Investment Strategy:  Fourth Quarter – General Market Review


  • Global growth remains firm, led by the US, but there has been some loss of momentum in Europe, China and the rest of Asia. There is likely to be a gentle cooling in the coming quarters as the extended business cycle matures and policy support fades, but no signs of an imminent recession.

  • Inflation remains muted despite tight labour markets in several major economies and rising energy prices this year.

  • Central Bank monetary policy remains divergent. The US Federal Reserve Bank is gradually raising interest rates, the UK is ‘one and done’ for this year whilst the cautious ECB is unlikely to raise rates until the end of 2019.

  • The outlook for the UK economy remains downbeat with growth subdued as the Brexit cloud continues to hover.

  • Fundamentals continue to support equity markets with broad based economic growth, muted inflation and strong corporate earnings. However, much of this good news is already discounted in share prices and the rise in bond yields represents a headwind to continued asset price appreciation.

  • Geopolitical concerns are intensifying and becoming the major driver of financial markets. Trump, trade wars, Italy, and emerging market distress centred on Turkey and Argentina dominated market sentiment in the last quarter.

  • Brexit and its imponderable outcome moves ever closer and can no longer be ignored by the markets. Expect more volatility in UK assets.

  • There has been a wide disparity in regional equity market returns this year; US firm, UK and Europe flat, Asia and Emerging Markets weak.

  • Government Bonds yields continue to drift higher but we do not expect ‘peak yields’ to be significantly higher in this interest rate cycle, especially in the US.

  • Credit spreads have widened such that Corporate and High Yields Bonds are underperforming Government Bonds.

  • The US dollar has strengthened markedly over the last six months which has been 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.

  • Valuations across all asset classes remain extended which is likely to suppress portfolio returns in the coming years.

  • Oil remains firm, breaching the $80/bl barrier whilst Gold has stayed weak in the face of the stronger dollar.

Facing up to the music…

I titled the Q2 newsletter ‘Wake-Up Call’ so there’s a bit of a theme developing here as the chill autumnal winds begin to blow through the markets. The global economy and corporate earnings remain in good shape but there are some sweeping multi-decade trend changes taking place in Central Bank policy and geopolitics that are presenting new challenges. This year has seen a big new negative with the imposition of US trade tariffs and for the first time in several years there has been distress in parts of the emerging world, notably Turkey and Argentina. Against this background the markets have become more nervous and volatile with minimal returns except from the seemingly impregnable Wall Street which marches on regardless. The UK stock market has its very own bullet to bite; having tried hard to ignore Brexit because it is just too difficult to compute the inexorable passing of time means that March 2019 is now just around the corner and eggs are about to be smashed all over the kitchen as investors are presented with, well whatever they will be presented with. In the end piece to this newsletter I make an attempt to explain how markets may react (caveats, guesstimates, provisos, disclaimers etc.)

Macro – past the peak

Global growth remains firm but is starting to lose a little momentum as it faces an increasing number of headwinds; tighter monetary policy, a stronger US dollar, firmer oil prices, escalating trade friction and some emerging market distress. The locomotive remains the US, powered by the sweeping new Trump tax cuts with both business and consumer confidence buoyant and employment growth strong. Growth though is moderating in Europe and Asia, Brexit haunted UK remains stuck in the slow lane whilst, most significantly, China looks to be cooling. Inflation remains muted with modest wage growth but in the US in particular this remains around a tipping point level which could lead to more hawkish Fed policy. Much is being made of the US expansion being amongst the longest on record but it has also been the shallowest. Economic cycles normally end because of aggressive monetary tightening but this time round the Fed has moved slowly in response to the slow economic recovery and cleverly guided the market so as to avoid any nasty surprises. The cycle will end eventually but not imminently, with consensus thinking seeming to pencil in a recession in 2020.

Central Bank monetary policy has become increasingly divergent with a proactive Fed but a cautious ECB. The US is by a distance furthest down the tightening track with eight 0.25% interest rate rises since 2015 with another one likely to follow this year and up to three next. By this point the Fed Fund rate would be at 3.25% with the expectation that the economy would be cooling down, making this the terminal Fed Fund rate for the cycle. If this were not the case and more rate rises were needed then bond markets could become rather jittery. Other countries lag well behind with the Bank of England probably ‘one and done’ this year and the dovish ECB currently still tapering its QE policy which it will finally end in December, with no interest rate rises on the horizon until the second half of next year. The Bank of Japan continues to forge on with its massive monetary stimulus by buying as many bonds as necessary to keep the 10 year JGB around 0%.

