Alternative Ending

Counterfactual writing has been popular for many years. What if the Nazis had won the war in Europe? What if there had been no Reformation? Extending the genre to finance one might ask, what if the bond market had closed to Italy in 2011? (More of a niche market there, perhaps, but an interesting question nonetheless . . . )

Investment decision making by contrast concerns the future, of course, whose range of outcomes is practically limitless. Where the FTSE 100 index will close the year is a matter of opinion. A successful investor could be defined as someone who gets those sorts of things right more often than she gets them wrong. The only certainty she has, however, is that the future could hold almost anything.

And so to inflation, the UK, and what happens next.

The data out last week showing another uptick in the rate of price increases in Britain will have come as no surprise to readers of this blog. CPI is catching up with PPI output prices which have continued to catch up with PPI input prices, which have continued to come in at around 20% higher than the same time twelve months previously. Notably, “RPIX” – the rate of retail price inflation excluding the impact of mortgage interest payments and the rate once targeted by the Bank of England – came in at +3.5% year-on-year (to February). A full point above the old target, that would once have provoked a letter from the Governor to the Chancellor. CPI has only just got up to +2.3%, however, so under the new regime there is officially nothing to worry about.

Yet.

Bearing in mind the enormous range of possibilities encompassed by the future we ought to be surprised at the strength of the consensus about what happens next. The Bank, the City, the leading independent forecasters: all are agreed that rising inflation will eat into wage packets, dampen growth, soften the labour market a little then fall away again. This time we all know how the story will end.

Taking this as read, then, let us try to be counterfactual, if only for entertainment’s sake.

On February data, real wage growth either flatlined (using CPI) or fell by 1% (using headline RPI). Let us follow the consensus in assuming that inflation grows by another point or so into the end of this year. That would push real wage growth down to between -1% and -2%.

Now: what if the effect of this was not only, or primarily, to impact growth? What if the expectation that wage growth will muddle along at a steady +2% is wrong? What if earnings actually start to rise to compensate for higher prices?

Like any good counterfactual tale our story needs to have its roots in genuine history to come across as believable to its readers.

In this case we might look at the distance travelled by the UK economy since the unemployment rate peaked in November 2011 at 8.5%. At that time average earnings growth was coming in at +1.7-1.8%, just a little lower than its present rate, though at the time this was a noteworthy trough and a level not seen since 1967. Wage growth subsequently fell further, hitting lows of +0.7-0.8% during the 2013-14 period. During those two years, however, employment growth had taken off in earnest with joblessness falling from 7.8% to 5.7%. Average earnings growth subsequently rose too, hitting +2.8% by mid-2015.

That British pay packets began to grow as spare workers became that bit harder to get hold of might well have been a complete coincidence. Indeed if we are to believe that earnings growth will not continue to accelerate today, as unemployment is down even further at 4.7%, equalling its post-1975 low, then that must be taken as read. The consensus, after all, is convinced of it.

Let us persist with our radical, counterfactual account, however. Suppose that labour market strength might genuinely correlate with wage growth. Where might that take us?

Prior to the Great Recession the average rate of earnings growth in the UK was +4%. Using a five-year lag from earlier peaks in unemployment wage growth reached +4.9% (February 1998) and +9.3% (May 1989). The economic, market and demographic environments were very different in their own ways at each of those different times, so the absolute numbers are not perhaps that illustrative. What they have in common is that they occurred during uptrends in wage growth established in the wake of falling unemployment.

For our fictional account of the British economy, then, let us assume that 2017 were to end with average earnings growing at 3-4%. With CPI and RPI inflation settling in the same range this would not represent boom times for wage packets in real terms. But it would not mean a growth-threatening contraction either. Expectations for increased labour market slack would surely go out of the window. Inflation projections would rise. Interest rate expectations would change. We might be entering 2018 worried not so much about contraction as about an overheating economy and a monetary policy that looked to have long since fallen behind the curve.

This is hardly a gripping, mass-market narrative. But it is the kind of thing that investors might want to weigh up in their thinking from time to time.

At least it would be if it were not the most absurd counterfactual, of course. Luckily the consensus is universally settled. We all know what is going to happen. In Britain’s immediate future, there is no alternative ending.

31/03/2017 at 3:55 pm

Nothing To See?

