Market Commentary – 27th March 2019

 Where are we now and what next?

Over the last four months, we have pursued a very defensive strategy as global economic headwinds have persisted, highlighting significant potential downside risk in equity markets. By the end of December, it looked like we had made the right decision, but as the market rallied over the first months of 2019 on optimism in the absence of real data, the gains over the benchmarks achieved in December have been eroded. Yes, we have delivered significantly less volatility and put capital preservation ahead of taking blind risk, but when compared to the benchmark, we are now behind, and this is always an uncomfortable position to be in.

Despite recent movements in the benchmark, it is important to remember that downside risks remain significant, and in our view, they still outweigh the upside potential in equity markets. We accepted when we went defensive that we were potentially missing out on a few percent of upside to protect against the 20% plus downside risks that we see ahead. Since then, the risks have grown, and our position has become stronger, with recent movements in the bond markets reinforcing the weaknesses we see in the global economy. Despite the declining health of key economies, the market has been ignoring those risks and continued to gain, signifying a risk that markets are running at great speed with limited path ahead. For this reason, supported by our economic analysis, we remain confident in our defensive positioning, and will remain defensive until such time as the data tells us something different.

Overall, we went defensive in December because of four risks.

1. The first was that economic data was suggesting an economic slowdown which will reduce corporate earnings and therefore pull equity markets lower on a global scale;
2. The second was sterling: As risks of a no Brexit increase, the potential permanent strengthening in the pound would result in a structural (non-recoverable) decline in asset values in globally diversified portfolios;
3. The third was that trade tensions were looking increasingly risky and the war of words was getting worse.
4. The fourth was that the US was seemingly continuing to raise rates and ignoring the economic data suggesting weakness in the US economy;

If we now take another look at those risks:

1. Risk 1: Economic data has declined further, and every week we see more evidence that global activity is cooling and the global economy is starting to slow significantly. US growth hasslowed from 4% annualised in September 2018 to an expected 0% in Q1 2019. China’seconomy continues to slow further, Europe is in decline with some areas already in a recession, Asia has slowed, and the UK has slowed. As a result, virtually all countries globally are downgrading global growth expectations for 2019, and that is feeding into the central banks which are attempting to provide stimulus and more accommodative financial conditions, a further indication of a deteriorating growth outlook over the short and medium term. In short, this is not good
2. Risk 2: Currency risk looms as Brexit negotiations continue into this week, accepting May has to have confirmation that the Withdrawal agreement is passed by Parliament by Friday this week, otherwise the EU will either force a hard Brexit or a long extension. A hard Brexit is not on the cards but is still technically an option if we agree nothing else by the 12th April. We are therefore 95% certain that we will either have the existing withdrawal deal and an extension to ratify, or a long delay and potentially an election or another referendum which would likely result in either no Brexit or a much softer Brexit. Therefore, when we look at Brexit, and the risks associated, we see is a soft Brexit or no Brexit, and that means that the pound willincrease in value to circa $1.45 and €1.25 compared to today where we are at $1.31 and €1.17.As a holiday maker going abroad and converting sterling you hold in your pocket, that is great news as you get more for your pound. On the other hand, if you have a globally diversified portfolio of assets (therefore holding assets in foreign currencies) and this happens, it will result in a significant and structural decline in your portfolio that is not recoverable, because rather than being based on volatility which can be traded, it is a permanent move. Additionally, we also think that as the Chancellor has hinted that he would increase public spending if we have a soft Brexit or no Brexit, we expect the government to have an emergency budget and increase public spending as soon as we have clarity over the Brexit outcome. This would push sterling higher and potentiallytowards and above $1.50 and €1.30 for every £1. In English, for anyone still not following this risk, imagine you had €1000 in your drawer athome and decided that you wanted to cash it in. If you did it today, you would get £854. If the pound then strengthens as forecast, then you would get £800 reflecting a loss of £54 due to politics, and that will happen over a week. The truth is, though this risk would have happened by now and we are positioned to avoid that scenario as much we can, we cannot totally mitigate it unless we stay 100% in cash or UK assets. As an example, 70% of UK FTSE 100 corporate revenues come from overseas. Once we see that move in sterling UK FTSE 100 corporates will see their revenues drop and as a result, we expect the FTSE 100 to fall. We are positioned to take advantage of that and therefore potentially mitigate some of our other positions that will have the risk in them. We do hold significant cash and UK assets where possible and that also helps mitigate the risks. Through our asset allocation, we have significantly reduced our exposure to this risk, however the benchmarks are extremely exposed to this, which is another reason why we are less concerned about their recent performance. In short, this is not good when it happens, and it is imminent, but portfolios have low exposure to this risk.

