The most significant observation is the behaviour of the bond markets where yields have fallen to record lows in many countries. Indeed, many ten-year benchmark yields are quoted at a negative real rate, after deducting the inflation rate. For example, as of last Friday, if you had purchased the ten-year benchmark UK gilt, it will return the investor an income of 0.487% per annum for each of those ten years, and a capital reduction of 3.832% based on what you pay today ahead of your certain return of capital. This is before the effect of inflation is applied which in the UK is currently running at 2.0% as measured by the Consumer Price Index as published by the Office of National Statistics (ONS) for July 2019. So, this means that the risk-free real rate of return is actually quite negative.
This situation is mirrored around the developed world and is being driven by an expectation of further monetary stimulus from central banks in light of the slowing global economy. The evidence of this slowdown is yet to be felt in terms of rising unemployment or recessionary talk, but the forward-looking indicators are suggesting this is very much the case. Of course, many interpret the word ‘recession’ with dread and fear as if it is calamitous and disastrous, but it all depends on whether it is a normal trade cycle recession or a dramatic economic shock such as that experienced after the credit crisis. At the moment, the indications are that this slowdown is gradual, partly caused by the US/China trade war and partly due to a maturity of the recovery that we have enjoyed ever since the credit crisis of 2008. Some weakness is country specific, such as in Germany, whilst elsewhere it is due to temporary external factors, such as trepidation in light of the US/China trade war or Brexit.
The mere fact that the markets are already pricing in very cheap borrowing rates, even before any significant interest rates cuts have occurred, suggests that the stimulus is already there and we have not had to put the brakes on to temper rampant inflation after a boom, which has historically often been the case. These low returns from fixed interest and cash are one of the reasons why the gold price has been increasing. If risk-free returns are negative then holding gold, another risk-free asset in terms of risk to capital, will be more attractive as it yields nothing, which is superior. Of course, the risk to capital is the price movement, which is highly unpredictable but is likely to remain well supported whilst we are in this slowdown phase of monetary loosening.
Taken in the round, the choices available to the investor to seek out a decent real return are quite narrow and dominated by the equity markets. Looking at the UK equity market in isolation and ignoring all the Brexit discount and associated sterling weakness, the FTSE All Share Index is currently yielding 4.29% (Source: Alpha Terminal). In addition, this is a real yield such that it increases each year as most underlying constituents seek to increase their dividend by at least inflation every year to maintain their shareholder support. Of course, we are all aware of the volatility of the equity market relative to a risk-free investment but unless you are expecting deflation, then a well-diversified equity portfolio looks appealing on a relative and real basis.
This would look suspect if the valuations were expensive, suggesting that the forthcoming earnings slowdown is not sufficiently priced in, but this is not the case with most developed equity markets priced at a discount to long term averages. Investors have short memories and invariably don’t feel wealthier when markets are doing well but are very aware when markets are weak. Some of this responsibility rests with the mainstream media, which always reports significant index falls but never the opposite and so the perception is always skewed to the negative.
2018 was a poor year for equity investors with the FTSE World Index recording a -3.1% fall with the worst of this felt in the UK, Europe and Emerging Markets where losses of between -9.3% and -11.1% were experienced for the sterling investor (Source: FE Analytics). 2019 feels a lot more volatile and politically influenced. Returns, however, have actually been strong to date with the FTSE World Index up 20.8% led by the US. Even the weakest has risen by 10% being Hong Kong whilst the UK equity market has returned 12.6%. Many private investors keep a casual eye on the level of the FTSE-100 which continues to languish around 7,200 having peaked at 7,877 in May 2018 and hit a low of 6,584 on 24 Dec 2018. So, we are almost equidistant between the two, but this gives a false reading, as does any capital-only reference point; especially when dividends are so high as a percentage.
The two-year capital return of the FTSE-100 is -0.98% to last Friday (Source: FE Analytics), so slightly worse than the negative returns available from risk-free assets. However, the equivalent with reinvested dividends is 8.02% reflecting two years’ of dividend income, even without any growth. If you extend this over five years when there has been some capital return, then the five-year capital-only return of 6.23% is transformed to 30% inclusive of dividends. With these historic comparatives on offer today, it is no wonder that many investors are reluctant to sell, because you would have to be extremely bearish and scared to walk away from those sorts of potential returns and accept a certain risk-free negative real return.
Sterling rallies on lower no-deal fears
Sterling’s volatile ride continued last week as politics once again dominated the domestic landscape. It was a particularly difficult week for Prime Minister Boris Johnson who lost four parliamentary votes, including proposals to keep a no-deal exit on the table and call for an immediate General Election. Currency traders took comfort from the events, helping to lift Sterling from its recent lows; it rose by +1.1% against the Dollar and +0.8% versus the Euro to $1.231 and €1.114 respectively.
Meanwhile, reduced tensions in Hong Kong and news that Chinese and US officials had finally scheduled trade talks helped lift equity markets around the world. In the US, the S&P500 climbed +1.8% with technology and energy stocks leading the index higher. Domestically, the FTSE100 rose by +1.0% whilst the mid-cap focussed FTSE250 jumped by +1.6%. On the Continent, the German DAX30 added +2.1% despite further deterioration in the country’s economic data. However, expectations of monetary stimulus from the ECB have helped lift European markets with the French CAC40 also rising by more than +2.0%. In Japan, the Nikkei rose +2.4%.
In the bond markets, sovereign yields on both sides of the Atlantic edged higher with the domestic 10-year rising by 3 basis points (bps) to 0.51% and the US treasury equivalent up 4bps to 1.55%. In Europe, Italian yields fell to record lows following the establishment of a new coalition government between the Five Star Movement and the Democratic Party.
Elsewhere, Brent Crude benefitted from positive Chinese business activity data to rise by +1.8% to $61.54 a barrel. Brent has been hovering around the $60.00 for around a month with any rises dampened by the US-China trade rhetoric. Gold meanwhile pulled back from the 6-year high it reached earlier the week to close out Friday at $1521 an ounce, a weekly reduction of -0.6%.
The week ahead
Political developments to one side, the domestic agenda is fairly light this week after Monday’s Gross Domestic Product (GDP) reading and Manufacturing Production data. Further economic data of note on home soil is limited to Wednesday’s employment numbers which will provide an updated unemployment rate and wage growth data.
Overseas, Thursday’s European Central Bank (ECB) meeting comes on the back of comments from a number of ECB members, downplaying the need for an extensive stimulus package. Market expectations had risen during H1 2019 to forecast a rate cut this year and a return of quantitative easing. However, members of the ECB's Council from Germany, France, the Netherlands, Austria and Scandinavian countries were among those to seemingly voice concern recently. In the US, the Consumer Price Index release on Thursday along with Retail sales data on Friday will help to gauge the current level and outlook for consumer spending in the States.
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Past performance is not indicative of future performance.
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Source: FE Analytics (information is correct as at 9th September 2019)
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