02 Jul 2020
Market Commentary: March 2018
The first quarter of 2018 can be succinctly described as one during which we witnessed the return of volatility to financial markets.
The first quarter of 2018 can be succinctly described as one during which we witnessed the return of volatility to financial markets. Following a record-breaking period of calm during 2017 when equity investors, in particular, enjoyed strong gains, there was much expectation that a return to more volatile markets was overdue, but that still didn’t prevent the change in conditions from taking many by surprise. Adding to the new sense of uncertainty was the fact that investors had several different factors to consider during the quarter, none of which appear to have been resolved at the time of writing this review. In order of appearance, as it were, they were an inflation scare, potential trade wars and a fall from grace of certain mega-cap technology companies.
The first four weeks of 2018 saw risk assets continue to deliver strong returns. Indeed, for the first time in a while, there was a sense of euphoria in the air as the MSCI All-Countries World Index rose more than 7% over the first seventeen trading days of the year. Traders were looking forward to synchronised global growth of around 4% for the year ahead, the first such burst of consistency since the financial crisis, and Donald Trump had just pushed through a series of tax cuts which provided a strong boost to US corporate earnings. Much of the feeling of political uncertainty that was prevalent a year earlier had subsided. This idyll was shattered at the beginning of February by an employment report in the US showing that annual wage inflation had jumped from 2.4% in December to 2.9% in January (later revised lower to 2.8%). Many economists had been concerned for some time that an unemployment rate nearing 4% was indicative of a very tight labour market, and that this would inevitably lead to higher wages, setting off a classic inflationary cycle. This one piece of data set alarm bells ringing. Bond yields rose as investors anticipated more aggressive action from the Federal Reserve and also demanded higher yields to compensate for the higher inflation risk.
This, in turn, undermined the valuation case for equities, triggering a sharp correction amounting to around 10% in many indices. Following the serene progress of markets until that point, it was the sharp rise in volatility that contributed to such a violent correction that saw the S&P 500 Index register a double-digit percentage fall in just eight trading days. Many funds that were relying on volatility remaining low to sustain their returns suddenly found themselves under intense pressure and there was “forced” selling of shares amounting to several hundred billion dollars’ worth.
‘The final straw was a sell-off for technology stocks, a sector that had been a strong market leader.’
Markets recovered their poise as it was generally agreed that prospects for growth remained unaffected, but this optimism was slowly undermined as the quarter wore on. After the first year of his presidency during which Donald Trump, for all his bluster, had contributed little to the markets’ direction, he announced import tariffs on steel and aluminium, followed by very specific tariffs on a number of Chinese goods. Europe threatened retaliation and China proposed its own tariffs on certain imports from the US. These moves brought into question the whole concept of open global trade, something which is deemed to have been a positive force for both consumers and investors over recent decades. The uncertainty was reflected in a dip in business sentiment surveys, although growth forecasts have yet to be discernibly downgraded.
The final straw was a sell-off for technology stocks, a sector that had been a strong market leader. It started with revelations that Facebook, the social media giant, had allowed the unauthorised use of private data, bringing into question a business model that relies on the mining of such data for a large share of its profits. The fact that the data was allegedly used to manipulate the outcome of 2016’s US presidential election only served to fan the flames of indignation. Suddenly the dominance of companies such as Facebook, Amazon, Apple, Netflix and Alphabet (formerly Google), the so-called “FAANG” stocks, was put on trial in the court of public opinion, with politicians also spotting an opportunity to play to the populist audience. The misery was completed by the tragic deaths of two people in accidents involving cars using “driverless” technology, one an Uber test car, the other a production model Tesla. While we have great belief in the future of the technology industry, it appears inevitable that investors will take some time to digest what has been a materially volatile period for the sector.
The influence of populism on political outcomes and the shifting emphasis of global monetary policy have consistently been our prime concerns for some time now. However, we appear to be entering a new phase in how they are being transmitted to markets. Furthermore, we believe that the long period of subdued volatility is behind us. Even if this only means a return to a more normal environment, it will still feel unsettling relative to recent experience.
Whatever the roots of what is now generally described as populism, whether they be in the long-term effects of globalisation or the unexpected consequences of extreme monetary policy, we cannot doubt that its influence is highly pervasive. In 2016 and 2017 it was all about the ballot box, with elections and referendums dominating the calendar. Now we know who is in charge, but we have to see how their policies develop. President Trump’s trade tariffs, squarely aimed at China (even if some other countries have been caught in the crossfire), are the most important variable currently. There is arguably some merit in his objectives, not least in attempting to rein in China’s well-documented abuse of intellectual property rights, but his methods are heavy-handed, to say the least. However, we are of the opinion that increased global trade has been good for consumers (more choice, lower prices) and good for investors (lower inflation, higher profits), and so any reversal of long-term global trade trends could lower choice, raise prices and gnaw at corporate profitability. Any sense of a more diplomatic approach by Mr Trump is undermined by the looming November mid-term elections and the ongoing investigation into Russian involvement in the presidential election by Robert Mueller. We must hope that other trading nations are not tempted to be drawn into tit-for-tat measures. However, we also recognise that ruling politicians have some responsibility to respond to the causes of populism, which could lead to less popular (for the wealthy) redistributive policies.
On the monetary policy front, the US Federal Reserve continues to lead the charge on tightening, both raising interest rates and reducing the outstanding balance of assets purchased under its Quantitative Easing (QE) programme. Global markets and economies have weathered the initial phases well, but with other countries also raising rates (the UK and Canada, for example) and the imminent ending of the European Central Bank’s own QE purchases, monetary headwinds are increasing. Investors have been relaxed as long as growth and earnings forecasts have been accelerating, but any sign of a slowdown – and we have begun to see a few – will stoke fear that a monetary policy mistake is in the making. Once again, monthly economic data releases will have greater capacity to increase volatility.