Tomorrow’s election in the Netherlands may not be very exciting after all. Until recently it looked as though the nationalist PVV would emerge the clear winner, to the extent that keeping its leader from the Prime Ministership would be very difficult. (PVV wishes the Netherlands to leave the European Union among its other policies.) But then the party’s leader, Geert Wilders, was convicted for inciting discrimination before Christmas, and as the campaign got underway the incumbent PM, Mark Rutte, deployed much hard rhetoric and advertising on PVV’s key issue, immigration. The current polling is finely balanced. Mr Rutte has repeatedly ruled out coalition with Mr Wilders. Dutch politics may remain an earthquake-free zone; we will soon know either way.

Eurozone asset markets are priced rather sanguinely in any case. Back in 2011 it was the bond market, and specifically the Italian bond market, which threatened to ignite a wholesale global banking collapse with an internationally unaffordable sovereign default. Back then, the credit default swaps which can be bought to hedge against Italian credit risk cost almost 6% over LIBOR, as against 6bp in mid-2007. Today the rate is 192bp: higher than the pre-credit crunch levels, but then Italy has been downgraded from AA to borderline junk since then. Even the end of the country’s government last December at the hands of a referendum seen as a valve for anti-Establishment sentiment did relatively little to move the price.

Elsewhere in the euro area the story is similar. The exception, which is worth dealing with separately, is Greece. Here the debt burden, which has of course already been restructured once, has reached over 180% of GDP. The IMF – one of the “troika” of creditors dictating Greek fiscal policy – has said that it has again become unsustainable. Fraught negotiations with the Greek government have continued. But none of this is news. Furthermore the Bank of Greece’s November estimate for the country’s budget was of a “primary surplus” (budget balance before debt interest) of +4% of GDP, indicating both a sustainable underlying spending pattern and compliance with creditor demands. There are those who expect the contradiction between monetary union and fiscal autonomy to upend the single currency at some point, but then at the zone-wide level debt to GDP peaked back in 2014 and again, this is hardly news.

Another recent source of concern over Europe was the banking system – or, to be more accurate, the solvency (or otherwise) of various European banks. Deutsche Bank caused consternation for a time, but then the German government has been cutting its debt burden since 2010 and if anyone can afford a major bailout, it is surely them. In any case, no bailout was necessary; DB shares have risen by more than 70% from their lows. Where restructuring has been needed, at Banca Monte dei Paschi di Siena, it has not been anything like sufficiently material to threaten the whole Continent. And where banks are daily dependent on emergency central bank facilities (Athens), this is, once again, not news. Their shares have been available for a handful of cents for years.

There is only one moving part that has shown real signs of weakness: the euro itself. This has fallen by 23% over the last three years. Its low against the dollar of $1.0388 back in December was the weakest level it had reached since the opening sessions of 2003. However, even this is not a credible sign of structural malaise. The currency has been much lower still in the past, hitting an all-time record of $0.8272 in late 2000. And while the ECB has been loosening policy in a range of ways, the Fed has embarked on a tightening cycle. Like the Italian credit spread the euro’s weakness can be interpreted as nothing more than a rational response to changed circumstances.

In other words, there appears to be nothing to see here. Political risk remains, yet seems not to be priced in.

This blog argued at the time that the support of the stronger eurozone economies for the weaker ones in 2010 answered a key existential question for the single currency. In theory, (a) there is no debt mutualisation in Euroland and (b) its members enjoy complete fiscal autonomy. In practice, when the going got tough, there was a very EU-esque “pooling of sovereignty” over debt via the European Financial Stability Facility / European Stability Mechanism. And bailout nations have had to comply with the rules of their emergency lending regimes.

There is another factor to consider, however, and that is Brexit. Attention in the UK tends quite understandably to focus on the consequences for ourselves, but there will also be consequences for the rest of the EU.

A harsh deal, or no deal, with Britain, and some businesses and industries will suffer. It was interesting that a senior executive at global food giant Mars Incorporated spoke about this a few days ago. Agriculture has managed to remain immune to the GATT / WTO decades of compromise on tariff reduction and quota control. Look at the WTO tariff tables and food, drink and tobacco are about the last redoubts of punitive import duties. From the BBC last Friday:

Fiona Dawson . . . said the absence of a deal with EU member states would see tariffs of up to 30% for the industry.

Speaking at the American Chamber of Commerce to the EU, she warned this would “threaten [the] supply chain and the jobs that come with it.”

