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Inching towards more normal markets - and US tax reform

Weekly Investment View – 19 November 2017

Perhaps most importantly, the US House of Representatives last week passed its own version of the Republican tax reform bill, which we regard as good news, pending further political horse-trading. The S&P 500 recovered from some small downside earlier in the week to close just 0.13% lower over the period, at 2,578.85. Wal-Mart and Cisco Systems results came in above expectations, and with positive guidance; these are big companies, so beats for these will have helped to keep the market in its recent range. Otherwise, many commentators - as for many months – have been doing their best to talk the market down (‘Technology is very overbought’, ‘Robert Mueller’s investigation of Russian interference in last year’s election will continue to spook the market’, and/or ‘We doubt that US tax reform will actually happen’, and so on). Those downside moments last week even resulted in a spike (to above 13) on the VIX S&P volatility index, from a closing low of 9.14 earlier this month, although supposed calmness was the rule by the end of the week, with the VIX closing back down at 11.43 (going back a few years trading levels of 15 or above in Wall Street’s ‘fear gauge’ were commonplace. Many traders actually welcomed the spike, and not simply those who had shorted the index as a hedge against an overall down-move in equities. The S&P500 was left standing just 0.60% below its all-time closing high of 2,594.38 reached on the 8th November. Fortunately the FAB AAC (Asset Allocation Committee, which met at the end of last week) remains overweight in US equities in its asset allocation models. European equities, as measured by the STOXX Europe 600 index, underperformed over the week, closing 1.26% lower, and 3.27% below its recent high; equities suffered from weakness in miners, and in energy stocks, led by Royal Dutch; Norges (the Norwegian sovereign wealth fund, the largest SWF globally) has said it may sell its oil-related stocks on the basis that to retain them results in too much concentrated risk for an economy already over-exposed to hydrocarbons. Also, although Germany posted some good GDP data, investors appeared to become impatient with the time it is taking Angela Merkel to form a governing coalition. The FAB AAC remains overweight in European equities, ex-the UK.

“Chinese equities look cheap as a class, and are globally under-owned”

Japanese equities, measured by the TOPIX index, traded 2.03% lower on the week, which in fairness was its first down week in ten, and more than anything had the look of a rather overdue technical correction in an asset class that is up 18.44% for the year-to-date. In the short-term just a hint of yen strength (as seen last week) is capable of bringing about a correction in Japanese stocks. At its previous meeting the AAC seriously considered Japanese stocks in principle (or rather the potential to overweight them vs. the benchmark), but held back on the basis they had simply been very strong in recent weeks. Meanwhile, our readers will know that in terms of investment strategy, the Committee has favoured being overweight the MSCI Asia-Pacific (ex-Japan) index (APEJ), and this has worked well for some months. The APEJ index closed 0.15% lower last week, favourably influenced by Chinese stocks, which were 0.21% firmer – and continuing to frustrate those bearish of Chinese stocks and their economy. While the transformation that the Chinese authorities is working towards (from an industrial, to more of a consumption-driven economy) can be a bit bumpy, and not helped by pockets of debt, corporate earnings are now being revised upwards, such that the P/E ratio on the CSI300 index is just 13.8x for 2018, with earnings growth of 14.5% for that year. Chinese equities are very under-owned globally, although we expect this to change - and quite dramatically - as index compilers (such as MSCI) make further upward adjustments in favour of the asset class over the next few years. In the short-term, the regulators’ crackdown on inappropriate wealth management products in China hasn’t been helpful to its bonds. In this regard the People’s Bank of China, the central bank, is continuing to walk a fine line, adding liquidity as and when necessary, as they did last week.

“We are not very concerned if US tax reform does take until early 2018 to achieve”

In bond markets, the Bloomberg Barclays Global-Aggregate index (unhedged) rose by 0.57%, largely reflecting the moderate risk-off tone in other markets, and broadly equating to a 5 ½ basis point reduction in the yield on US 10-year Treasuries (to 2.3435%), together with five basis points off the 10-year Bund yield (to 0.3610%), and 0.7 of a basis point lower on the Japanese 10-year yield. The main talking point all week was the continued flattening in the 2-10 year US Treasuries yield curve, to 0.63%, down from 1.24% at the end of last year, and 0.74% at the end of the previous week. The US 2-year yield continued to move ahead, up almost seven basis points over the week as monetary conditions continued to tighten. There was also a sharp move upwards in US High Yield bond yield indices, although this was judged by the AAC to have gone too far, too fast, and serves as a warning shot at this stage of the economic cycle. Many commentators are talking about, or extrapolating the curve-flattening to predict actual inversion (with short-rates above the 10-year rate), which in previous cycles has been predictive of imminent recession. The AAC has been overweight in High Yield (broadly consistent with being overweight in equities at a time of normal default rates), and has this under review. In foreign exchange markets, the dollar closed 0.77% on its index (at 93.662), consistent with the euro rising to $1.1790, a stronger yen (at 112.10 to the dollar), and slightly stronger sterling, at $1.3215. The issuing of subpoenas to Trump election campaign officials by Special Counsel, Robert Mueller, harmed the dollar last week, and more than offset the positive news regarding the House vote on its version of the tax bill. There are still some ‘conservative fiscal’ Republican ‘hold-outs’ in the Senate, and while the House and the Senate versions of the legislation have to be reconciled. In this regard the discussion will continue this week, with there still being a chance that a bill could arrive on President Trump’s desk before Christmas - however we are not counting on this.

“The Asset Allocation Committee was happy to leave its positions unchanged last week”

INVESTMENT SUMMARY:

  • In other markets, Brent crude experienced only a small decline over the week, despite the IEA lowering its global demand forecasts, and raising its US crude output estimates.
  • Gold closed 1.36% (or $17/oz) firmer over the week, reflecting a weaker dollar, and geopolitics.
  • Brexit negotiations have been going badly, with the European Commission issuing threats to Theresa May and her team – can the UK put forward a better financial ‘exit’ offer before the end of this month, to facilitate trade talks? So the brinkmanship continues.
  • In Saudi Arabia, it looks as though deals are being worked out between those eminent individuals detained and the rulers, designed to boost the country’s finances.
  • We reiterate that the US economy could sustain a rate of 3% growth if White House elements of tax reform are enacted. As far as we can tell, Steve Mnuchin, US Treasury Secretary, is doing a fine job in policy formulation, and has been consistently good at rationalizing the likely outcomes.
  • Moody’s have upgraded India’s sovereign debt rating to investment grade (to ‘Baa2’, from ‘Baa3’). This will ideally be followed by other credit agencies, although for the time being is the kind of judgment we want to see as we maintain our overweight stance in Indian equities.
  • We reiterate that the Asset Allocation Committee last week left the overweight positions in equities (US, European, India, and Asia-Pacific ex-Japan) intact, and the underweight in G3 government bonds.

For any inquiries related to this article, please contact Alain Marckus or Clint Dove.

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Weekly Investment View – 19 November 2017

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