Last week equity markets experienced a sharp fall that created headlines around the world. A few days later they had recovered most of the losses, leaving many investors to wonder what happened and why.
We are seeing the beginning of the final phase of the equity bull market that began in March 2009. In the latter stages of any bull market investors are known to climb a wall of worry, but at an Asset Allocation Committee meeting – held in the midst of the tumult – one member of the team characterised the investment environment as “a wall of ‘why worry?’”.
It is a legitimate point given the synchronised growth economies around the world are currently enjoying. Let us first consider the context in which the fall happened last week, and then consider what next.
We are in the middle of the corporate earnings season in the US; it has been one of the most successful on record. News of tax cuts has led to a sharp increase in the ratio of earnings upgrades to downgrades, lifting the global earnings revisions ratio to its highest level since the 2010 earnings recovery, and the sixth highest on record. There are upgrades in most sectors, with the exception of utilities, real estate and telecoms.
A record $100bn inflow into US equity markets in January saw the S&P 500 US Equity Index rise by 7.5%. Effectively, we had witnessed a stock market return more commonly seen over the course of a year compressed into the first month of the year.
The spur for the recent move in markets is paradoxically the strength of the US and global economy, which has increased concerns about rising inflationary pressures. After a long period since the 2008 financial crisis when deflation has been a more pervasive concern than inflation, the dynamics have now changed. The Fed expects its 2% inflation target to be achieved this year.
It remains to be seen whether productivity improvements in the US will dampen the linkage between higher economic growth and inflation. The slow pace of capital expenditure in this economic cycle has perhaps contributed to disappointing productivity, but the proposed tax changes in the US should create an incentive for firms to bring forward plans to invest in growth and efficiency. But the benefits will be some way off.
At the beginning of February we saw a surprise set of stronger than expected growth in US wages Investors are concerned that US monetary policy will not be able to contain the inflationary pressures coming from faster growth. Up to this point, central banks have intentionally prioritised growth over controlling inflation; they wished to avoid another recession at all costs. Combatting inflation may now become a higher priority. Some fear this will lead to sharper than previously expected increases in interest rates, in turn impacting global growth and depressing market valuations. That sparked a sharp uptick in US government bond yields and a concurrent pick-up in volatility.
The impact on markets was heightened by the short-term influence of systematic and algorithmic trading strategies that are often leveraged and driven by technical signals from markets rather than business or economic fundamentals. These often include rules-based selling and deleveraging that accelerates as markets fall and volatility rises. We expected the market volatility to contribute to further outflows from these systematic strategies in the days following and for volatility to persist for a number of days – like after-shocks from an earthquake – reaching a conclusion as exposures were wound down. That is largely what happened.
As longer-term investors in businesses rather than traders in markets, we will always be more concerned with the underlying fundamentals and valuation than short-term market moves. Market valuations have been above average and so we have been tactically underweight equities for some time, particularly the more cyclical parts of the market that typically get hit hardest in a downdraft, as well as avoiding deeply indebted companies. We have built up cash resources within client portfolios and additionally have good exposure to diversifying assets, such as absolute returns funds and gold.
The recent falls have been rather indiscriminate and therefore could throw up opportunities in companies that we have long wanted to own but have not because we felt prices were too high. Having liquidity in portfolios enables us to take advantage of these opportunities if there are further falls.
We believe equities remain a key driver of returns in portfolios and especially if the spectre of inflation is returning. However, we are happy to hold a somewhat higher cash buffer than normal while financial asset prices remain volatile. We have further reduced US Treasuries on concerns that the US dollar will remain weak. We have also decided to sell one of our funds which has performed very well over the long term.
We do not subscribe to the strategy of buy and hold whatever the market conditions, but nor do we try to time markets. We are watching closely what unfolds in the weeks and months ahead and will react quickly if we believe portfolios are at serious risk.
One of the strengths of this business is that clients have a relationship directly with the person managing their money. If you are concerned as a client, do not hesitate to pick up the phone and contact your investment manager.
Posted 14 February 2018
You should not act on the content of this market commentary without taking professional advice. Opinions and views expressed are personal and subject to change. No representation or warranty, express or implied, is made of given by or on behalf of the Firm or its partners or any other person as to the accuracy, completeness or fairness of the information or opinions contained in this document, and no responsibility or liability is accepted for any such information or opinions.
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