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End of a stormy quarter

29 March 2018

Investors might think it appropriate that the first quarter of the year should end with a damp Easter bank holiday weekend (at least in the UK). After a pleasing last quarter of 2017, investors enjoyed what we refer to as a ‘melt-up’ in stock markets during January. Global growth had picked up markedly into the year end, and the expectation was that this would continue for most of 2018, boosted by US corporate tax cuts.

As more and more US retail investors re-entered into US equities, the professional investment community was swaying between trying to rationalise the increasingly lofty valuations with the growth outlook and warning that the ever-higher highs were pushing stock markets into dangerous ‘bubble territory’.

In the end, the melt-up party was brought to an end by concerns that an overheating economy would push inflation and, in its wake, interest rates higher and more quickly than anticipated. Interestingly, wider market commentators only started to notice the slowing economic momentum after the first sell-off round, which swiftly led to the second round we experienced only last week. It is somewhat ironic that the second wave was on the back of the exact opposite concern to what triggered the initial correction at the beginning of February – slowing, rather than overheating economic conditions. Once euphoria and overconfidence has left the stage, the resurgent volatility in markets can be triggered by all sorts of concerns that would previously have been quickly dismissed.

In the meantime, central banks demonstrated that they were not inclined to overreact to inflation edging back towards more normal levels of around 2%. This, together with the moderation in the pace of growth, led to the much-watched longer term US bond yields ending the quarter well below the 3% watershed – the level which some had feared would cause bond markets to start misfiring and upsetting financial markets more broadly.

The rapid recovery from last week’s fall tells us that stock markets still have legs. From our perspective, this makes a lot of sense, given global growth rates remain healthy, just not worryingly frothy. So why do we remain been underweight equities then? Well, as regular readers will know, we anticipated the return of volatility, and felt we would spare investors as much of the unpleasantness as we can. That is, without jeopardising the long-term return benefits of being invested at least. After all, given that markets broadly track the economy (which is still growing steadily), markets could resume the uptrend earlier than we anticipate.

The challenge of the coming quarter will be to foresee market reaction to the changing (but broadly normalising) environment, as well as the timing of those reactions. Macro-economic data flow over the coming weeks will be as important as the Q1 corporate earnings reports, which start to come out towards the end of April. Unfortunately, there are a number of additional factors which will make it difficult to make investment calls one way or the other with high conviction.

As laid out above, overshooting economic growth momentum no longer poses a particular threat, but growth remains strong enough to warrant expectations of gradually rising interest rates and bond yields. This in turn should prevent valuations from running away, as the competition of fixed interest bond yields returns.

However, more difficult to assess is the likely impact of the end of abundantly cheap capital. After a decade of ultra-low cost of capital, we must expect that it has, in instances, been allocated less efficiently than can be expected when it is more scarce. We therefore cannot be entirely sure how the corporate sector will cope under the higher burden of interest payments – though economic growth should soften the impact. We should expect more defaults in companies who were either kept afloat by cheap credit for longer than their underperforming businesses would have normally permitted, or overloaded on debt in the expectation that the ‘old normal’ would never return. This will bring back memories (and fears) of the credit crunch, but defaults from underperforming firms have always been part of a functioning economy which, by its nature, reallocates scarce resources to the most beneficial use available.

We had noticed this gradual tightening of money supply towards the end of last year and, since we know (and were around) when this happened during the last 1/3 of previous economic cycles, we projected that the runaway markets would sooner or later come to their senses. As a consequence, our more cautious portfolio positioning has meant our investors will have suffered smaller setbacks over the first quarter than they would have if we had stuck with the longer-term asset allocations. Nevertheless, 2018 returns are, thus far, slightly negative in lower single digit numbers across the spectrum of profiles.

While shorter-term setbacks like these do not tend to make too big a dent for investors who have already ‘banked’ a couple of years of positive returns, it is painful for those who have only recently taken the step to invest. I can feel the pain and I am never happy at the end of a negative quarter. However, in this instance, the continuation of economic growth and the generally positive outlook (despite the occasional political blow-out) for the global economy gives us fairly high conviction that, over the medium term, returns will be back in positive territory for 2018. Over the shorter-term, however, volatility will continue to reign. While unpleasant, it is also a helpful mechanism to purge unhealthy market developments and help capital markets to adjust gradually rather than postpone the adjustment to a changed set of valuation variables.

As such, we were all but surprised by the sector rotation we witnessed over the past week, with tech stocks like Facebook, Google and Amazon turning from leaders to laggards. Again, regular readers will remember various articles last year in which we expressed our expectation that this backlash would happen. As such, we are pleased that the positioning against this event which we adopted in December last year has now come to benefit.