Wealth Management & Investment Insights - December 2018

How markets have performed (to end November 2018)

Following a summer of relative calm in the financial markets, October’s considerable volatility and equity market falls abated in early November. Some of the market’s concerns were soothed as the outcome of the US midterm elections was broadly as markets expected (Democrats took control of the House of Representatives and the Republicans increased their majority in the Senate). As the month progressed, increasing concerns about the evolution of the Brexit negotiations, Italian Budget deficit concerns and a worsening of the trade dispute between the US and China weighed heavily on investor sentiment. A reportedly cordial dinner between Presidents Trump and Xi at the G20 meeting at the end of November triggered a rally in risk assets, only for this optimism of a resolution to the trade dispute to evaporate during the first week of December. At the time of writing, the falls in the US and Europe have taken markets to new lows for the year. Investors who had been hoping for a ‘Santa Claus rally’ towards the year end look likely to be disappointed should the prevailing market sentiment persist.

Asian and Emerging Market equities led the brief market rally in November, outperforming the US and European bourses, however on a year to date basis the US market remains the stand-out market delivering a relative return of 10% greater than the other regional markets. Government bonds have been well supported, with benchmark treasury yields falling from recent highs. Credit markets continue to struggle as investors become increasingly concerned about corporate leverage and slower economic growth.

In commodities, Oil has fallen precipitously from its highs at the end of the third quarter ($76/barrel on US WTI to a current price of $51/barrel). Gold has provided some protection for investors, rallying in the face of weaker equity markets, and is currently priced at $1240/oz.

What we are thinking

In our last letter we included a quote which suggested that investors were ‘talking worried but being complacent’. Market price movement since this date has shaken the complacency and focused on some of the market risks that we have been monitoring all year; the tightening US interest rate cycle, trade tariff disputes, Italy and the UK Brexit talks.

Economic data releases have been broadly positive, but in the US have fallen away from the blockbuster data releases posted in the earlier part of the year. As the impact of the tax reform plan implemented by President Trump at the turn of the year wanes, and worries about the impact of the continued and escalating trade disputes increase, expectations for economic growth and corporate earnings forecasts have been dimmed.

In our recent House View discussion we reviewed the conclusions of our 2018 debate and looked forward to 2019. We believe the core conclusion of our 2018 house view remains valid – that a recession in the US is very likely by 2020 and that we are in the late stages of this economic and financial market cycle. Financial markets have a strong track record of anticipating economic weakness, with a 6-12 month lead time, and therefore we anticipate the need to take more significant defensive measures in our investment strategy as we move into 2019. The critical judgement for 2019 is how close to the end of the cycle we believe we are today. History rarely repeats, but it frequently rhymes, and therefore we believe in looking to similar historic periods as a guide for what metrics and market behaviour we should monitor. To help inform our timing, our research has focused on four periods which we think have a resonance with the current market situation; the 1890s, late 1960s, late 1990s and mid 2000s. We will share our analysis with you in future newsletters.

Our defensive investment strategy positioning has not changed, holding a modest underweight to equity markets, little interest rate duration and significantly reduced credit risk exposure. Allied to this we hold positions in gold (which we view as cheap ‘insurance’) and cash in anticipation of opportunities to deploy this capital at more attractive valuations.

Insights from some of our managers

During a recent update meeting one of our Asian equity managers made a compelling case for two Macau gaming stocks which have suffered from fears about the trade wars and, on the face of it, disappointing earnings. The manager believes this is an incorrect market conclusion. The companies have recently gone through significant capital expenditure plans to increase the scale and scope of their Casino resorts, which have weighed on recent earnings, but as of this summer these new operations were opened. We hear many stories of this kind, companies with ‘under-earning’ assets which the broad market overlooks – but which offer active managers, who have the patience to understand the underlying businesses, an opportunity to buy into a very high likelihood of improving earnings power as prior investments become cash generative.

Other news

US housing was a bell weather for the overextended lending practices pre-Global Financial Crisis and subsequent falls in house prices had a significant impact on the US consumer. Whilst the US personal savings rate is at higher levels than pre-crisis, we note that higher interest rates are beginning to take effect. Las Vegas is reporting lower sales and higher inventories, and San Francisco single family house prices appear to have fallen 15% from their peak in February.

We listened to a fascinating presentation by a climate change research centre in the US discussing the medium to long term outlook for some of the USA’s housing markets, and Florida in particular. Their sobering conclusion is that the Floridian housing market is set for a shake-up and re-appraisal of its values well ahead of most people’s expectations and that this will be driven by the increased frequency of disruptive weather events. These more frequent ‘extreme’ storms will recalibrate the insurance models applied to Floridian property, and in some cases tip the balance towards defining these assets as uninsurable. If this happens, the long-term mortgage financing market will see significant disruption and there will be a corresponding drop in property prices.