Global Market Overview
October proved to be a torrid month in global equity markets with the most significant monthly declines we have seen for six years. The MSCI World index fell 6.8% over the month. Many markets in local currency terms have come close to correction territory this year, defined as a fall of 10% or more, whilst the MSCI Emerging Markets index is nearing a bear market (a fall of 20% or more). Following last month’s strength Japan’s fortunes reversed and it was the worst performing of the major markets (-9.41%). The FTSE 100 fared the best declining 4.85%. Within equity markets value outperformed growth shares. Put simplistically this means that shares trading on lower prices relative to fundamentals such as earnings or book value fared better than those where investors have been prepared to pay a significant premium for higher than average growth prospects, such as the so called FAANG stocks (Facebook, Apple, Amazon, Netflix and Google (Alphabet)).
October is usually a positive month for markets. Analysis by Schroders shows that since 1992 the market has only fallen in five Octobers but perhaps investors were spooked by the fact that ten years ago this month the MSCI World fell -19.0% over the course of the month as the world plunged into the Great Financial Crisis. Otherwise it is hard to identify a catalyst for the volatility. Certainly, investors have had a lot to worry about in 2018 including US-China trade tensions, tighter monetary conditions and European political uncertainty but these are not new concerns.
The US economy remains in rude health with initial estimates for third-quarter US GDP of 3.5% (annualised), beating consensus expectations. The unemployment rate for September fell to 3.7% – the lowest in almost 50 years – and consumer confidence remains close to record highs. The earnings season has also gone well with over 85% of companies that have so far reported beating earnings-per-share estimates although guidance on future earnings has been weaker than expected with companies highlighting the potential increase in costs from higher tariffs. The US 10-year Treasury yield breached 3.2% in October, surprising many market observers. The S&P index declined 4.95% over the month.
In the UK, the Budget was brought forward to October to avoid a clash with Brexit negotiations and the Office for Budget Responsibility (OBR) published its revised growth forecasts for the UK economy. Real GDP growth for 2018 was revised down from 1.5% to 1.3% largely because of the poor weather in the first quarter but longer dated forecasts were upgraded. Wage growth grew at an annual pace of 3.1% although inflation overall fell as the impact of imported inflation from a weaker currency lessens. These dynamics should be supportive of the UK consumer. The UK stock market proved its defensive characteristics, outperforming the rest of the world although, in a pattern familiar since the EU referendum, the FTSE 250 and Small Cap indices suffered more as the lack of a breakthrough in the negotiations with the EU continued to weigh on sentiment.
Economic data continues to point to a slowdown in Europe with a 0.2% quarter-on-quarter growth rate in Q3 compared to 0.4% in Q2. The Purchasing Manager’s Index (PMI) declined from 54.1 to 52.7, a 25-month low, likely as a result of the global trade tensions. Against this backdrop whilst the European Central Bank still expects to end quantitative easing by the end of this year, interest rates are likely to remain on hold for the foreseeable future. Italian politics continue to dominate the headlines, but both ratings agencies, Moody’s and Standard & Poor’s, kept the country’s debt rating at investment grade, providing some comfort. The FTSE World Europe ex UK index retreated 6.14% over the month.
Although Japanese equities bore the brunt of fears surrounding the escalation of a global trade war, there was little change in the domestic economy or policy. Economic data was somewhat mixed, but it is hard to derive an accurate picture of the underlying health of the economy given the natural disasters affecting Japan in recent months. Growth stocks which have led the market higher in recent quarter suffered a particularly sharp reversal in Japan. The next increase in consumption tax will go ahead as planned in October 2019 but the government is also planning a series of stimulus measures to offset any negative impact.
Asia and Emerging Markets are perceived to be higher risk and as a consequence it was no surprise that Asian and Emerging Market indices suffered sharp losses in October although as a heterogeneous group of countries it is convention rather than reality which lumps them all into one pot. By way of example, although most markets fell, Brazilian equities and the Real rallied in anticipation of a market friendly election outcome which was confirmed at the end of the month. Chinese growth slowed in the third quarter by more than expected to 6.5% year-on-year and the stock market lagged the broader index. It is notable that whilst industrial production fell in September, retail sales growth accelerated and the Chinese authorities continue to put in place a series of measures designed to stimulate the economy and market sentiment.
US government bond yields rose in October. This ran counter to the broader trend towards less risky assets and which propelled the dollar index to gain 2% against a basket of other currencies. Elsewhere the risk off environment meant that government bonds rose with the FTSE Actuaries UK Conventional Gilts All Stocks index rising 0.93%. European government bonds also fared well. Credit markets underperformed government bonds.
