Half Yearly Economic & Market Commentary

The first half of 2018 has represented an interesting period for the global investment markets with increased volatility for most asset classes. Both the FTSE 100 and MSCI World Index, for example, ended the half year with a small increase of circa 2% including dividends, but this hides an intra year fall of almost 10% for the FTSE 100 since the start of the year and an intra year fall of almost 8% for the MSCI World Index.

During the equity market falls in February and March, fixed interest markets did not provide the historical ‘safe-haven’ that investors have come to expect during stock market falls. The FTSE Actuaries UK Conventional Gilts All Stock Index fell by more than 3% and the Investment Association Sterling Corporate Bond Sector fell by more than 4%. Although the Gilts All Stocks Index has since recovered into positive territory for the half year, the Sterling Corporate Bond Sector is still down by more than 1%. This begs the question that traditional cautious portfolios may not be quite as low risk as Investors expect, particularly as interest rates look set to move gradually higher with a corresponding fall in bond prices.

This has been a difficult year to interpret in terms of short term events but has worked well from the perspective of our medium and longer-term expectations. The overall result is that our investment strategy has worked well but has required steady nerves, as it could have been tempting to take risk off the table during the sharp market falls without the confidence we derived from our wider understanding. On reflection, we are reminded again of the investment words of wisdom from Mr Warren Buffett; “If you are going to panic, panic early”!!

The stock market falls initially began in the later weeks of January and were attributed to further improvements in the US labour market which commentators felt could lead the Federal Reserve to tighten interest rates faster than previously expected. This is effectively the counterintuitive process by which the “good news” about an improving economy appears “bad news” because of the possibility of interest rate rises.

Shortly after interest rate fears sounded the start of a correction, further worrying news emerged that President Trump was looking to apply tariffs on certain metals and other goods particularly with reference to the US trade imbalances between China, Canada, Mexico and Europe. The potential for a global trade war damaged sentiment and stock markets dived again. The possibility of a full-blown trade war between America and China has become a recurring theme this year, but markets seem to be drawing the conclusion that the “bully boy” tactics employed by the US President will eventually be tempered and common sense will prevail. Brinkmanship is being practiced by both sides, but China being the net exporter has more to lose in terms of the trade relationship, although President Xi knows that if the trade war escalates and there is a recession, unlike President Trump, he does not have to answer to the electorate. Tension between the two trading super powers is likely to increase in the short term leading to further volatility in stock markets.

The second quarter of the year was almost an exact reversal of the above as economic data began to weaken, pushing back the prospect of higher interest rates. Mark Carney and the UK Monetary Policy Committee came close to hiking interest rates in May but a rash of poor economic data forced them to hold off. Employment is at a record high, import price inflation is fading, real wages are rising, domestic inflationary pressures are gradually building to rates consistent with the inflation target, but the economic outlook for the UK remains fragile due to Brexit uncertainties.

Although the factors above explain the performance of stock markets during the period, most of these are unpredictable short-term events. Whilst it is important to understand market movements, the year to date has predominantly been about political risk which is difficult to manage and predict. Nevertheless, there have been less obvious observations which provide useful insights for the future medium and longer-term trends.

Firstly, the US seems intent on changing the world economic order and its trading system, whilst the other countries that have dominated the post war world economy are crying “foul”. If the US is erecting tariffs against China, Canada and the Eurozone, for “national security”, then profound changes in liberal pro-markets assumptions are afoot.

Secondly, Central Banks now seem determined to exit from the monetary policies that staved off the financial crisis a decade ago. The Federal Reserve Bank of America has already set out a road map for winding down its programme of asset purchases and the European Central Bank has now indicated that it will follow that lead.

Thirdly, with interest rates rising in the US, it seems clear that the long-term interest rate cycle has changed from downwards to upwards. Real yields are rising, even if they are still low by historical standards. This is very important as the downward cycle has been in place since the early 1980s and investors have become familiar with certain asset class characteristics during this long-term cycle. Notably, during this period, which has outlived many investment professionals’ careers, fixed interest assets have usually provided strong profits when equity markets fell due to the expectation of lower future interest rates.

If the long-term interest rate cycle has now changed, this may no longer be the case and therefore the usual methods of reducing risk by holding a balanced portfolio of bonds and equities may not now be appropriate. There was some evidence of this in the market downturn earlier in the year as the benefit of holding Gilts was very limited and corporate bonds lost money.