“The absence of hard borders (in Europe) with all their attendant tariff, customs and non-tariff barriers allows for this integrated supply chain, which helps to keep costs down,” she said. “The return of those barriers would create higher costs which would threaten that supply chain and the jobs that come with it.” Ms Dawson said those costs could not be absorbed by confectionery companies, meaning consumers would have to pay more for their products . . .

Companies in the automotive and the financial sector have been the focus since the vote, according to Ms Dawson. But with food and drink the largest manufacturing sector in the UK, accounting for 16% of turnover, she said she wanted a new focus, and called for EU leaders to look at the bigger picture when negotiating. “There can be no economic advantage either side restricting trade with a large market situated on its doorstep,” she said.

“In simple terms, if the UK and the EU fail to agree on a new preferential deal, it will be to the detriment of all. Other member states should remember this is not about ‘punishing’ Britain for her decision to withdraw, but rather about finding the best solution for European and UK workers and consumers.

The emphasis at the end there is my own. And it is not just manufacturers who could, in theory, be walloped in this sector. Pity the poor farmers, logistics firms, supermarkets, restaurauteurs who would be crippled by the reimposition of border controls. (The EU’s “Border Inspection Post” system is, to put it mildly, neither rapid nor straightforward. Our own government has helpfully printed the details here.)

A no-deal Brexit, then, would entail potentially disastrous consequences for certain sectors.

This is not priced in. Does this mean that Britain will leave with many of the customs union’s features still in place? That we will, as Ms Dawson clearly desires, not be “punished”?

That is a possibility but it could spell the end of the EU, which appears not to be priced in either . . .

Just imagine. An economically benign Brexit would mean Britain securing a free trade deal that goes way beyond current WTO rules in the key areas of agriculture and fish, while maintaining border control-free access in these and related markets. At the same time we would be regaining complete control of our immigration, lawmaking and judicial processes – and saving part, if not all, of our contributions to the Brussels budget.

A core of true believers – Luxembourg, for instance – might want to stay in the bloc and accelerate the move towards political federation. But surely, plenty of other “member states” would want to follow such an example.

This year’s electoral cycles across the Channel may not threaten the euro, then. But Brexit seemingly has to threaten either some sector-specific but nonetheless material economic damage, or the continued existence, to some extent, of the EU. If a eurozone country wanted to leave the EU, it could in theory continue to use the single currency. But might financial market pricing, by that point, not have begun to look rather different . . ?

So much of the focus has been on Article 50 and the possibility that Brexit might be somehow derailed that thinking has yet to turn to this apparently logical conclusion. The question for investors is: what are the euro assets which are so compellingly attractive that one should wait until it does so?

14/03/2017 at 6:43 pm

Fire!

It is almost four months since Donald Trump won the US presidency but the shockwaves from his victory still reverberate. Coverage of supposed scandals, protests and presidential Tweets have continued to abound. Those who were delighted by November’s result, so polling suggests, remain so; those who reverted to hysteria continue their frenzy. Amid all the drama it is perhaps an odd expression to pick, but: Amercian politics has found an equilibrium.

Assumptions about the US economy have also become entrenched. It has long been obvious that a Trump presidency would be inflationary and the bond market reacted to the result accordingly: on the day of the election the ten-year Treasury yielded 1.85%, but by the end of November had hit 2.4%. It has stayed firmly in a range of 2.3%-2.6% ever since. The dollar likewise strengthened sharply after the election and has comfortably held its range against other major currencies. Eurodollar rates moved from pricing in two Fed hikes by the end of this year to pricing in three, and have held that view right up to the present.

While American politics has become energized, however – by the ambition of the new incumbent and the vitriol of his critics – financial opinion has become complacent. While markets and observers have in many cases settled on a static view, the ground since the election has shifted. Look away from fixed income and the currency, and towards risk markets and the data and this is easily clarified.

The US stock market found a secure range after the election, but only for a time. Last month it smashed it. From meandering around the 2,250 level throughout December-January the S&P 500 broke 2,300 in early February and 2,400 less than a month later. The index has now risen by more than 6% since the beginning of the year, comfortably beating other major bourses around the world.

