Two weeks ago, we made the decision to go partially defensive in our model portfolios to protect client capital as the data became more negative, leading us to revise our outlook for 2019 based on weaker global growth. Yesterday, following a further deterioration of the fundamental economic data, we made the decision to remove the remaining sources of directional equity exposure from portfolios, implementing the fully defensive models as we go into the new year. As we look forward we see Q1 2019 being very volatile with momentum positioned on the downside and although we expect it to be turbulent, we are in some aspects excited at the prospect that we are finally seeing the end of this cycle, and looking forward in the coming quarters at protecting capital then deploying at it again when we feel the markets have bottomed. We can do that as we have removed the threat b going defensive and are now going to be working tirelessly over the coming 3 to 6 months to review the markets and assets and get the re-entry point correct to turn the threat into an opportunity.
Near Term as we state above the year, we see a deepening rout in financial markets heightening the downside risks to the near-term economic outlook resulting in fluctuating credit markets, trade wars and increased political uncertainty. All of these factors are likely to continue to weigh on global growth in Q1 2019, resulting in lower returns expectations for first half of the year. The subsequent slowdown is likely to impact on all asset classes, however due to solid global demand and controlled inflation levels, the slowdown is not expected to be significant or long-lasting.
The key reasons behind our decision to implement the full defensive models are:
- The US- China trade War
The trade war between the US and China is likely to continue to influence market movements in the new year. A temporary truce currently exists between the two nations, however whether a more permanent agreement will be made remains uncertain as the tensions between the two nations go much deeper than tariffs. As the risk of new tariffs and other barriers remains heightened in 2019, markets will be extremely sensitive to updates on the relationship. President Xi was expected to reference the US trade relationship in his speech at China’s 40th Anniversary of reform and opening up on Tuesday, however made no reference to the relationship and only made passing reference to his market-orientated reform goals. It is possible that Xi wishes to hold back from revealing too much ahead of negotiations with the US, however all eyes remain on developments in the relationship. As the world’s two largest economies, an escalation of trade tensions would significantly weigh down global growth. A deal may be done due to emerging weakness in both economies, however tensions are likely to remain in Q1 of 2019.
- US Economy
2019 is shaping up to be a year of slowing growth for the US economy due to fading fiscal stimulus, Congress paralysis following the mid-term elections and Fed rate hikes. The Fed has recently indicated a more dovish stance, reducing expectations for a rate rise, however with further rate rises expected in 2019, the US economy appears to be on a downward growth trajectory. Domestic and overseas political tensions are likely to provide significant headwinds to the US economy, teamed with increased protectionism which is likely to negatively impact trade, further reducing the pace of growth in 2019. Weakening growth expectations for the year have recently resulted in a selloff in US equities, and we view this as an area of continued weakness given the significant risks facing the US economy.
The fate of the UK economy in 2019 lies in the hands of the deal or no-deal Brexit situation. With the UK expected to leave the European Union in March, Brexit negotiations have become increasingly chaotic towards the end 2018. At this stage, if the UK government fails to agree a Brexit deal, the UK could crash out of the EU in March with no deal. The Bank of England has warned that this scenario could lead to an 8% reduction in GDP, an unemployment rate of 7.5% and a 25% decline in the value sterling. It is in no doubt that in this situation, financial markets would be in turmoil, and UK assets would be sold off. If a deal can be agreed in the first months of the year, this would significantly reduce the risks to UK assets, however at this stage we view UK assets as being heavily exposed to potential downside risk.
- Euro Crisis
As 2018 progressed, it appeared that political risk in the Eurozone was abating, however following the Italian government’s budget standoff with the European Commission and social unrest in France towards the end of the year, significant risks remain within the bloc. The Italian government’s defiance of European budget rules in recent weeks had sparked fears that the ECB could be forced to intervene with untested tools, adding further pressure to the already fragile political consensus in the bloc. Today, the two sides have reached a new budget deal, reducing the deficit target from 2.4% to 2.04%, and avoiding the possibility of sanctions; however, it is likely that tensions between the new populist Italian government and the EU will remain heightened over 2019.
Despite the resolution of the Italian budget conflict, continued uncertainty and recent negative economic data paints a gloomy picture of the near-term growth outlook. The unrest in France was dealt with internally, however could pose a greater threat to the French economy as the deficit target rises to 3.4%, breeching the EC’s target of 3%. It remains to be seen if France will be subjected to sanctions or intervention as a result of the target breech, therefore significant risks persist. Additionally, slowing growth in Germany is a key concern as tariff risks and slowing global trade weigh on the export-dependent industrial sector. Uncertainty is high going into 2019, and with weakness appearing in the largest economies in the bloc, very little upside can be seen for EU equities in the new year.
