Market jitters often raise more questions than answers. It has been a long time since we experienced a 10% correction, so it is little surprise that it has garnered the headlines it has. Is this the start of something serious? Are the fundamental drivers such as earnings at risk of decline? Why are people so worried about wage growth and inflation? Isn’t this interest rate ‘normalisation’ and what the market wanted?
While some investors saw the correction as a buying opportunity, others saw it as validation that equities, especially in the US, are expensive and would fall under their own weight. Global earnings growth over the last 12 months has been very healthy at circa 18%, and if 2018 forecasts are to be relied upon, another 10% growth is in store.
The commodity rebound has played its part, but the labour market is also strong and consumer confidence is high. Some economists see this as good news and are quick to cite that these are not the typical conditions for an economic or earnings downturn. Some are even brave enough to extrapolate this view into a short-term prediction of further gains. Others emphasise Donald Trump’s trade war threats and the concerns over European political events as reasons for a further market decline.
Yet, instead of obsessing over these short-term prospects, we prefer to advocate perspective and apply this thinking in our Managed Portfolios. For example, we know that US equities have increased by 107% over the past five calendar years in aggregate, while earnings have increased by approximately 15% nominally over the same period. This has created significant disparity and poses much more concern to asset values than any short-term political policy change.
As such, short-term events are unlikely to change our conviction that the US market remains expensive in aggregate and an unexciting place to invest. Furthermore, we are acutely aware of our inability to predict short-term earnings growth, and you should be too, so instead remain focused on maximising reward for risk by identifying specific unloved opportunities and constructing portfolios around these opportunities.
Are there Any Pockets of Weakness?
We have long commented that we were in the midst of a largely synchronised bull market, supported by a cyclical boost in sentiment. Interestingly, the setback impacted all areas of the market, with every sector declining over February. With widespread weakness, we have not really witnessed much of a change in the attractiveness of the opportunity set – unloved pockets remaining few and far between.
The UK remains one pocket of relative opportunity, and while the FTSE All Share also suffered in February, falling approximately 3.3% over the month in local currency terms, we see meaningfully less valuation pressure in a longer-term context. Naturally, the apprehension surrounding Brexit will continue to impact sentiment, however our long-term approach considers the UK in 2028 and beyond. Russia is a similar opportunity, and was one of few markets to rise in February, gaining 2.7%, although carries greater fundamental risk and thus is sized accordingly.
Fixed income markets are also showing some interesting developments – although this is fragmented and off a low base. In the short-term, rising bond yields have resulted in negative performance, with higher-risk corporate debt underperforming in February. Pleasingly, we had reduced our corporate bond exposure as credit spreads narrowed, which helped buffer against these falls, although we note this was a longer-term view rather than an accurate shorter-term prediction. Elsewhere, we like US Treasuries, as the yields continue to increase much higher than many global equivalents, as well as emerging market debt for similar reasons.
Currencies have been the other area of focus, with recent sterling weakness, the British pound fell 3.2% against the US dollar, 1.1% against the euro and 5.6% against the Japanese yen in February, reversing some of the previous gains. While this supported offshore holdings for UK investors that are unhedged, it doesn’t change our long-term thesis for sterling strength.
What Impact Does this Have?
While negative returns are undesirable, they are a part of investing and something all investors must accept. So far, the drawdown has been limited, and we note that it could get much worse, this is not a prediction, but merely setting reasonable expectations that the range of outcomes can be wide. We must acknowledge that valuation pressures remain among many core markets, and thus we have been happy to hold generally high cash levels to protect capital while maximising returns by diversifying across our higher conviction opportunities.
In a broader context, the developments over the past month don’t mean a great deal. The moves have marginally improved reward for risk across our portfolios, although have not really changed enough to get us excited nor to warrant an overhaul of our approach. When considering the opportunity set, we believe it is important to maintain the right behaviours, minimise underlying costs and to act independently – if we can do this consistently, we are in a great position to achieve investment success.
