Market Commentary – 7th February 2018

Melt-up-down?

It was inevitable given that we have had no volatility in the market throughout 2017 nor in the first month of 2018. February possessed its new challenges and is testing investors and global markets. Market volatility is normal providing that the current situation of letting some air out of the tyres does not result in a puncture, this reset could be seen as a justified reaction to recent exuberance. We find it unlikely that this market episode will be associated with a sustained economic downturn. The ingredients are inconsistent with that most fearsome of scenarios in which inflation picks up sharply while the economy stagnates.

At the beginning of this week, the market reversal we have seen has been quite severe, of similar magnitude to other tantrums and episodes since mid 2013. Regardless, our view is that at least for Q1 and Q2, this might be normal market behaviour and all the tantrums and market episodes of recent years have petered out quite quickly. The key common theme for such an episode to turn into a sustained bear market with strong macro-consequences is the realisation of a fundamental economic weakness and/or balance sheet vulnerabilities. What might make this period of weakness infect the global economy? The current episode brings to the fore a tail risk that has haunted markets and the global economy for several years. What if central banks have to respond to higher inflationary pressures, with limited offsetting good news on output? Indeed, our forthcoming note will argue that the movement in bond prices is about changed expectations of policy, since implied inflation expectations from swaps have moved less than real rates.

This all started last when the US posted better than expected US wage data. This has signalled a potential rate hike in the next Federal Reserve meeting. Traders have been rattled by the prospect of tighter monetary policy around the world which is causing the volatility we are seeing in the markets. Like we have said in the past, economic data is strong, and continues to stay positive to the markets, however we are cautious that the risks in 2018 will be higher then where they have been in 2017. This episode of market volatility has not yet played out and could well involve more wrenching trading sessions for investors. Central banks are gradually moving towards a more normal interest rate policy, and this will see some of the distortions of the last few years unwinding, and this isn’t always smooth. But the economic cycle has not yet turned, the growth outlook remains healthy, and this suggests that we face a market correction, not a sustained downturn or a recession.

One thing that is important to note is that market volatility is normal. It may not have been portrayed as such by the media, but a correction is sometimes healthy and removes the day traders who are causing most of the volatility and are trading the markets just for short term gains. We do expect volatility to pick up as central bankers now start their tightening approach from record low interest rates since the 2007/8 financial crash. It is inevitable that interest rates will start to now rise given the global growth we are seeing, and at a time when the global economy needs money for the increased corporate investment activity which is taking place. This now means that there wouldn’t be the constant flow into the equity markets which has been supporting prices over the last couple of years.

With the volatility and turbulence we saw throughout this week, it has been exacerbated by day traders, as well as algorithmic computer-generated trading tools which pace up the volatility and the amount of volumes of trade. The art of algorithmic trading is to be more efficient, however a major weakness to adopting this strategy is once the limits set are passed, the computer algorithm automatically trades, which builds up the volatility. Corporate earnings continue to justify valuations, the general synchronised economic recovery is still intact, and even an aggressive increase in the interest rate across the pond would still likely leave US rates at historic lows. Usually, when investors are worried about markets, the flight to safe haven assets go up. In 2017, the price of gold went down 7%, which is interesting as the markets went up that much proportionately. It is not surprising to see overall gold demand drop down given the backdrop of monetary policy tightening and strong equity markets in 2017, but one thing to note is that the markets are not in a bad state at all. Yes, the correction is worrying based on our principles about capital preservation through our OBI strategy and we will maintain this approach given the stage of the cycle were in.

For anyone who wants further data to substantiate the position please review the attached Global Economic News Document.

Model Portfolios & Indices

The fall we see below is simply the fear we have been having in the markets throughout last year. As we approach closer to the end of this phase of the economic cycle, we are cautious of the risks. Even though the main indices highlighted below have had a reasonable correction over the past week, the change in our portfolios hasn’t been as bad purely based on the equity and non-equity split we aim to achieve, and by cyclically rotating our asset allocation to prepare for these spikes.

The Investment committee gathered this week following the much-anticipated correction and we have sold down the following long equity positions, which would have dragged the portfolios down further:

  1. Invesco Perpetual Pacific
  2. Old Mutual Global Opportunities
  3. Royal London Sustainable
  4. FP Crux European Special Situations
  5. Invesco Perpetual Global Opportunities

By removing these positions, we are now able to focus on capital preservation, as risks remain high, and placed the proceeds of the sales in cash. This will leave us in a strong position where when the markets have fallen further, we will be able to use this cash to buy back into the markets when the correction has reduced valuations. By implementing this strategy, we would have hedged our portfolios and got back into the markets by achieving capital preservation. We haven’t reduced our equity components completely and have let the more cautious focussed multi asset funds, where the fund manager has flexibility and the global equity funds that have the ability to short and will halve our exposure to Europe. Although I still believe in the data and that this will be a blip before another rally and then the storm, it makes sense to put capital preservation ahead of riding this roller coaster that could fall as much as 20% plus before a bottom is found as in early 2016 if analysts are to be listened to. The bears are certainly dominating the air waves.

Important Information

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 1935, the infamous and beloved board game, Monopoly made its debut. The earliest known version of Monopoly, known as The Landlord’s Game, was designed by an American, Elizabeth Magie, and first patented in 1904 but existed as early as 1902. A series of board games were developed from 1906 through the 1930s that involved the buying and selling of land and the development of that land. By 1933, a board game had been created much like the version of Monopoly sold by Parker Brothers and its related companies through the rest of the 20th century, and into the 21st. Several people, mostly in the Midwestern United States and near the East Coast, contributed to the game’s design and evolution.

As always have a wonderful week and stay safe.

VBW

Jason Stather-Lodge  CFP, MCSI, APFS
CEO & Founder
Chartered & Certified Financial Planner
Chartered Wealth Manager