23 January 2019
‘None of us want to be in calm waters all our lives…’
Jane Austen (Persuasion 1817)
David Palmer, co-fund manager for the HC Verbatim Portfolio 5 Income Fund, answers questions on the impact of the end of QE on market volatility and equity valuations.
After nearly a decade of rising equity prices, was a ‘down year’ well overdue?
After nine US rate rises and the steady dial-back of central bank ‘QE’, investors are now starting to feel the swell. While US corporate earnings rose by more than 20% in 2018, thanks to tax cuts and a domestic growth surge, equity market multiples fell by even more – the result is the first year of negative returns for the US market since the credit crisis and double-digit losses for Europe and Asia. For the first year in seven, US equity prices underperformed US corporate profits – so yes, market valuations are normalising but after a very strong 2017.
December’s market volatility was extraordinary – is something more sinister happening?
Thin holiday season trading volumes likely exaggerated the moves but more frequent bursts of volatility across asset classes (we saw them in February too) will be a fact of investment life as monetary policy is regularised. Central bank support and near-zero rates have kept equity volatility (measured by the VIX index) at an average of 15.3% over the last five years, less than three-quarters of the average level that prevailed in the twenty years prior to that, so some normalisation is inevitable. Typically, tighter money means lower valuations and lower real returns across all asset classes– so I fear 2018 was almost ‘text book’ in terms of the market response.
The US President’s criticism of Jerome Powell, chair of the Federal Reserve, breaks a number of taboos – will this hurt world markets?
Donald Trump’s blizzard of tweets criticising the US central bank is clearly attempting to change the debate about how US monetary policy should be conducted – it leaves the ‘Fed’ less insulated from politics and it’s natural for investors to demand a premium for this. There is rumour that President and Chairman will meet and ‘make up’ and there is precedent for this - Greenspan, Bernanke and Yellen all attended such meetings but more to inform the President than to answer criticism. So yes, Trump’s comments are contributing to volatility but as long as inflation remains under control (and the President would say we have him to thank for low oil prices), the risk is probably not yet material.
Should we worry about rising bond spreads (especially in high yield credit markets)?
Yes – investment grade bond spreads (the additional yield they afford over government bonds) have now widened back to the levels we saw in mid-2016, with all of the tightening that resulted from Trump’s election and his ‘business –friendly’ agenda more than fully reversed. The IMF for example is concerned that while governments and consumers have reigned in deficits, absolute levels of corporate debt are still high (especially in Asia). The leveraged loan market in particular is showing that some excesses of 2008 are again re-emerging. This supports a deliberately conservative bond strategy at Sarasin – our balanced funds for example target an average credit rating of A+, and we are increasingly cautious of high yield and other specialist strategies.
Brexit, budget woes and the prospect of an Italian recession are not encouraging but could 2019 herald a surprise renaissance for the European economy?
The short-term outlook is not promising; German inflation recently slowed to the weakest in eight months, while output contracted in two of the three largest economies in the region in the third quarter, with Italy close to technical recession. All of this suggests that the deflationary forces that have plagued the eurozone remain a threat just as the European Central Bank steps back. Further fundamental reform could be possible in 2019 after European parliamentary elections in May with new heads of the Commission and ECB. With Chancellor Merkel’s successor also now assured, a renewed urgency for reform (especially financial) could emerge. This has the potential to stabilise the selloff in European banks (currently trading at just half the price-book ratio of their US counterparts) and hence to drive a broader re-rating of European equities – in short value is clear but investors will need (even more) patience…
What is your biggest worry for 2019?
The shorter maturity segment of the US treasury yield curve is gradually inverting, indicating that we are ‘late’ in the economic cycle and hence face a rising risk of recession, although it does not provide a precise timetable. My growth worries though are not in the West, where unemployment is low and consumer confidence and corporate profits are still robust, but in China. Economic visibility is poor with manufacturing survey data now looking consistently weak. In short, global growth ‘ex-China’ will be difficult to achieve – hence, a more defensive equity strategy with an emphasis on sustainable dividend growth alongside higher than normal cash positions remains our broad policy until we know more.
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