It was notable that liquid equity asset classes initially fell further but then recovered more strongly than non-mainstream asset classes. This is more common than some may think as often those incurring losses on specialist assets have to sell down liquid assets to restore their cash positions, especially where they are using leverage. As a result, liquid markets fall on the increased selling pressure but, importantly, provide liquidity and are then more likely to recover as the selling pressure abates. In contrast, cryptocurrencies, as an example, suffered losses during this period but have only staged a muted recovery to date.

A further notable observation within the period is that value orientated strategies have performed in-line with growth strategies, which has pegged back the recent trend of underperformance. Value investing, buying stocks when they are cheap compared with their fundamentals, generally focuses on mature businesses which often have predictable revenues whilst growth strategies focus on companies which are expected to grow revenues, although not necessarily profits, rapidly. Value investing may gradually return to favour as interest rates gradually rise over the next few years.

The rise of growth stocks has been spectacular in recent years and the car manufacturer Tesla is a useful example. Tesla manufactures electric cars and clearly has a great product, however, the financial position of the company is less traditional. The company has a negative Price/Earnings ratio as it loses money and requires considerable cash injections to continually cover these losses.

Investors have been keen to support the massive cash burn to date however, concerns are beginning to emerge that the anticipated pot of gold may not be at the end of the rainbow, as manufacturing delays have reduced earnings below targets and increasing competition from other manufacturers presents further risks. Although some growth stocks may deliver to investors, the risks posed are clear.

There are concerns about the role of index tracking fund strategies in creating these types of situations as companies, which are hungry for capital, issue more stock which increases their size within the index and leads to further automatic allocation of capital by tracking funds. There could be an issue where moral hazard exists as companies which consume and burn capital are potentially rewarded with even more capital. The potential risk to this situation could be exposed if a company, such as Tesla, failed and led to a dramatic loss for a significant index constituent.

Tesla is reported to be a very actively ‘shorted’ stock and therefore an interesting battleground between active managers and passive funds. As more of the market becomes passive in nature due to the continued inflows into these funds, the opportunities for active managers should increase as capital is likely to be misallocated if company size is the most significant factor.

Gathering all the information for the year to date together, we believe that the political risk around a potential trade war between the US and the rest of the world can be largely disregarded as, whilst it is possible, managing this type of political risk is closer to gambling than a rational investment strategy.

The observation that strong economic data could be bad news for markets is very relevant, and we continue to expect the global economy to expand and interest rates to move upwards, albeit gradually, over the medium and longer term. This is likely to lead to similar bouts of volatility in the future. However, on each of these falls, quality assets may offer a short-term buying opportunity as they will recover if economic growth remains positive. Although higher interest rates will provide some head wind, the actual increases will be small in magnitude and therefore the benefits of economic growth will outweigh these concerns over time, leading to equity markets remaining in an upward cycle.

There are valuation bubbles within equity markets and these will be easy to identify with hindsight. We have touched on Tesla and this may be an example, but there are plenty of potential options including Facebook, Netflix, Cryptocurrencies and other assets pushed up by cheap, easy money which has been available since the credit crisis. During the expected future periods of volatility these stocks may fall with the market but may not enjoy the same recovery potential.

We continue to echo our comments within previous commentaries with respect to fixed interest markets. Bond investors could face downside risks from a rising interest rate environment, and these assets may not provide the historic non-correlation benefits which many continue to expect and rely upon. It is worth mentioning that the fixed interest component of most passive cautious, risk rated, portfolios has an average ‘duration’ of 8.5 years. Duration of this length could result in serious falls in the investment when interest rates rise. A 1% rise in interest rates could translate into a fall of more 8% in the fixed interest part of the cautious portfolio with further falls likely as interest rates continue on an upward path.

Strategy

In conclusion, we expect the rate rising cycle will be gentle, but negative for fixed interest investments. Sensitivity is increased due to the current historically low yields and credit spreads. As mentioned above duration will also increase the risks. Clarion have already limited our exposure to these areas and restrict our fixed interest exposure to quality bonds of short duration.

Equities are favoured as continued economic growth will support valuations however, there are some valuation bubbles, particularly within the larger indices. We expect active management may provide an advantage to index tracking funds especially where the process is aligned with a traditional value approach.

The UK, Asia and Emerging Markets are preferred on a valuation basis. Europe is neutral, but trending downwards as the impact of interest rate normalisation could be more significant due to the lower starting position. The US has an underweight allocation due to the higher valuations in this market although US smaller companies may offer an interesting opportunity.