2018: A Year of Two Halves
At the beginning of last year, there was a sense of optimism in financial markets with investors still seeing benefit from the effect of the US tax cut on corporate profits. As a consequence, January 2018 saw a strong rally ahead of periods of volatility which came to characterise the year as it went on.
The UK’s FTSE 100 Index went on to peak in the early Summer, the S&P 500, in the USA, in September. By the end of December however, on the year the FTSE 100 was down by 12%, the S&P 500 by approximately 6.5% while China’s CSI 300 closed a remarkable 25% lower.
In other markets, oil as measured by Brent Crude fell 20% on the year on increased supply and weaker demand after a strong rally last Winter and Spring, while in currency markets the strengthening Dollar put significant pressure on weaker emerging market economies and on their currencies.
We consider it important to look at 2018’s disappointing equity performance in the context of the strong growth seen in global equities over the last ten years, ie. since the financial crash. The FTSE All World Index had risen by around two and a half times up until the end of last December. When taking dividends into account, the total return has been materially higher. For many equity markets 2018 looks to have been a time of correction after years of good growth.
Perhaps the biggest factor in unsettling markets was the strength of the US Dollar and the impact of the reasons for it. Put simply, the end of quantitative easing in the US, together with several small moves towards higher US interest rates, felt necessary to head off inflationary trends that were beginning to emerge, put the Dollar onto strong footing. The currencies of, notably, Argentina, Turkey, Brazil, Russia and South Africa suffered significant devaluation as a result of US Dollar strength but in each of these cases the trend was exacerbated as a consequence of those countries perceived internal weaknesses.
President Trump’s view on global trade has also negatively affected markets, with China (where GDP grew by an apparent 6.6% last year) being a particular ‘target’. This has clearly been a factor impacting wider global equity markets as has the sharp decline in the share prices of many of the leading US technology stocks, such as Facebook, Amazon, Apple and Netflix. Perhaps the increased awareness of the power that this small group of companies wields, and the evident need to reduce scope for scandals such as Cambridge Analytica, will lead to greater regulation and lower growth, justifying the share price falls that have occurred.
Elsewhere, Italian equities were negatively impacted by political developments, which were at least temporarily relieved by December’s budget agreement while the UK equity market has been driven by ongoing Brexit uncertainty and by political instability (in part offset by record levels of dividend payments), on which more later. Throughout all of this uncertainty and not withstanding significant volatility in the interim, the UK 10 year Gilt yield ended the year not greatly changed. The yield on a typical UK corporate bond has risen from perhaps 2.3% to around 2.6%, which has clearly had a modest negative impact on values, however generally UK fixed interest markets ended much as they began. This reflects a gradual approach to interest rate increases by the Bank of England who, as the year has gone on, have been unable to come to a firm view on interest rate direction, in part because of political issues referred to earlier and also because, for the moment at least, UK inflation remains relatively stable.
The question now facing investors, looking into 2019 and beyond, is whether 2018’s uncertainties have largely played themselves out, or whether more remains to emerge. We hope that our comments below will provide you with some guidance.
2019 and Beyond: regional round up
- The USA
The USA remains the world’s largest economy and, as such, developments there have a material impact on all investment portfolios.
Last year’s tax cut in the US has helped to lift US growth well above its trend rate. Employment statistics are strong, as is wage growth, while company profitability looks set to be boosted and we anticipate that many US companies will soon be announcing strong results for 2018. However, evidence so far is that annualised growth in business investment has decelerated after an initial increase while the US government is faced with widening budget deficits. As yet, the case for tax cuts as levers towards higher growth has not yet been proven.
On balance, we think it likely that US interest rates will rise further this year, but perhaps at a slower pace than previously anticipated, while the strength of the US corporate sector is in the main considerable. We think that many US stocks are sensibly valued while opportunities are emerging in the battered technology sector.
Growth in China remains substantial, albeit at a somewhat decreased pace. Problems associated with excess debt, and with a slowdown in domestic consumer demand, are evident and China remains considerably reliant upon its export markets. Last year’s equity market correction was valid: however we believe the heavily state controlled Chinese economy will continue to support global growth this year and into the next decade.
So far this year, the Chinese Government has instigated a number of measures targeted at boosting the domestic economy including fiscal easing (cutting bank’s reserve ratios), while substantial infrastructure expenditure is planned, principally on considerably extending the countries railway system.
From an external point of view, Sino/US trade talks are restarting: we envisage no immediate breakthrough but note that the current situation is hurting a number of American industries (many US soya bean farmers are in crisis as a result of the loss of China as a major export market) so that the impact is far from one sided. Our feeling is that in the end, face saving compromises will be found.
