Q3 Investment Review & Outlook 2018

Global macro and geo-political concerns weighed heavily on markets over the third quarter leading to significant market divergence as investors attempt to digest the complicated backdrop of steady fundamentals and how to value long-term structural growth themes against US interest rate expectations and rising trade tension concerns. During Q3 UK indices traded in a narrow range with some weakness into the end of the quarter, whereas the US market continued to outperform making new highs and the S&P posting the best quarterly return since 2013. The key UK risk into year-end remains headline Brexit risks that investors up until recently were somewhat sanguine on. As the deadline approaches the UK market is expected to be volatile throughout Q4 as we await clarification on the outcome then assess the likely impact.

This is in stark contrast to European & Emerging markets where several factors – trade sanctions, rising interest rates in the US and geopolitical factors, have led to outflows. The desynchronization of global market performance can be attributed to contagion pressure in the EM space with Turkey, Brazil and Argentina, political pressure and uncertainty in the UK & Europe, NAFTA (Canada and Mexico) and trade tariff concerns. Towards the end of September when markets had stabilised, headlines on the Italian government spending plans being at odds with the EU target re-ignited selling pressure.

 

All the above highlights how in times of synchronised global growth one negative factor has a follow-on effect that brings into question the short-term outlook for markets, given how interconnected they are in the current climate. As we approach the US midterms, where historically the market performs strongly (from October to February the market usually rallies), we remain alert to the impact that the outcome is likely to have on both domestic and International policy. Adding to recent market nervousness the IMF World Economic Outlook commented that global markets are “susceptible to sudden re-pricing if growth and expected corporate profits stall”. Furthermore, they trimmed 2018 GDP forecasts for Germany, Italy, France, UK and Japan. Taking all these factors into account reiterates how fragile investor sentiment can become leading to a dispersion of equity market performance.

Europe

European markets have suffered a tough Q3 in absolute terms due to Turkey, Italy and broader Emerging Market concerns. Due to this, investor flows have moved out of the perceived risk in Europe to the safe haven of the US (on the basis that there is less risk in the domestic US market where growth remains strong). The impact of an EM slowdown on EU exports (lower demand for EU products and weaker EM FX impacting revenue exchange) continued to weigh on sentiment. The European market has near twice the exposure to EM than the US – hence one of the reasons for underperformance and investors looked to try and reposition assets.

Decisions made by the Italian government on spending plans and concerns on the viability of budget reforms led to some broad-based selling as many questioned why election pledges were not adhered to and then what subsequent action the ECB may take.

At the corporate level, earnings remained strong; of those that reported in Q3 50% of companies beat earnings estimates with EPS (Earnings Per Share) up 7% whilst the majority either upped or maintained FY guidance. Overseas earners reported stronger profit numbers and guidance vs. domestic earners, a pattern we have also seen replicated in the UK. What this does confirm is that, even though the political landscape remains fragile, EPS momentum is growing healthily. The current EM weakness has resulted in EU P/E (Price/Earnings) multiples reverting to its historical median level but amid strong earnings they should be well supported, even with the high correlation Europe has with Emerging Markets. If there are signs of a slowdown in global growth, more FX volatility, weaker economic activity and cost pressures persisting then we would expect to see some downside revision to current earnings estimates.

US

The performance gap between the US and non-US equities was one of the largest on record. US equities were helped by tax cuts, buybacks and strong earnings leading to a material divergence. Over the last 5-6 months US equities are up nearly 10%. With the Fed on a tightening cycle a stronger dollar may be a headwind for future earnings. US earnings were overall pleasing with nearly 80% of S&P 500 companies beating EPS estimates, the highest in 10 years, further showing confidence in the US economy in the midst of other weaker global markets. In addition to strong earnings the benefit of tax cuts is still flowing into bottom line earnings, the US earnings cycle is still robust and corporate profit margins are being upgraded yet again.

The rhetoric effect from tariffs can be viewed as broadly positive for US equities and investors have shown support for Trumps’ view that the US must protect jobs backing his stance to challenge global trade agreements and halt subsidising China. We are mindful that much of this could be more vocal into the midterms to garner further domestic support.

In terms of the wildly reported spike in yields, it is likely that the most recent change in Fed commentary, which is suddenly emphasising continued steady hikes because of a solid economy, was also an important driver of the move up in yields. While uncertainty about the level of the terminal or neutral funds rate appears to be increasing, we note that the gap between the current level of US bond yields and nominal GDP growth is still wide. Indeed, the long-term correlation between equities and bonds is typically negative and we do not see a reason why it should reverse sustainably, if bond yields move up for the ‘right’ reasons. Relative to bonds, equities still look attractively valued. The yield differential between equities and bonds remains significant in most regions. It is only in the US that bond yields are now above the equity dividend yield. In Europe, the UK and Japan, equities still have a significant valuation cushion to absorb a potential increase in bond yields.

