Q1 Investment Review & Outlook 2018

Performance of Global equities in 2017 was heralded as one of the strongest on record – volatility was at extreme lows, confidence was high, and investors were looking forward to more outperformance in Q1 2018. However, against this backdrop of long-awaited synchronised global growth markets have since been shaken by an abrupt and aggressive return of volatility.

This began in earnest back in February when we witnessed the largest drop in the S&P 500 since the Chinese currency depreciation scare back in 2015. The sell-off was broad-based however, having experienced previous market corrections, the key synopsis was to remain objective and understand the catalysts driving the correction; this was not, as the press stated, a global macro event, but instead it was driven by the combination of complex volatility instruments imploding and a sharp upward move in US 10-year bond yields, with automated trading programmes then accelerating the downward trend (a trigger price was hit and the algorithms continued to sell down). One key point worth highlighting is that during the selling and thereafter company earnings did not guide lower, it was merely asset prices skewing lower from fair value and overall a short-term equity revaluation process. What happens thereafter is a period of extreme volatility.

More recently market concerns have not been centred on rising wages and bond yields but instead focus has turned to the impact of a policy face-off between the US and China and the wider threat posed by President Trump’s protectionist rhetoric. It is our view that that, while this may transpire to be another play by Trump to impose his authority over existing global protocol (which in his view punishes the US), the potential evolution of a trade war poses a greater and more imminent threat than central bank tightening and rising bond yields.

Europe

Despite the increased volatility arising from trade concerns the European economy appears to be resilient; we don’t see the positive fundamental outlook for European earnings being challenged although further ratcheting up of protectionist rhetoric is clearly a concern (especially for export- biased Industrial, Auto and Tech firms) and although selected economic data for the region may have moderated it remains firmly is positive territory. The rationale remains that European earnings recovery is still in the early stages and is therefore rebounding from a lower base. Furthermore, the recent weakness has resulted in valuations moderating therefore providing a more attractive entry point. This is confirmed by the increase in equity inflows into the region since the start of the year.

US

2018 earnings expectations accelerated sharply over the last few months as investors sought to price in the combination of tax cuts, lighter regulation and the prospects of repatriation of overseas cash. However, equity markets may become increasingly defensive if the focus on tax cuts now shifts more toward protectionism. The Tech sector, even with the recent drop at the end of March, has again delivered the strongest sector performance in terms of absolute value – although the sustainability of this could be challenged given the increased regulatory scrutiny the widely known FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks now find themselves under. Meanwhile, newly appointed Jerome Powell gave his first speech as Chair of the Fed – outlining his plan for a ‘patient’ tightening of interest rates. The Fed also stuck to its forecast of two more 0.25% rate hikes for 2018, which would take the Fed Funds rate to 2.00 – 2.25%.

China

With his position entrenched President Xi’s focus will continue to be on maintaining China’s growth trajectory whilst navigating through rising trade concerns (principally the relationship with the US) and managing financial risk on the home front (specifically – limiting asset price bubbles, taming corporate debt, and managing shadow banking practices). Maximising growth around the 6.5% y-o-y needed to double 2010’s GDP level and per capita income by 2020 should remain the Communist Party of China’s (CPC) long-term objectives. We would argue that an overly pessimistic outlook is harsh given corporate earnings have remained strong and innovation (China is on course to overtake the US in expenditure on science research and development) can still be a big driver leading to further earnings upgrades.

Japan

In Japan earnings continue to show positive momentum supported by policy divergence between the Bank of Japan (BoJ) and the Rest of the World (RoW), we expect minimal, if any, slowing of QE, which is now directed at the yield curve. For Governor Kuroda, there is no QE ‘reversal’ until 2% CPI inflation becomes the norm. This spring’s annual wage-round (‘shunto’) will again be telling and hopefully perkier than the +2% average one-off wage hikes in each of the 2014-17 rounds. Encouragingly, though, land prices, after falling for 25 years, are now stabilising. Building momentum here will be important for inflation, balance sheets and collateral. Consensus Earnings Per Share (EPS) growth for 2018 is around 7% which we think is achievable; profit margins have reached the highest level since 1995, although asset turns have lagged. Given that there has been little in terms of additional capex, we believe an improvement in the top line can quickly lead to recovery in earnings growth. Deflationary pressures have finally started to ease and the widely observed Tankan survey is now printing at a 10-year high, exports continue to be resilient so overall, so we remain confident in the outlook.

UK

The UK market has underperformed Global peers YTD; having recently reached record highs the headline index has now retraced 10% and is yet to recover meaningfully from the February flash crash lows. The derating took the markets dividend yield back to c.4% – it has only been higher in 2008-09 during the last 20 years. The FTSE has not been helped by uncertainty around Brexit negotiations alongside FX volatility driven in part by a lack of coherent messages from politicians. This is against a gloomy backdrop of decreasing consumer spending and increasing debt levels in the face of further rate hikes expected from the BoE. The follow on from this is more pressure on the high street as habitual spending trends shift to online.  On the flip side, with rate rises on the horizon, banks are finally being touted as an attractive value and dividend play and should start to find favour in the coming months. They have been a laggard in terms of performance but should start to narrow non-UK peer discounts and be one of the highest dividend sectors in the market overall. In a market where there seems to be a lack of growth (except for selected small and mid-caps) many high dividend names can represent value traps so avoiding those names and owning sustainable value is critical. The key will be understanding what is defensive and outperforms a lacklustre domestic market with the many challenges that remain in a rising interest rate environment. The volatility in FX (GBP vs. USD pricing above £1.40 again) could also turn to be a negative for FTSE 100 names given the index’s bias to overseas earnings.

