No Hiding Place

30 Jan No Hiding Place

We titled our last market commentary “Why volatility might be the new normal” and so the suggestion proved prescient. We discussed the fact that the first half of 2018 was volatile, but at the half way point, markets were showing a slightly positive return. The second half of the year was anything but ……

By the end of the year, all major global stock markets were in negative territory, with China at the bottom of the league table, slumping by more than 25%. Markets suffered much of the damage in December to cap off what was the worst year for equity markets since the financial crisis. We also said in our last report that there was a long list of concerns weighing on investors’ minds, with potential for a slow-down in world economic growth, trade war talk, policy error risk and of course the dreaded Brexit uncertainty.

We noted that a diversified approach would best suit our clients and indeed referencing ‘Modern Portfolio Theory’ as propounded by Harry Markowitz in 1952, suggests it is possible to create a blended portfolio to obtain the optimal return for a given level of risk. At the heart of this lies ‘correlation coefficients’, or more simply put, blending assets with different behavioural characteristics to help smooth returns. What we actually witnessed in 2018 was something approaching convergence of returns, where most assets fell, and this impaired the benefits associated with diversification. Whilst periods of synchronised downturn have been seen before, it is unusual, but when it has happened in the past, it has generally been followed by years exhibiting a more normal dispersion of returns.

2018 was an odd year for the US equity market, with the initial outlook seemingly positive but any gains being extinguished as the year drew to a close. President Trump had been typically self-congratulatory, for the surge in US Equity markets since his tenure began and remained in bullish form regarding the December fall, which was amongst the worst of all time and certainly since the Great Depression of 1931. He said “We had a little glitch in the stock market last month, but we’re still up about 30 percent from the time I got elected………..It’s going to go up once we settle trade issues and a couple of other things happen.” As simple as A, B, C Mr Trump !

He sought to place the blame for the market malaise squarely with the Federal Reserve (Fed) as he believed they were tightening monetary policy too rapidly. Whilst he may well have a point, he was less vocal about the impact of trade tensions with China, where he is the major protagonist. It is clear the Fed has been committed to policy normalisation over 2018 and in December Jerome Powell (the Fed Charmain) suggested that the reduction of the balance sheet known as Quantitative Tightening (QT), remains on “Auto Pilot”. But following a very poor year end for financial markets, he has recently been at pains to suggest there is some flexibility on both QT and interest rate policy.

The world is very concerned that although the strength of the US has led the global economic recovery, it may now be running out of steam or potentially reversing altogether. It is true US Corporate earnings could slow albeit from very elevated levels and the US market may still look a little toppy even after the correction, but this is very sector specific. Those sectors perceived to be stable (utilities and healthcare for example) have held up better than the likes of financials or direct energy stocks, which have been hardest-hit. But it is not all doom and gloom: Mastercard reported that festive trading in the US leapt 5% compared to 2017 and we expect consumer activity to underpin growth in the US during 2019. The elephant in the room remains the extent to which the ongoing trade war between the US and China plays out. Similarly we must also be aware of the possibility of a prolonged US Government shutdown as Trump looks unlikely to clear the huge sum (circa $5bn) to fund his much coveted wall.

Moving to the UK, at the time of writing Theresa May’s much maligned Brexit deal has been voted down, but yet her Government has won a confidence vote. We do not believe that we are necessarily any closer to seeing a version of that deal ratified, but we are closer to the 29th March and the unwanted prospect of a cliff edge Brexit, despite protestations from all sides that this is to be avoided. It is extremely difficult to assess whether the stories surrounding significant preparations for no deal are scaremongering, but what we can say is that neither the UK nor the EU will, in all honesty, wish to progress with no deal. We have written at length about the Brexit outcome or at least the potential impact of various outcomes but with so many moving parts it is difficult to assess where we truly are but with the passing of time some clarity may arise.

The broad FTSE All Share had an awful year, down 13% in price terms which was softened by a reasonable dividend yield to take the total return to -9.5%. This represents the worst return since the height of the financial crisis in 2008 which saw the same index fall by 33%. The last major negative year we saw was in 2011 when at its worst, the All Share was down 17% but recovered some ground to finish down 7%. 2018 bore witness to a not-dissimilar pattern, at its worst crumbling to a 17% fall but ending down 13%. It is worth noting that in the years following 2011 the UK market returned 8% and 17% respectively.

Whilst it is extremely difficult to pinpoint the short term direction of markets, what we can say is that the UK, which seemed undervalued previously, certainly looks so now and with the forward price to earnings ratio well below the 30 year average, there should be opportunity in the UK, once some of the immediate uncertainty clears. We have talked about the relationship between Sterling and the FTSE 100. The currency has become a barometer for the success of Brexit negotiations, fluctuating with each step of the process. The Monetary Policy Committee elected to hold rates citing that increasing uncertainty surrounding Brexit presents a real threat to the UK economic outlook.

The MSCI Europe Ex UK index fell sharply last year. European markets are not only plagued by geopolitical uncertainty but also by political issues at home. We commented on the receding of the populist parties in Europe last year, but that threat has not evaporated and with European parliament elections in May, we could see the rise of Eurosceptic parties taking a larger share of the vote. The budget submission in Italy may have headed off the emergency measures that would have been forced upon them, however, it is worth remembering that France has been in equivalent monitoring for 15 out of the last 17 years. Indeed potential for ongoing political protest, such as the Gilets Jaune, may weigh on markets in Europe.

In Asia, markets suffered a similar fate to their western counterparts. The Asia Ex Japan index was down 10% on a total return basis as was the Japan index, both in Sterling terms. Chinese authorities seem to be attempting to stave off slowing exports by encouraging domestic infrastructure spending through local government bond issuance and as we have previously stated the authorities should be able to engineer a growth rate of circa 6%.

For emerging markets, slowing global growth and the US/China trade war have had an impact, but this was much less severe than in developed markets. Emerging markets are often a hostage to the fortunes of the dollar, where a strong currency tends to have a negative impact. We think 2019 might provide some respite as any slowdown in the US, could see some slackening in the dollar, benefiting emerging markets. This prognosis could be unhinged if economic activity in China were to lurch much further downwards.

Bond markets did provide a little comfort but not to any real degree. Government bonds were the standout but Investment Grade and Emerging Market Debt also produced some small positive returns. We have spoken about the tapering of quantitative easing and the cessation of bond buying programmes, along with rising interest rates and inflation, being negative for bonds and whilst 2018 did not perhaps demonstrate the risks associated with bond markets, we just do not see an investment case for building up our underweight exposure.

So whilst the rhetoric appears to point to the risks being greater than ever, we believe the global outlook would need to worsen significantly from here before investors would be better off in cash or bonds than equities. To reinforce this point, it is worth giving the final word in this section to the doyen of the investment world, Warren Buffet, who famously said ‘’be fearful when others are greedy and greedy when others are fearful”. We suspect with so much fear out there, those prepared to take a longer term view will be amply rewarded.