Global growth has become desynchronised and has clearly peaked. US growth remains firm for now but is expected to slow sharply in 2019 and there has been a marked loss of momentum in Europe and Asia, notably in China.
Inflation remains muted despite higher wage costs in several major economies. The big fall in energy prices last quarter should help keep inflation under control.
Central Bank monetary policy remains divergent. The US Federal Reserve Bank rate rising cycle is drawing to a close whereas the ever-cautious ECB is not expected to begin raising rates until the end of the year. UK interest rate policy remains Brexit dependant and clouded in mystery.
Most asset classes lost money in 2018 with big falls in the last few months of the year as equity markets well-nigh collapsed into year end. Investor sentiment has swung markedly from optimism to despair fearing a marked slowdown in global growth and earnings in 2019 and battered by the unremittingly negative political news flow centred on the US/China trade war and Brexit.
Equity markets are questioning whether the long-term earnings outlook and high valuations of certain sectors, notably US technology, are sustainable in an environment of higher interest rates and slower global growth.
Equity market valuations are now more supportive after the heavy falls in share prices. There is still potential for upside in equities, but the uncertainty over US monetary policy and the political clouds regarding trade tensions and Brexit need to lift.
Government Bond yields fell sharply into year-end as they began discounting a pronounced slowdown in growth. This may be premature, but we do not expect bond yields anywhere to be significantly higher than their 2018 peaks and the 10-year US Treasury yield has in all likelihood peaked for this cycle.
Credit spreads have widened considerably in line with bearish investor sentiment such that Corporate and High Yields bonds continue to underperform Government Bonds.
The US dollar strengthened last year which was a negative for several asset classes, notably the Emerging Markets and commodities. EM currencies have been weak.
Commercial Property remains resilient but is a yield rather than a capital growth story at this mature stage of the cycle.
The oil price collapsed back to US$53/bl by the end of the quarter whilst Gold strengthened into year-end as a ‘safe haven’ asset.
In the eye of the storm
Last year was challenging, miserable, and ultimately shocking for investors. It was the worst year for a decade with virtually all asset classes losing money and big falls in equity markets during the final quarter of the year. This climaxed with wild swings over the Christmas period as President Trump picked needless arguments with Congress and the Federal Reserve Bank and in doing so shattered the already fragile market confidence. There has not been a radical change in economic data and earnings growth, but investor sentiment has swung from complacent in the summer to despair by Christmas. The reasons for the compounding gloom are essentially threefold; tighter Central Bank monetary policy, a sense that global growth and earnings are set to slow markedly, and the unremittingly negative political news flow centring on Trump, the US/China trade war and Brexit. Markets are discounting mechanisms and are currently taking the gloomiest of views. The concerns are real and are still ahead of us but one of the oldest stock market clichés is ‘markets climb a wall of worry’. While it doesn’t feel like it at the moment, stock markets can still produce positive returns should the economic or political news flow show some improvement.
Macro…. Down, but not out
Global growth has become divergent; the US remains firm for now at least but growth has slowed in Europe and Asia, notably in China. The US is surfing on the Trump tax cuts but this wave won’t last forever and tighter monetary policy and waning fiscal support will cause growth to slow this year, possibly quite sharply though not we think to the point of recession as financial markets currently fear. Higher US interest rates and the stronger dollar are impacting global growth, most notably in Asia and the Emerging Markets with the trade tariffs a further headwind. Europe’s promise of a growth renaissance proved illusory with the old continent slipping back to its sclerotic ways whilst Brexit haunted Britain remains in the slow lane. Wages are rising in developed economies but inflation remains muted, helped by the big falls in the oil price last quarter.
Central Bank monetary policy takes its cue from domestic economic strength and so is also divergent with the US Federal Reserve reaching the end of its rate rising cycle whilst everywhere else has barely begun. The Fed raised rates four times last year to 2.5% and is signalling just two rises this year but even this relatively dovish tone is considered too hawkish by the markets who are signalling a sharp slowdown in growth and fear that further rate rises will push the US into recession. The ever-cautious ECB is fretting over the slowing momentum in the Eurozone economy and the risk of rate rises on the fragile European banking system. Draghi finally ended his QE bond buying programme in December but even the smallest of rate rises is still a few quarters away. In the UK the sheer unknowns surrounding Brexit will keep Mark Carney in the most watchful of moods. Interest rate rises in the UK are possible this year, but only if there is a smooth Brexit which is looking increasingly more problematic. The only player still priming the printing presses is Japan where the BoJ continues to forge on with its massive monetary stimulus.
Thank you as always to Schroders for their latest batch of consensus economic forecasts which show that growth is expected to have peaked last year before tailing off, though only gradually, into 2019. Rather excitingly, I have added an extra column this quarter showing Schroders own forecasts for 2020 (no consensus numbers yet available) to highlight the sharp slowdown forecast a further year out, notably in the US. All in all, there is now a wider and less predictable range of possible outcomes which is increasingly unsettling markets.