It is not just the stock market that is optimistic, and setting new records. Consumer confidence hit a new high this week, eclipsing the levels reached prior to the credit crunch and threatening to visit territory last occupied during the go-go boom of the later 1990s. This is of a picture with earlier data on retail sales, showing the fastest annual rate of growth (+5.6% in January) since the early stages of the recovery in 2010-11, and buoyant numbers on existing home sales, which have reached a pitch last seen before the credit crunch in 2007. (Bear in mind that mortgage costs have actually been increasing at the same time, pushed up by higher long-term interest rates.)

Industrial indicators have strengthened too. Purchasing manager activity surveys out this week for both manufacturing and service sectors continued their sharp rise. The rotary rig count released last Friday showed that US oil production has continued to recover even though the price of crude has been no better than stable since December. Again, this is consistent with earlier data such as the NFIB survey of smaller firms and the “Philly Fed” report on the national outlook for business, both of which have been rocketing up, in the latter case to a 33-year high.

If one tries very hard to find them there are more equivocal releases. Monthly variability on jobs data, for instance, has been weak in some instances; then again, the broader context is one of effectively full employment, and short-term moves from 4.6% to 4.7% in the headline jobless rate are neither here nor there.

More seriously, while vague expectations of higher inflation have been priced in since November, underlying price indicators have started to move. Import price inflation, which had been negative since mid-2014, flattened out to +0.2% in election month and has since hit +3.7% (year to January). The price components of PMI surveys have also risen. Public statements from various Fed presidents and board governors has been preparing markets for a hike this month which leaves ample scope for those three rises this year, and more.

Put all the pieces together and it seems more and more obvious that there is no longer any broad backdrop of bad economic news, whatever one’s views of American politics. The credit crunch hit housing and the banking sector – all recovered. The oil price collapse hit the shale business – recovering nicely. A strong dollar dampened activity – that effect has fallen away.

On the other hand, sentiment and output indicators are on the up. The economy is at full employment. The core rate of CPI inflation has already been running above 2% for more than a year and in January posted its fastest monthly increase since 2006.

The US economy is catching fire. This will make a novel change from the sclerotic pace of recovery we have seen there to date. The question is: are markets properly discounting the eventual need to put the fire out?

03/03/2017 at 5:24 pm

Every Cloud . . .

The gilt market has staged a modest rally over the past couple of weeks though this should not fool us: there remains a good deal of attention focused on the inflationary outlook. Data for January, out earlier this month, was entirely unsurprising on this front. Input prices were up by more than 20%, eclipsing the prior peak of +17.6% reached in 2011, CPI is almost back on target and RPI ex mortgage interest payments came in just shy of +3%. The ONS quite predictably singled out currency weakness and fuel costs as the main culprits.

But the weak currency is not all bad news as we were reminded with the publication of GDP figures for the UK this Wednesday. Export growth of over 4% on the final quarter of last year was celebrated by some of those on the Leave side of the Brexit vote; though there is considerable quarter-to-quarter volatility in this data it was, undeniably, positive.

In fact there was already evidence of this effect from industrial production numbers out for December a couple of weeks ago. The yearly IP increase of +4.3% was the highest posted since the country’s recovery from the Great Recession and smashed expectations. Looking beyond exports too there was good news from the personal consumption component of GDP, which hit a solid +0.7% for Q4 while the Q3 estimate was revised up to +0.9%, suggesting a Brexit bounce. Business investment – as highlighted by the Remain side – flattened off into the end of the year but the picture is unequivocally of an economy ticking along rather nicely and enjoying a boost from its currency-enhanced competitiveness.

Returning to the theme of inflation, there has been some coverage of the oncoming squeeze on real wages and that is a perfectly valid concern. However this cloud may not be quite as dark as all that. As of December both headline RPI and average earnings growth hit +2.6%, meaning that real wage growth was zero – not a supportive situation for the economy. But throughout the period from 2010-2014 real wage growth was negative, on several occasions falling below -3% (and hitting a nadir of -3.8% at one point). Over the same horizon annual growth in household consumption averaged 1% and broad GDP growth +2%. Today, RPI inflation would have to hit 5.6% plus to achieve the same depressive force on real wages. That is a risk and by coincidence exactly the peak reached in the autumn of 2011, but we are not there yet.

Some have turned to the second consecutive month of contracting retail sales as evidence of consumer weakness but again the short-term data here is incredibly volatile. The six month running mean for annual growth in retail sales was +4.9% as of January, a little less than double the average rate over the past 20 years. Might there be a sustained reversal in consumer behaviour? It’s possible – but the GfK consumer confidence survey actually rose for two consecutive months into January.