3. Risk 3: Trade tensions have reduced in recent weeks, however we feel that optimism is overdone as the watermarks that are being touted by the US are too high. President Trump needs a deal as he is hoping to be re-elected, and therefore we expect a trade deal which will see China buying many more US goods but will fall short of what Trump wants. Unlike Prime Minister May though, his red lines do seem to move a great deal which will mean a deal could be agreed that is below market expectations. Either way, the market has fully priced in a very good outcome. This is fully priced in so reality (which will likely be underwhelming) would cause the markets to fall.
4. Risk 4: Since December, the Federal reserve has moved from two rate rises in 2019 to none and potentially rate cuts if the market is to be listened too. This has boosted the markets in the short term as it creates optimism that the Fed has not raising rates too far, however highlights the weakness in the US economy and the need to trade carefully with monetary policy over 2019. This is good in the short term but indicates a poor short-term US outlook.

Overall therefore despite the risk 1, global stock markets have rallied so far this year following lastyear’s sell off because of a reduction in risk 3 and risk 4. Investors are ignoring risk 1 and lookingthrough expectations of an increasingly poor earnings season for Q1 because the lemmings are expecting upgrades to forward earnings in Q2 which will then translate to a pickup in Q3 and Q4. If that happens then brilliant, and we will reinvest once risk 2 is removed, however we see this as being highly unlikely. We are therefore on hold and sticking to our conviction and staying in capital preservation mode because risk 1 is increasing, and we are soon to get greater clarity on risk 2. To change our position we need to see the following:-

1. We need the Brexit debate to end and a conclusion to become prevalent;
2. We need the earnings seasons for Q1 to start which will be in full swing by mid-April. We will then be able to gauge what the outlook is for companies who are reporting and see whether the slowdown in Q1 globally is seen as something that is turning around or about to get worse.Data does not lie, however optimism and momentum does if you follow it with blind hope,

   therefore we are waiting on a change in the data.

We should have an answer to risk 1 and risk 2 by the end of April, therefore we expect the coming month to be one of greater clarity and significant movement in assets. If risk 1 increases and risk 2 is removed, we will buy more government debt and defensive assets and reduce cash levels, and if risk 1 abates we will buy more global equity and risk assets and remove our capital preservation mandate as the 3 to 6-month outlook will improve.

The chart below looks at our models against the benchmark since we went defensive on the 5thDecember. It shows significantly less volatility, losses in December for our peers, and then the rally since then to early Feb. Based on what we see with risk 2 we do not see that outperformance continuing for much further as the benchmarks are every much focussed on overseas assets and will therefore see a sharp move down if sterling appreciates. If Risk 1 gets greater then what happenedin December will look like a picnic. We do not therefore expect the benchmark’s outperformance tocontinue and expect it to have reversed by the end of April in varying degrees of severity depending on what happens this month.

We could be wrong on both accounts and risk 1 could disappear and risk 2 could end up being a hard Brexit. For those who invest that way, the worst is they will be same as everyone else and win or lose, but as we see ourselves as caretakers of wealth, our position is one of sensibility and security and therefore what the benchmark does over a few weeks is of no concern. We continue to carefully monitor markets and the asset allocation and are poised to take advantage of opportunities as they arise and as we gain greater clarity over the direction of markets. In the meantime, please be patient a while longer.

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. Overall, global indices declined over the week due to a reduction in yields and a yield inversion in the US, combined with weaker economic data for the US and Eurozone and continued Brexit uncertainty. Markets are beginning to pause, with a number of key economists now questioning the sustainability of equity valuations given global economic conditions. Following a challenging week, the OBI portfolios gained from a decline in markets, gaining 0.5% while the Cautious and Balanced benchmarks declined by 0.84% and 1.22% respectively, owing to the defensive, well-diversified positioning in the OBI portfolios.

Overall, while we know missing out on the gains in comparison to the benchmark is painful, we continue to see significant risks ahead in equity markets, with investor sentiment tilting towards the downside and risk off sentiment spreading as risks intensify. 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 fluctuations in the context of longer-term market trends and stay content in the knowledge that portfolios are protected from the excessive risks in markets.

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 1871, England and Scotland competed in the first international rugby match. Have a great week,

VBW

Gina & Jason