Q4 Investment Review & Outlook for 2019

2018 exhibited from a volatility perspective, levels we have not seen for almost 20 years in terms of daily percentage moves, led mainly by geopolitical tensions, political uncertainty, sector rotation and some slowing economic data points. The equity market has been particularly volatile since the end of the summer and more worryingly, the debt market is starting to show signs of exhaustion that has added pressure onto already fragile financial markets. We also note the increasing influence of algorithmic trading in driving market activity adding somewhat more volatility when data points suggest otherwise. Developed Market equities ended the year down over 11% with over 95% of asset classes generating a negative return for the calendar year.

Q4 2018 Perfomance Chart (2)

Volatility will most likely remain elevated into 2019 and questions on the global economy slowing down in the face of tightening financial conditions will once again bring investor focus on the actions of Central Banks. As we saw in Q4 rhetoric changes from policy makers can have an immediate market impact, more so than we have seen previously, which confirms investor anxiety as exhibited by large market swings.  Trade war headlines, uncertainty regarding central bank policies, Brexit and political tension in Europe have contributed to wider credit spreads of High Yield (HY) corporates in European and US markets.

Across most of the investment community the common theme into 2019 revolves around a slowdown in the US led by easing corporate profits, growth slowdown and the economy entering a late cycle phase. There are growing concerns that we are on the brink of a classic late cycle environment characterised by an overheated economy with the prospect of entering recession, where growth eases when monetary policy becomes restrictive and credit tightens in the midst of decreasing corporate profits whilst inventories build as growth slows.  Given this less buoyant and increasingly uncertain backdrop the ability to manage risk through a flexible and dynamic investment approach is increasingly important. It allows us to continue to manage risk and reward by monitoring global trends and adjusting our view and executing changes as required to portfolios from an asset allocation, regional and sector specific perspective. Of particular importance given the mixed signals through 2018, we have maintained our process of continually evaluating global investment correlations to reduce portfolio risk.

European markets gave up gains into the end of 2018. Profits in the Eurozone have been pressured by elections, higher input costs, exposure to trade tensions and slowing growth in China. Italy continues to be troubled by growing debts and associated budget pressures, President Macron is struggling with protests and being overly reliant on a German alliance to promote EU reform to counter populism. The EU parliament elections in May will be important in this regard and have the potential to material alter the profile of European politics. Europe continues to face structural and cyclical challenges and as the ECB reigns back its bond-purchase programme this is likely to influence sentiment as a key source of liquidity is withdrawn. Germany’s export driven economy has undoubtedly been hampered by ongoing trade tensions and worries over future demand – this is reflected in the softer data prints which still show expansion but at a declining rate. That said – valuations in Europe are now trading near 5-year lows which can provide significant mispricing opportunities and there is scope for a meaningful re-rating should trade tensions abate.

Q4 saw US markets give back most of their gains for 2018. Headline numbers were not overly negative but most of the volatility on the downside was geo-political – associated with lack of trade talk progress and mixed messages from policy makers. Towards the end of December, the eagerly awaited Fed announcement gave way to more market swings yet again the message was somewhat mixed.  The Federal Reserve hiked interest rates by 0.25% with Chairman Powell, the head of the Fed, issuing a dovish statement, the so-called dot-plot was revised to show a median projection for two rate hikes in 2019, versus three previously.

The 2018 earnings cycle in the US remained positive led by tax cuts, EPS growth and huge share buybacks. Many of the catalysts that drove asset gains for much of 2018 are unlikely to be repeated unless new reforms are introduced. This results in consensus forward estimates being trimmed into 2019 (2019 EPS forecasts were 10% YoY and have begun to slip further into the year-end).

The acute selling in Q4 is in line with other historical periods of market weakness typically lasting 5-6 weeks. This is an important observation as although its due to different (although often politically induced) factors each time the timelines have previously been similar. Sept-Oct ’11 (US debt downgrade + recession concerns), Mar-Apr ’14 (TMT/growth rotation), Oct-Nov ’14 (Energy sell-off, and market dip), Sep-Oct ’15 (Factor unwind post China devaluation), Feb-Mar ’16 (Recession Fears and High Frequency Trading unwind, Jul ’16 (Brexit), Nov-Dec ’16 (US election), Nov-Dec ’17 (tax reform and factor rotation). This should provide some comfort that most of the selling of long exposure/portfolio de risking should be near the end in the short-term. With some valuations coming back to reasonable levels, inflows into the US Equity market continuing and rotations seemingly completed the market should look to trade in a narrower range as much of the re pricing has occurred.

