For professional advisers only. Not to be relied upon by retail investors.
Capital Markets Update
- No surprise on US rate rise
- Italy’s budget deficit riles EU
- Little clarity on trade tariffs or Brexit
In a nutshell
Market uncertainties from the summer continued into September. The US Federal Reserve’s (Fed) announcement accompanying its latest interest rate rise was open to interpretation. Italy’s government delivered its expected controversial budget and we await the European Union’s (EU) response. While both the to and fro of tit-for-tat trade war tariffs and tortuous Brexit negotiations left investors none the wiser.
September’s news – No surprise on US rate rise
With the 0.25% rate rise pretty much a certainty, the market turned its focus to the wording of the Fed’s accompanying statement. The most notable change was dropping the word ‘accommodative’ from the Fed’s monetary policy position. This was considered important as it provides a clue as to how close the Fed believes it is to the neutral rate (the hypothetical point where inflation is stable and monetary policy neither accommodates nor restricts economic growth). The market believes the Fed is likely to pause at the point the neutral rate is reached, thereby slowing the projected path of interest rate rises. As a consequence, this change has been interpreted in many quarters as being dovish – or less aggressive. But this may well prove to be wrong as Fed Chairman Jerome Powell opted for stronger words in the statement to offset any overly dovish interpretation and signalled to the market to expect a higher likelihood of rate rises. However, the market remains sceptical.
Game on: Italy v EU
Italy’s new coalition government outlined its intent to fulfil its campaign policies of lowering taxes, reversing pension reforms and increasing spending. The budget announcement was a little short on details but the government is targeting an increased deficit level that is outside of the range that markets were expecting and the EU is comfortable with. The result will be a marked increase in national debt over time and will put downward pressure on Italian bond prices as investors factor in the increasing probability of an eventual Italian default. We will wait to hear the EU’s verdict when it reviews the Italian budget proposal and makes its comments.
Deal or no deal?
US President Donald Trump broadened the basket of Chinese goods on which he has imposed tariffs. China has retaliated with a focus on goods produced in Republican strongholds. As the US mid-term elections approach we will see how effective that strategy proves to be. Despite the escalation, markets remain fairly sanguine. That may in part be due to the fact that there isn’t enough certainty as to how far this trade war will play out and, at the same time, enough clarity as to the overall impact on the global economy. The new USMCA agreement between the US, Canada and Mexico replacing the existing NAFTA agreement demonstrated Trump’s ability to strike last minute deals. Markets are likely to be hoping tensions between the US and China will soften before they get out of hand.
Closer to home, we’re only a few months away from the Brexit deadline in March 2019 but still seemingly no nearer to a resolution. Prime Minister Theresa May returned from meetings with EU leaders in Salzburg surprised by the reaction there to her Chequers plan. Chastened, May and her cabinet are holding a firmer line and waiting for the EU to come back with a better suggestion. A last minute fudge is still the hoped for conclusion but a hard Brexit, where the UK leaves without a deal in March, remains a possibility.
After a relatively quiet summer for markets the autumn months will be livelier. Against a ‘noisy’ and fractious geo-political backdrop an element of caution remains an extremely prudent position to take. We continue to believe the equity market bull-run still has some life left in it, led by the US, and offers some positives that we want to take advantage of. However, we have to be wary about catalysts that have the potential to derail markets. We are in the latter stages of an economic cycle and would expect to move into a period of economic contraction at some stage in the near future. Expectations are that this current environment could persist through next year and into 2020. That timeframe might be compressed if the central banks raise interest rates too much, too soon, although that seems unlikely given their current positioning. The escalation of trade wars could have a major impact on global growth but, for the time being, markets believe some resolution will be reached before it goes too far. Idiosyncratic issues within emerging markets, most notably Turkey and Argentina, have abated but a strengthening US dollar and trade war concerns make emerging markets vulnerable.
Overall, given these concerns, we feel having a slightly underweight equity exposure is warranted across our portfolios. Rising interest rates and inflationary pressures in the US aren’t good for the longer-term prospects for US government bonds, while Italy’s reckless fiscal policy is already resulting in higher yields and falling prices in its government bonds. So, a continued underweight position in our portfolios for government bonds and a preference for investment grade corporate bonds remains the order of the day. We will be looking to return to bond markets as yields become more attractive, which will be a natural consequence of falling bond prices. To offset our cautious view on the two key asset groups, of equities and bonds, we are building our cash position tactically so we can deploy funds when opportunities present themselves. Alternative asset classes offer our portfolios some shelter from the expected short-term increase in equity and bond market volatility.
Oliver Wallin, Octopus Investments
t: +44 (0)20 7776 3153
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: October 2018.