Review of the year
The year opened well but in February, investors began to fret about Trump tariffs and the start of a US-China trade war. Elsewhere in the world, Merkel struggled to establish a coalition government in Germany. In emerging markets, the beginnings of crises in Argentina and Turkey became apparent by April. Zuma resigned as president of South Africa over corruption allegations. Russia was dealt a blow of fresh sanctions from the West. In May, a new populist coalition government took power in Italy, causing Italian bond and equity prices to fall sharply. June saw the first ever meeting between the leaders of the US and North Korea, ‘agreeing’ to the denuclearisation of the peninsula. Over the summer, Japan was struck by earthquakes, heavy flooding, extreme heat and typhoons causing economic activity to contract.
Autumn saw the UK government finally produce the Chequers Agreement, a compromise between a soft and hard Brexit. Few people liked the plan. In Europe, new emissions standards created a huge supply bottleneck causing industrial production and retail sales to slump. In Japan, Prime Minster Abe won his ruling party leadership election and reaffirmed his plan to hike VAT to 10% in 2019. The crises in Argentina and Turkey worsened, with the former turning to the IMF for help and the central bank in the latter returning to aggressive monetary policy. Back in the US, the replacement of NAFTA by the USMCA (United States Mexico Canada Agreement) was agreed, ending months of worry that trade barriers would be erected between the North American nations.
Then came winter. Italy kicked off with a budget that broke EU spending rules causing an acrimonious dispute with Brussels. In France, President Macron faced huge national protests due to fuel duty increases, which disrupted output and hit tourism. In Germany, Chancellor Merkel announced that she would not seek re-election as party leader. The UK and EU agreed on terms of the Brexit divorce and a transition period until the end of 2020. The Irish border issue caused PM May to delay the parliamentary vote on the agreement until January. The US mid-term election results saw the Democrats take control of the House of Representatives, but the Republicans retained control of the Senate. A preview of the fight likely in 2019 began with yet another federal government shutdown as Trump was denied funding for his Mexican wall. Trump delayed further China tariffs to March 2019 while the two sides conduct further talks.
Central banks held a steady course. The US Federal Reserve raised its interest rate target range to 2.25-2.50% under new chairman Powell. Although the Fed lowered its forecast for future rate increases in December, it maintained its policy of withdrawing quantitative easing. The European Central Bank ended its quantitative easing programme in December. The Bank of England hiked once in 2018 to 0.75% but Brexit prevented further normalisation. The Bank of Japan toned down its easing too, whilst the Bank of China eased policy, not by cutting rates but by injecting cash into the banking system. Most other emerging market central banks enacted rate hikes during 2018, in part as a reaction to the tighter policy emanating from the US. Turkey doubled interest rates. In India, interest rates saw modest hikes but the bigger news was the resignation of the central bank governor in December following disagreements with the government.
Asset class performance comparison
In dollar terms, only US cash made a positive return (2%) in 2018. Commodities were the worst performing asset class (-11.2%), closely followed by the MSCI World equities index (-8.2%). Even the US NASDAQ tech index (-2.8%) fell. Oddly, lower risk investment grade credit bonds (-3.5%) underperformed their riskier counterpart, high yield bonds (-3.3%). Lastly, gold was down -1.7% and Bitcoin lost 72.5%.
2018 was only the third year since 1900 where both equities and bonds underperformed cash. The German DAX30 index, lost -18.3% in local currency and -23.1% in US dollars. It suffered most from being both a cyclical index and also having a high exposure to Asia, which was suffering from trade war concerns. Less cyclical European indices fared better, including the French CAC40 (-8% in local currency and -12.8% in USD) and the UK FTSE All-Share (-9.5% in local currency and -15.3% in USD). In emerging markets, while the overall index was down 14.3%, this masked considerable dispersion, particularly in dollar terms. Turkey was the year’s worst performer with equities losing investors 57.6% in dollar terms.
Regular readers will know we have had a contrarian stance for some time. Our view was that growth was likely to disappoint as employment peaked and monetary policy tightened, causing lower valuations in markets. Despite a lower allocation to risk assets this did not help performance much for three principle reasons. Firstly, we see no value in government bonds which provided small but positive returns last year. Secondly, a rapid deterioration in both the US fiscal and trade balances led us to be underweight dollar assets. Lastly, we prefer the better long-term dynamics of emerging markets to developed markets, which did us no favours in the second half of the year.
We still anticipate that the US will slow into 2019, joining the rest of the world, as Trump tax cuts fade and trade sanctions bite. Still, US consumer confidence remains high and unemployment very low so there remains upward pressure on wages and inflation, countered partially by lower oil prices and lower corporate margins. That still leaves room for the Fed to raise rates further in 2019 but they are no longer on a set course of regular hikes.
Other developed economies are already in lower growth mode due to political uncertainty and US protectionism. China has been going through a managed slowdown, as it rebalances its economy towards consumers and away from fixed asset spending. The trade war hasn’t helped so we expect further stimulus but that may only impact later in 2019. Despite this softer global economic patch, we do not believe a global recession is imminent. However, we remain concerned about the level of debt and leverage in the system and cyclical risks have risen with the end of quantitative easing.
Trump’s protectionist measures are being met with countermeasures from affected countries. China, Europe and Japan run trade surpluses with the US and it is hard to see Trump cooling his hard-line stance particularly since domestic policy may now be stymied by the Democrats.
We maintained portfolios at the lower end of our allowable risk bands in the last quarter. We are underweight equities and overweight fixed income, absolute return funds, and cash as a hedge against downside risk. However, given the correction seen in markets, we anticipate adding to equity exposure in the first half of the year. Valuations are significantly cheaper than a year ago. Within fixed income, we maintain a short duration stance as long term yields are unattractive. Our preference for infrastructure assets over commercial property remains and we believe there is further value in the sector. Commodities are unlikely to rise much given the slowing economic 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 history. During the quarter we repositioned our absolute return allocation to strategies that we believe are more appropriate to the environment ahead.