Market Outlook Report – October 2017

Market Overview

Globally, there has been a synchronised improvement in key economic barometers over the last 12 months. Global industrial production, trade and corporate earnings growth have all picked up significantly.

Japan’s Nikkei index posted one of its biggest daily rises in recent weeks, closing more than 1% higher above 22,000 points, a fresh 21-year high. Markets in continental Europe are higher on Friday morning after the European Central Bank revealed that its withdrawal of monetary stimulus would be a gradual process. Investors were also buoyed by upbeat comments from ECB chief Mario Draghi on the state of the eurozone economy. A recent weakening euro against the dollar helped boost European indices. The UK’s growth momentum is much weaker as the negative effects of the EU referendum continue to bite. However, there are few signs that the economy is set to contract.

The near-term picture in most emerging markets is no less positive. China’s debt imbalances may be unusually large – and still growing – but the credit impulse is fading. Elsewhere, Brazil and Russia are both emerging from deep recessions in 2015 and 2016. Meanwhile, India appears to have the best long-term growth outlook of the major emerging economies.

UK

The markets believe an interest rate rise (the first in a decade) is all but a done deal, with markets pricing in a 90% chance of the first increase in more than 10 years. Better-than-expected figures last week showing the economy grew by 0.4% in the third quarter have cemented expectations that the Bank of England will undo its rate cut of August last year, with the base rate moving from 0.25% to 0.5%. The last rise, in July 2007, took rates to 5.75%. However, in a recent survey by Nomura bank, nearly half of investors said an increase this week would be a “policy mistake”.

Interests rates in the UK have not risen in the past decade.

Higher interest rates generally push down the price of government and corporate bonds. Rising rates can also have a negative impact on companies that pay a high dividend, as they become less attractive in relation to savings accounts, depressing those share prices. Financial stocks such as banks, on the other hand, benefit from higher margins when interest rates go up, so their share prices could rise. These implications have been carefully considered by the Reeves Investment Team and reflected in some changes made to our model investment portfolios, as outlined later in this report.

US

Corporate America has confounded expectations time and again this year, with stock markets hitting repeated highs despite turmoil in the White House, a weakened dollar and a Federal Reserve that is steadily raising interest rates — and there appears to be still more fuel in the tank.

The Dow Jones industrial average is on course to add nearly 1,000 points over the next year, according to Factset, a research company, driven by the underlying financial strength of America’s largest companies. The Dow has put on 3,005 points, or 15.2 per cent, since the start of the year to reach 22,773.67, with the broader-based S&P 500 up by 13.9 per cent to 2,549.33 and the technology-focused Nasdaq higher by 22.4 per cent at 6,590.18.

Companies in the S&P 500 announced average profit growth of 13.6 per cent in the first quarter of this year and 11.1 per cent in the second. Factset estimates that profits at S&P 500 companies rose by 2.8 per cent on average in the third quarter compared with a year ago, down from its end-of-June estimate of 7.5 per cent growth. Zacks, another research company, estimates that profits climbed by 2.3 per cent on average, down from a June forecast of 6.3 per cent growth. Twenty-two S&P 500 companies had reported third-quarter earnings by the end of last week. Of these, 19 beat analysts’ profit expectations, with the average profit higher by 27.1 per cent compared with the same period in 2016.

There are, however, signs of a correction. The needle on CNN’s fear and greed index, a gauge of the emotions driving Wall Street, pointed yesterday to “extreme greed”, suggesting that share prices have risen well beyond their true value. So it is perhaps it’s a timely opportunity to reflect on events 30 years ago.

30 Years Since Black Monday

It is 30 years since the stock market crash of October 1987. On October 19 (Black Monday) the US stock market plunged 20.5 per cent, while the FTSE 100 dropped 10.8 per cent. The next day the FTSE dropped a further 12.2 per cent, still its biggest one-day fall.

The simultaneous share price falls in London and New York, thought to have been caused by a glitch in computer program trades, triggered a sell-off around the globe as investors panicked. Panic turned to pandemonium partly for technical reasons: the worst storm in living memory had hit southeast England the previous Thursday night and Friday morning, disrupting rail, road and telephone communications. In the days before mobile phones or the internet, that meant many City folk couldn’t get into the office and couldn’t work from home either — but they still knew the American market was falling. So, with trading in many London offices suspended, fear spread like wildfire. This helped turn mildly disappointing economic data into a proper, old-fashioned stock market crash. Teething troubles with newish technology made matters worse. During October and November 1987 the FTSE 100 lost 33.2 per cent of its value in what remains the sharpest short-term market crash in the index’s history.

Since then, there have been plenty of bumps and a couple of crashes but the long-term trend has been upward. For example, the Footsie fell to 1,684 points in October 1987 — that’s less than a quarter of its level now. Those who managed to keep calm in the midst of the panic and stayed invested for the long term have been richly rewarded. Justin Urquhart Stewart of Seven Investment Management, the wealth manager, says that from the market close on October 20 to the end of September 2017 the FTSE 100 has generated a return of 876 per cent (with income reinvested). That means someone who was brave enough to go against the crowd and invest £10,000 in the FTSE 100 on the day after Black Tuesday would be sitting on a lump sum of £97,600 today. You could have done even better if you had picked a good fund - the best-performing UK fund was Halifax UK Growth, which turned £10,000 into £319,500. The top overseas fund was Jupiter European, where a £10,000 investment would now be worth £433,100.

