Investment Update – Winter 2018/19
- Hitting ‘the wall’- key market overview
- Conviction in ‘Value’ Stocks
- Good things come to those who wait
- With volatility comes opportunity
Hitting ‘the wall’
The last quarter of 2018 was particularly difficult for equity markets. This translated into the toughest calendar year for KMD strategies since the credit crisis of 2008, although not nearly on the same scale. The quarter began with US Federal Reserve Chairman Jerome Powell’s statement that US interest rates were a ‘long way from neutral’. Expectations of higher interest rates lifted bond yields, with 10Y rates hitting 3.2%. This was not far off the levels that commentators have said will cause trouble for the US economy. However, as global share prices continued to decline, in mid-November the ‘classic’ safe haven status of bonds eventually prevailed with bond values rising and yields falling.
Investors became more concerned that we are later on in the economic cycle bringing into question the sustainability of current share price growth from here. Corporate tax cuts were a big boost for US companies last year, but that stimulus will fade in 2019. So far, there is little evidence that those tax cuts are materialising into meaningful investment. Instead, they have left a black hole in the Government budget, accompanied by several department shutdowns. For now, the focus is on building ‘The Wall’ on the US-Mexico border and not a particularly productive allocation of capital. More importantly, the ongoing battle Trump is having to push this through highlights his reduced power since losing the House of Representatives. That is making further fiscal stimulus, which buoyed markets in 2018, seem less likely.
Growth in China is slowing as the money supply contracts alongside ongoing US trade disputes. Retail sales have slowed, as have global exports. This has had knock on effects for the European manufacturing sector, which is now experiencing a steep decline in new orders.
Business Climate Surveys have been weakening with those in Q4 at historical lows and consistent with an outright contraction. Political factors have hindered progress, be it Brexit, unrest in France over rising fuel costs or the ongoing budget deficit tussle with Italy. The European Central Bank has also just ended its QE programme, which will not aid lower borrowing costs.
UK markets also suffered in Q4, albeit to a slightly lesser extent than the US. It was certainly evident that it was the US leading markets lower. This is important for KMD portfolios as our strategies are positioned to weather a weaker US stock market. This is due to our lower US equity holding, but also because our portfolios have a distinct bias towards ‘Value’ stocks.
Conviction in ‘Value’ Stocks
‘Value’ stocks are those companies whose share prices are typically lower relative to their profits. The Financial Sector, still unloved following the credit crisis, currently dominates ‘Value’ indices. On the other hand, technology stocks dominate ‘Growth’ indices. The US market is, of course, very technology focused.
Over the very long-term, ‘Value’ stocks have out-performed ‘Growth’. However, in recent years, with all the excitement generated by rapid technological innovation, ‘Growth’/tech stocks have enjoyed a prolonged period of out-performance. While we risk underperforming in the short-term if the winners from recent years continue to win, we will stick with our ‘Value’ bias. This is in anticipation of higher relative returns in the long-term as well as the ability to better preserve value in any short-term pull back. ‘Value’ stocks certainly proved their protective qualities in Q4, holding up better than their ‘Growth’ counterparts and boosting the relative performance of KMD portfolios.
Good things come to those who wait
The New Year brought some market cheer, with equities and credit recovering from lows formed over the festive period. Stocks rose to end the best January in three decades, as the Federal Reserve indicated they would slow the pace of rate rises alongside a slew of strong earnings reports. Hopes of a US-China trade deal has also helped to create a more positive tone in recent weeks.
Patience is an investment virtue as year to date ‘Growth’ stocks have recovered more than their ‘Value’ counterparts, but there are signs the gap is narrowing.
We remain confident that patient investors will be rewarded by our ‘Value’ strategy, one we believe is naturally less speculative or at risk from earnings downgrades.
Over the last few months, one significant shift in our portfolios has been the reduction in commercial property. Reduced sentiment ahead of Brexit, combined with lower occupier demand and increased availability has increased downside risks for Bricks and Mortar funds. So far this has been the right decision as the values of both funds we sold have since experienced a slight decline. We are continuing to assess opportunities to redeploy the proceeds.
Our preference for ‘Value’ stocks has been well documented in KMD Investment Updates over the past year, as has our preference for ‘All Weather’ funds over traditional fixed interest funds. Where we do still hold fixed interest funds, we favour higher quality Government-issued, short-term bonds.
There is little change in our stance here. In fact, we see more reason to maintain caution on credit than we have for a long time. This is due to non-financial corporate debt-to-GDP hitting the highest level in over 70 years. The credit quality of investment grade bonds has also deteriorated and other concerns include sub-prime lending in the auto market.
With volatility comes opportunity
The recent correction has improved value in equity markets. That is despite the January recovery and it has even provided opportunities for long-term investors to selectively top-up equity positions. Investors are currently mulling over whether the latest move is the beginning of the next leg up, or just a bounce from oversold levels. We are not attempting to make this call as we see a move in either direction as equally justifiable.
We expect political outcomes to continue to dominate the media, but markets will remain fixed on fundamentals, with monetary policy being the main focus. For now, the Fed’s soothing words on more ‘patient’ tightening have calmed investor nerves. However, we are not under-estimating the potential for a reversal of this stance if inflation pressures build which they quite easily could.
The Government’s inability to progress the UK’s departure from the EU has likely delayed further investment decisions in the UK and this has been felt.
Logically, we feel the passing of a withdrawal agreement should carry the highest probability of being the ‘least bad’ outcome for MPs on both sides of the House. In the event that this occurs, we would anticipate a relief rally from domestically focused UK stocks as well as a stronger Sterling. Either way, we remain positive on the ‘unloved’ UK market, with undemanding valuations a key attraction to this trade.
We do not feel that last year’s volatility has gone away, merely paused for now. However, with volatility comes opportunity. It is therefore important for us to maintain sufficient ‘dry powder’ for now as well as allow time for the true value of our equity strategies to be reflected, if only relatively.