What happened in 2018 and more importantly why?

Stock markets experienced a major sell off at the end of 2018, with the FTSE 100 falling 12% over the year, its worst performance since the financial crisis ten years ago. Investors remain concerned that rising interest rates in the US, high levels of debt in China and Donald Trump’s trade war could cause a major slowdown in world growth this year. However, the third-quarter earnings season was positive on both sides of the Atlantic, with a majority of companies posting good growth in sales and profits.

A major upset for markets in December came in the form of the Federal Reserve. The US central bank raised interest rates by 25 basis points, as expected, but the language in its accompanying statement was not dovish enough for some in the market. This was despite a stream of public criticism of Federal Reserve Chairman Jay Powell by US President Trump about the dangers of higher borrowing costs. US interest rates were increased four times in 2018 and rising US yields have made bonds more attractive for income seekers. With the UK facing a slowdown and challenges relating to Brexit, no increase in rates by the Bank of England is expected soon. Recent falls in the oil price should also keep inflation subdued.    

Disagreements over the shape of the UK’s exit from the European Union continue, but the UK government and Brussels have agreed a withdrawal deal. A vote on Theresa May’s agreement will be held in the House of Commons in January. The chance of leaving the bloc on 29 March without a deal remains high as a number of sticking points remain, particularly the nature of the Irish border after Brexit.

There was some positive news from Europe. The European Commission and Italy reached an agreement over its 2019 budget and there will be no “excessive deficit procedure” that could have led to an EU fine – and potentially fuelled euro-scepticism in Italy.

Emerging markets were hit by the relative strength of the dollar, the trade war, a plunge in oil prices and the emergence of populist leaders in countries such as Brazil. Countries with large amounts of foreign debt were hit particularly hard. 

Getting the crystal ball out – what do you think will happen in 2019

We expect we will see more volatility within markets. Brexit will continue to be debated. The US and China may or may not agree a trade deal, and even if they do, they will surely continue to engage in a strategic conflict, as each of these world super powers flex their economic muscle. And make no mistake, debt levels are high. Indeed, eye wateringly so in the most vulnerable of countries, such as, Canada, Hong Kong, Norway and Sweden.

However, the most important issue will remain the one that has contributed so greatly to returns since the last financial crisis: interest rates. The financial and economic conditions created and actively encouraged through central banks have seen all types of assets increase, whether that be houses, final salary pensions, fine wine, or indeed, shares and bonds.

The dollar, as the world’s truly global currency, is going to be a key factor to watch for in this regard. We expect that signs of reduction in the earnings of US companies (evidenced already this year through a more cautious update from Apple) will prompt investors to act. This may see reduced US allocations, in favour of regions with more attractive relative valuations, such as, the Emerging Markets, Asia and Europe. Even if we see little movement in the dollar at the start of 2019, the potential for less liquidity later in the year means we may start to see greater share price volatility around growth and earnings expectations. Of course, we must remember that as with any dramatic shifts lower in share prices, we may also see dramatic moves higher in this new market dynamic.

What should Berry & Oak clients be looking out for?

In a world where the media is quick to focus on uncertainty it is ever more important to focus on what we know and how this can impacts our investment strategy.

We know, for example, that life expectancy will continue to increase across the world, increasing the demand on healthcare and social services. We can be sure that this population growth will be skewed toward cities and therefore the opportunities that complement urbanisation and electrification are important. We will also see rising middle class incomes, particularly in Asia, and increasing demand from consumers and businesses. It is through this demand, as well as world class research and development in developed and advancing economies, that we anticipate further innovations will be delivered.               

It is also important to remember that over time the world is becoming better off. Of course, there will be shorter term periods that are more painful, but it is also true that these times always represent the best entry point for investment returns. Just look back to the start of the last US equity market bull run way back in March 2009. It would have taken a brave investor to be fully weighted at that moment in time, but for those who were committed the returns were stratospheric. Without stating the obvious, that is the benefit of hindsight though and investing based on the past is a bit like driving a car by looking through the rear mirror.

What steps are you taking to protect client portfolios, while still participating in any potential upside.

I would highlight diversification here, across equities for income and long term growth, and bonds and cash for capital preservation.

For example, taking the UK equity market, it is relatively cheap and has largely been ignored by global investors for a number of years. However, after the recent sell off it now provides an even more generous dividend yield premium over UK bonds. However, the market has a high degree of dividend concentration in a limited amount of equities, so diversification remains crucial. We think that as the year progresses greater certainty from Brexit will likely see sterling and UK listed multinationals rise in value. However, some of the short term pain may persist.

We can look at cash and bonds as two areas combined, as where we are committing money to bond markets we do so with a short time horizon and promise of repayment of capital.  Although we expect equities to outperform bonds in 2019, fixed interest securities still perform an important role in portfolio diversification and providing a yield premium above cash. The key to avoiding permanent capital loss will remain the same as 2018 in our view: keep bonds at short duration because interest rates are rising.

As the largest economy in Asia, China may be hit by trade concerns in the short term. We continue to favour a diversified approach to investing in the region, taking advantage of structural growth opportunities offered by the rising middle classes. We will be watching for clarity on Donald Trump’s trade war with China, as a resolution to this may see significant inflows to such a demographically attractive region.

For some time we had been concerned that the overvalued US market would have to correct. Indeed, we reduced our US exposure too early and missed out on some of the upside. At the end of last year the US Federal Reserve’s hawkish commentary on interest rates prompted a reassessment of US stocks, in particular the highly valued FAANGs – Facebook, Amazon, Alphabet, Netflix and Google. The challenge is to balance a potential lower purchase price for US shares, with the prospect of further weakness in 2019.

Interest rate rises can be a negative for property, although yields remain attractive. Economic growth may support rental yields. Commercial Property, particularly warehouse distribution centres and healthcare premises, are attractive in terms of providing relatively high rental yields. 

For further information please read the full article here

*Past performance is not a reliable indicator of future results

Article Credit – Charles Stanley

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