The oil price declined 7.21% in October as Saudi Arabia announced that it will be increasing output.
Performance of RPW Models over one month to 31st October 2018
All RPW models declined over the month on a sliding scale commensurate with attitude to risk.
Performance of RPW Models Year to Date, to 31st October 2018
All RPW Models are now in negative territory for the year.
Performance of RPW Models over 1 Year to 31st October 2018
Over one year to 31st October 2018, the Cautious model has returned 0.51% whilst the Adventurous Model has declined by 0.88% (Source: Financial Express Analytics, Total return, Gross of fees, as at 30th September 2018).
Please note that these figures are unaudited and indicative. The performance of actual client portfolios may be different. The effect of fees will reduce the returns achieved.
Unsurprisingly the best performing funds over the month were cash, bonds or property funds. The Allianz Gilt Yield fund proved its defensive credentials by rising 0.82% and L&G Property achieved another positive month with a return of 0.25%. Fidelity Cash and Royal London Cash Plus each returned 0.06%. The equity funds experienced a tough month with some experiencing double digit declines. Legg Mason IF Japan Equity, which has often been the best performing fund over the course of a month, fell 14.12%. Investing in Japanese smaller companies with a focus on domestic sectors such as technology and healthcare it is a highly volatile fund and therefore only held within the Adventurous model. Smaller companies elsewhere were not immune with the Merian UK Smaller Companies Focus fund falling 11.37%.
Since the end of October financial markets have recovered some poise with strong bounce backs seen in certain sectors and stocks. As previously mentioned, value shares, those with low price to earnings and low price to book ratios, outperformed growth shares. A key question is whether mean reversion is underway, with the outperformance of value set to continue (after a prolonged period of underperformance) or whether investors will continue to want exposures to higher growth companies and be prepared to pay up for it. Certainly, many of the top performing technology and consumer related stocks such as Amazon experienced significant setbacks in October, in some cases falling 20-25%, and some will argue that they now offer an attractive entry point. An important consideration is the likely path of interest rates. As they rise, the rate at which future cashflows are discounted is higher which means growth stocks suffer disproportionately. With the US 10-year Treasury above 3% investors are worried about what price to pay for future growth.
However, global growth, whilst still positive, is not as strong as it has been and although labour markets are tight, signs of rampant inflation are few and far between. Many value managers cite a change in inflation expectations as being one of the catalysts for value to do better but with the US yield curve fairly flat (implying that future interest rates are not expected to increase dramatically), one interpretation is that inflation is not as much of a concern as some would suggest. Moreover, further analysis of the performance of individual sectors suggests that characterising October’s returns according to a simple growth-value dichotomy is too simplistic. Plenty of value managers have exposure to energy and materials but these sectors sold off as part of a widespread dumping off more cyclical stocks. This would imply greater fears about a global growth slowdown than an uptick in inflation unless at the same time the US Treasury yield curve starts to steepen (a higher yield demanded for bonds with a longer maturity). Indeed, whilst not an explicit part of their remit, October’s volatility may give the Federal Reserve pause for thought in their rate hiking cycle. It was the more defensive sectors such as utilities, consumer staples and communication services which declined less in October. If the world is on the brink of a recession, then these sectors will continue to outperform but if a recession is averted and growth becomes scarcer then the price that investors are prepared to pay for that growth is likely to be higher.
There is a coherent argument to be made that with unemployment at record lows and wages starting to rise Central Banks will be required to raise interest rates faster than expected. The alternative argument is that the data is not being correctly quantified (zero hours contracts being included in the jobs data for example) and there is still spare capacity within the economy and that technological disruption is keeping inflation lower for longer. Other well documented risks such as US-China trade tensions, rising debt levels, Italian politics and Brexit have not gone away.
The upshot of all of this is that we remain comfortable with our asset allocation across all risk profiles and that it remains appropriate to have exposure to both growth (e.g. Baillie Gifford Pacific) and value (e.g. Man GLG Undervalued Assets) managers within the portfolios. That said, we are very far from complacent and continue to think deeply about the balance of risks and exposure to different investment styles within our clients’ portfolios.
Volatility is likely to persist and investors should continue to maintain diversified portfolios with a blend of defensive and more risky investments. A disciplined approach to asset allocation and identifying good active managers who can navigate these conditions successfully remains of the utmost importance.
12th November 2018