Tactical Asset Allocator: sterling a worry, but US earnings strong

For UK investors, the volatility in the sterling/dollar exchange rate is a major concern. With this in mind, Ceri Jones has hedged the S&P 500 dollar exposure.

Stockmarkets around the world enjoyed their strongest start to a year for three decades. The S&P 500 index rose 7.8% and 3% in January and February respectively, the best first two months of any year since 1991. That run was broken in the first week of March, as stockmarkets fell on disappointing economic news, particularly US jobs data, downward growth forecasts from the OECD, and the announcement that the European Central Bank feels the need to launch fresh stimulus.

Of all markets, the UK remains the best prospect for an opportunistic play on equities, with the prospect of a post-Brexit sigh of relief and solid fundamentals evidenced by data such as the best UK services PMI survey for four months.

The stockmarket has viewed the Brexit mayhem as a stark option between a vote to extend Article 50 or to leave without a deal, and the prospect of the latter has hammered sterling in recent weeks, which in turn for a while drove FTSE 100 outperformance. However, since it has become clear that parliament doesn’t want a no-deal, sterling has begun to rally and could strengthen further. Morgan Stanley for example believes the pound will rise to $1.36 against the dollar.

This matters to investors because returns from overseas holdings are converted back into pounds at the prevailing exchange rate. For instance, if the shares of a US company rise in price from $10 to $11 so there is a gain of $1 per share, but the dollar depreciates 10% against sterling during the period you own the share, your gain would disappear.

It could therefore make sense to switch the portfolio’s iShares S&P 500 ETF into the sterling-hedged version, GSPX, which was launched last July. If the currency exposure is fully hedged and sterling bounces, investors will still receive the full benefit from any rise in the stocks held.

Credit to the Fed

Over the pond, the US Federal Reserve’s new patience mantra can take a lot of the credit for the storming first two months of the year. Fed chair Jerome Powell clearly wants to follow a wait-and-see approach in the wake of the stock meltdown in the autumn, lower global growth and the US government shutdown which has dented consumer confidence and spending.

His argument is that the US economy has yet to feel the full impact of the Fed’s four rate rises last year.

This patient stance will help US small caps in particular, as they tend to carry greater debt than their larger, more established peers and are more sensitive to interest rates. However, the central bank has not abandoned its plan to revert eventually to more normal interest rates, so it may only delay the pain for tiddler stocks. We will be watching this closely as we have a holding in iShares S&P SmallCap 600 ETF.

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Tactical Asset Allocator portfolio holdings


Trade tensions focus

Last year smaller companies rallied, because they were seen as more resilient than international companies that tend to be relatively badly affected by trade disputes between the US and China. Progress on trade talks remains the main talking point of international markets, much more than Brexit or a possible impeachment of president Trump. For example the International Monetary Fund (IMF) cited trade tensions as the main factor when it downgraded its global growth forecast for 2019 to 3.7%, cutting 0.2% from its earlier forecast. Yet the underlying fundamentals remain good. Goldman Sachs for instance does not foresee any recessions in major economies in 2019, although its house view is that earnings growth will probably be on the low side. It is predicting profit growth in the US of about 6% this year, a big reduction on the 23% seen last year (though much of that was inflated by the tax breaks), and 4% in Europe, which is quite healthy.

Arguably, one concern about the US/China trade talks is that the market seems certain the dispute will be resolved, leaving room only for a sharp, negative shock, although any slump in shares would probably be limited to around 10% rather than a wholesale meltdown.

Equally, the market is shrugging off the sudden end to Trump’s talks with North Korea’s Kim Jong-un, and ongoing tensions between India and Pakistan. The second summit between Trump and Kim Jong-un ended without any deal, and is at an impasse over the North Korean leader’s refusal to abandon the country’s nuclear programme unless the US takes “genuine measures”.

North Korea initially dismantled its nuclear testing site at Punggye-ri and announced a moratorium on nuclear tests and intercontinental-range ballistic missile tests. But Kim Jong-un is holding out the winding down of nuclear facilities at Yongbyon as an example of something the North would put on the table in exchange for “corresponding measures” from the US, in essence demanding the US agree sanctions relief up-front before any further concessions on denuclearisation.

This is not something Trump could agree to even if he wanted, as UN sanctions cannot be removed until complete and irreversible dismantlement of North Korea’s nuclear programme takes place and human rights are improved.

For now, despite such huge political uncertainty, the S&P seems marginally more willing to focus on good news such as the results of the ISM non-manufacturing PMI survey, which point to greater growth in the services sector.  Recent market stutters seem to be just a pause after the extraordinary last few months, rather than the mouth of a new bear market.

The S&P 500 has suffered eight bear markets – defined as 20% slides from a recent high – in 60 years, which is about one every 7.5 years, so the analysts keep saying one is overdue. However, over 96% of S&P 500 companies reported positive surprises in their fourth-quarter earnings, according to Factset. Earnings per share (EPS) expanded by over 13% compared with last year. If earnings continue to hold up, nothing else will much matter.

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