The trade tariff wars are a constantly changing battlefield of rhetoric and action and vast amounts of ink have been spilled trying to quantify their effect. This is task of Herculean proportions and all you need to know is that the historical precedent is one of lower growth  and higher inflation. Trump talks of trade wars being ‘easy to win’ because he is backed up by the stats which explain why the US is the aggressor – exports as a percentage of GDP are USA 12%, China 20%, UK 30% and Europe 44%.The hope is that Trump is playing to the crowd ahead of the US mid-term elections in November and that tensions will ease markedly afterwards, the worry is that he isn’t and trade war instead escalates. Sadly the latter appears more likely as relations with China in particular become ever more fractious and dangerous both economically and politically. With its ‘Made in China 2025’ programme to be the world’s top producer in a number of key new industries China has failed to heed its own proverb ‘don’t be the highest nail’, hugely irking Trump and making US/China trade the key battleground with neither side wishing to lose face. Trade wars don’t usually make much sense, especially in this complex world of multinational companies, offshore production and global supply chains but sadly sense will probably be in short supply.

Thank you as always to Schroders for their latest batch of consensus economic forecasts which show that growth is expected to peak this year before tailing off, though only marginally, into 2019. All in all, there is now a wider and less predictable range of possible outcomes which is increasingly unsettling markets.

Markets – the turning tide

I sit in one of the dives on Fifty-Second Street, uncertain and afraid As the clever hopes expire, of a low dishonest decade

Investing has been a trickier game this year with only Wall Street producing decent returns. From 2009 to 2017 the secret was just to remain invested as markets were driven by two huge tailwinds, Central Bank liquidity and recovering global growth. The challenge now is both in the long and short term as the ‘everything is getting better’ trade draws to a close. Looking at the ‘big picture’ there is a gradual reversal taking place with major trends turning from tailwinds into headwinds. The Central Banks led by the US Federal Reserve are moving from loosening to tightening, interest rates and bond  yields are rising and the dollar is strengthening, all typically a negative for risk assets. At a geopolitical level 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. One is reminded of W.H.Auden’s description of the 1930s. These trend reversals are long term however and stock market fundamentals for now are still pretty supportive; growth and earnings momentum may have peaked but they are still pretty robust and valuations are by no means excessive. It is the short term that is problematic with the cats amongst the pigeons being political rather than economic encompassing Trump, trade wars, Italy, Brexit and the re-emergence of that old chestnut ‘the EM crisis’ with Turkey and Argentina in distress. Investors have felt increasingly uncomfortable and uncertain this year and this has been reflected in flat and sometimes falling equity markets. Over time stock prices follow earnings and until we get a much stronger sense that an economic slowdown is appearing on the horizon we remain ‘constructive’ on equity markets; stock markets historically have peaked six months before a recession and this still seems some distance away. This does not make us particularly bullish however and our central case is for only low to mid-single digit nominal returns over the next few years with a lot more volatility and an increased risk of capital loss.

Fixed Income markets remain a difficult place to make money with minimal or negative returns from bond funds this year. Bond yields have drifted higher this year and credit spreads have widened, especially in Emerging Market and High Yield debt, which has further eroded capital. We see this as a benign rather than savage bear market with only a gradual and shallow increase in yields to come with Central Banks tip-toeing their tightening and inflation remaining under control. The US 10 year yield has moved out from 1.5% two years ago to 3% today and our sense is that the terminal rate may settle around 3.5%. This should not do too much further damage to portfolios and at that level investors may begin to welcome rather than shun longer duration.

Just saying…

Apropos of the launch of a zero cost index tracking fund in the US by Fidelity I saw an interesting chart from Ruffer Asset Management

recently which shows that the percentage of assets passively managed in the US market is now pretty much 50%, with the rest of the world not far behind. Whilst not quite on the scale of Brexiteers vs. Remoaners, the Passive vs. Active debate can become very tribal and emotional. As I aim to avoid such extremes I don’t usually enter the debate but this is a pretty big Rubicon to cross so worthy of comment.

I can see the attraction of passives, not least the low costs, but am concerned about their inexorable inflows as the bull market careers ever upwards. Passive investing assumes that markets efficiently assimilate all relevant information and reflect it in share prices making it well-nigh impossible for active managers to consistently beat the market, particularly after fees. However, it is active managers who identify the inefficiencies which initially drive the stock price movements that passive managers then follow. If the actives are driven out then the market becomes static with companies allowed to creep into inefficiency without censure. Consequently passive funds can become concentrated around large, fully grown, most mature companies bought for their size in the index rather than on the basics of business outlook and valuation, which can be problematic. Ruffer cited the example of passive investing leading what they emotively termed ‘lambs to the slaughter’ when UK banks exceeded 20% of the index just before the financial crisis in 2008 and fingered the technology FAANGS as the likely next suspect. Apple for example is owned by over 250 US listed ETFs from straightforward index tracker to those tracking large cap, tech, dividend paying and (confusingly) both growth and value.

