At the start of 2018, we issued a message of cautious optimism to investors. A key tenet of this was that the synchronised global growth of 2017 was unlikely to continue indefinitely and that, as downside risks to the economy increased, higher valuations may be a sign of complacency in equity markets that were becoming progressively more expensive.
We believed that a slowing global economy presented a more nuanced environment that would create ‘winners’, but also ‘losers’, and the disparity between the parts of the market delivering and disappointing on expectations would be stark. Clients needed to adjust to a more volatile environment, albeit one which would still be broadly supportive for risk assets.
While we were correct in predicting that global markets would become less forgiving, we failed to anticipate just how great the regional divergence in growth would be, as well as how much weight would be placed on the decisions of politicians and central bankers. The ability of investors to ‘brush off’ the noise caused by political rhetoric appeared to evaporate as equities hung in the balance, awaiting the next word from Washington, the US Federal Reserve or China. The focus on economic data and earnings expectations, meanwhile, diminished significantly.
Optimism quickly turned to pessimism, most notably during the wide market sell-offs in February and October, as investors, searched for signs of a slowdown.
And Q4 provided the evidence – the fourth US interest rate rise of the year led to concerns that the Fed may be tightening too fast and strangling global growth; company reporting on earnings was distinctively lacklustre; trade aggression exacerbated weakness in China, impacting emerging markets already suffering from the effects of US dollar strength.
Although market movements suggest otherwise, we remain relatively sanguine about prospects for 2019. Global growth is moderating, but not to the extent that it signals an absolute end to expansion, or eradicates earnings growth for corporates. World GDP growth is unlikely to differ dramatically from expectations at the start of the year, but even minimal downgrades are perceived as a disappointment by investors who were seduced by the ‘Goldilocks’ environment of 2017. While we now have greater evidence of a global economic slowdown, it is still unclear when this will become recessionary, although there is little sign of this occurring imminently.
We do not attempt to predict the timing of the next recession but seek to increase the resilience of portfolios against market downturns, while ensuring that we do not miss out on growth opportunities at the latter stage of the cycle. The following strategies are key to achieving this:
Broad diversification among asset classes, regions and investment styles:
Because of the ability for equity markets to perform relatively strongly towards the end of the economic cycle, we possess a neutral position to the asset class, but avoid any large regional or style over- or under-weights to prevent favouring certain markets based on short-term divergence. This strategy was not rewarded in 2018 as the US market outperformed strongly. It is not a trend we expect to persist, given the diminishing effect of US fiscal stimulus and a pause in monetary tightening, which should prevent further strengthening of the US dollar.
Exposure to high quality funds and securities:
The Q4 sell-off was most strongly felt in cyclical growth stocks which became less attractive due to rising costs of capital and declining economic growth. Our ethical, sustainable, and thematic (EST) investment philosophy advocates investment in areas which can deliver strong underlying growth and identify opportunities and risks that may be underappreciated by the market. It is primarily about identifying societal challenges, changing consumer preferences, and opportunities for innovation, and analysing how an investment may capitalise upon them to generate a sustainable business advantage. This approach gives our portfolios an inherent quality bias which we believe will lead to outperformance in the current market environment.
An allocation to alternative asset classes:
In times past, investors traditionally flocked to developed market government bonds to safeguard against volatility due to the downside protection characteristics they exhibited versus equities. As a result of ultra-low level of interest rates in many developed economies today, the correlations with equities have increased meaning these securities no longer fulfil their roles as ‘safe-haven’ assets, nor do they offer attractive risk-reward profiles. This became evident in 2018 when fixed interest assets failed to offer protection from equity market falls.
Short-term US government debt may be relatively attractive, but in Europe and the UK we make heavy use of property and infrastructure assets as alternatives. This is due both to their yield superiority over traditional fixed income, and diversification characteristics which ensure a low correlation to both equity and bond markets.