Back in December, as a result of continued weakness in the global economic outlook and significant ongoing risks to equity markets, we made the decision to implement a defensive strategy to protect client capital from an expected pull back in markets. At this point, a Value at Risk (VAR) analysis presented us with c. 2% upside potential and c. 20% downside potential. Given the significant risks and continued uncertainty, we failed to see any benefit in putting client capital at risk in the pursuit of eking out further gains from equity markets. Two months on, as we reflect on what has changed since December, we consider the economic data alongside developments in key issues weighing on global growth, and see that while very little has altered to the upside, a considerable amount of economic data has now tilted to the downside. Based on this data, we continue to view a significant pull back in equity markets as being highly likely, and maintain our defensive positioning, despite the temporary rally and “bull trap” seen in markets in January.
For further information on “bull traps” and an update on rationale supporting our defensive positioning, please see the briefing note attached.
In December, one of our key expectations was that earnings data would begin to feed through into markets, forcing investors to take a step back and examine the strength and profitability expectations of index constituent companies. Instead, while earnings data has been as we expected, market movements have been driven by sentiment and short-term currency movements relating to ongoing issues such as the US-China trade war and Brexit. Over the short term, markets have rallied over January while economic data suggests that the global economic outlook has been weakening, with some key Eurozone economies appearing near breaking point.
While we continue to monitor market movements closely, analysing market risks in the context of our positioning, we encourage clients to look through the euphoria in markets, not be fooled by the recent rally, and to concentrate on the economic data. Recent earnings data puts this into context, with weaker Q4 earnings reports and Q1 earnings reversions leading the trend for lower earnings in 2019. Given weaker earnings expectations, the rally is unlikely to be sustained and is likely to end with a sharp fall back to reality.
January Earnings Data
According to Factset, during the month of January, analysts lowered earnings estimates for companies in the S&P 500 for the first quarter. The Q1 EPS estimate dropped by 4.1%, representing the largest decline in EPS estimate during the first month of a quarter since Q1 2016 (-5.5%). To put this into context, over the past 15 years, the average decline in EPS estimate during the first month of a quarter is 1.7%. As a result, the S&P 500 is now projected to report a year on year decline in earnings of -0.8% for Q1, the first year on year decline in earnings since Q2 2016 (-3.1%).
As it stands, 46% of the companies in the S&P 500 have reported actual results for Q4 2018. Out of those, the percentage of companies reporting EPS above estimates (70%) is below the five-year average. On average, companies are reporting earnings that are 3.5% above the estimates, which is also below the five-year average. It is clear that weaknesses are emerging in the earnings data, with Q1 earnings reversions now indicating a significantly weaker Q1. Over this week, a further 103 S&P 500 companies are scheduled to report Q4 results.
New Data Releases
Markets rallied this week on the back of speculation and short-term currency movements despite the release of increasingly negative data. The key take-aways in the data from this week are:
- European PMI data has been disappointing as subdued external demand and temporary factors weighed on output and sentiment, with January PMI data suggesting that H2 2018 weakness is likely to have extended into Q1 2019. Italian GDP is expected to contract in Q1, creating concerns over a recession in the area.
- In the US, a healthy labour market and rising wages have provided a boost to consumers in recent months, but in January, consumers’ expectations for the six months ahead declined to its lowest level in over two years, causing the headline index to fall as shown in the chart below. It is possible that this was influenced by the recent government shutdown, however now the economic outlook appears more uncertain, it will be a key datapoint for the Fed to consider in its monetary policy decisions in 2019. It is clear that there are key comparisons to be made with conditions in 2001 and 2008.
The Fed took a much more dovish tone on Friday, indicating a rate hike pause and the potential to alter balance sheet normalisation plans based on market conditions. Although this is likely to provide a short-term boost to US markets, it also communicates that the Fed views there as being sufficient weakness within the US economy to delay further tightening.
- In the UK, services, construction and manufacturing activity in January fell on the back of political uncertainty surrounding Brexit, fuelling concerns that the UK economy could stagnate in 2019. Services sector activity stalled to 50.1 in January, indicating a stagnation of the sector which makes up four-fifths of the UK economy.
Given market movements over the week and considering recent data, it is our view that current market conditions are creating a perfect storm for the herd to run itself off the cliff edge being created in markets. As we are now defensively positioned, we are effectively watching from the side lines with low exposure to the high levels of volatility in markets. Despite the recent rally, we remain confident in our defensive positioning and still do not see benefit in chasing limited returns in equity markets considering the significant downside risks. It is key to highlight that what is currently happening is typical of bear market conditions, with comparisons to be drawn between current market conditions and 2001 and 2008. Our expectations are that we should still see the drop back play out within this half of 2019.
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 up over the week on speculation and short-term currency movements, alongside optimism that the Fed will reduce its pace of tightening over 2019. The FTSE 100 was up significantly over the week due to weaker sterling as a result of Brexit related uncertainty, with the FTSE rallying 2% yesterday despite significantly weaker UK services data. Over the week, the OBI portfolios suffered as a result of the inverse correlation with US and UK markets, however we continue to view the rally as being temporary and not unusual in bear markets.
Despite a challenging week for portfolios, it is key to highlight that markets fluctuate, and we must not allow ourselves to be caught up in short-term sentiment. The economic data continues to support our expectation for a drop back in markets in H1, therefore we remain defensively positioned. 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 1952, Queen Elizabeth II succeeded King George VI to the British throne and was proclaimed Queen of the United Kingdom and the other Commonwealth realms including Canada, Australia and New Zealand.
Have a great week,
Gina & Jason