On the Tech space some of the heavily owned FAANG (Facebook, Amazon, Apple, Netflix and Alphabet/Google) stocks missed consensus estimates leading to sharp share price reversals. Given the tech sector accounts for nearly 25% of the US market cap and is heavily owned it currently tends to be the lead driver of volatility. Many investors, both private and institutional have exposure in this sector, with some focusing wrongly on the short-term performance and ignoring forward looking estimates.  Even through some earning weakness in the tech sector investors should continue to focus on themes that will benefit from structural growth and disruptors.

Given the above outlook, domestic growth – even with tariff retaliation concerns, the US market should perform strongly into the end of the year. We still await the potential growth and retaliation impact on Trump’s policies on metals, tech, autos, China and the EU. As mentioned previously, macro forecasts are inherently intertwined with the FX markets with a resurgent USD reflecting global risks being elevated. The USD should continue to be supported by the rate differentials vs. the rest of the world in addition to the GDP growth gap.

China

Most investors have been long term bulls on China and the growth outlook, but sentiment has started to turn given concerns on tariffs having a long-term impact on growth models. In particular debt, GDP ratios, a housing bubble and a potential downgrade to forecasts are suddenly making headlines, yet it is something we have been mindful of for some time. The Chinese market into the end of Q3 started to show signs of trade war stress between the US & China evidenced by the widely observed PMI (Purchasing Managers Index) dropping to a 2-year low. Some analysts think that the usual H2 6.8% growth number will be revised down closer to 6.3%.

Most of the weakness is trade is a result of rising tensions between the US-China relationship. The rhetoric and an increase in tariffs on the 24th September of an additional $200bn of Chinese goods (10% for now and 25% from January, mostly consumer goods) will undoubtedly push US inflation higher. The response was for China to levy duties on additional $60bn of US goods. It is important to note that exports to the US account for about 20% of China’s total exports and 4% of China’s GDP, a full-blown trade war will have a sizable impact on the Chinese economy.

The US will also be faced with a tricky dilemma given that the huge volumes of consumer goods they purchase from China can’t easily be replaced from other countries – as we mention above the real impact of these tariffs will be higher CPI (companies will seek to pass on the increased costs on their supply chains to the end consumer).  The effect will be hurtful to both economies. The escalating trade war narrative will most likely be into the year end and this makes investors nervous. At this juncture it’s difficult to try and second guess who will benefit from these trade wars as both Chinese exporters will suffer as will US imported components.

A response is expected by the PBOC (Peoples Bank of China – the Chinese Central Bank) with actions such as RRR (Reserve Requirement Ratio – the minimum amount of reserves that must be held by a commercial bank) cuts and policy changes such as concessions and supported by the boom in housing (house prices up 15% yoy meaning local government finances remain elevated resulting in more infrastructure spending boosting demand).  In addition to this thesis we do expect credit quality to improve led by dealing with unregulated lending and having the foresight to managing fiscal policy more credibly. Structural reforms should be enough to deal with macro shocks and trade concerns in the short-medium term.

Japan

The Japanese economy has not been immune to geographical concerns yet the outlook remains positive. Investors have trimmed back exposure and have sold circa $34.7bn of Japanese stocks so far this year as trade war and potential sales tax increases continue to weigh on performance.  Some of the weakness was talk on Japan exiting monetary easing but not until inflation achieves its 2% target. Given that Japan is an export reliant economy, tariff concerns gave rise to supply chain disruptions that are yet to be quantified. Abe did reach out to Trump in order to try and protect Japanese automakers from further tariffs. In addition, the US stated it would protect the important farm sector from access that goes beyond the terms in the Trans-Pacific Partnership agreement that Trump abandoned last year. U.S. Trade Representative Lighthizer said the talks would occur in two “tranches” with hopes for an “early harvest” from the initial talks on lowering trade barriers. Again, we have to await developments on these matters.

Further ‘safe haven’ driven Yen appreciation is the obvious short-term risk. Corporate profit margins have continued to remain positive and margins have shown signs of stabilising after exhibiting weakness led by yet again tariff impacts. Other positives include shareholder-friendly corporate behaviour, solid company earnings and support from Bank of Japan stock buying.

UK

The main catalyst for UK underperformance can be attributed to market sentiment and concern on Brexit leading to some investor nervousness on what post Brexit UK will consist of. On a headline level a chance of an orderly exit seems less plausible but with the underperformance of the UK market (even with £ volatility) recent inflows suggest the bearish tide is turning, even though a recent Reuters poll prices in a 25% chance of a hard Brexit. Recent headline macro data has been somewhat weak but when we focus on the outlook we take comfort that wage growth coupled with the consumer outlook slowly improving, and the economy still in expansion (PMI still above 50), should mean the discount that the UK trades to global markets should narrow.

