Beaufort Investment Management have provided the following Commentary.
In the last quarter of the year, our expectations were for a less volatile period than what was delivered. Consequently, during the last three months of 2018, we revised our short-term views and have become more cautious, which led us to reduce our equity exposure across the model portfolios, bringing the weightings to neutral as a maximum, as we did not feel it was appropriate to have an overweight position to equities going into 2019.
This move is a natural progression of the alterations we have been making to the model portfolios over the past 18 months. We have been reducing the number of the funds we hold, as well as moving towards value as an investment style. Whilst our view was becoming more cautious at the beginning and throughout 2018, it gathered pace in the last quarter.
We entered 2018 on the back of one of the calmest global equity markets since the end of the global financial crisis. For the first time ever, the main US equity index (S&P 500) and the main world index (MSCI AC World) delivered a positive return for each calendar month. The volatility measure (VIX) delivered nine of the ten lowest ever readings.
In 2018, on the back of a heady cocktail of positive earnings and growth forecasts, optimism was consensually high. Too high as it turned out, especially when one considers how long the current bull market rally has run. That is why we started to make changes to the model portfolios to more cautious positionings.
What no-one could have expected was the rise of political influence in the markets. We were expecting central banks to take centre stage, with quantitative easing (QE) being replaced by quantitative tightening (QT) in the US, with the Federal Reserve bringing interest rates back to a more normal level. They would also have a new chair sworn in in February, and our main concern was how this new leadership would affect interest rate rises in the US.
A change of leadership at a central bank always brings with uncertainty, which is why we were positive about the renewal of tenure for governor Haruhiko Kuroda at the Bank of Japan, as well as Mark Carney’s extension at the Bank of England to 2020.
However, the unknown unknown to paraphrase Donald Rumsfeld, was how geopolitics would steal the limelight and create greater uncertainty than anticipated, especially in the last quarter of the year.
Inevitably, after such a calm 2017, the probability of higher volatility was, higher; since the start of the recovery in 2009, markets have had a correction every year, however 2017 bucked that trend, so a correction in 2018 was expected, but not before the market hit another high. The euphoria had a final rally at the start of 2018, sending the markets to another record high on 26th January.
The record high was helped by comments made by US Treasury Secretary Steven Mnuchin, at the annual economic gathering at Davos, Switzerland. In a rash comment, he voiced the desire for the US to have a weaker currency, “a weaker dollar is good for us as it relates to trade and opportunities.”
2017 saw a consistent and gradual weakening of the US dollar, which is typically advantageous for equity markets as it provides more accommodative financial conditions globally. Ironically, the point at which Mr Mnuchin made his comment, was the lowest point for the US dollar. For the rest of the 2018 the dollar strengthened considerably, making global trading conditions tighter and laid the groundwork of the trade tensions that would follow and overshadow the rest of the macro environment.
The following month brought the delayed correction. On 2nd February the average earnings in the US was published for January, and the resultant 200,000 new jobs and an increase of 2.9% in average hourly wages was much higher than expected. This was perversely the catalyst, as this good news triggered a revival of inflation fears and sent yields on bonds sharply higher, triggering a risk-off episode as investors heavily sold equity positions.
The initial outflow in equities intensified as inverse-volatility funds, which were used to bet on markets remaining tranquil and increased in popularity throughout 2017, collapsed. Their fall from grace rippled through markets, while traders rushed to hedge their own positions and we saw one the quickest corrections in history.
Powell kept to the story line and raised interest rates in March and gave forward guidance for a further three hikes in 2018. This proved attractive and flows to US denominated debt pushed the dollar higher. The US dollar continued to strengthen in line with the rhetoric of trade wars between the US and most notably China.
Expectations for US growth continued to rise, partly based on the effect of the tax cuts and partly because of the strength of the economy enabling the Fed to raise interest rates. However, as good as this was for the US, a strong dollar is particularly painful for emerging markets, particularly against a backdrop of tough trade conditions.
Turkey was the hardest hit of the emerging markets and their woe was not helped by politicians. This time it was their own President Erdoğan who declared interest rates the “mother of all evil.” Unsurprisingly, this started a full-blown currency crisis, not helped with a spat with the US over detained American pastor Andrew Brunson. Eventually the Turkish central bank raised interest rates, after trying other initiatives which had failed to stem the inflation and currency fears.
As the crisis in Turkey deepened over the summer, the contagion spread to the other emerging market countries. Most notably of these was Argentina who requested a bailout from the International Monetary Fund (IMF) and made the headlines with the biggest loan in the IMFs history.
The loan of $57 billion came with the expected strings attached, including hitting a zero deficit for 2019 and restrictions on their central bank, markedly not inferring with currency markets. To exacerbate matters, Argentina’s central bank had to raise interest rates from 45% to 60%.
