2018 was a very different year for investors from 2017. During that year, the share markets generally produced positive returns with very little volatility. Both years had their fair share of dramas, with Brexit and Donald Trump sources of concern across the 24 months. However, whereas in 2017 stock markets seemed relatively unphased by events, the opposite was true in 2018.
Below is a more detailed review from one of our investment partners' (Albert E Sharp) which echoes our own.
After six straight calendar years of positive returns across the world's major developed stock markets, 2018 marked the first fall. The US fared better than most, with the S&P-500 index down only' 6.2%, supported by strong gains in technology earlier in the year. This compares to the UK and Japan off around 12.5%, better than most European indices with the German DAX 18.3% lower. Emerging markets generally held up well in the final quarter and some Asian markets finished in positive territory. There was little succour to be found for bond investors as their winning run also came to an end. UK government bonds (gilts) rallied sharply in December, arguably due to their safe haven status, but only recovering losses suffered earlier in the year. Corporate bonds were generally weak too as US interest rates moved higher and investors rotated into newer issues with higher yields.
Elsewhere, unexpectedly high production levels sent the price of crude oil down by over 40% from October's peak at $76 a barrel. Gold bounced in the last few weeks but not quite enough to finish in positive territory. In fact there were very few hiding places for investors in 2018 and according to M&G, 90% of all asset classes fell in value. The few areas in the black included cash, direct property and emerging market bonds.
Whilst trade wars, Brexit and European politics in general didn't help investor sentiment, we would argue that the main source of the weakness across the financial markets in the second half of 2018 stemmed from the US tightening monetary policy, i.e. higher interest rates and the end of quantitative easing (QE). In the aftermath of the Financial Crisis, the Federal Reserve slashed interest rates to near zero and started buying vast quantities of government bonds and related fixed-income securities in an attempt to stimulate economic growth. One of the side-effects of the resultant low rates is the forcing of many investors out of low-yielding assets such as savings accounts (often with negative inflation-adjusted returns) into riskier equities and other higher-yielding asset classes. Why get locked into a 2 year Post Office savings bond offering 1.0% per annum when inflation is running nearer 2% when you could own Vodafone bonds yielding 6% and have the prospect of seeing capital growth? This search for yield extended into equities and countless other asset classes, inflating prices of emerging market property, vintage wines and classic cars, to name but a few.
Despite huge doubts at certain points along the way, the consensus seems to be that the policy ultimately worked, the evidence finally coming through in 2017 when, for the very first time since 2009, we saw synchronised global GDP growth across all 45 OECD countries. Although the growth rate wasn't especially high, unemployment rates were improving as were real disposable incomes. Conditions were such that the policy could be reversed. QE is now over in the US and interest rates have risen nine times to the current level of 2.50%. The Bank of England and European Central bank have also ended QE, though both are some way behind in terms of raising rates.
So why are markets all of a sudden so erratic? We believe that the recent turmoil and volatility across all of the financial markets lies in the resetting of future interest rate expectations, led by the US. This time last year a consensus was forming that Trump-induced tax breaks would provide a stimulus sufficient to spur the US and the global economy ahead well through 2020 and that any thoughts of a natural economic slowdown, or worse, a recession, would be pushed out by several years. That was based on solid fundamental evidence and there is still good reason to hold this view. However, the introduction of a new Fed governor in February (Jerome Powell) has muddied the waters. It is taking time for markets to become accustomed to his communication style and there is a body of thought that he is raising rates too fast and on the verge of a policy mistake. Add into the mix Donald Trump and comments that the Fed is the only problem our economy has and all of a sudden US Inc's reputation for being well-managed becomes tarnished. A demonstrably independent and prudent central bank is one of the most important factors for stability in the financial markets.
Should we have seen this coming? We certainly felt that bonds were going to find it difficult to appreciate markedly in an environment of rising interest rates and the ending of QE. If the biggest buyer in town stops buying, the laws of supply and demand suggest this will not be good for prices. However the story is somewhat different for equities. Even with interest rates approaching 3% this is still well below historic norms. With the FTSE-100 yielding nearly 5% the relative attraction is still material. Also, it is not as if we have seen a huge economic boom in recent years, the trajectory of recovery has been extremely shallow. Furthermore, the bull market that began in 2009, though the longest in history, is far from being the most profitable.
At the point of writing it seems as though interest rate expectations are being reset once again. Rather than two rises in 2019 as per Fed guidance, the odds (as read through bond market prices) are suggesting that there will be no further moves. If this is in response to a rapidly deteriorating economy then, intuitively, this isn't helpful for share prices. However, putting rates on hold could allow the economy to heat back up, and that is helpful.