On the domestic front, the outlook for the retail environment has not improved. Profit warnings have continued on the high street, CVAs (Company Voluntary Arrangement) have increased considerably on a like for like basis vs. Q2 with major names such as Debenhams, Pandora, Carpetright, New Look, Byron, Gourmet Burger Kitchen, House of Fraser, Quiz and Footasylum, undergoing major restructuring. This suggests that landlords are continuing to be stuck in a quandary and being pushed to accept the CVAs on tenant terms or face multiple empty commercial sites that will further depress the yield and valuation of high street commercial property income and valuations. A lack of government Brexit plans makes it difficult for domestic companies to plan ahead in terms of inventory, staffing, forecasts and growth models. This current negative outlook for retail and consumers has resulted in a sector de-rating vs. historical positioning.

The gap between UK listed domestic and international company performance has widened again in Q3, even with the drop in sterling, to 50% since the Brexit vote (10 year high valuation gap). With UK listed corporates trading as substantial discounts we continue to see more M&A activity given the move in UK share prices and sterling, allowing overseas companies to continue on the acquisition trail led by activist investor positioning to unlock shareholder value.  Examples of which include Barclays, Virgin Money, Randgold Resources, Whitbread & Smiths.

We are mindful that the political landscape and a current lack of any coherent plan suggests that until this is dealt with then Brexit uncertainties will be prevalent for the coming months. Through this volatile period, we are encouraged to see signs that the macro environment should be supportive to the UK economy. The June BAML fund manager survey revealed 21% of were underweight UK equities, but that is an improvement from 37% in November 2017.  Even in the midst of this Brexit uncertainty wage growth is starting to outpace inflation (leading to a pick up in real disposable income) and consumer confidence; the rising rate environment should be net on net positive for the UK and lead to greater inflows.

Asset Allocation

Through times of market volatility, we must remember that equity markets are forward looking and when we experience bouts of weakness, unless the investment case has materially changed, they remain the favoured asset class. With the recent re-balancing, the pull back in valuations and lack of meaningful yield from alternatives we see the outlook for equities as positive into year end.

Equities still represent good value vs. fixed income – we are now witnessing the impact of increasing rates – bond prices are falling, and debt holders are being exposed to real capital losses that are hastened by inflationary forces. We remain very concerned by the lack of liquidity across fixed income markets.

We maintain our exposure to alternatives such as Global listed infrastructure and European logistics (distribution facilities within or close to cities that are used to store and make ready goods for customer delivery – are benefiting from the boom in online retail).

Summary

Markets have exhibited periods of higher volatility in recent weeks as concerns over trade tensions increase, the Eurozone contends with the political situation in Italy and the uncertainty over Brexit persists. The fundamentals do not suggest that a wholesale change in strategy is appropriate – growth is firm, liquidity conditions are supportive, while valuations are not overly stretched relative to earnings prospects.

Including last week’s, there have been 62 ‘panic attacks’ since this bull market began in March 2009. These include five outright corrections with the S&P 500 down by 10% or more (but not the 20% or more which would mark a bear market.) The causes of the first 61 ‘panic attacks’, all of which were followed by rallies of relief, are well rehearsed. The rationale for last week’s appears to centre on concerns of the Fed overdoing its ‘normalisation’ and of the yield on the 10-year Treasury reaching a point that compromises Global growth prospects. The main focus points for Q4 will be on US growth metrics being sustainable, improvement in Chinese macro data, tariff updates (and the knock-on effect), Trump’s commentary into the mid-terms, global monetary policy tightening (Fed / UK raising, ECB nearing end of bond buying), Brexit and the political landscape in Europe and within Emerging Markets.

From an historical perspective UBS note that into US midterm elections “S&P 500 returns have averaged 6.8% from end Aug to year-end vs. 3.4% for other years. Extending the return period from August to end Mar, the S&P has risen 14.5% on average vs. 6.1% for other years”. History therefore suggests that equities are well set to perform strongly into the year end.

We construct globally diversified portfolios with low levels of stock-specific and sector correlation. Our aim is to provide exposure to long-term thematic trends whilst also investing in alternative asset holdings that serve as counterbalance to riskier holdings that may exhibit higher levels of volatility over short time periods. In the short-term therefore we expect markets to continue to experience heightened levels of volatility until we get better clarity on the outcomes of these headline geopolitical issues. However, at this stage we remain confident in our current portfolio positioning and don’t envisage making any wholesale changes to our risk-graded strategies.