Argy Bargy, Turkey Stuffed

You can go several years without an old school emerging markets crisis then suddenly they’re coming  along like London buses. Tighter US monetary policy and a stronger dollar are headwinds as they attract money away from riskier assets but the catalyst has been a series of geopolitical factors. Trade friction is the most obvious, especially that with China, but add in inept macro-economic management (Venezuela and Turkey), chronic trade and budget deficits (Argentina and Turkey) and arguments with Trump (everyone, especially Turkey). There is a common denominator here and Turkey has had a shocker with its collapsing currency and stock market and sky high interest rates. The weakness of the currency adds to the pain with the MSCI Turkey Index down 11% ytd in local currency terms which is bad enough but factoring in the weakness of the lira means that returns to the sterling based investor are down by a whopping 42%. Turkey has stabilised and rallied in the short term with the Central Bank hiking interest rates to regain credibility but its situation is disturbing as it morphs from potential EU member to a radical Islamic dictatorship, not least because of its geographic position as a buffer between Europe and the Middle East and as a member of NATO. Similarly Argentina, which a year ago was offering 100 year bonds but has now been forced to increase interest rates to 60% as the peso collapsed.

We do not see Turkey and Argentina as being representative of the Emerging Markets as whole, which have become increasingly heterogeneous. Emerging rather than developed markets will increasingly power global growth with most of the individual economies showing a growing resilience to external threats as a result of significant structural improvements since the Asian crisis of 1997. They also have a growing independence and are decoupling from the developed world’s business cycle as their own domestic economies expand, powered by their excellent demographics. US dollar denominated debt uncovered by FX reserves is no longer the potential nightmare it was a decade ago whilst gone are the days when Asian companies were awash with debt. Valuations are not excessive, the MSCI EM index trades on a forward P/E of around 11x, a significant discount to the 15x forward P/E of the MSCI World Index.

Scores on the doors

Equities have produced better returns than bonds whilst regional disparities in equity market returns have increased as the year has progressed. Wall Street climbs forever upwards with returns further enhanced to sterling based investors by the strength of the dollar. European and UK markets have largely marked time but the Emerging Markets in particular and Asia have suffered losses. Reasons are a plenty; a stronger dollar, tighter US monetary policy, a slowing Chinese economy and being at the sharp end of the Trump trade wars. The distress in Turkey added fuel to already smouldering  fire whilst weak EM currencies further reduced returns to sterling based investors. At the stock and sector level, growth continues to outperform value in 2018, as has been predominantly the case over the last decade. Technology continues to be the best performing sector though not without some of its headline names such as Facebook, Tesla, and Tencent taking a kicking over the summer months. The energy and healthcare sectors have also done well this year but financials, consumer staples and telecoms have produced negative returns. Rising bond yields and widening credit spreads have meant an uphill struggle for all Fixed Income funds whilst rather too many of our Absolute Return and conservative multi-assets funds continue to underwhelm. On a happier note, our Commercial Property ‘bricks and mortar’ funds have plodded slowly and consistently upwards returning around 4% year to date.

Bears have the best stories

Anyone who has had the misfortune to have been closeted in a meeting with me at any time in the last decade will have been regaled by my telling them that being bearish makes you sound serious and clever whereas being bullish makes you sound like a double glazing salesman. The bulls can appear naively optimistic and intellectually lightweight but it is by accepting risk that you harvest the returns. Over the last decade I have fretted and brooded but on reflection decided it was best to stay in the game rather than pile up the cash and sit on the sideliners, safe and secure but losing ever increasing amounts of opportunity cost. The bear case today sounds more compelling than ever, and I have spent the last few pages highlighting Central Bank tightening, rising interest rates, climbing bond yields, Trump, tariffs, EM crises, peak earnings, high valuations, blah, blah, blah. There are certainly quite enough flashing warning signs; the flattening yield curve is a well touted recession indicator and widening credit spreads are signs of increasingly nervous credit markets. On balance though we see these warning signs as flashing amber not red and so wish to remain invested, albeit acknowledging volatility has increased and the risk to capital is greater now than at any time in the last few years. The global economy and earnings are still firm and there is no sign of recession on the imminent horizon. It is only when we feel there is a clear and obvious threat to earnings growth that we will move from cautiously positive to bearish.

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