For investors, the big picture is therefore as follows. The UK economy is growing at a healthy rate, “despite Brexit”. This is in part due to the weak pound; a currency depreciation is a straightforward monetary expansion and this seems to have been forgotten. There is presently a risk that rising inflation will take some of the edge off the growth rate but on the basis of current data and recent history we ought not to be too anxious. Markets in some respects do appear complacent about the risk of more seriously damaging price behaviour – but that is another story.

24/02/2017 at 5:32 pm

Conspiracy Theories

Let’s start with the facts.

  • Yesterday saw the release of the Bank of England’s latest quarterly Inflation Report.
  • For the second time, its growth forecast for 2017 was revised up. This now stands at 2% as against the 0.8% forecast in the wake of the EU referendum result, which the Bank officially and Mark Carney personally expected to usher in immediate economic disaster.
  • Projected unemployment now stands at 5.0%, up from a 2017 forecast of 5.5% last August.
  • Despite this the CPI forecast for this year has been trimmed back: to 2.7% down from 2.8% back in November.
  • The “equilibrium unemployment rate” [a.k.a. the “natural unemployment rate”, a.k.a. the “non accelerating inflation rate of unemployment” (NAIRU)] has been revised down from 5% to “around” 4.5%.
  • Despite its lower CPI forecast the Bank’s sub-trend growth forecast for the years following this one (+1.6% for both 2018 and 2019) is predicated on squeezed real wages under pressure from higher inflation.

Governor Carney took considerable pains to wipe the egg off his face by way of his opening remarks to the press conference yesterday. He admitted, obliquely, that consumer behaviour has not remotely suffered in the way which the Bank assumed it would last summer. But this was dismissed as the least important reason for the higher growth outlook, behind the Autumn Statement, improvements in economic confidence abroad and supportive financial conditions. Be that as it may, Mr Carney’s insouciant defence of his institution’s forecasting record does speak of a certain strength of character and for that at least he may perhaps be applauded.

The fact remains, however, that monetary conditions are still set firmly in emergency mode at a time when inflation is projected to exceed the notional target, the economy is close to full employment and growth is nudging trend. From its rhetoric, however, the Bank is wedded to accommodating unspecified and unquantifiable risks surrounding Brexit and seems intent on keeping policy unchanged for the foreseeable future.

This already looked curious last summer. Today it seems downright insane.

Now to the conspiracy.

Britain is no stranger to having her financial affairs managed on the basis of seeming insanity. Back in 1999 Gordon Brown infamously sold a large amount of the country’s gold reserves in an auction process which he announced publicly in advance. This secured him a bargain basement price for the sale. Gold subsequently multiplied in value and the period was dubbed the “Brown bottom” as a result.

The official explanation for the sale was that it would rebalance the country’s foreign exchange reserves away from a volatile commodity and into thrusting new assets such as euros. Gossip emerged later, however, that at least one major bank, likely JP Morgan, had been shorting gold to fund asset purchases in some size – a classic “carry trade” – and was threatened with serious difficulties should the price rise. Brown’s actions were therefore explicable as being for the greater good of the financial sector: there was method in the madness.

A similar case could be made today. The Brexit vote set sterling on a downward trend which persisted into the autumn. Last year’s foreign asset returns, in sterling terms, were astronomically higher than long run expected rates. And with interest rates near zero the pound is very cheap to borrow. (Remember too that it is one of the world’s reserve currencies and extremely liquid.)

Last year, then, the sterling carry trade was one of the deals of the century. As with the gold carry trade in the 90s, however, if the price of the borrowed asset goes up it doesn’t look very good for the borrowers. A rise in the value of the pound due to changing expectations for interest rates could well pose a risk to one or more banks assessable by a Bank of England Governor as systemic.

Surely it would be absurd to think that the MPC was secretly conspiring to hold down the value of sterling? Well – probably. But its official position appears no less absurd. It is also worth noting that the one key reaction to yesterday’s release and Mark Carney’s comments was a fall in the value of the pound. (Sterling had gone up as high as $1.27 in the morning, then crashed down towards $1.25 again over the course of the day.) The Bank’s forecast for the exchange rate is of near-complete stability at the current level into 2019 – or should that read, “the Bank’s target”?

It is an intriguing possibility. But this blog cannot go in for tin foil hats. So let us conclude simply by repeating the observation that the Bank’s current stance is extraordinary, and, apparently, inexplicable.