China specific tariffs and associated retaliatory actions with the US were a drag on the economy in Q4. We do note, the impact of these tariffs had a larger impact on US exports to China than vice versa. The market reaction has focused on the drop-in growth that these might lead to, but we remain confident that a deal can be agreed. Tariffs have started to filter through into macro data in Q4. China’s Retail Sales YoY in Nov dipped 8.1%, vs est 8.8%, Industrial Production YoY in Nov fell 5.4%, vs est 5.9%, Fixed-Asset Investments YTD in Nov rose 5.9%, vs est 5.8%, and Jobless Rate was 4.8%, vs 4.9% previously. Auto sales (even with some policy amendments that should reverse the downtrend into Q1) for November were down 13.1% YoY.

Alongside tariff uncertainties, China continues to face short term headwinds (both domestic and external). Domestic deleveraging has somewhat tightened financial conditions but changes to fiscal policy (corporate tax cuts and release of reserves), selective credit easing for the private sector and structural reform should allow a cushion to any likely drop in growth. During Q4 macro data exhibited some declines in household consumption and more vocal calls from policy makers to undertake some further steps to shore up growth targets.

PMI’s have started to recover with a further improvement in the credit impulse and the boost from RMB weakness offsetting the drag from US tariffs and growth projections are expected to move towards 6.2% for 2019. The main catalyst for easing growth in China is namely due to an easing in manufacturing investment, effects of US stimulus and slowing consumption. Not forgetting the impact of trade but the reality is even if there is a full 25% import tariff on all Chinese exports the net impact would only be a small 0.4% drop in GDP growth, much of which is already being priced in (most pessimistic models have been quick to reduce forward estimates). Should tariff concerns continue to linger into Q1 and a deal cannot be reached then we expect further actions to be taken by Beijing (which has already started reflating the economy through fiscal and monetary policy)

Chinese policymakers do have tools available to attempt to counteract this weakness using foreign assets, credit stimulus packages further reducing RRR which could plausibly lead to a valuation recovery. They remain committed and have had continued to push market-based reform which in turn will allow growth led by the private sector which historically has been the lead for upward trend swings. Reforms and deregulation that results in effective capital and resource allocation to drive sustained economic growth should provide a cushion for any negative catalysts.

Japan’s global exposure was a weakness in 2018 as global growth slowed last year and Japan’s export-oriented economy was caught in the crosshairs. However, in contrast to China – Japan’s tariffs are already low, intellectual property is respected and they remain a close ally to the US. A stronger Yen hindered many large index constituents whilst providing a boost to consumption and domestically oriented companies. Japans performance has been driven by earnings growth while valuations have become even more attractive, however earnings outlook has moderated amid slower global growth and rising costs. We expect Japanese companies to maintain mid-to-upper single digit growth. It should be noted that profitability has improved markedly in recent years – profits in Japan have surged from 1% to >4% of GDP.  Furthermore, Return on Equity (ROE) is at its highest level since the Global Financial Crisis (GFC), it remains under appreciated and there is significant scope for further ROE improvement through better capital management.  In addition, c. 60% of Japanese companies are cash rich.

The Japanese market is now trading at a 15% discount to global equities and on 12x trailing earnings estimates having barely moved since 2012 with the market being driven by earnings growth rather than a re-rating such as in the US.  The tight labour market has started to boost consumption (rising wages) and capex (firms try and boost labour productivity). Alongside these productivity gains, continued progress on corporate governance should negate and reverse some of the weakness seen in Q4. We therefore see a positive profile of growing profits, rising cash holdings and increasing shareholder returns. In addition, the economy should benefit from reconstruction after a number of natural disasters throughout 2018 and also from construction towards the 2020 Olympics.

Political uncertainty makes the UK macro picture difficult to price in. This is an unusual situation as we await developments and headlines into the 29th March deadline that will not be driven by the earnings cycle but on a combination of unknowns that seem to be changing daily.  We continue to expect a Withdrawal Agreement will be concluded, which should open the door to an orderly exit of the UK from the EU in March. But internal UK politics remain worrisome and a ‘no deal’ is not impossible. We note, however, that UK equities are consensus underweight and have witnessed significant outflows since the EU referendum in June 2016.

The Brexit process will dictate projections for inflation, currency, growth, policy and interest rates but all these are what if scenarios. We do expect a fiscal policy reaction if growth continues to falter and if the UK were to leave without a deal. Suffice to say, as perhaps due to Brexit, the pace of domestic profit warnings and weak equity prices did not relent. Both domestic and international businesses struggled with the lack of direction from the EU and UK government on what type of Brexit deal would be presented. This has led to a large drop in GBP, slowdown in inward investment, increase in inventories and generally investor sentiment has been sanguine. The FTSE 100 has dropped over 1100 points from its high in May 2018 and although valuations are near multi-year lows and could spur further M&A activity, until some clear visibility regarding the future outlook is confirmed, volatility will remain.