The last few years have clearly ended up surprising most analysts and pundits. At the end of 2016 following the unexpected arrival of Trump and the consequences of Brexit, the outlook for 2017 was gloomy at best. However, many of the fears didn't materialise and it proved to be a great year for economic growth and the financial markets. By the end of that year, prospects heading into 2018 were improving with GDP growth exceeding expectations. However as we entered the final quarter these hopes were increasingly coming into question, leading to a very disappointing outcome for nearly every investor. Maybe the point to be made here is that a positive outlook does not guarantee positive returns. Second-guessing the market is ultimately a futile task as illustrated by this excellent article entitled 29 Reasons Not To Invest In the Stock Market from Schroders. Below we lay down our thoughts on each major asset class.
Global Equities
Taking a top down view across the main global equity markets, valuations certainly do not reflect high expectations. The chart below shows the price earnings (P/E) ratios of the major global indices along with their 10 year average. Looking at the FTSE All-Share, we see that based on current forecasts, the 2019 P/E ratio is at 11.7x, as shown by the yellow vertical bar. This represents a sizeable discount to the US on 15.1x, but maybe the most important message from this chart is that current valuations are quite comfortably below their comparable 10 year average as shown by the orange bar. This time last year the story was quite different with many markets trading above their average ' the S&P-500 was trading well over 18x.
In other words, since P/E ratios are currently quite low relative to history, this makes them cheap. If you believe in reversion to the mean theory, then the ratio should revert back to the average and for this to happen, share prices (the P in the equation) need to move higher. If the FTSEAll Share gets back to its average, that's a 14% return; for Japan it is over 20%*.
The chart also shows the 2018 and 2020 ratios ' what this shows is that since prices P' are static at the year end 2018 level, for the ration to be falling the E', earnings, must be rising. Looking closer the chart therefore reveals that earnings are expected to rise quite sharply for the UK in 2019 unlike Asia or the emerging markets; Japan is looking at slightly lower aggregate earnings, with an improvement in 2010. Valuations could get cheaper first though, of course.
Dividend yield analysis brings us to the same conclusion. The chart below shows that the dividend yield for the UK is expected to be 4.8% in 2019 (yellow bar), compared to the 10 year average of 3.8% (orange bar). For the FTSE All Share to revert back to the mean, the index would need to rise by over 26%.
UK Equities
The gap between the UK and the rest of the world is largely due to the higher weightings that mature industries in the index hold. Companies such as BP, HSBC and GlaxoSmith- Kline are hardly racy growth stories and because they are unlikely to dramatically grow their business in the way that Google or Apple might, they reward investors with higher dividends. The gap could well have been exacerbated by Brexit and the resulting lack of investor appetite. Regardless, with these dividends looking secure we are inclined to conclude that the UK market is very attractive, with the caveat that it may take some time to come through.
US Equities
Despite the daily bombardment of shocking Trump headlines we find it difficult to form a negative view on US equities. It is not just the size, it is the pro-business mindset, structurally lower tax rates and globally dominant position that many of the companies hold that places the region at the centre of the investment universe. To be positive on the US generally, requires being positive on technology, given the high weighing of the likes of Microsoft, Google and Apple across the various largecap indices. The combined market capitalisation of on these four alone is almost £2.5 trillion, compared to all of the top 100 companies in the UK worth £1.8 trillion. In our view, valuations still look attractive with sales and profits expected to grow by 20% this year amongst them. Maybe the added attraction is the scope for merger activity that didn't quite materialise last year on the scale some expected.
As Q4 results come out over the next few weeks, we expect to see that earnings for the S&P-500 index will have grown by almost 28% in 2018. This huge number is largely the result of tax cuts and so without this stimulus, 2019 should be much lower. Goldman Sachs forecasts something closer to 6% but warns that this could prove closer to 3% if economic growth fades.
Europe ex-UK
In the past we have happily held a zero position in Europe on the view that (a) the region was increasingly being badly governed, (b) nearly every country was beset with political risk, (c) the ECB was making the wrong decisions and (d) the odds of the EU and euro to imploding were becoming shorter. As a result we had an overweight position in Asia and the US and for the most part it paid off handsomely. However we shifted our position when the valuation gap become so pronounced, it became difficult to ignore. All of the risks continue to exist and we cannot ignore them, but we do see pockets of value.
There is a general point across all of the regions that is maybe more pronounced in Europe, in that it is still possible to make money in a market that is going sideways or down if you do your homework. It is all very well being negative on a region, but you might find a vehicle that works. That is the case here, although it is probably fair to say that our overall position is underweight.
