Capital Markets Update: March 2017

For professional advisers only. Not to be relied upon by retail investors.

  • Global economy slowly picking up
  • Prepare for impact: Trumponomics and tax cuts
  • Markets would respond positively if Europe voted off populism

In a nutshell

The economic numbers underpinning capital market activity showed steady, if unspectacular, growth. In the US, the Federal Reserve (Fed) raised interest rates, but must now worry whether president Donald Trump’s inflationary policies could cause the US economy to overheat. In the UK, inflation increased and the Bank of England held fire on raising interest rates. The decision to trigger Article 50 means the Government must now start revealing its plan to leave the European Union (EU). We may be on the way out of the EU, but the prospect of other countries voting to follow suit now appears less likely, which would be welcome news for global investment markets.

Economic progress: slowly does it

The prospects for global growth are a key factor in determining the levels at which markets are trading. March saw the Organisation for Economic Co-operation and Development (OECD) publish its Global Interim Economic Outlook, which projected a modest pick-up in global GDP growth from 3% in 2016 to 3.3% in 2017 and 3.6% in 2018. For reference, the 20-year average for annual global GDP growth is 4%. So, although the numbers are below the long-term average, they are slowly moving in the right direction.

The OECD pointed to a marked gain in US GDP growth (1.6% in 2016 and 2.8% in 2018), a managed slowdown in China (which we had expected) and a reduced level of growth in Japan and the UK (where growth forecasts have been revised downwards from 1.8% in 2016 to 1% in 2018). The US GDP number is a consequence of improving domestic demand and the prospects for fiscal expansion under US president Donald Trump’s administration. In the UK, inflation concerns arising from sterling’s weakness and low wage growth are expected to have a negative effect on consumption. Low consumption combined with the uncertainty around Brexit led to a lower forecast by the OECD for the UK economy.

Fed wary of Trumponomic heat

The Fed raised rates by 0.25% in a well-flagged move that was mostly welcomed by markets. The Fed presented a well-managed message that pointed to improvements in the US economy and the likelihood of a gentle path of further rises. Unemployment is below the Fed’s current target and there are signs that ‘good’ inflation (namely wage rises) is coming through. Combined with high levels of consumer confidence and household wealth, this should lead to an increase in consumer spending. This is important because the consumer is a key driver of the US economy. The question now, given the inflationary expectations of ‘Trumponomics’, is whether the Fed will be happy to allow the economy to overheat a little in the coming year, or whether it will need to raise rates faster to contain it.

Investors await benefits from Trump tax cuts

President Trump submitted his budget proposal to the US Congress, although it will not be implemented until October. The budget was a bit of a damp squib. Those expecting to see more information on his planned tax reform were disappointed. It put forward plans for increased defence spending, cuts in federal spending and not much on infrastructure. It’s the tax reform that investors are interested in and that information isn’t due to be released for another few weeks.

Generous tax breaks for companies and citizens will provide additional stimulus to the US economy. This fiscal stimulus combined with continued support on economic growth from the Fed should provide a ‘sweet spot’ for equity markets. The question is, by how much have investors already priced tax breaks into their decisions? We suspect tax breaks have been factored in to an extent, but we would point to improving fundamentals as a justification for some of the frenzied investment activity we have been seeing. Interestingly, there was a sell-off in the S&P 500 Index of large US companies, causing its biggest fall for some time. This was attributed in part to the Republican Party’s failure to get its healthcare plan passed, which some have seen as a precursor to future political uncertainty. Markets have since recovered some of their losses and hope is being placed on the success of expected tax reforms, however slow that may be to happen. Republicans are long-term advocates of lower taxes, so Congress may look more favourably on Trump’s tax reform bill when it is tabled in May.

Brexit triggered, now what?

In the UK, the Bank of England kept interest rate rises on hold. Inflation moved through its 2% target to reach 2.3%, but most of this was ‘imported inflation’ arising from a weakened sterling. Bank of England governor Mark Carney has form when it comes to looking through temporary inflation spikes, as he did when the oil price rose, so he isn’t expected to change his current position on rates. Chancellor Philip Hammond’s budget said little of any consequence, other than prompting an embarrassing climb-down on raising tax for the self-employed. There was continued ‘noise’ around Brexit, with Scotland’s first minister Nicola Sturgeon throwing the Scottish National Party’s hat into the ring by calling for a second referendum on Scottish independence. This was promptly rejected by Prime Minister Theresa May. May invoked Article 50 on 29 March triggering the start of two years of negotiation for the UK to leave the EU. We still await news of what the Brexit plan is.

Populism a possible red herring in Europe

Concerns over the rise of European populism abated when the far-right PVV party failed to secure enough seats to be part of the government in the Netherlands. National elections in Europe may prove to be a bit of a red herring in terms of other countries heading for the EU exit. Marine Le Pen, president of France’s National Front, is the next populist in the spotlight as the country goes to the polls. In the unlikely event that she wins the second round and becomes president, there are enough constitutional obstacles in place to prevent her extracting France from the EU. Global investment markets are likely to react badly in the short term to any signs of right-wing or populist party wins.

Fund manager views

There are reasons for investors to be cheerful, but they face risks as well. That’s why we retain an element of caution across our portfolios. US equities have the potential to move higher depending on the scale of tax reform and whether Trump makes any major mistakes. A policy error on raising interest rates from the Fed could cause problems for markets, but it has managed the message well to date and an error seems unlikely. On that basis, we’re not buying US equities, but we’re not selling them either. Despite the strong US dollar and Trump’s protectionist rhetoric, global emerging markets have been surprisingly resilient and we have become less negative about the short-term prospects for these regions.

Politics in Europe has the potential to worry investors and this may create buying opportunities. We believe the current round of elections is unlikely to challenge the future of the EU. With a supportive approach from the European Central Bank, the prospects for European investments may not be quite as bleak as market prices might suggest should the populists gain ground. The UK’s Brexit issues have been well flagged and mostly priced in by investors, but we are maintaining a lower than usual exposure to UK markets. With further interest rate rises expected in the US, the short-term outlook for bonds looks relatively weak. However, we have already positioned our portfolios defensively in preparation, so they should be shielded somewhat from the impact of rate rises on government bond prices.

Oliver Wallin, Octopus Investments

e: owallin@octopusinvestments.com

t: +44 (0)20 7776 3153

Important information:

For professional advisers only. Not to be relied upon by retail investors. The value of an investment, and any income from it, can fall or rise. Investors may not get back the full amount they invest. Past performance is not a reliable indicator of future results. Personal opinions may change and should not be seen as advice or a recommendation. Issued by Octopus Investments Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 33 Holborn, London, EC1N 2HT. Registered in England and Wales No. 03942880. Issued: April 2017. CAM04985.