Review of 2018
Steady growth in asset prices over the previous two years has been supplanted by an environment of price volatility since the beginning of 2018. This article will consider the factors that have caused this and where it leaves investors as we look ahead to another year.
“Wall of worry”
Global stock prices were given a boost in 2017 thanks to tax cuts implemented in the US by President Donald Trump. By the beginning of 2018 the effects were beginning to wear off and investors had more negative considerations in mind.
These included international trade disputes, uncertainty in Europe due to negotiations between the European Union and two erstwhile member countries, rising inflation, reduced central bank stimulus, concerns that profit growth in the US had peaked, slowing economic growth in China, and the implications of falling bond prices.
Collectively these factors have been referred to as a wall of worry. We’ll look at each in turn.
Since the financial crisis a decade ago, central banks reduced interest rates and pumped cash into the financial system. This was necessary in order to ensure that companies and people weren’t suddenly required to repay massive loans or mortgages at the same time. Debt levels were too high for this to be possible, so the actions of central banks kept the financial system running.
One of the methods they used for this was to buy bonds that investment institutions held. The idea being that those institutions could use the cash from bond sales to lend to others. After a slow start, this began to register some success, but it had side effects.
One such was to increase the overall demand for and price of bonds. While this was beneficial for bondholders who watched some of their assets rise in value, it created an unnaturally high price for bonds.
The environment has changed and central banks are now reining in such stimulus measures.
In recent months, inflation has begun to rise across a number of regions. This is significant because most bonds pay a fixed annual coupon to bondholders, and the value of that coupon is eroded by inflation. If inflation rises unexpectedly, it can make bonds less attractive, sending their prices down.
What’s more, in order to keep inflation under control, major central banks have begun to increase interest rates and reduce their bond-buying programmes, bringing prices down further. Also, higher interest rates can make lower-risk rated opportunities, such as savings deposits, more attractive than some bonds, putting even more downward pressure on bond prices.
So bond prices have been under pressure. But this has had a significant effect on share prices as well in 2018.
Relationship with stocks
As the bond price is pushed down, the yield (the return on the investment) rises.
Twice in 2018 the rising yield on benchmark US government bonds, 10-year Treasuries, has risen sufficiently to draw investors away from higher-risk rated company shares.
On both occasions, this contributed to sharp falls in overall stock prices, so sharp that the benchmark S&P 500 stock index dropped by more than 10% from its previous peak. A drop of this magnitude is known as a correction.
It wasn’t just influences from the US that affected asset prices.
Uncertainty over the UK’s departure from the European Union has left investors guessing what sort of a relationship will remain when all is said and done. When investors have been more optimistic about the future prospects of the UK, the value of the pound has risen relative to other currencies. That has put downward pressure on some of the largest UK companies which generate significant revenues overseas: a higher value to the pound can reduce overseas sales or lower the value of profits that are repatriated into pounds. The reverse has also been true: when optimism has fallen taking the pound down with it, some major company stock prices have risen. The upshot is that uncertainty over Brexit has created turbulence in asset prices.
But the UK was not alone in its unpredictable future. Italy’s coalition government consists of a left-right alliance which has promised its country’s voters higher incomes and lower taxes. Unfortunately, the Italian economy is not sufficiently profitable to fund this expensive combination while also keeping the country’s huge debt burden under control.
Nevertheless, the Italian government submitted its budget complete with their projected deficit to fund electoral promises. Unfortunately for them, Italy’s proposed budget became the first ever to be rejected by the European Commission (EC). If Italy cannot produce a budget that the EC deems sufficiently viable in good time, it will face a suspension of funding on which the country relies to sustain its poorer regions.
In the meantime, the prospect of the Italian government having to raise more finance through bond sales to pay for its budget has increased the risk associated with the bonds it has already issued. That has pushed their prices down and their yields up.
This is bad news for the country’s banks which have to hold a minimum amount of cash and near-cash assets (e.g. government bonds) to hand. This enables them to cope with everyday transactions, i.e. it helps to keep them solvent.
If the values of those bonds fall too far, then the banks have to call in loans. A large chunk of those loans are non-performing, i.e. the borrowers aren’t maintaining repayments. And that leaves Italian banks in serious trouble.
So, falling Italian bond prices are bad news for Italian banks, bad news for the government and have negative implications for European economic stability, as well as undermining the value of pensions and other investment portfolios which hold government bonds.
While we anticipate the situation being resolved over the coming months, the uncertainty has added to asset price turbulence in 2018.
International trade disputes
Sources of turbulence have been truly global. President Trump’s administration in the US has implemented a range of trade renegotiations. While sometimes controversial, these are intended to address the trade imbalance that the US faces with its international partners. In short, the US buys far more from overseas than it sells, which the president is addressing through the imposition of tariffs and changes to non-financial trade barriers.
This has had what we consider to be an exaggerated effect on sentiment as the total trade volumes concerned are not sufficient to have serious implications for global trade (see our recently published 2019 Outlook).
Nevertheless, confidence in economic growth and asset prices across the US and China as well as the two countries suppliers have been affected. It will take time for these economic giants to find a mutually acceptable solution. Nerves will continue to fray and asset prices fluctuate until that solution presents itself.
One of the countries most likely to be affected by the US-China dispute is Taiwan. It has significant interests in the companies targeted by US trade sanctions. What’s more, its economy is dominated by the production of computer components, especially microprocessors.
But technology is also being affected by other forces. Technology giant Apple was reported to have slashed demand for component parts as sales failed to meet expectations. Meanwhile, Facebook was in the spotlight for breeches of data privacy protection. New rules could impede online companies’ ability to generate advertising revenue while also increasing the bureaucratic burden.
The technology sector has been instrumental in driving the growth of share prices in the US and beyond. With this sector beginning to show signs of weakness, the prospects of sustained profit growth in the US are looking less assured.
Has the rate of profit growth peaked?
The technology sector is not alone in appearing to have reached peak profit growth over the current economic cycle (i.e. the progress of an economy from growth to retraction and back to growth). All the factors that have already been outlined are contributing to a growing sense that the rate of profit growth across the spectrum of industrial sectors is likely to slow.
With inflation and interest rates rising, individuals and companies will have bigger debt burdens and less disposable income. Those factors tend to reduce spending which, in turn, affects profits and share price growth.
President Trump’s tax stimulus appears to have run its course. Now that the Democrats control the House of Representatives, the chances of the Republican president getting a further round of tax cuts through appears much less likely.
On top of that, as we have seen, central banks are reducing their stimulus measures, so there is less cash being pumped into the system.
All in all, then, it’s been a difficult year for investors as different forces have created an unpredictable ebb and flow of confidence. However, the data that we look at in our 2019 Outlook suggest that, while the rate of profit growth is likely to fall, economic growth ought to continue into the coming year. But the stable growth of economies and asset prices that marked 2016 and 2017 are not likely to return over the next year or two. A quick guide to our views on ‘What’s in store for investors in 2019?’ can be found here.
Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise. No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed herein.
Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions. Any views expressed within this report are our in house views as at December 2018 and should not be relied upon as fact and could be proved wrong. The information contained in this document has been derived from sources which we consider to be reasonable and appropriate. This document may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent.
Important Legal Information
Lloyds Bank plc. Registered office: 25 Gresham Street, London EC2V 7HN. Registered in England and Wales, no. 2065. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority under number 119278.