Markets demonstrated excessive volatility this week, as new releases of economic data and corporate earnings casted further doubt over the health of key global economies. Over the week since the last market commentary, UK and European markets closed lower overall, while US markets ended broadly flat following strong trading sessions over the last two days. The week was essentially a tale of two halves: while markets declined on the back of weaker PMI and GDP data alongside more negative corporate earnings data for the first half of the week, renewed optimism for a trade deal between Xi and Trump artificially lifted markets during the second half.
Short term movements vs. long term trends
While volatility remains high in markets, short term market movements will continue to be influenced by uncertainty, politics and sentiment, however it is vital to remember that while temporary factors influence temporary movements, long term trends are based on hard facts and economic data. When we analyse the data, we see significant weakness in the global economy, and continue to see considerable downside risks in equity markets. For this reason, while intra-week market movements are likely to be volatile, and may rise based on temporary factors from week to week, we continue to focus on the data, and we remain confident in our thesis and positioning.
A challenging economic backdrop
As we look at the global economy, there are a number of comparisons to be drawn between current conditions and those present prior to past crises as highlighted in previous market commentaries, as fears of a slowdown in China, recession in the Eurozone and Brexit risks remain at the forefront of macroeconomic discussion. On the surface, trade tensions are a key concern, with higher tariffs threatening future global growth, however underneath, considerable weaknesses already exist in the global economy which indicate that we are closer to a pull back in markets than previously thought. Although risks are country-specific, the general trend appears to be one of weaker growth and lower demand. To summarise, on an area-specific basis, key risks are:
The UK economy continues to weaken on the back of continued Brexit uncertainty, lower global growth, US and China trade tensions and a slowdown in key European trading partners. This week, the Office for National Statistics (ONS) announced Q4 GDP growth of 0.2%, with December delivering a 0.4% decline in output, with all major sectors contracting. This left 2018 growth at only 1.4%, the slowest since the 2009 financial crisis. Additionally, the Bank of England downgraded its forecast for GDP growth in 2019 earlier in the week due to the weaker global outlook and Brexit-related uncertainty, with the committee indicating that Brexit uncertainty has been more damaging than previously anticipated. Assuming an orderly Brexit, falling inflation and looser fiscal policy, the UK economy should recover somewhat, however current data suggests that the 2019 outlook remains weak.
While concerns over US-China trade tensions impact on markets on the surface, Europe is increasingly looking like the biggest threat to global growth, with industrial production falling at its fastest level since the 2009 financial crisis and deteriorating demand across the bloc. As it stands, GDP growth is at risk of barely topping 1% in 2019, a sharp slowdown from 2018. In comparison, while China is experiencing a slowdown, stimulus is in the pipeline. In Europe, the situation is deteriorating fast, with underlying weakness in domestic economies remaining cause for concern following a slump in manufacturing in Germany, declining consumption in France and weakness in Italy’s banking sector.
Easing financial conditions in the US and encouraging trade talks with China may have helped to alleviate fears of an immediate recession as the government shutdown ended, however the economy continues to slow, with the impact of the slowdown on GDP yet to be seen. With fiscal stimulus expected to dissipate over 2019, slowdowns in China and Europe could accelerate slowing in the US economy. With US-China trade talks continuing on Friday, optimism is high in markets that a trade deal can be done, however weaknesses continue to appear in the US economy.
The slowdown in China presents a serious threat to global growth should it intensify, with risks of decade low global growth if Chinese growth slows sharply this year, or lower in the event of a combined slowdown in the US and China. Data suggests that Chinese imports contracted at the fastest pace since 2015-16 in late 2018 and China-sensitive commodities have softened. With China accounting for c. 10% of world trade, import weakening presents a key threat to global growth. Weakness in the domestic economy and lower demand are creating significant headwinds for the global industrial sector. Chinese growth is expected to bottom out in Q2 but not rebound.
As we consult the economic data, we see very limited upside potential in markets, and significant downside potential. As the data is now heavily skewed towards the downside, the global economy is showing considerable weakness, which we expect to translate into markets. It is our view that markets are currently artificially inflated by uncertainty and optimism, and not reflective of a significantly weaker economic backdrop.
