Markets topping or pausing for breath?

Coming into the year, our expectation was that global growth prospects would prove to have been overestimated. The first half has indeed been full of economic data falling short of expectations, perhaps especially in Europe. The “wild-card” to this was always going to be the impact of US tax reform, and unusually loose fiscal policy, which seemed likely to at least ameliorate the problem for the US economy, in the short term, but was less certain to drag the rest of the world along with it.

Well, US corporates had ended 2017 on a high, and first quarter 2018 earnings turned out to be exceptional. We will find out this month to what extent the second quarter replicated this achievement. Analysts expect that 2019 will be much harder work though, we should point out, and if CEOs guide forward expectations lower, due to uncertainty around “trade wars”, then the market is likely to react negatively.

Chinese equities entered a bear market in the first half of the year, and in fact, it was the worst first half of a year for Asian markets in general since 2010. The average crypto-currency, for what that is worth, fell more than 60% over this same period. More generic investor sentiment started feeling queasy in June, when we saw record outflows from Emerging Market funds, and $12bn out of global equity funds, which was the most since October 2008 (hardly auspicious). Additionally, there was profit taking in the technology and smaller company space, at the end of the month, and some arguably indiscriminate selling too, suggesting “fear”, and possibly some oversold securities.

One can see from the MSCI World ex US index (Fig. 1), how 2018, after a strong 2017 (and then the January 2018 “melt-up”), has turned into an increasingly difficult year for other global markets:

As longer standing clients will know, we built out significant exposure to the US stock market from 2011, which has worked well (US equities were near an all-time low versus Europe in 2011, but now are at a post 1976 high), and H1 2018 was no different in that regard. This performance has been built on superior earnings per share appreciation, compared to the rest of the world, and driven by US growth sectors, especially Technology. Investors are now starting to reward these stocks with higher valuation ratings, which is to say that rather than expecting profit margins to mean revert (which they do, historically, and has been used as a stick to beat the US market for years), they suspect that these may now be higher, and permanently.

So, our US exposure has continued to work well. However, although we spent years thinking that profit margins could indeed move higher and for longer, we are still wary of their mean reverting potential (Fig. 2), which is also true of valuation levels, and the ratio of capital to labour’s share of GDP. All three areas are stretched at the same time, so a significant re-rating and probable market correction is quite possible at some point, perhaps after the next downturn (exacerbated by populism), and not just in the US (although it is most prevalent there).

In any event, investors had felt, entering 2018, that better returns would be found in Emerging markets and Europe, rather than the US, and this has proven erroneous (so far) or at least premature. The Financial Times recently pointed out that “the Davos consensus” (essentially the same theme) had been completely wrong this year. We feel that we have made a reasonable assessment in interpreting the economic environment, although it has been difficult to fully monetize this at the portfolio level. There is no singular investment strategy

that would have worked particularly well in the first half of 2018, given the inconsistencies and abrupt reversals that we have seen, allied to excess volatility (finally) and a news flow driven environment, dominated by Sunday evening tweets from the White House. Indeed, Bloomberg reports that “quantitative” funds are having their worst run for eight years, “Value” strategies have had their worst quarter since 2011, and “Momentum” it’s worst month (June) for two years. Not so “Smart Beta”.

Our sense is that many peer wealth managers have ended up in roughly the same place as us, six months into the year. There was plenty of scope for some to have performed rather worse, although we would have some sympathy as tactical asset allocation, for example, would have been horrendously difficult. The market tends to struggle to focus on more than one thing at a time, and corporate fundamentals rarely threatened to get to near the top of the list of investor priorities, over this period, so any valuation-driven approach will have failed to fire too.

One of the great uncertainties this year (and next) is how markets will react to the end of Quantitative Easing, and its replacement with Quantitative Tightening. This has already been going on in the US, but Mario Draghi has now pledged to finish QE in Europe too, at year end. There is certainly a feeling of tightening credit conditions, and bond markets have been uncomfortable all year, as one would expect (and especially given the deluge of new issuance due from the US. NB interestingly there is no issuance of TIPS (Treasury Inflation Protected Securities) this year though).

Stock markets used to be a good litmus test to the health of their underlying economies, and growth therein. However, they have been rather co-opted, over the last decade, by central banks, as engines of growth, with the hope of creating a “wealth effect”, with the economy then reflecting the market.