- Other Emerging Markets
The more troubled areas in 2018 look set to remain troubled well into the New Year and beyond. Despite this, we consider that interesting opportunities are arising in the many better managed emerging markets where share prices and currencies stand at relatively depressed levels.
The European economy has had a mixed start to the year with industrial production in for example Germany and France slowing as is overall growth. However, while the European Central Bank has now ceased active quantitative easing, there is little chance of Eurozone interest rates being increased in the near term, while unemployment has fallen albeit to levels that remain high by US and UK standards.
Politically, Eurozone remains divided along an east west axis, with a number of southern states continuing to lag behind those to the north but economically the zone remains a powerful force. We anticipate that many strong European companies will announce sound trading results as we move through the first few months of this year, underpinning equity valuations at current lower levels.
The Japanese economy has been through a long period of expansion which came to an end in the third quarter of last year, in part as a result of natural disasters. At the time of writing, the outcome for quarter four is not known but something of a rebound is anticipated. Nonetheless, surveys indicate that business confidence in Japan is at a six year low while household spending has declined steadily over the last quarter. Many Japanese companies have found their export activities to be caught up in the ongoing trade dispute between the US and China while the appreciating currency (the Yen has been seen as a ‘safe haven’ in uncertain times) has provided a further headwind.
We note the rather more positive turn that US/China trade talks appear to be taking which may relieve pressure on Japan, we suspect that the Yen maybe overbought and Japanese equities oversold. With this in mind, we believe that Japanese equity weightings should at least be maintained and, as the year progresses, possibly increased.
UK equities appear cheap by international comparison, presenting an interesting opportunity. However, at the time of writing the Brexit situation remains as unpredictable as ever, both in the short term and in respect of our longer-term trading relationship with the EU and the rest of the world, matters of vital consequence. In our view, many UK companies will announce satisfactory profits for 2018, often based on overseas earnings although some sectors (e.g. shop based retail) will not. Many will remark cautiously on the outlook for this year and beyond while business investment within the UK looks set to remain subdued. Our view is that out of all this, some worthwhile medium and longer-term investment opportunities are emerging, however timing remains problematic.
We read that UK companies have been stockpiling ahead of Brexit, to protect their production lines at least for a short period into the future. In a sense therefore, aspects of 2019’s economic activity were brought forward into 2018. As this restocking effect wears off, we anticipate that the winter of 2019 will not be an easy one in terms of the UK’s overall economic growth, such growth being desperately required to shore up government revenue so as to better protect spending on public services. On the outcome of this and on the outcome of the Brexit situation depends the direction of UK interest rates for the year ahead and beyond. Given current unpredictability, we feel it wrong to attempt to forecast the trend in UK interest rates or indeed in the value of Sterling, both of which may move materially in either direction. In the meanwhile the UK’s services exports to the EU continue to increase a pace (14% in the first three quarters of last year as against less than 9% with the rest of the world): given that services account for a far greater share of the UK economy than does manufacturing, the frictionless continuation of this trade matters greatly. Among other things services include retail, hotels, finance, IT and advertising.
2019 and beyond: our investment conclusions
We believe that for a number of reasons 2019 will be the year of overall global economic growth, albeit at a slower rate than last year. This view is based on the strength of the US economy, the relative lack of inflationary pressures and the probability that US interest rates are approaching a neutral level, i.e. one that supports sound growth, rather than being either too expansionary or too restrictive. In such an environment, the US Dollar looks set to stabilise after last year’s gains, in turn taking pressure off other currencies. The recent announcement of steps to encourage growth within China and the resumption of talks on trade between the US and China is at least a start.
In so far as stock markets are concerned, the general fall in equities last year reasonably reflects uncertainties, giving rise to the appearance of sensible value at current levels. Indeed, as we have moved further into January, global equity markets have rallied as investors become more confident that good value is to be found at lower levels.
Interest rate trends are of course of key importance to investors in fixed interest markets where rapidly rising rates can undermine values. We now believe that rate increases in 2019 are likely to be more modest than we have previously anticipated as a consequence of lower global inflation, implying that the environment for global fixed interest investors, while not strong, may prove to be more stable than we had previously anticipated. The one area of risk for those invested in UK focussed fixed interest investments is of course Brexit: we have commented earlier on volatility that may, or indeed may not, happen, this being entirely dependent on political developments over the next few months.
In summary, we expect a generally steadier year in markets overall, perhaps punctuated by periods of enhanced volatility in specific markets as news stories unfold. In all of this our aim remains the provision of sensibly balanced portfolios for individual investors taking account of their medium and long term aims plus their views on risk. As such, we believe that balanced portfolios containing a mixture of asset classes will remain central to our offering and hold potential to add medium and long term value.
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