Near-term market sentiment: Confident, with the S&P500 holding on to last week’s new highs thanks in part to yesterday’s release of stronger than expected China second quarter GDP data.
Janet Yellen’s testimony to Congress last week demonstrated a more dovish view on future interest rates than we have seen of late, which was justified later when U.S inflation data showed CPI stuck at 1.7% y/y. Consequently the interest rate futures market is now suggesting no further hike in Fed rates this year. Therefore, whichever risk free rate we use as investors will remain low and relatively unattractive compared to the expected total returns from stock market investments and other risk assets. As I have said before, any market correction over the coming months is likely to be met with investor buying and a swift recovery thanks to three on-going supportive themes: rising corporate earnings growth, a reduction of geopolitical risk, and continuing very loose monetary policy from central banks.
Sterling appears trapped between a falling dollar and stronger euro, as explained below. This situation likely to persist over the coming months. Weaker U.K economic data will reduce the likelihood of rate hikes from the Bank of England, perhaps putting downward pressure on the currency, but the ever-softening position of the U.K government on Brexit negotiations is supportive (eg, a growing acceptance of the need for a transitional arrangement to be in place from April 2019).
Dollar/ Sterling. The GBP fell after the U.K election result, but has since been stronger than expected against the USD, currently trading at $1.310 (on the 18th July). This is a little more than a cent and a half than before the U.K election in early June. There are several political themes helping sterling. First, the U.K election reduces the risk of a hard Brexit because it has delivered a much reduced majority for the ruling Conservative party. The majority of MPs are thought to be ‘remainers’, who now have the ability to vote down Brexit-related legislation in the House of Commons. Furthermore, the risk of Scottish independence is now reduced, after the Conservative party won 12 seats in Scotland (from one in the 2015 election) after running a strong campaign against a second Scottish independence referendum. Currency traders, gilt investors and other investors in sterling assets are not by definition pro-E.U and pro-Union, but they dislike any political and economic disruption that carries risk.
Second, having peaked at a multi-year high on 28th December, the dollar has been steadily falling this year on a trade weighted basis and is now down 5.5% since that peak. This reflects lower U.S economic growth forecasts, as it appears that Trump may struggle to get both his supply side measures through Congress (eg, tax simplification and business de-regulation), and his Keynesian fiscal ‘pump priming’ measures of tax cuts and infrastructure spending. GDP rates of 3%-4% over the coming years now look unrealistic, and with that inflation and Fed rate hike expectations have been reduced. Indeed, Yellen last week pointed out that ‘normal’ interest rates in the future may be only a percentage point, or less, than the Fed’s current target rate of between 1% and 1.25%.
Euro/ Sterling. The GBP has fared worse against the euro, which is currently at EUR 1.137, a euro cent lower than before the U.K election. This reflects a run of relatively strong euro zone economic news, efforts by the ECB to convince the markets that its bond purchase program may be curtailed in light of rising inflation, and a sense that French President Macron will help promote fiscal union within the euro zone, which is needed for the long term future of the single currency. The ECB’s nominal effective exchange rate is up 4.0% since 28th December.
A balanced fund for the long term. A typical long-term balanced portfolio based around 60% global equities and 40% global bonds. Financial history shows this combination to offer good returns relative to risk (ie, volatility). Investors should try to be as diversified as possible, perhaps using the 60/40 model as their guide. Multi-asset funds based on this principle are available, often with different ratios of bonds and equities depending on the level of risk suitable for an investor. Note that the neutral weightings for the long-term investor, it does not incorporate the near-term weighting suggestions of the previous paragraph.