Earnings data is beginning to reflect a weaker global growth outlook
As we are now around halfway through the Q4 earnings season, slower economic growth and trade tensions are beginning to feed into corporate earnings in the US, with companies with more global exposure reporting lower growth in Q4. According to Factset data, based on current EPS and revenue estimates for 2019, S&P 500 companies with higher global exposure are expected to underperform more domestic focused companies. For companies who generate more than 50% of sales inside the US, the estimated earnings growth rate is 6.7%. For companies that generate less than 50% of sales inside the US, the estimated earnings growth rate is 1.9%.
In the UK, over the week, particular weakness was exposed in the UK automobiles sector, with Jaguar Land Rover announcing significant losses for Q4 2018, Nissan reneged on plans to build the X-Trail sport utility vehicle in Sunderland, and Ford announced that its UK factories were at risk in the case of a disorderly Brexit. Whilst key supply chain issues remain unresolved and weaker confidence persists as we approach the Brexit deadline, UK earnings remain at risk.
Investors are rotating away from equities into cash
According to data from Bank of America, global equity allocations in February fell to the lowest level since September 2016, even as global indices were c. 8% higher. This indicates low conviction in the sustainability of January’s rebound in equities. The net allocation of 44% to cash is the highest overweight since the 2009 financial crisis. This shows a big rotation from equities into cash this month.
We reiterate that movements made on temporary factors are just that, and we are concerned about long term trends, therefore our focus remains on the economic data. We are not concerned about missing returns on an intraweek basis which are based on optimism or sentiment, and encourage clients to consider the long term outlook for the global economy considering the risks highlighted in this email. We would rather be cautious and miss out on a small amount of upside if we are wrong than risk client assets when all of the economic data suggests that a pull back is coming.
To reverse our thesis, we would need to see a significant improvement in economic conditions, and sustained stimulus to form a recovery in markets, which given the extent of the weakness across global economies appears highly unlikely. A trade deal may provide a temporary boost to markets, however with the current weaknesses as discussed in the global economy, this does not change our outlook.
1 month performance
The below chart illustrates how volatile markets have been over the last month, with portfolios producing flat returns with considerably lower levels of volatility. While in the last few weeks markets have trended higher based on optimism and sentiment, the economic data continues to highlight significant downside risks. Given the excessive levels of volatility currently in markets, differences in intraweek returns are stark, whereas our portfolios remain relatively consistent.
For anyone who wants further data to substantiate the position please review the attached Global Economic News Document.
Model Portfolios & Indices
Following the defensive repositioning of portfolios in December, our OBI portfolios have a low equity allocation, with exposure predominantly coming from the FTSE 100 and S&P 500 shorts as well as the Odey Long/Short European fund. For this reason, the equity exposure within portfolios is inversely correlated to markets ahead of the expected decline this half. Markets were slightly lower over the week in the UK and Europe, however were flat in the US and higher in China on optimism over a US-China trade agreement ahead of trade talks on Friday. Over the week, the OBI portfolios gained as a result of the inverse correlation with UK and European markets, with trade optimism on Monday and Tuesday reducing the gains from earlier in the week.
Despite a challenging week for portfolios, all models gained over the week while the AFI Cautious and Balanced benchmarks declined by around 1.5%. In comparison, the portfolios gained around 0.3% at a considerably lower level of risk. The economic data continues to support our expectation for a drop back in markets in H1, therefore we remain defensively positioned going forward. It takes time for the data to feed through structurally, therefore as we wait for the data to feed through into markets, we are expecting volatile market conditions to continue, however it is key to bear in mind that the scenario will take time to play out. We must view intra week market movements in the context of longer-term market trends and stay content in the knowledge that portfolios are protected from the excessive risks in markets.
The data above will not directly correlate to the indices as there is always a delay in pricing because the US markets close significantly later than the European markets and the Asian markets. The data set above reflects the last close and much of the days movements will not yet be reflected in the portfolios due to pricing delays. You cannot therefore directly correlate indices to the portfolios. The value of investments may fluctuate in price or value and you may get back less than the amount originally invested. Past performance is not a guarantee of future performance. Performance figures quoted include the fund manager charges but exclude other fees such as adviser, custodian, switch and/or discretionary investment management fees. Unless otherwise instructed and accrued, income is reinvested into the portfolio.
This Day in History
On this day in 1970, General Motors announced it was redesigning automobiles to run on unleaded fuel.
Have a great week,
Gina & Jason