Markets…. Down in a lift
Last quarter I referenced a few lines from one my favourite poets WH Auden to compare the current political backdrop to that of the 1930s. Life follows art and last month turned out to be the worst December on Wall Street since 1931 as stock markets collapsed into year-end. Markets have become very emotional, with small changes in fundamentals and news flow leading to wild swings in share prices. As the cliché says ‘Markets go up on an escalator but down in a lift’. There are a number of reasons why investor sentiment has changed so markedly from complacency in summer to despair by Christmas, well worth bullet pointing for emphasis
- Central Banks, led by the US Federal Reserve, are now tightening monetary policy which is a headwind for risk assets like equities. Higher borrowing costs also expose and endanger lower quality, highly leveraged, higher risk investments.
- Investors are suddenly taking a much more negative stance on global growth and beginning to price in a very sharp slowdown in the US and faltering growth in China.
- Markets have decided that the earnings cycle has peaked and have begun to doubt the long-term growth prospects and high valuations of the stocks which had driven the bull market, notably US technology.
- The political news flow has been unremittingly negative centred on Trump, the US/China trade war, and ongoing Eurozone dysfunction with most palpably Brexit but also including Italy and France. We are moving from decades of globalisation, free trade, democracy and co-operation into a rather meaner feeling one of nationalism, protectionism, confrontation and autocracy.
These changes mark a reversal in the strong headwinds (improving growth, abundant liquidity, globalisation) which had been powering the market upwards over the last ten years. With sentiment quickly turning bearish, financial markets behaved in classic ‘risk off’ mode last quarter. Equities got hammered but Government bonds produced a positive return, outperforming investment grade and high yield bonds where credit spreads widened. Gold showed some strength as did the ‘safe haven’ currencies the yen, Swiss franc and US dollar. The greatest victims of the last quarter sell-off were the almighty technology stocks, dashing investors’ hopes that they were immune to the laws of gravity. The ones you love are always the ones that hurt you the most. The sector had driven the markets for years but higher interest rates call into question their extended valuations whilst slower global growth will impact the earnings of even the previously impregnable Apple, Amazon et al. The share prices of the tech behemoths fell by around a third, pulling Wall Street down with them. At a regional level, Europe and Japan got clobbered as ‘global cyclicals’ despite the increasingly attractive valuation of the latter.
The markets are currently factoring in close to ‘worst case scenarios’ on the both the economic and political fronts. There are though some chinks of light in the unremitting gloom. The US Federal Reserve Bank has indicated that their rate rising cycle is nearly over (though not as over as markets would currently wish!) and a more dovish policy should weaken the dollar which helps Asia and the Emerging Markets. The strong oil price had been a major headwind to both households and business last year but fell precipitously from US$80/bl to YS$53/bl in the final months of the year. This is significant as each 10% fall in the oil price adds around 0.3% to global growth. The political news flow continues to worsen though with Trump ranting against all and sundry and Brexit proving the circle it is impossible to square. While all appears lost at the moment, any sense of improvement could be the catalyst for a sharp rally in stock markets.
The one thing that has improved is valuation. Equity markets are now much cheaper with a forward P/E of 15x for the US, 12.5x for Europe, and 10.5x for EMs. The UK, trading on 11.5x forward earnings and with a dividend yield of nearly 4.5% offers a level of valuation support it hasn’t had for a number of years. Our sense is that we are unlikely to enter a full-blown bear market as global growth and corporate profits, though moderating, will avoid the recession that the financial markets appear to be already signalling. We have though entered the late stage of the bull market cycle where there is far greater uncertainty and with optimism struggling to overcome pessimism. In this environment equity markets can still produce gains, but with a far greater volatility and sense of unease.
You’re fed up reading about Brexit, I’m fed up writing about it but we can’t ignore it. Suffice to say, the UK stock market hates the idea of a hard Brexit, so too sterling which has plummeted to the lows it saw back in summer 2016. There has been a marked differential in the performance of individual stocks with domestics (banks, retailers, homebuilders) being absolutely mullered whilst the mega-cap multinationals whose earnings are enhanced by the falling currency and are considered a bit more ‘safe haven’ have fallen less. Gilts have been sanguine, seen as a ‘risk off’ asset and yields have fallen alongside those of other global bonds as markets obsess about a sharp slowdown in global growth.
Beyond this there is little to say. Markets are looking for certainty and an outcome that keeps the UK as close to possible to the EU in terms of economic relationship and is the least disruptive for business, something that obviously isn’t happening at the moment! A no-deal Brexit will see the current painful trends extend, especially so if the end game is Corbyn in No.10 at which point Gilt yields may take fright as well. Any sort of ‘soft’ Brexit deal, or indeed postponement, will likely see a reversal with strong rallies in sterling and the stock market.
Throughout the process we have tried to manage client portfolios through whatever form Brexit could possibly take rather than trying to second guess what this form will be. The range of Brexit outcomes has been uncomfortably wide and the balancing act has been to protect assets against a disastrously hard Brexit whilst retaining the capacity to benefit from the opportunity afforded by the cheap valuation and high dividend yield of the UK equity market. Our ‘defensive’ UK larger cap funds haven’t done too badly, the more domestically oriented smaller cap UK funds we hold have been absolutely hammered, and for this we apologise. The hope is that having suffered the most, these funds have the potential to gain the most from any respite from the misery.