03/02/2017 at 6:11 pm

Linking Fortunes

Markets have begun to think about inflation again. In the US the new President is expected to contribute further towards existing pressure on prices; in Britain the weak pound has led to imported inflation as we saw again only this week. Talk in some quarters has turned, quite reasonably, to inflation protection, and specifically to index-linked bonds. This post is for anyone who is unsure what these are or how they work.

The UK was the first significant issuer of index-linked sovereign debt beginning in 1981. Details of the history and mechanics of the market are available from the Debt Management Office (DMO) website here. But the gist is as follows.

Gilts pay coupon interest semi-annually and repay principal on maturity. In an inflationary environment the real value of these interest and principal payments falls over time. So index-linked gilts, or “linkers”, have their coupon and principal varied in line with the Retail Price Index (RPI, the old measure of inflation, as distinct from the CPI measure which the Bank of England still officially targets).

Complicating things slightly there are two sorts of linker. The first, older variety lag RPI by eight months. This is to allow coupons to accrue on the basis of known values: a payment due in six month’s time will be based on the RPI print from two months ago (the additional month allowing for revision to the initial data release), so there is no uncertainty. Reflecting advances in technology, this type of gilt was superseded in 2005 by another which lags by only three months. This still allows for data revisions but by adjusting coupon and principal payments during accrual periods it follows RPI more closely over the life of the bond.

One further concept to mention is the breakeven inflation rate. This is the rate at which RPI would have to run to equalize returns between conventional and index-linked gilts of the same maturity. At present the benchmark ten-year linker yields -1.8% (these yields are always quoted in real terms). The ten-year conventional gilt yields 1.4%. So if RPI runs at 3.2% over the life of the bonds the linker will end up paying the same as the conventional. This tells investors about the relative value of the two types of security at different times, and about the market’s view on RPI inflation of course.

Index-linked gilts are the key securities for investors looking to protect themselves against UK inflation, as measured by the RPI. Of course in the event of RPI deflation then linker payments are cut rather than increased, which is something to bear in mind, as is the tax treatment: while gilt coupons are taxable as income any change in principal, including the full value of the indexation uplift, is completely tax free.

There are some index-linked corporate bonds in issue too. Like ordinary corporate bonds these pay a spread over government bonds to reflect credit risk and other things, but corporate linkers also track RPI in the same way as gilts. For individuals investing outside a tax wrapper, however, there is bad news. Unlike gilts, the principal uplift on corporate linkers is taxable – and taxable as income at that . . .

Of course the UK is not the only country to issue linkers. There is a sizeable French market, for instance. This offers bonds linked to two indices: the standard CPI and the CPI ex tobacco. Other eurozone countries also have index-linked government bonds in issue, which gives investors the opportunity to take views on respective inflation rates for different economies while bearing the same currency risk.

Some emerging market borrowers also issue linkers. Here, of course, currency volatility can be very high. But if inflation is imported on the back of currency weakness this benefits index-linked securities. In 2015 for instance the Brazilian real lost 49% of its value against the dollar. Year-on-year CPI peaked at 10.7%. And over the course of the year, the conventional government bond maturing in 2025 returned -8.1% while the 2024 linker returned 9.9%. For those interested in emerging market debt, then, there are times when indexation can be a helpful angle – where it is available of course.

Less exotically, the largest issuer of linkers is the US government by way of Treasury Inflation-Protected Securities (“TIPS”). The value of this market is currently $1.2trn (as against £603bn for index-linked gilts). TIPS seem to have found their strongest ever following at present. And not without reason: US breakevens from five years onwards are at about 2%, as against a 20-year average for CPI inflation of 2.2%. Should the US economy be entering a period of above average inflation, therefore, TIPS would offer value relative to conventional Treasuries – while giving dollar investors protection from the real-terms erosion of their wealth of course.

Index-linked securities are generally less volatile than conventionals, or thinking about this another way, even more boring. But there can be a place for dullness, or dependability, in portfolios. And in the event of a serious inflationary outbreak, linkers could well turn out to be the best bet in town. It is no coincidence that the British government first issued them on the back of a report from a committee that started work under Harold Wilson in 1977 – a short time after the oil crisis and a year over which UK inflation averaged 16%.