Japan
After moving in a trading range for much of 2018, the final quarter was brutal for stocks in the region as investors worried about slower global growth, a factor critical to corporate profitability. The prospect of a new VAT regime in 2019 also spooked investors who cannot forget the disastrous implementation in 2014 which nearly triggered a recession. Nevertheless, the long-term story for Japan continues to offer appeal as Shinzo Abe continues with reforms, supported by a stable government. Chinese tourism, up fourfold in the last five years, is helping and the consumer is in good health with a tight labour market pushing wage growth and discretionary spending. Corporate governance continues to improve and the culture of paying out dividends is catching on. The sell-off looks overdone and as discussed above, we see healthy upside potential.
Asia ex-Japan
This is an area where currencies matter too and as the chart shows there seems to be a clear link between a stronger dollar (black line, right hand scale [RHS]) and the performance of the Asian index (thick orange line). The reason for this and emerging markets in general (orange dotted line) is that many governments in this category have high dollar-denominated debts and in order to meet repayments, they need to find more of their own currency to convert, which can suddenly become a huge drain on resources if the dollar goes up in value. This environment has been in place for the last 12 months and appears to have held back equities, but further dollar appreciation looks limited as US interest rates moderate.
Of course there is more to it than that and the recent weakening of the Chinese economic data and how authorities respond is highly relevant as is the Trump tariff dispute. The end of this saga doesn't feel as though it is likely to end anytime soon and that is unhelpful, but making generalised comments risks overlooking the countless exciting opportunities that exist across this huge and varied region.
Emerging Markets
As we saw above, dollar strength is an issue here too, but the dynamics are quite different depending upon the country-specific conditions. The fortunes of Russia and Brazil are both somewhat reliant upon the oil price, but the political forces, the composition of the workforce and the corporate cultures are strikingly different. So generalisation is difficult although we cannot ignore the fact that the valuation discount that EM now trades on is at similar levels to the financial crisis, which is difficult to justify.
UK Property
The open-end direct bricks and mortar funds such as Aviva Property enjoyed being amongst the few categories showing a gain last year and we believe that there is a more to come in 2019, again with most of the return coming from income rather than capital appreciation. The spectre of the Brexit result still hangs over this sub asset class but we think that nervous sellers have probably been shaken out by now, reducing the chance of another lock down.
Fixed Income
Nearly every category of bond lost money last year with UK government issues (gilts) up less than 1 and bunds up 3.3%, the year-end beneficiaries of a rush to safe-haven assets. Given what proved to be a very steep rise in US interest rates, with the 10 year treasury yield jumping from 2.4% to 3.3%, this outcome is unsurprising. However with the yield back down to 2.7% expectations have clearly moderated in recent weeks and many bond prices have recovered. Even if rates do go up in the US, the angle is not likely to be anything as acute as 2018 in which case conditions for positive returns now look far better. That said, the ending of QE means that with the Fed and ECB not buying bonds in the open market, simple rules of demand and supply suggest that prices will at best lose support. For this reason we find it very difficult to make a positive case for gilts and European government bonds.
Currencies
We believe that betting on the direction of a currency is exactly that ' gambling. However in order to manage portfolio risk, FX needs to be considered and we do not take the view that it simply all comes out in the wash'. For a start, if some clarity on Brexit is achieved sterling could rally very sharply. In which case all other international holdings would fall in value, all else equal. Also, having gone through a period of dollar strength, flattening interest rates and more treasury issuance could temper further appreciation or even weaken it. It is not to say that we are bearish on the dollar, more that we see risks building and for that reason it is prudent to hedge some exposure. The yen also requires consideration and with structural reasons to believe that it will weaken over the long-term, we think it appropriate to hedge here too.
In summary, we will continue to invest where we see value, to stay diversified in the knowledge that concentrated positions create risk and in a state of preparedness to move quickly if needed. Our views might change, but they will not be based upon the biased opinions of the media; we prefer reading economic data to newspaper headlines.
The views expressed in this report are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument. The views reflect the views of Albert E Sharp at the date of this document and, whilst the opinions stated are honestly held, they are not guarantees and should not be relied upon and may be subject to change without notice. Investments entail risks. Past performance is not necessarily a guide to future performance. There is no guarantee that you will recover the amount of your original investment. The information contained in this document does not constitute investment advice and should not be used as the basis of any investment decision. Any references to specific securities or indices are included for the purposes of illustration only and should not be construed as a recommendation to either buy or sell these securities, or invest in a particular sector. If you are in any doubt, please speak to us or your financial adviser as appropriate. Issued by Albert E Sharp, a trading name of Albert E Sharp LLP which is authorised and regulated by the Financial Conduct Authority. © Albert E Sharp LLP 2019. Registered in England & Wales with the partnership number OC339858.
About the Author: Glen Callow