Attention was drawn back to developed markets; Italy was a prime example of what could go wrong. In March, we saw the populist parties Five Star and the Northern League ahead of peers in their general election, a result which was unexpected by many investors. A government was eventually formed by the two parties, which sent bond prices spiralling higher as Italy’s spending plan was scrutinised. Their budget broke the EU’s fiscal rules and negotiations began in earnest. Cynically, this could be interpreted as another episode of kicking the can down the road, waiting until the European Elections in May are over, when 751 Members of the European Parliament (MEPs) will be voted in.
The second correction came in October. In a replay of February’s correction, bond yields spiked higher, accelerated by Fed chairman Jerome Powell comments that interest rates were “a long way from neutral.” This was construed by investors that the pace of tightening (an increase in rising interest rates) would quicken and consequently sparked a sell off that was dubbed ‘Red October’. Almost all asset classes were affected and in particularly the technology stocks which had done so well in the summer, caused the technical correction of a 10% drop globally.
Analysts forecasts for corporate earnings were subsequently cut for 2019. To make matters worse, the Federal Reserve delivered its promised fourth interest rate rise, despite a backdrop of market volatility and arguably weaker economic data.
In November, we increased our weighting to Japanese equites, as our most favoured asset class and the only developed market to still have an accommodative monetary policy.
At our Investment and Asset Allocation Committee December meeting, we increased our value bias within the model portfolios. Our base case for the short-term had become more cautious and as such, entering 2019 with an overweight to equities seemed inappropriate. We took the decision to reduce the risk across the entire spectrum.
What will happen?
As the high from the US tax cuts begins to fade, all good news is arguably priced into global markets. This could mean that future good news barely registers, while worse than expected news could be greeted with sharp, downward movements. This is typical at the end of a bull market, and while flows would not suggest that panic has set in, it certainly looks like we are closer to the end of the market rally that started almost ten years ago.
We have previously commented that recessions and bear markets have been created by central banks increasing interest rates too quickly and by too much. The Federal Reserve has an unenviable track record of causing ten of the last 13 recessions since World War II through tightening monetary policy too hastily.
The Fed purport to be data dependent and when they raised interest rates in September, the data could be interpreted as suitable for further tightening. Since then, data has become more subdued and the lagged effects of the tightening monetary policy are starting to bite, including the effects of the reduction in their balance sheet. It would have been extremely difficult for Jerome Powell to climb down from the fourth and final rate rise for last year and that is why the rhetoric has markedly changed.
The markets are calling the central bank’s bluff and have priced in no interest rate rises in 2019. The odds that the funds rate closes 2019 at or below its current level are at 91%. This is a complete turnaround from just two months ago, when the odds of rates closing higher by year end were 90%. Such is the degree and swiftness of change in market expectations.
The draining of liquidity in markets, which started with QE ten years ago, is having a negative effect on investor sentiment. The Federal Reserve may be the furthest down the line with tightening monetary policy, but the European Central Bank have joined them as their tapering programme finished in December. Only the Bank of Japan have a degree of looseness in their monetary policy.
As we have witnessed in 2018, political sentiment can change extremely quickly, against what has been a difficult economic backdrop. It is likely that as the current bull market, which will have reached a milestone of 10 years in March, begins to fade, that volatility will become more pronounced. The level of political noise and pressure on central banking policy is expected to increase unabated, as markets look to decipher the economic indicators and decide whether we are heading towards a recession.
While it may seem counterintuitive, it is important to have a steady hand during these periods of increased political, economic and market activity. Being over-reactive to quickly changing and largely unpredictable events can be damaging to both the short and long-term performance of the model portfolios. We have made appropriate changes across the risk spectrum, bringing our equity exposure back to neutral (underweight for our lower risk model portfolios), while ensuring we have the correct level of diversification within the underlying funds themselves. This means a bias towards value and quality over growth.
It is important that the model portfolios are not reliant on binary outcomes. That is why they are fully diversified and although we have biases within the overall construction, they are not predicated on any single event. We are more cautious going into 2019 than we were at the end of the third quarter last year. The risk of a recession has certainly been brought forward from our previous base case of 2020/2021. Global growth is clearly receding, and the slowdown is spreading across both emerging and developed markets.
We cannot predict when the next recession and subsequent bear market will fall, however we can ensure that the model portfolios, which by remain fully invested at all times, are as defensively positioned as appropriate to the level of risk being taken.
Our message for 2019 is to stick to the investment horizon you set and stay the course. There will be headlines and turbulence to navigate (Brexit, trade wars, interest rate hikes, interest rate pauses, European elections, change at the ECB, Democrats in control of the House, currencies and debt ceilings), but staying the course is the important thing to remember.
*Past performance is not a reliable indicator of future results
Article Credit – Shane Balkham – Beaufort Investment Management