There can be no escaping the issue; the final quarter of 2018 was grim. In the concluding three months of the year sterling investors have seen an approximate 10% fall in the equity component of their portfolios and, in so doing, will likely have taken portfolios from gains to losses for the year. This quarterly report will attempt to explain why markets have endured such a difficult period, but also offer some reassurance, encouraging investors to hold their nerve as we look ahead to 2019.
Easing the Tightening
At first glance it would seem reasonable to lay the blame of the stock market’s travails on the political uncertainty plaguing the halls of Westminster, Washington and Brussels. Yet, whilst the respective soap operas continue to provoke volatility, the more likely explanation is the development of the economic cycle. Over the course of 2018, and particularly into the end of the year, we have seen global growth forecasts for the year ahead taken lower.
This is naturally a worrying predicament; a slowdown is a necessary (but not definitive) step before a recession. It is particularly worrying if policymakers are moving only slowly in their attempts to alleviate the situation. It was pleasing to see; therefore, the US Federal Reserve move in an accommodating fashion in December. In their final meeting of the year members revealed they are taking a more cautious approach to future interest rate hikes. However, despite this positive step, markets took little comfort from the move, evidently craving something even more generous. The modest accommodative adjustment, however, came after only a modest deterioration to the outlook. By that measure at least, it would appear the Federal Reserve is acting appropriately, and would also be willing to offer a more significant response if the circumstances required. The ‘Fed’ remain, as they so frequently attest, ‘data dependent’.
North America versus the Rest of the World
If we cast our minds back to the tail of 2017, the buzz phrase within investment circles was the ‘synchronised’ nature of the global recovery; in which a resurgent Europe and China joined the US in propelling global growth to levels beyond trend. These latter two contributors, however, have fallen away in 2018. China’s economy has come under pressure this year as policymakers have sought to tackle ongoing corruption, environmental degradation, and a shadow banking system that exposes the economy to less visible financial risks. By taking on such challenges the Chinese leadership is transitioning China to a more sustainable growth trajectory. Such a cause is both sensible and noble but, in the short term, is a net negative for job creation, particularly as banks ‘close the back door’ to funding needs. This predicament, therefore, requires careful management. Indeed, we have already seen steps taken to promote ‘official’ bank lending; but either the hesitancy to lend or, more worryingly, the reluctance to borrow, has meant China data continues to disappoint. One apparent bright spot is manufacturing, but with US buyers bringing forward purchases of Chinese goods in advance of potentially higher tariffs, this trend is not sustainable. In fact, this corporate strategy threatens near term disappointment as the same US buyers run down Chinese stock piles.
This broader economic weakness has spilled over into the rest of Asia, most commodity producing economies and Europe, with each region far more dependent on Chinese demand than the US. European economic performance has also been plagued by internal strife as, yet again, Europe demonstrates its generosity in delivering geopolitical risks to the world. Adding to Italian woe, where the coalition government has clashed with EU officials over expansionary budgetary proposals, German electoral results have led to Merkel’s formal withdrawal from running in the next General Election, currently cited for 2021. In addition, in response to reform efforts from the hitherto exalted leader of France, Emmanuel Macron, civil unrest is again afflicting the streets of France.
Akin to its US counterpart, rather than reversing policy, the European Central Bank signalled it will remove accommodation at a slower pace in response to the increasing economic risks. Again, these efforts did little to assuage markets, but the message remains one of pragmatism and support.
Deal or No Deal…or No Deal Yet
Brexit, and the government’s management of the process, has enjoyed almost complete domination of domestic newswires in the fourth quarter. With so much ink having been spilled on the topic it’s difficult to reveal any sensational insight, however, from an investment perspective, we do know that sterling is cheap. Much of this value has manifest as a result of Brexit risks and, over the quarter, the increased prospect of ‘No deal’. Such an outcome would elevate risks for growth in the short term and, almost certainly, compel our central bank Governor to lower interest rates and extend other forms of stimulus; all of which place downward pressure on a currency. Conversely, therefore, one might assume avoiding a ‘No deal’ would see some level of appreciation for the pound. This may well be the case but the circumstances in which ‘No deal’ is avoided will be crucial. If, for example, Article 50 is extended to allow more ‘No deal’ preparations to be made then sterling may even cheapen up.
The uncertainty over the final Brexit outcome, and the associated impact on sterling has also led to UK equity under performance relative to global equities this year. Despite the significant proportion of international revenues from UK listed businesses, a greater proportion of sterling derived revenues exist relative to global stock markets. On that basis, whilst UK equities are a good hedge against sterling weakness, international equities are an even better one.
Do not get bogged down in currency performance, however, it is the anticipation of where earnings are headed, not currencies, which ultimately determines whether equities go up or down. It is on this basis, therefore, that some optimism can be drawn from the recent behaviour in markets. Share price falls have not been a measured response to a dramatic decline in earnings expectations, rather, they have fallen on a sharp deterioration in sentiment following modest downgrades to global growth expectations. Fundamentally, therefore, with earnings holding up reasonably well, stocks have cheapened up considerably over recent months.
Also notable over the quarter was the stark decline in the oil price which, when combined with concerns over a decelerating China, reveals a global economy operating under eerily similar conditions to those which prevailed in 2015/16. Then, as now, stock markets were hit by the blow to oil related revenues and investment, as well as waning Chinese demand. Both outcomes, however, resulted in stimuli which paved the way for a very rewarding period for stock markets. But also based on this example, such a boost is most likely to come later in the year and, as always, there are risks. Oil price falls have already boosted consumer incomes, but such gains may need to be delivered for an extended period before they are spent. We also have very little transparency on the response of the Chinese government, who are walking a very difficult line between reform and avoiding a major economic slowdown.
Equities have endured a dreadful quarter and investors will surely be feeling uneasy as a result. However, what we have also seen over recent months is central banks showcase their willingness to alter course as conditions require. Notably, this reduced probability for further interest rates hikes also makes the income return from stocks increasingly attractive.
There can be no doubting the outlook for domestic politics remains fluid and increasingly complex, but do not be lulled into thinking this will be the key determinant of investment success. Given the broader conditions described in this report, the outlook for equities has improved.
“For every complex problem there is an answer that is clear, simple, and wrong”
H. L. Mencken, 1880-1956, US journalist and satirist
Ben Gutteridge, CFA
Head of Fund Research, Brewin Dolphin