Regardless of how sensible one thinks that may be, or how much success one attributes to it (and as there is no counter-factual, little can ever be proven), the point is it is now going away, and indeed reversing. Central Bank support is being removed from financial assets, and they will have to stand on their own two feet. Some of Schumpeter’s (much delayed) famous “creative destruction” could be in the cards, although whether this brings the central banks racing back with support is an interesting question.

Clearly the greatest unknown for the market today though, surrounds tariffs and potential trade wars. Is Donald Trump’s bark worse than his bite (has been so far), is it all the “Art of the Deal”, or instead a sign of things to come in a post-multilateral post-peak globalisation world?

So, 2018 is turning out to be one of those rare years where politics really does matter and matters a lot, at least to markets. The latest example being Andres Obrador, who won’t take power in Mexico until December, but is a (left-wing) populist, albeit who claims he will run balanced budgets. In fairness, Lula was of a similar mould in Brazil but turned out to be rather more moderate when in actual power. Nevertheless, the issue at hand is that of ongoing anti-elite, or at least anti status quo, electorates, and with what implications for e.g. the free(ish) movement of capital, jobs and labour?

In the US, it is midterm election year, which is the least profitable of the four-year election cycle for investors and often includes a significant drawdown. However, its other compelling attribute is the strong rally that then occurs over the subsequent 12 months, usually from around October. As it stands the Republicans have a (supposedly) roughly 40% chance of keeping the House, but a near three-quarters chance of retaining the Senate (they are defending a mere nine seats, and only one of which is in a State that Hilary Clinton won in the Presidential election in 2016). That said, usually if the House flips then so does the Senate.

A greater division of power in Washington is actually most often a good sign for markets, if only because there is then less chance of changes to, or additional, legislation and regulation, and corporates can get on with delighting their shareholders.

In any event, our current stance is to be fully invested, until our Cash Overlay Process tells us differently. That said, within that

stance we are still pretty defensively positioned in that we have high weightings to diversifiers in Alternative Strategies and Real Assets, relative to portfolio core assets (equities and fixed interest investments).

Our valuation concerns from the start of the year remain, but financial markets are, if not cheap, then at least less expensive than they were then. The chart in Fig.3 illustrates this, by showing the valuation of the S&P 500 index of US companies since 1995. The sheer strength of corporate earnings this year means that the price to earnings ratio has now fallen back to its average, which

is acceptable if the US economy is still, and remains, in expansion mode (600,000 re-entered the workforce in June, so for now this seems ok).

This is not “sale of the century”, far from it, but is certainly not a reason to be entirely out of equities. We are neither optimists or pessimists of course, we just try to be “probablists” (to paraphrase the late Hans Rosling), and to adapt to new information each day, without anchoring to our initial prognosis.

Our view of the market is that it is uncertain whether equities (S&P 500/MSCI World index) are forming a top, or in a medium-term correction (before pushing on to new highs). The sideways action of recent months certainly won’t last forever. However, it is sensible to embrace the fact that for now no one can predict which way the trend will break, you just need to wait for the market to reveal all in due course. Our underling “Signals” will confirm this to us, and hence the appropriate stance to take, although they don’t call tops and bottoms, rather identifying an appropriate forward-looking stance given the underlying health of the market.

That is not to down play the disputes (various) over tariffs – trade barriers are a big negative for investors – rather that we simply need to be patient. Societe Generale is of the view that currently China is set to lose 1% of GDP (and 4 million) jobs, while the US will lose “only” 0.2%. However, one consequence of the confluence of various of these measures, is that the price of washing machines in the US is up 16% (according to CBS News) in recent months, nicely illustrating the law of unintended consequences.

So, ultimately no one really wins, sentiment gets damaged, and few can suggest how the 3rd and 4th order iterations and feedback loops will play out. One simple example; China has taken tariffs on Soybean imports from the US up to 28%, while reducing them to zero for others. Brazil is then in position to sell as much of their own crop as they can to fill demand in China, and meanwhile can import cheaply for their own needs from the US. Strange and unpredictable outcomes should be expected, and at times like these it is some comfort to be running a rules-based investment approach rather than acting as a broking soothsayer reliant upon tactical guesses in an increasingly uncertain world.

Overall, we sense difficult investment conditions for the coming years, which of course is why we have designed a process specifically to deal with this. It is important to harvest market returns when and while they are available though, and we also won’t be shy about doing that, with the generation of positive real returns a necessity in supporting our clients’ financial plans.

Andrew Wilson, Chief Investment Officer July 2018

The content of this newsletter is for information only. It does not represent personal advice or a personal recommendation, and should not be interpreted as such. Please do not act upon any part of it without first having consulted an Independent Financial Adviser.