20/01/2017 at 6:39 pm

2016: By The Numbers

The year just gone was noteworthy for its political surprises. Events of great magnitude such as the Brexit vote, the election of Donald Trump and the collapse of the Renzi government might be marked “good” or “bad” according to taste; under “ugly” the threat of terrorism reminded us of its presence by way of some glaring atrocities in Nice and elsewhere. Markets, too, were haunted by fear for much of 2016. We began the year apparently convinced that the financial world would be eviscerated by a Chinese economic collapse, or sequel to the global banking crisis. But while they were haunted by fear markets were not to be governed by it – at least not exclusively.

After some periods of exceptionally high volatility most major stock markets closed the year higher. The S&P 500 returned +11.8%, the Nikkei 225 +2.1% and the Euro Stoxx 50 +4.4%. Leading the pack was the FTSE 100 with +18.6%, its highest return for any calendar year since its recovery post crash in 2009.

As many observers noted – especially those inclined to file Brexit under “bad” – this stupendous performance was to a large degree attributable to translation effects, with much of the large cap index’s earnings coming from abroad. (The FTSE 250 by way of comparison did +6.5% – nothing to be sniffed at but clearly not so much a beneficiary of the weak pound.)

And how the pound did weaken! It lost 16% of its value against the dollar, 14% against the euro, 18% against the yen and 15% against the Swiss franc, its worst performances since 2008.

The distorting effect of the currency on the return profile of international assets to sterling investors was accordingly enormous. The MSCI indices for the developed and EM worlds returned +8.0% and +11.2% respectively last year; in GBP terms those figures rocket to +28.9% and +32.7%.

Look at the EM equity markets individually and the effect was compounded in certain cases by currency strengthening on the other side. The Bovespa Index (Brazil) had a great rally in local terms anyway, up 39%. Since the real also had a super year its sterling terms return was +105%.

Brazil (and Russia) were helped by a recovery in commodity prices which had seemed unthinkable at the start of the year. Oil, whose price collapse had been so very influential, rallied strongly with the near Brent future rising +52.4% (+81.9% GBP). Natural gas did slightly better. The other start performer in commodity world was zinc, up 61%, reflecting renewed demand for steel in China. Other indicators of global economic activity also enjoyed a buoyant 2016 overall, with the Baltic Dry freight index up 101% and the WCI Composite (container) index putting on +65%. At the other end of the pile were some of the other base metals and gold, which did only +8.6%, despite some shows of promise during the year’s various periods of panic and confusion.

With risk assets having more than recovered themselves and energy prices up significantly overall, one might have expected the key bond markets to suffer. As indeed they did – but only into the closing weeks of the year. This turned out not to be enough to take the shine off the massive, record-breaking rallies they were able to set when the sky was falling in. The BofA ML conventional gilts index returned +10.6% last year, while their index-linked cousins trounced even the FTSE 100 with a return of +25.2%. Germany and Japan also saw positive returns (+4.1% and +3.3%), and even the US, where yields were boosted by Trump’s victory, saw an overall positive TR of +1.1% (or +20.6% in sterling terms).

Hard currency emerging market bonds outperformed on the back of spread compression to deliver +9.0% (reflecting a mix of dollar and euro exposure). But the real winner in the credit space, outperforming equity even in the positive year that was 2016, was high yield. The US HY index delivered +17.5% last year (+40.1% in GBP), with euro HY putting on +9.1% (+26.3%).

Finally, property. This was a mixed bag, depending not least on how one approached investing. Anecdotal fears of a negative Brexit effect into the summer were borne out by IPD data on commercial property, with UK prices falling by over 4% to September from their February peak. They recovered very slightly into year end, however, and with rental yield on top the asset class managed a positive total return of +2.6%.

If one had bought REITs rather than buildings, however, the story was different. Falling price/book ratios as sentiment deteriorated saw the sector deliver -7.0% – along with the Chinese stock market, one of the very few negative numbers delivered over the twelve months as a whole. Meanwhile, housing pursued a different path altogether, with residential property prices for the UK still rising at a pace of +6.9% over the year to October.

2016 was a truly extraordinary year in many areas, and asset class returns was one of them – especially for those of us with sterling as our reference currency. It started out as Armageddon, but as these numbers show, the hard thing for investors in hindsight would have been to avoid making money.

Does this mean markets are heading into the New Year with a false sense of confidence?

We will know for sure in another year’s time.

06/01/2017 at 6:47 pm

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