Welcome to our latest investment commentary covering the second quarter of 2018. We have generally seen lower levels of volatility and a recovery in the markets when compared with Q1, however, volatility levels remain elevated relative to recent history, which is what we expect in an environment of rising interest rates.
The portfolios have returned to positive territory for the year and whilst threats of trade tariffs have kept them from rising higher, we believe that we will continue to see these positive returns for the rest of the year.
Q2 2018 REVIEW
The key talking point in Q1 was the pickup in volatility, which was very aggressive and unlike what we had become accustomed to over the past few years. Whilst still elevated, volatility has fallen into the background and we have since had two further key talking points.
The first follows on from Q1 and relates to trade tariffs. The threats have continued from Donald Trump and have become more menacing than during Q1, with tariffs against $200bn of Chinese goods being proposed. This is in addition to the $60bn proposed earlier this year. The tariffs have in fact not only targeted the Chinese, but also the Canadians and Europeans. Both have retaliated, with the Canadians proposing tariffs on US steel, aluminium and consumer goods such as coffee. The Europeans have decided to target Trump’s key supporters, proposing tariffs on Bourbon Whiskey, Levi’s and Harley-Davidson. This could escalate to other areas as Trump is proposing $300bn in tariffs against Europe’s car industry.
Despite some tariffs against the Chinese have come into effect, we continue to believe the developments won’t materialise into a full-scale trade war. Large swathes of the US business community have pushed back against Trump, asking him to stop his actions due to the detrimental effects they could have on US business and that they could lead to millions of Americans losing their jobs. An interesting article suggested that the Chinese actually stand to benefit from these tensions due to their Belt and Road initiative. They have engaged with over 60 countries to improve trade and relations and Trump’s stance could push more countries to increase trade with China, leaving the US isolated and China less reliant on them.
The second key talking point relates to Europe, with the right-wing populist parties taking power in Italy. Up until the victory the investment community had remained complacent about the potential electoral outcomes. This was reflected in the yields offered on Italian Government bonds, which were not far off the yields offered on German Government Bunds, suggesting the risk in Italy was low. Following the win, Italian Government bonds sold off very aggressively, sending shockwaves across the markets. The new leaders were quick to point out that they were not against their membership in the European Union or the Euro but felt reforms were needed. These words helped to soothe markets soon after.
Continuing with Europe, we highlighted our thoughts on the central banks in our last note and the European Central Bank have indeed come out to say they are ending their Quantitative Easing programme by the end of 2018. However, they have decided to push the first interest rate hike back further into 2019, causing the Euro to fall.
Also as expected, the US Federal Reserve (The Fed) raised interest rates once again bringing US rates up to 2%. The Fed is in a difficult position because on one hand, they want to raise interest rates to a level at which they can then comfortably cut rates in the event of a recession. However, on the other hand, they are wary that short-term bond yields are rising more quickly than longer-term bond yields, which can create problems for the economy and so they may well pause on raising rates much further.
Lastly, the Brexit negotiations continue with the potential for a no deal outcome rising. Tory infighting continues and at this stage, it does not look like they will form a unified approach amongst themselves let alone with the Europeans.
Despite how the year has unfolded so far, we continue to be positive on equities relative to bonds. Trade tensions could weigh on sentiment and growth and we will monitor the developments closely to see if our outlook must change.
Certain parts of the equity markets appear to be performing better, such as the smaller companies, and so we have focussed on building our positions here where applicable.
We will look to continue reducing some of our exposure to certain parts of the bond markets, which remain vulnerable to a rising interest rate environment.
Our broader themes continue to be in play, some of which are discussed below:
The return of inflation. Inflationary pressures continue to build and we believe the headline data does not reflect the reality on the ground. As an example, truck drivers in the US are now paid $150,000 a year due to a shortage in drivers and higher demand for transportation. We continue to believe in this theme and will remain positioned accordingly, with an underweight to Government and certain corporate bonds.
Central bank action. The Fed is likely to continue raising interest rates, although there is a chance they could pause. In contrast, the European Central Bank may need to raise interest rates sooner than anticipated due to the maturing economic cycle. In any case, the main Central Banks are reversing the policy stance they have maintained for almost a decade. This backdrop is yet another negative for parts of the bond markets, providing further support for our move away from long duration bonds as well as certain equities.
As mentioned earlier, we believe smaller companies are better suited to navigate the current global environment since they are less impacted by global flows and currency fluctuations.
In summary, we maintain our bias towards equities relative to bonds. We continue to see higher equity markets by the end of 2018, albeit with a higher degree of volatility than in the recent past and the threat of trade wars potentially limiting any upside.
We hope you find this review informative and look forward to hearing from you if you have any questions.