‘President Trump’s trade tariffs, squarely aimed at China (even if some other countries have been caught in the crossfire), are the most important variable currently.’
The FTSE 100 was the worst-performing major equity market in the first quarter when measured in local currencies, which is an ignominious achievement. Allowing for currency movements, with the pound having strengthened 2.2% on a trade-weighted basis, things don’t look quite so bad, but the losses cannot be avoided. There is no doubt that sterling’s recovery is partially responsible for the pressure, with overseas earnings being translated at less favourable rates. The same goes for dividends that are reported in dollars or euros. Another reason is that international investors have continued to reduce their exposure to the UK owing to political uncertainties.
Despite the “softer” tone of Brexit negotiations, the UK’s future departure from the European Union is a key factor, as is the lingering risk of a Labour government. These are the sorts of situations in which undiscriminating investment decisions are made, and UK equities are beginning to screen attractively on valuation.
Volatility is back with a vengeance. The S&P 500 Index closed up or down by more than 1% on just ten days in the thirteen months to the end of January 2018, a record period of calm. Since the beginning of February, this has happened on no fewer than twenty-one occasions. That being the case, one could argue that the index has done well to be just 1.2% below the level it closed at the end of 2017. However, January was a storming month, and the index ended the period 8.1% below its peak of 26th January. Technology shares were a prime contributor to performance, and the tech-heavy NASDAQ index, in fact, made its own all-time high as late as March 12th. Thereafter the revelations of Facebook’s unauthorised release of personal data, amongst other travails, provided a more-than-ample excuse for investors to take profits.
European markets have failed to escape the malaise. A strong euro has eaten into export competitiveness, and trade war fears have weighed on German multinationals in
particular. Despite the fact that there have been some disappointing economic datapoints, we continue to believe that Europe’s recovery is far from done. It was a very late starter in the recovery process following the financial crisis, having pursued fiscal and monetary policy that was too tight, and being too slow to recapitalise its banking sector. We do not believe that the ECB will prematurely derail the recovery.
However positive we might have been about the potential cheapness of Japanese stocks and the embracing of more shareholder-friendly corporate governance rules, the local indices remain vulnerable to a stronger yen and worries about global trade – Japan was notably excluded from President Trump’s exemptions on steel and aluminium tariffs. A whiff of scandal surrounding Prime Minister Abe has also been unhelpful, but as long as he remains in power (alongside Haruhiko Kuroda as head of the Bank of Japan), it is hard to see economic stimulus being
Having been the best-performing sector in 2017, Emerging Markets in aggregate have continued to prosper on a relative basis in 2018, although only by standing still as other markets have fallen. There has been a notable performance divergence amongst the regions. Mexico, for example, has suffered from Donald Trump’s trade threats, whereas Brazil has enjoyed the benefits of a more stable political background as well as decent growth, falling inflation and lower interest rates. Russia has also done well, while China has lost a little ground. No doubt the threat of trade wars is unhelpful for emerging economies in aggregate, but we continue to believe that demographic and social trends support long-term exposure to the asset class.
In the first few weeks of the year, bond markets swooned under the threat of higher inflation and rising interest rates. By the end of the quarter there was more concern about a slowdown in growth, thanks to Donald Trump’s trade tariffs and the steadily tightening monetary environment. The US 10-year Treasury yield, a key driver of valuations across the investment spectrum, started the year at 2.4%, came close to breaching the psychologically important 3% level in February (peaking at 2.95%), and ended the quarter at 2.73%.
The UK 10-year Gilt was equally volatile, moving from a low of 1.19% to a peak of 1.69%, finishing at 1.34%. There remains much debate about whether or not the 35-year bond bull market can officially be declared dead, often dependent on the thickness of a chartist’s pencil. Our sense is that markets remain vulnerable to any meaningful upside breakout of inflation expectations, but cyclical inflationary forces (tightening labour markets, resistance to globalisation) appear to be well balanced by secular disinflationary trends (ageing western populations, technology). However, one thing is clearer, and that is that central bankers, in aggregate, see less need to sustain emergency monetary policy settings. Thus the tide of liquidity that has floated all financial boats will continue to recede.
UK Gilts have delivered a total return of 0.26% over the last three months and 0.46% over the last year. Index-Linked Gilts returned -0.3% and –0.1% over the same respective periods. Emerging Market sovereign bonds produced a total return of -5.3% in sterling over the quarter to end March (-7.5% over 12m). Global High Yield bonds delivered -3.9% (-4.6% over 12m).
Conclusion and outlook
The first quarter of 2018 has provided the long-awaited, and perhaps not entirely unwelcome, reminder to investors that, as per the disclaimers, markets can move down as well as up. We have argued for some time that a return to higher volatility was inevitable, although we could never be sure of the exact catalyst or timing. Now we know! In anticipation of such a development, we have been recommending that clients gradually reduce the level of risk within portfolios (relative to benchmarks), although we have not taken a hard defensive stance. Low interest rates and bond yields remain supportive of equity valuations, and global growth appears set to deliver decent advances in corporate earnings and dividends for the next couple of years.
Left to their own devices, companies are capable of generating good rewards for investors, but we have highlighted policy risk as the greatest threat, either at the behest of central bankers or politicians. Currently, both groups are tweaking policies in such a way as to undermine confidence and threaten growth. In the past, we have placed trust in both to “do the right thing”. Our confidence, especially in certain politicians, is not as great as it was, and therefore we continue to believe that now is not the time to be taking big risks with clients’ wealth. We believe that equities in the long-term remain an excellent source of wealth creation, and we are beginning to see signs of better value appearing in some areas of the bond market, notably US government bonds. But for now, the uncertainty demands a little more circumspection on our part.