Oil prices have fluctuated heavily throughout 2018, with lower prices reflecting weak demand and large supplies of US shale. Low oil prices are likely to continue to negatively impact energy reliant economies in 2019, however are likely to provide a temporary benefit to consumers and keep inflation under control, reducing the need for Central Banks to raise rates in the near-term. The oil price outlook has softened recently as a result of OPEC cuts to oil production, reinforcing the notion that the benefit to consumers will be temporary and inflationary pressures are likely to return later in 2019.
- Central Banks
Despite adopting a more Dovish tone in recent weeks, the Fed is likely to continue rising rates in 2019. Powell is expected to make an announcement later today regarding a potential December rate rise alongside expectations for rate rises over 2019. The pace of US rate tightening has reduced recently due to moderating US growth and low inflation, however as inflation picks up, the Fed is likely to tighten further. Further tightening will increase pressure on borrowers and markets in 2019.
A weakening global economy and central bank liquidity withdrawal as a result of rate tightening could heavily impact credit fundamentals in 2019. In recent years, there has been a boom in the issuance of credit which has been compared to the credit situation leading up to the 2008 financial crisis. In the US, an increase in the issuance of structured products such as collateralised loan obligations have spurred warnings from regulators, indicating potential risks in the case of a global growth slowdown and further rate tightening.
Recent data suggests that global debt is now more than three times the level it was 20 years ago, raising fears for a potential debt crisis. Rising interest rates are likely to heavily impact households and nonfinancial firms, reiterating the risks of a global slowdown in 2019. Emerging markets sovereign debt is extremely exposed to increases in US rates, therefore further tightening by the Fed poses as a significant risk to this asset class. If economic growth declines, borrowers will be less likely to service their debt, therefore in 2019 we choose our bond exposure carefully going into 2019.
Overall, given the risks facing the global economy, we are bearish about the outlook in 2019 and therefore have made the decision to go defensive as we head into the new year. As a result, we are now fully defensively positioned to protect capital. In our view, there are significant headwinds facing markets in 2019, and volatility is likely to remain high throughout the year. Given the economic data and limited remaining upside risk to equities, the most beneficial strategic move at this point in our view is to take risk off the table, allowing us to limit downside risk and retain high cash levels to take advantage of opportunities as they arise. At the same time, it is key to highlight that we are expecting a gradual rather than abrupt economic slowdown in 2019, following which we will reinvest when the outlook becomes more positive.
For anyone who wants further data to substantiate the position please review the attached Global Economic News Document.
Model Portfolios & Indices
Over the last week we have seen most of the indices that we track fall further with the US markets falling the furthest at more than 3%. The rest of the world has been following suit, however they haven’t fallen as sharply and we are seeing a bit of stabilisation today as we await the FOMC decision and meeting later tonight. The US indices have had elevated levels of growth, and therefore are most susceptible to market sell offs. With regards to the model portfolios, with the spilt more skewed towards non-equities, the balance in the portfolios has been hedged to reduce the impact of the sell offs in the model portfolios and that hedge has been increased today as we only see this getting worse.
The barbell of risk is therefore now skewed fully towards being projectionist and on that basis if the markets rallied it would be negative for the portfolio and if they continue to fall further it will be positive for the portfolios. As a point to note in 2000 the FTSE 100 peaked at nearly 6700 before falling to 3600 at end of 2002, then rose again to 6700 in 2007. It then fell following the financial crisis towards the end of 2008 reaching a low again in March 2009 of again 3600. Since then we have risen steadily and had a wobble at the start of 2016 due to an oil crisis and the FTSE 100 again fell from a just under 7000 to 6000 before rising again in the last 12 months to a recent high of just under 7900. If we are now at 6800 and we are about to enter a global slowdown and have a real downturn in equity prices because earnings globally are going to go backwards then I would see a low on the FTSE 100 being somewhere between 4500 and 5500. From where we are today that is range of -33% to -20% as potential downside with no upside. That is in its simplest terms why we are defensive.
Over all time periods now the benchmarks are below the models on the equity side and on the non-equity side they are over everything but the 12 months. Over the coming months this disparity will only increase if the market correction continues and the rout turns into a full correction caused by the 8 negative issues above becoming more and more prominent.
We are still maintaining a high cash position and continue to not hold any commercial property or corporate debt in the portfolio directionally whilst the Brexit situations remains so chaotic. The high cash position will enable us to have a buying opportunity when we see a potential in the market so if the data is substantiated, we will buy back into equities.
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 1843, ‘A Christmas Carol’ was published in Britain, written by Charles Dickens. The story is an immediate success and will remain one of Dickens’ most beloved works.
As always have a wonderful week and stay safe. The next Market Commentary will be on the 28th December, so I would like to wish everyone a safe and lovely Christmas and lets hope 2019 brings me and you what we expect and that is lots of volatility and an opportunity to make the year a special one.