Trade tensions continue to simmer between the world’s two great superpowers. Tariffs are bad for global growth as China is the world’s largest exporter, third largest importer and is integral to global manufacturing supply chains. China imports vast quantities of Australian minerals, components made in Singapore, Taiwan, and South Korea along with shiploads of cars and machinery from Europe. The trade war is actually more nuanced than just the bluntness of tariffs with issues such as China stealing US technological intellectual property being more important in the longer-term. Trump’s objective is to very publicly (and vote-winningly) confront China whilst restoring some jobs in domestic US manufacturing. The key driver of trade policy will be the extent to which Trump thinks he is inflicting damage but suffering none in return. Public opinion is currently right behind Trump but this may change quickly if tariffs begin to impact US jobs, profits and prices. China will be happy to take the long view and sit out the Trump presidency and is already making more conciliatory noises as the year ended, feeling it has enough internal economic problems without looking for more trouble externally.
Fifty Shades of Green
ESG (Environmental, Social and Governance) is the current ‘big thing’ in investment management, or actually the repackaged big thing of 15 years ago SRI (Socially Responsible Investing), in itself a repackaged version of Ethical Investing which is the old-fashioned term I still prefer. This makes me sound a bit cynical which in fact I’m not. Two Generation Z daughters (daren’t say Generation Snowflake!) ensure I live in a very environmentally and socially aware household with world leading recycling, halloumi superbowl for dinner, and a zero-tolerance approach to any prejudice, apart from against Chelsea of course. Professionally I used to work for Friends Provident where I once managed the International fund in the Stewardship range, the original (and best!) ethical proposition. Our knowledge base on ESG investing is actually quite high and though not a DFM proposition, we do have an Ethical Model Portfolio for advisory clients. ESG investing is a bigger debate than just the ‘feel good’ ethical considerations. Proponents will argue that irrespective of the ethical benefits, companies that follow an ESG philosophy will benefit from improved revenues and profits over the longer term. Cynics will claim that ESG portfolios are just virtue-signalling tokenism, a marketing tag added to a portfolio that is barely distinguishable from a traditional portfolio. There are many shades of green and it is important to differentiate between ‘negative’ screening (or ‘greenwashing’ to use the current buzzword) which excludes animal testing, weapons, tobacco, gambling etc. and ‘positive’ investment centring on sustainability and impact factors such as renewable energy, conservation, and affordable and accessible basic services. It’s quite a debate and something we may return to in a more substantial note in a later newsletter.
Scores on the Doors
This doesn’t make pretty reading at all with only Commercial Property and a late rally in Government bond prices preventing negative returns from all asset classes, something you rarely see in any year. Pretty much all the damage was done in the fourth quarter, with the biggest turnaround in US equities which saw a double-digit year to date gain at the start of the quarter become a small loss by year end for sterling-based investors whose return was at least enhanced by a 6% gain the dollar. UK investors in Japan gained a similar benefit from the strong yen which protected them to some extent from the near 20% fall in the Japanese TOPIX index. At a sector level, safer havens healthcare and utilities produced a positive return but most everyone else got whacked, most notably the financials and cyclical sectors such as materials and industrials. As discussed earlier, the technology sector went from penthouse to outhouse in a New York minute. Government Bonds benefited from a ‘risk off’ trade in December to at least achieve parity for the year whilst our Absolute Return funds continued to underwhelm. On a happier note, the ‘bricks and mortar’ Commercial Property funds eked out a 4% return, a classic case of tortoise and hare.
As investment managers we always caution against placing too much reliance on the accuracy of economic and market forecasting. Nevertheless, we consider we usually have a pretty good handle on how the world is panning out in a general sense, affording us a feeling of some reassurance and control. This is why 2018 was such a horrible year for investors; falling markets are bad enough but falling markets driven by irresponsible and self-interested politicians resulting in multiple and widely divergent possible outcomes, some of them truly awful, lessens this control significantly making nervous and anxious investors out of all of us.
In the short term it is difficult to see the markets making much progress until they have more clarity on US monetary policy, US-China trade relations and Brexit. On the first two some there could be some light at the end of the tunnel. The Federal Reserve will be watching economic data and capital markets closely and has already indicated that the interest rate rising cycle is coming to end. Something will eventually happen with Brexit, though I am as clueless as everyone else as to the form it will actually take. As a consequence, there is plenty more volatility ahead of us sadly with a continued risk to capital. However, economic fundamentals are maybe not as bad the market is currently discounting and valuations are now more supportive. Last year opened with markets in a mood of optimism that proved hopelessly misplaced. This year is opening with markets in the grip of despair but hopefully as the year progresses this too will be seen as being equally wide of the mark. While more wild swings are probably a given, financial markets can still generate positive returns in 2019.