Q1 2018 Investment Review and 2018 Outlook
2017 turned out to be an unusually quiet year for financial markets. Politics was as rumbustious and headline making as always but markets generally look through this unless someone somewhere is about to do something really stupid (like start a trade war, of which more below). Meanwhile, the news from the economy was of strong and/or improving growth combined with stable and/or falling inflation. This created an environment where prices could rise on the economic backdrop without being de-railed by nasty surprises elsewhere. In 2018, things have changed. Volatility has returned. Equity markets fell around -10% from their January highs to their mid-February lows and there were more days with 1% or larger moves in February than we saw in the whole of 2017. Global equities lost -4.5% in Q1 2018 (in unhedged sterling terms) and the UK FTSE All-Share market lost -6.9%.
Part of the reason for the return of volatility is that politics has started to matter again. In the US, the Trump tax plan gave a one-off boost to corporate profits helping drive strong earnings growth for US companies and this kicked off a strong first few weeks of the year. Then came the bad news with Trump following through on his campaign promises and imposing tariffs on selected steel and aluminum imports as well as tariffs on imports from China across a range of products. The actual economic impact here is very limited so far: the measures taken only affect about 3% of total US imports and only increase total tariff rates by around 1%. The net effect of all this on the US economy is basically a rounding error. The symbolic effect, however, is more important. An unpredictable Trump damaging the economy to win populist votes is not a good narrative for equity markets. The US S&P 500 had two intra-day falls of over 3% as trade tensions started to escalate. To the extent this is mainly posturing and the economic impact stays limited then markets will eventually look through the noise to the economic reality and should recover recent losses. The problem is: with Trump, who knows what is coming next? The more volatile environment we saw in Q1 looks to us that it will be here to stay.
Closer to home, Brexit also had an important impact on markets. UK equity markets tend to move with developments in the US, China or Europe rather than domestic stories mainly because the majority of UK listed companies are global in nature rather than UK focused. At around 3.4% of global GDP, the UK economy is rarely on its own able to move broader equity markets. Currency markets are, however, a very different story. Exchange rates reflect expectations of interest and inflation rate differentials between different countries. Brexit caused expected future UK interest rates to fall sharply and the currency fell with it. Immediately post referendum there were worries of (a) a sharp recession and (b) the so-called cliff edge hard-Brexit scenario. The much talked about recession never in fact materialised. Interest rate cuts from the Bank of England and (ironically) a strengthening European economy helped soften the blow of the Brexit shock. Plus, with hindsight, it is likely that economists (the majority of whom were pro-Remain) over-estimated the impact of Brexit as an unintended consequence of their pro-Remain leanings.
As time has passed, it has also become clear that the cliff-edge, hard-Brexit scenario is just a fantasy of Jacob Rees-Mogg. Negotiating stances aside, there never was a serious plan for leaving the EU without some sort of bespoke deal. How this deal looks is yet to be determined, but the Irish border issue has forced the UK into being more rather than less aligned with the EU and its current laws and trade arrangements.
This means that the Brexit issue is slowly becoming less of a major economic risk. This and the stability of the UK economy has seen sterling strengthen 14% against the US dollar since the start of 2017. Though there is still some more to go this has been a major driver of UK equity underperformance in the last few quarters. As sterling strengthens so, for our sterling based clients, the value of their international investments fall, all other things being equal. Though we cannot remove all of this effect for our UK clients (who similarly benefited from the collapse of sterling in 2016), our currency hedging program has limited some of the impact and this continued to help in Q1 2018.
If that is the politics, what of the economics? The story of synchronised global growth remains intact and the leading indicators we track suggest there is enough momentum to keep growth moving along for the next few quarters at least. Markets are, however, forward looking and are more sensitive to the change in the outlook rather than how good or bad conditions are today. Here, there is a sense that the latest mini economic boom may have peaked and we may be seeing a slowing from today’s strong levels. The evidence for this is clearest in continental Europe which has shown the best performance in recent quarters (with faster growth than the US for instance) but which has started to slow (albeit from elevated levels). Higher oil prices (back above $60 a barrel) and a weaker US dollar means that it is hard to see US inflation falling from here. So 2017’s environment of better growth and lower inflation might be replaced by lower growth and higher inflation. While we are hardly in the 1970s yet this is not a good mix for markets. We are not surprised that some of the froth came off in Q1. In fact, we took some action to take some profits and cut risk a little in client portfolios in January (ahead of the sell-off, happily) for exactly these reasons.