Asset Allocation

We continue to favour equities whilst acknowledging we are in a late cycle phase characterised by heightened volatility. Current valuations are now trading at a discount to historical averages and we have seen previously in this type of scenario that returns in the latter part of the cycle tend to outperform.  Value also historically outperforms growth in the US and EM space even if global GDP only expands at lower rates – closer to 3.6%. Although past performance should never be used as a definitive guide US stocks have tended to move +12% on average 1 year prior to a recession.

On a broad (non-sector-specific) basis earnings have continued to beat estimates. We are however facing increased uncertainty in the midst of Central Banks tightening monetary policy, political risk and concerns over global growth. With its dominant influence on Global markets (and currencies) Fed activity will be monitored closely although we are of the view that it now has the ability to be more flexible around the rate path, while the job market remains robust.  Even if there is a moderate drop in global growth overall – key metrics should remain solid and volatility around trade tensions should ease. Diversified portfolios can protect against bear markets by staying invested but being more selective and focusing on those names exposed to secular growth themes, alternative sources of income and capital returns (infrastructure, commercial property logistics) high quality earnings and those that have already priced in negative scenarios.

Summary

The reflation trade and long-awaited environment of synchronised Global growth touted by most strategists did not end the year as predicted as another year of positive returns for equities failed to materialise. Global equities finished 2018 in negative territory and on record for the worst year since 2011. Growth has disappointed and all major asset classes are down on a YoY basis. High beta equity names have struggled the most, EM names in a bear market (down over 20%) and EU markets suffering double digit declines. The US market has been more defensive when compared to RoW but has not been immune to selling pressure.

In 2018 nearly $13 trillion has been lost in global stocks, Emerging Markets have underperformed due to a rally in the US dollar and most government bonds have also been in negative territory. The cause of this has been led by US / China tensions, removal of central bank stimulus and growth slowing. The German market is down 18%, EM down 17%, Turkey down 45%, Argentina down 50%, oil down 35% in the last quarter and a spike in European borrowing costs (Italy, Greece & France). Global growth is starting to slow alongside some Emerging Market economies showing signs of recession. Germany, Japan, Italy, Switzerland and Swedish economies contracted in the last quarter. All this at a time where, due to trade tensions, weaker growth in China and the US – both major market catalysts, are also seeing evidence of stress and have led to equity market gains for 2018 being eroded. In conjunction with this, fears about the yield curve inverting results in cautious sentiment as we start 2019. What this does provide are significant global mispricing opportunities and we look to capitalise on these against a backdrop of moderating global growth.

Central bank policy changes will also continue to dominate headlines. More than $9 trillion of central bank asset purchases had resulted in a huge surplus of liquidity that boosted asset prices, decreased volatility and increases cross asset correlations. We are now in the midst of a change from QE to Quantitative Tightening (QT) with the Fed reducing its balance sheet, the ECB concluding its bond purchase programme and the BoJ scaling back asset purchases and allowing yields to move slightly higher. With the “Central Bank Put” (where central banks put a floor on asset prices) not working back to dominate the headlines inflation is now more concerning that deflation as it was for most of 2018, given growth has picked up.

Over the last 10 years low interest rates and QE has pushed up asset class valuations and 2019 is likely to the first year that balance sheets will ease. Central Bankers are faced with the complex task of accommodating steady inflation whilst managing growth and rising rates, just enough for the economy to continue to move ahead. This, we expect, will give way to more volatility between equities and fixed income. From an equity perspective advanced developments and innovations in areas such as healthcare (gene therapy and stem cell applications) and technological advances (across VR, AI and IoT’s) – hold the promise of growth over the long term. Given that the MSCI World Technology sector has outperformed the overall market by near 200% since 2009 this is an area of investor focus. A highly selective approach is essential as not all growth prospects will deliver, and many won’t grow into what are already punchy valuations.

The fundamentals remain supportive for further gains in global equity markets, but absolute returns are unlikely to be as strong as recent years. We are in a late cycle phase where volatility is likely to remain elevated and portfolio returns are likely to moderate. In such an environment attention to key macro themes whilst increasing downside protection seems prudent. By being able to diversify across asset classes and regions we look to reduce risk even in the event of protracted market weakness allowing our portfolios to retain exposure to secular grow themes and achieve long term investment objectives.

Global markets will naturally adjust to a more challenging environment led by the global economic cycle maturing.  Our remit is to navigate through these economic changes by constructing Internationally diversified portfolios that provide exposure to strategies that can steer through periods of heightened volatility and drawdowns. By focusing on a clear long-term objectives, we look through short-term market movements and by understanding the sources and impact of volatility on portfolios we seek to avoid making decisions based on snap market reactions. As we have seen through 2018 most of these factors tend to be contained to individual countries and sectors and we look to reduce exposure to these risks through uncorrelated, diversified and liquid holdings managed on a flexible and dynamic basis.