2018 started on the back of a year of synchronised global growth, and exceptionally good investment returns across pretty much every asset class and with much lower volatility than normal. As a result, investors received good risk adjusted returns in 2017. However, the environment changed abruptly after the release of the US Employment Report on 2nd February.
The report highlighted the firmest wage growth for a long time and triggered a big sell off in the bond market on fears of higher inflation and the risk that the Federal Reserve Bank of America (Fed) would tighten monetary policy more aggressively than previously anticipated. This led to a substantial correction in equity markets as one of the valuation props, low bond yields, fell away.
However, bonds then rallied as they were considered a safer bet than equities, and remained pretty much well behaved until the autumn, as fears over inflation subsided but then resurfaced again towards the end of the year. Despite this, stock markets remained on the back foot as the volatility genie – subdued for so long – was out of the bottle.
A good sense of the change in market sentiment over the year can be gleaned from investor reaction to recent 'news flow'. The Fed Chair Powell recently issued a slightly more dovish statement implying that interest rates were close to neutral and future moves would be data dependent rather than rigidly following the forward guidance. While the initial reaction was positive, the market subsequently decided this news increased uncertainty and therefore was negative after all. A year ago, this statement would have been taken as unambiguously positive. Similarly, the positive noise on China-US trade negotiations initially led to a huge rally, but this was quickly reversed as market participants decided that there was not enough detail. This highlights the tendency of the media to create negative narratives when stock markets fall prey to selling pressure.
This is what's known in the business as 'Confirmation Bias,' and is most keenly felt in the context of geopolitics, where commentary on the Middle East, the West's relations with Russia, Trump's trade policies and Brexit have all been cited as reasons for recent stock market weakness. However, whilst some of this is plausible, there is also a sense that what we have seen in 2018 is a reversion to the mean. Things tend to fluctuate either side of the long-term average. 2017 saw above average returns for almost all asset classes with below average volatility. In 2018, we have seen negative returns for 90% of asset classes with more normal levels of market volatility. This suggests we should take the last two years together, without overthinking whether everything has fundamentally changed over the course of 2018.
What we also know is that over the last 18 months we have had the strongest, most synchronised global economic growth for seven years aligned to the strongest growth in corporate profits since 2011. Developed world corporate profits have grown in the mid-teens, with the US leading the way at 26% year on year growth. In fact, we have had more fundamental underpinning for the equity market than we had in the 2014-2016 period when we saw weaker global activity, declining corporate profits and equity valuations no cheaper than they are today.
So why all the gloom? We have had the second longest US economic expansion on record and financial commentators are now saying we are in late cycle, which means the next downturn may just be around the corner.
This narrative is yet to be tested. Economic cycles don't die of old age. They end because of overheating—too much froth in the economy and too much exuberance in financial markets. At the moment the global economy is not running too hot. Indeed, it is a Goldilocks scenario, a world where the economy is neither too hot nor too cold. Inflation remains contained and is generally at or below levels central banks would like to see. Stock markets, whilst at fairly full valuation levels, are much less demanding than they were some months ago and euphoria, which generally characterises markets before a prolonged downturn, is not yet evident.
Having said that, financial markets and economies face a number of challenges in 2019. A wall of worries that equity bull markets must overcome to climb higher. Investors need to dance to a different, longer term, beat. The sharp swings in prices and expectations are due to an increasingly high level of uncertainty. Extrapolating increasingly marginal data result in ever sharper swings in sentiment and positioning which is likely to continue into next year and beyond. But heightened volatility is the friend of the active fund manager as it presents opportunity.
Two major concerns are geopolitical. First and foremost are Donald Trump's protectionist measures and related trade war. Second is the future of the European Union in light of the UK's decision to leave the bloc.
There is a large degree of focus on Brexit and trade because these issues can generate a high level of emotion. Emotion is the enemy of investors—it can twist your arm into making irrational decisions. That is why one of Warren Buffett's most quoted axioms urges investors "to be fearful when others are greedy and greedy when others are fearful." Markets are increasingly fragile, fickle and ultimately quite false these days. Headlines often neatly justify recent events, however, there is far more noise than signal. It appears fear has taken the rhythm out of the market.
But the main risk to the global economy relates more to the world adjusting to the withdrawal of the extraordinary monetary policy that was implemented following the financial crisis a decade ago. Central Banks cut interest rates to keep the cost of borrowing, and therefore debt servicing, cheaper. It was a key way to stimulate spending and to keep the economy growing. However, this also led to households taking on a significant amount of debt so there is a fine balancing act for the monetary policy authorities to navigate along the path to higher interest rates.
We have seen an improvement in economic growth around the world, especially in the US, which aligns with strong revenue generation for companies. A slight pick up in inflation has also boosted pricing power, something that is positive for earnings growth. Equity markets seem in better shape to weather tighter central bank policy, provided the withdrawal from quantitative easing and interest rate increases are managed effectively.
We at Clarion, whilst being aware of the obvious risks, try to ignore all the negative short-term noise about macroeconomics, and interest rates. We don't over worry about Trump, and we don't over think politics or Brexit. We believe we are much better off not wasting too much energy on trying to predict unpredictable events. Instead, we focus on selecting quality fund managers who invest in the shares of good companies and who base investment decisions on fundamentals, valuation, return on capital and balance sheet strength. We select fund managers who invest in companies whose share price has already priced in negative news, so that when the short-term noise dies down and the market stabilises, these stocks will recover more quickly and outperform.
As ever, there are many challenges on the road ahead and undoubtedly, we are moving into a world of low returns and high volatility. But at the same time the current uncertainty presents opportunity. With a sensible balance between equity, short dated fixed interest and cash investment, we are confident that our carefully selected fund managers will help to deliver strong risk adjusted returns in excess of both cash deposits and inflation.
Finally, a note of thanks to all our readers and clients for your kind comments about our regular articles and for your continued support. Very best wishes for a most enjoyable festive season to one and all.