policy will be implemented in order to protect the economy from a hard landing.
- It appears that the multi-year sell-off may be coming to an end. However, few investors expect a strong multi-year bull market to materialise given the ongoing uncertainties in the global economy. There is also the risk that higher metals prices actually put off the very plans for mine closures that have helped support the rally.
- Instead, we will be looking to the sector as a diversifier and as provider of dividends. A lot of the uncertainty concerning dividends from miners has been reduced after recent adjustments to pay-out policies, reflecting acceptance that the current era of relatively low metal prices may be with us for a long time to come.
- The gold price is up 20% since early January, helped in large part by the lower interest rate outlook from the Fed which has put downward pressure on the dollar. As a rule of thumb, the opposite is also true: higher US interest rates and a strong dollar tend to be bad for the gold price. A heightened fear of international terrorism has also contributed to the demand for gold as a safe haven.
- However, while ETF gold funds have sold well, we have seen little pick-up in physical demand from China, India and other large gold-consuming countries. Industrial use of gold has similarly been flat. Many gold analysts look to the demand for gold in the ‘real world’ as a backstop to the gold price, the lack of any improved end-user demand is therefore a warning to some investors not to chase the metal too high. Unless, of course, geo-political risk increases and/or the dollar appears set for a further bout of weakness.