Out of Sync?
In our last quarterly overview, we noted that consensus expectations of continued synchronised global growth were likely to disappoint. With the exception of the USA, most regions experienced a slowdown. Trump’s pro-cyclical fiscal stimulus has resulted in a booming economy that has driven US stocks and interest rates higher. The resultant dollar strength is a negative for commodities and emerging markets. Add to that Trump’s tariff wars, particularly targeted at China, and you have a significant headwind for emerging markets and to a lesser extent, other international markets.
In September, US consumer confidence hit its highest level since 2000, while the monthly average of initial jobless claims fell to the lowest level since 1969. Labour shortages are now showing up in wage growth, at the highest since 2009, a major concern for inflation. Markets did not expect the US Federal Reserve to deliver on its rate hikes and in December, it is likely to raise rates for a fourth time this year with a further four rate rises expected in 2019.
Our view has been that inflation and interest rates would eventually rise with tight labour markets in Europe, Japan, and the UK. These economies are currently experiencing relatively weaker economic growth, partly due to lower fiscal stimulus and partly due to political uncertainty surrounding Brexit, Italian debt issues, and US protectionism. Some weaker emerging economies are approaching recessionary levels already and China has been going through a managed slowdown, as it rebalances its economy towards local consumers and away from fixed asset spending. It is easing up on that policy now, cutting rates, and allowing the Yuan to weaken to offset Trump tariffs.
Equity markets generally ignored the threat of rising rates, continuing to grow during the quarter. In local currency terms, growth equities continued their outperformance. Value equities, serial underperformers, made up some ground but continue to languish year to date. Commodities and emerging markets are down year to date and had a poor 3rd quarter. The only game in town was US equities, especially tech names.
Our long-term bias to emerging markets caused us to underperform in higher risk profiles during the period. We remain of the view that emerging markets will continue to outperform developed markets over the long term but we have to be prepared to accept volatility. We are also of the view that ‘value’ stocks are too cheap relative to ‘growth’ stocks. Tilting portfolios towards them should be beneficial eventually. Global bonds again showed negative returns over the quarter and year to date as investors woke up to rates rising more than anticipated.
Asset Class Performance
In local currencies for major equity indices, the US was up 7.7% over the quarter, the UK fell 0.7% and Europe rose 1.9%. Emerging markets were flat and Asia ex Japan fell 0.9%. Interestingly, because it is full of value stocks, Japan rose 5.9%.
In the fixed income space in local currency, US high yield bonds rose 2.4% and Euro High Yield 1.7%. These moves just recouped falls in the previous quarter. Global investment grade bonds rose 0.4% but have lost 2.8% year to date. US governments bonds fell 0.6% and Euro government bonds 1%. UK government bonds lost 1.9%, the same as risky Italian bonds. We continue to avoid buying bonds with negative real yields and long duration.
The pound was marginally weaker in the quarter and so didn’t have a material impact on offshore returns.
Despite the softer global economic patch during Q2 & Q3 2018, with the exception of the US, we do not believe a global recession looks imminent. We have, however, factored in a more general slowdown from late 2019 and have reduced portfolio risk accordingly. The level of debt and leverage, fuelled by years of ultra-low interest rates, is the primary concern. Cyclical risks have risen: potential jumps in wage and price inflation, an unfavourable policy mix and tighter global liquidity.
Equities are sensitive to earnings failing to meet expectations. That can happen in an inflationary environment with rising interest rates. We continue to expect bond yields to rise. Inflation should pick up, given increased costs associated with tariffs and rising wages. Central banks are also stopping or reversing Quantitative Easing, creating another headwind for equity and bond markets.
Trump’s protectionist measures are being met with countermeasures from affected countries. Trump is likely to remain vocal ahead of November mid-term elections. His ‘wins’ in the trade war, weak modifications to existing agreements with Canada, Mexico, and Korea are overshadowed by the ongoing fight with China and Europe.
We have maintained portfolios at the lower end of our allowable risk bands. We are underweight equities and overweight fixed income, absolute return funds, and cash as a hedge against downside risk. We are tilting equities towards under-valued stocks within the sector. Within fixed income, we maintain a short duration stance. Our preference for Infrastructure assets over commercial property has been beneficial in the last quarter, and we believe there is further value in the sector. Commodities are unlikely to rise much given the outlook and the correlation with emerging markets causes us to have no direct exposure.
Our long-term view remains that economic growth and inflation will stay in lower ranges compared to previous economic cycles. Long term interest rates may not therefore rise as much as in the past. We will take any significant weakness in equity and bond markets as an opportunity to reposition portfolios accordingly. In the 4th quarter we are looking at a re-allocation of equity holdings in the Asia/Emerging market sectors due to the rise of China’s weighting in both sectors causing an increasing overlap.