2017 was a great reminder that markets move in cycles of variable speeds, inclines and durations, with the extremely strong recent performance among risk assets looking more akin to an energetic sprint than any kind of long-term marathon.
The UK battles slower investment growth and rising inflation
To put this into context, global equities delivered an astounding 25% in local currency terms over 2017, with China delivering 45%, India 41%, the US 22%, Europe 15%, and the UK 13%. These returns may not be in the same stratosphere as Bitcoin, which delivered over 1,000% in 2017 in US dollar terms, but they are at the outer bounds of normality. While positive returns are a pleasing investor outcome, for contrarian investors they ring the bell of caution as outsized gains that are not accompanied by improvements in the fundamental value of assets can indicate that we are merely ‘borrowing’ returns from the future.
What Happened in December?
December was busier than usual, with three key events shaping market movements – namely Brexit developments, Donald Trump’s tax reform and the normalisation of interest rates.
Specifically, Brexit negotiations were deemed to be constructive and positive, with the European Union declaring that “sufficient progress” had been made, including agreements on the divorce bill, the Irish border and the status of Europeans living in the UK. Donald Trump also confirmed that his much-anticipated tax reform bill had passed congress, possibly the biggest upheaval to the tax system since the 1970s and a form of fiscal stimulus that pundits hope will further propel the US economy. Perhaps the most expected event of the month was the Fed’s interest rate hike to a range of 1.25-1.5%, consistent with the Fed’s view of a strong job market and of inflation rising towards 2% in the medium-term.
As was the case for much of 2017, global economic growth has remained fairly synchronised, with recent business and consumer confidence surveys reinforcing a growing sense of optimism as we enter 2018. While the European economy is outperforming the US economy, according to recent GDP growth rates, the UK is on a different trajectory as it battles between slower investment growth and rising inflation.
Such sentiment is clearly impacting market valuations, with demand for risk assets continuing to bolster returns in many regions but simultaneously stretching valuations beyond a reasonable estimate of fair value. As a hint of sentimental euphoria, Greek bond yields are now at their lowest level since November 2006, seemingly implying that investors are no longer demanding much of a premium for such risk.
What Impact Does This Have?
Over the month of December, emerging market equities beat developed market equities for the 10th time in 2017, returning 3% and 1% respectively in local currency terms. Underlying this was some meaningful dispersion, with the resource-driven markets in emerging Europe and Latin America excelling as commodity prices strengthened. In fact, the materials and energy sectors performed strongly across the board, increasing over 4% in local currency terms and well ahead of the broad market.
This development also acted as a boost to the UK equity market, which has the highest exposure to the commodities sectors amongst the major equity regions. In fact, the UK increased almost 5% over the month whilst Japan and the US only experienced modest gains and Europe ex UK equities fell by approximately 0.5%.
Fixed income markets were generally subdued, yet experienced a similar fate by region. This was especially true for UK debt, which performed well to return approximately 1.5% for the month in sterling terms. Once again, riskier debt outperformed ‘safer’ instruments, with corporate bonds outperforming government bonds.
Emerging market debt has been the standout performer, with another positive month that has extended the performance of local- and hard-currency issuance to 9% and 15% respectively over 2017. Currency had a muted impact over the month, with changes generally limited to less than 1% between the major currencies.
Looking Forward – the Bigger Picture
Looking more broadly, it requires a strong memory to recall a period that encompassed such an optimistic global backdrop. Across many regions, both the hard data and sentiment surveys, including among businesses and consumers, closed 2017 strongly and in a pretty synchronised manner.
For investors this backdrop has to be thought of in terms of value, risk and durability.
Value. The economy is not the market. What matters greatly to us is to not overpay for a stream of long-term cash flows. Most markets continue to be priced above what we deem to be their long-term fair value.
Risk. Risk is the probability of falling short of one’s objectives. This often means the risk of a permanent loss of capital, and in buoyant market conditions, we must not be distracted by any euphoric claims or the general feeling of calm. Our process is designed to bring great discipline in this regard as portfolios are constructed with a long-term lens, aiming to unlock value from unloved areas and to control the controllable.
Durability. We know from financial market history that bull markets do not continue forever, and quite often, the turn of events happen both quickly and without warning. Remaining patient as always is key.