Asset Allocation

Equities	Fixed Income	Alternatives & Specialist
We continue to favour Equities as our preferred asset class whilst acknowledging that increased volatility is likely going forward; this means that stock-picking – with an ability to avoid companies compromised by rising rates and/or changes in consumer habits is critical. A more positive slant highlights that valuations are now clearly less expensive, and we do think that the impact of US tax reforms is yet to be fully priced in.Europe continues to be a value play and any escalation in trade concerns would favour domestically biased companies. The UK’s risk profile remains elevated while Japanese policy remains accommodative and prospects for China data driven. At sector level we continue to follow themes that expose portfolios to technological change and its widespread applications from the auto sector to healthcare. Key risks are an escalation in protectionist rhetoric, geopolitical tensions, Chinese slowdown, Brexit uncertainty and a central bank policy mistake.	We continue to run a distinct underweight position in fixed income.Our view that bonds have yet to really be impacted by capital penalties holds however, we would rather exit early than wait for the bubble to burst. When medium-term rates rise they will inevitably cause bond prices to fall and real capital losses will be hastened by inflationary forces. Against this backdrop we struggle to find opportunities with attractive risk/reward upside. Our exposure is therefore limited to specialist investment portfolios that invest in European Asset Backed securities (that are short duration – average maturity of only 3 years) and use derivatives to manage downside risk. Our only other exposure is through the fixed income components of Multi-Asset funds – which currently favour inflation-linked issuance.	We have recently invested into a strategy that seeks to benefit from the demand for infrastructure needed to support the increasing trend of retail commerce moving online; the European logistics strategy will invest in a diversified portfolio of ‘big box’ logistics and ‘last mile’ urban warehouses across the continent.In addition, we continue to favour Infrastructure assets which tend to have a significant proportion of their revenues fixed and inflation-linked, with lower exposure to the economic cycle. Importantly we focus our exposure on strategies that use ‘normalised’ rates in their valuation models (thereby accounting for the impact of rate rises on infrastructure assets) and those that employ a strict valuation discipline with an ability to identify those companies able to offset any negative impact of rate rises through inflation pass-throughs and higher revenue growth.

 

Summary

It’s been a more turbulent quarter for equities, characterised by the return of volatility – induced by a combination of technical and geo-political factors set against a backdrop of steady economic data and a healthy earnings outlook. Despite recent market volatility, equity funds globally continue to attract flows. YTD there’s been $136bn inflows into equities and $66bn into bonds, after strong inflows in 2017 (over $900bn into equities and bonds funds combined). On a regional basis, inflows have been strongest into EM and global funds while US equity funds experienced outflows both YTD and in 2017. In addition, Global merger and acquisition (M&A) activity hit a 17-year high in Q1 2018, as companies spent a gargantuan $890.7bn on 3,774 deals (according to Mergermarket). Amid the ongoing slow growth rate of the global economy, companies are increasingly looking to expand through acquisitions, particularly targeting innovative businesses that can help expansion into new industries or access different customers.

The challenge now for markets questioning the ‘Goldilocks’ scenario of ever faster growth and ultra-low rates is to identify which of the ‘bear’ risks to fear. As we have highlighted previously, equity market downturns are traditionally associated with macro shocks and/or a toxic policy mix. But with policy rates close to the floor, QE close at hand and little effort on fiscal-deficit cuts, policy doesn’t appear toxic. We anticipate that newly appointed Fed Chair Jerome Powell represents continuity of approach with a ‘patient’ and ‘data dependent’ mantra but clearly any extended rise in bond yields (and wages) would be a concern. A slowdown in China is also an ever-present concern however, we think that this can be contained.

We paid close attention to how different equity, fixed income and alternative strategies (at asset class, regional and sector level) behaved during the recent phases of market volatility and how these (in aggregate) influenced overall portfolio performance (paying particular attention to levels of correlations); whilst there was an absence of material shocks in how different holdings performed (including level of correction and ability to recover) it has influenced portfolio positioning and our views on how different holdings will behave under different market environments. We take comfort in our ability to communicate directly with fund management teams providing us with a much deeper understanding of how individual Fund (and Investment Trust) portfolios are positioned – what themes they are seeking exposure to and ultimately under what circumstances they are likely to out/underperform. Being able to follow our process during times of investor and market nervousness we can look beyond the nature of short-term volatility skews. This measured and considered approach provides us with a robust methodology to navigate through what are likely to be more volatile markets whilst still being able to identify opportunities and themes that we believe to be undervalued and/or offer superior risk-adjusted returns over the long-term.