The final feature of 2018 has been the sell-off in technology stocks. We have written before that all of the top 5 most valuable companies in the US are all technology companies. And three of the five (Facebook, Amazon and Google) did not exist 20 years ago. Being on the right side of the shift from the physical world to the world of software and the internet had been probably the key investment theme of the last decade. This has created a sector that has generated large returns for its investors but which has become over-owned, over-loved and ripe for a correction. Much of the value for these companies comes from the fact that they are, in effect, natural monopolies. This means that the main risk to their business models is really from tighter government regulation rather than more competition. Facebook’s recent privacy issues have put this into the forefront of investors’ minds and last year’s equity darlings have led the market lower recently. While we have exposure to these companies both with our US and Chinese investments, we try to balance it with more value based investments in Europe and Japan in particular. Our gut feel is 2018 might be a year when the less fashionable, value based investments stage something of a comeback.
This brings us to our outlook for the rest of the year. We have written before that there are generally four scenarios we plan for when we invest: (i) things staying the same, (ii) markets running too hot (higher growth, more inflation), (iii) markets running too cold (i.e. a slowdown or recession from here) and (iv) the unexpected shock. The unexpected is, by definition, almost impossible to plan for but here we rely on our stress testing (looking at the worst market events since the 1980s) and risk management to ensure that our portfolios operate within our pre- agreed risk levels even when and if a nasty surprise does come along.
This leaves inflation (too hot), deflation/recession (too cold) and where we are today (just right). The current economic expansion has been running over 7 years which is longer than most historically and means that we are likely nearer the end than the beginning of the cycle. It is tempting therefore to prepare for the end today and, in a limited way, we have started to do this by lowering our overall risk levels (which we did in 2017 and January 2018) and by limiting our exposure to corporate credit (which is a likely victim of any recession). But two reasons mean we are reluctant to do more today. First, BCA Research have run the numbers and shown that equity returns are often highest near the end of bull markets, even if this happens to be the final 12 months before a recession formally starts. Second, Goldman Sachs looked at the 25 bear markets (defined as a fall of 20% or more for US equities) that have occurred since 1835. They make the point that there is often a recovery phase after the bear market has begun. You therefore have time to adjust (if you are in fact able to identify the market turbulence as the real thing) after the bull market has ended. Either way this points to being a little brave here. We still think the economy is strong enough to justify sticking with current risk levels for now.
One striking feature of the last quarter is that many of the investments that worked best in previous sell-offs did not help much in this one. Government bonds lost money as interest rates drifted higher. The US dollar was weaker across the board and, within equity markets, US equities have been the source of the problem rather than the usual safer haven in a storm. Even gold, which has been out of favour for a while now, lost money once you adjust for the impact of the weaker US dollar. So supposedly “safer’ portfolios under-performed many more balanced ones so far this year. The lessons for us here are threefold. First, the next crisis is often different to the one that preceded so investments that look safe based on their track record may be exactly those that are hit next time round. Second, valuation matters. More expensive assets (which often have a safety premium built into them) are riskier precisely because they are more expensive.
Finally, going all-in on one scenario or one version of what safety may look like is a risk in itself. We are therefore currently maintaining a balanced approach across all our portfolios. Our equities remain positioned for a stronger global economy (the too hot or just right scenarios). Our fixed income is a hedge against this being wrong and recession/deflation rearing its head from here. Our absolute return investments are one of the few sectors that we think could benefit from rising interest rates. This is because they are, at heart, cash plus style investments that often sit on large amounts of cash and so should benefit if interest rates on that cash rise (as they already are in the US). Finally, our alternatives portfolio is designed to grind out inflation beating results irrespective of the state of the economy and/or equity markets. While short term prices for these assets will, of course, often reflect what is going on with other risk assets, longer term returns should not. As such, through an economic cycle they should stabilise portfolios and help generate inflation beating returns for clients. Within this mix we still lean a little to the too hot scenario (with rising inflation and interest rates) because, with unemployment this low, wage inflation in particular looks like it has only one place to go (up). But the message we want to convey here for clients is one of maintaining balance in our portfolios and waiting to see which one of these scenarios develops. As ever, if markets and conditions change so will our view but now we feel ready to react to whatever the rest of 2018 has to throw at us.