In plain English, if you can afford to remain invested for the long term (five years or more), then even the most dramatic short-term setbacks fade in significance. Research firm Morningstar say £100 invested in the average unit trust just before Black Monday would be worth £796 now. Only £258 was needed to keep pace with inflation, according to the Bank of England. £100 placed in the average investment trust in 1987 would now be worth £1,383.

Are we heading for another market crash?

The FTSE 100 index is hovering around the 7,500 mark, having more than doubled since March 2009 when the rally began. US stock markets are also breaking records and have gone nearly a year without suffering at least a 5% correction. This is now one of the longest bull runs in history. The FTSE 100 and America’s Dow Jones Industrial Average began their climb in March 2009, bouncing off the lows of the financial crisis. Britain’s blue-chip index has more than doubled, rising from 3,530.73 points to hit a record of 7,547.63 in May — and it is still hovering close to that level. The Dow has soared almost fourfold — from 6,626.94 since March 2009, to more than 23,000.

With markets reaching record highs on both sides of the Atlantic, many investors have been getting vertigo. Expectations of a crash have been mounting, with prominent investors including George Soros and Crispin Odey aligning themselves accordingly. Albert Edwards, a veteran Société Générale strategist is also nervous. By his reckoning, the next great crash is definitely coming. And it could be in the next 12 months.

Yet betting against this bull run has proved a costly mistake for many seasoned investors — and it is a trap that has snared big beasts such as George Soros and the hedge fund manager Crispin Odey. Calling the market is always a dangerous game. The evidence suggests that making predictions on when it will turn is a guaranteed way to lose out.

Our historical research shows investors roughly make the same amount of money in the three months before the peak as they lose in three months after the peak of a bull market.”

Christian
Equity Strategist @ Goldman Sachs

For the FTSE 100, much depends on the direction of sterling. With about 80% of the earnings in the index coming from overseas, foreign exchange gains have been a big driver of profits. That trend could go into reverse if the pound is pushed up by a rise in interest rates. Peter Hargreaves, billionaire co-founder of Britain’s biggest retail stockbroker, believes the eight-year bull run is set to continue — driving markets to more record highs. Hargreaves, still the largest shareholder in Hargreaves Lansdown, said: “I know it’s been a long bull run but it’s just when investors think we might be at the top of the market that it continues to go higher. I don’t think the stock market has peaked.”The best way to cope with share price volatility and the occasional stock market crisis remains to stay calm and buy on the dips. The rest, as they say, is hysteria.

Reeves Model Investment Portfolios

As the graph below illustrates, our model investment portfolios reflect the inherent risk profiles associated with a market downturn, with less impact on less risky portfolios and higher-risk portfolios suffering the most.

Generally, our model portfolios have performed as expected against the FTSE All-Share Index benchmark, depending on their risk profile. Over the reporting period, only 4 of our investment funds have made short-term losses.

Reeves Model Portfolio Performance

Reeves Model Portfolio Performance vs FTSE Allshare

Following this month’s Reeves Investment Team meeting, a number of stratgeic adjustments have been made to our model investment portfolios.

  • Higher interest rates generally push down the price of government and corporate bonds, therefore we have suspended regular investments in corporate bonds for the time being.
  • We are introducing a buy into the F&C Private Equity PLC. The Company's objective is to achieve long-term capital growth through investment in private equity assets, whilst providing shareholders with a predictable and above average level of dividend funded from a combination of the Company's revenue and realized capital profits. The Company makes private equity investments by taking stakes in private equity focused limited partnerships, offshore funds, investment companies and investment trusts. It may also purchase secondary private equity fund interests. The Company may also make direct private equity investments, mainly through co-investment with the funds in which the Company is invested. 
  • We have changed the fund composition to our exposure to the property sector, by replacing GCP (Gravis Capital Management Ltd) Student Living Plc with the TM Hearthstone UK Residential Property Fund. This is a property authorised investment fund (PAIF) which invests in private rented sector housing across the mainland UK regions and aims to capture UK house price growth plus provide an element of income return. We have retained exposure to the student property market via Empiric Student Property Plc.
  • We have reduced our cash holdings through added investments in the Pyrford Global Total Fund. The fund invests in a combination of shares, government bonds and cash with the aim of delivering attractive long term growth with less volatility than the stock market. The fund managers share our risk-averse, cautionary position and they hold a fair proportion of cash within their portfolio for the same reasons we do, with a longer-term expectation that they will drip-feed back in to the market when they feel the time is right (which isn't now). Meanwhile, the fund delivers a modest but consistent return from its diverse portfolio of equities, high quality sovereign bonds and currency positions. The fund proactively hedges against currency movements.
  • We have also added the Threadneedle Dynamic Real Return Fund. This is a research-driven multi asset portfolio targeting equity-like returns with around two-thirds the volatility, which targets an inflation +4% (gross) return, regardless of market conditions over the medium to long-term and has achieved top quartile performance over 1, 2, 3, years and since launch. The identification and selection of these funds reflects our stated objective of finding optimum investments which provide an attractive return within a safe and liquid investment product.

These portfolio changes have been made, irrespective of whether the Bank of England Monetary Policy Committee decide to change the Base Rate this week; interest rates will increase at some point in the foreseeable future. Since September, the Bank has said an increase could be expected “in the coming months” as long as the data turned out as expected. Therefore, we will not need to respond to the outcome of this week’s MPC meeting.