The last 3 months of 2018 marked one of the worst quarters for investment markets since the Global Financial Crisis. Whilst Brexit uncertainty here at home has to take some flack, concerns over the health of the global economy were more central. However, in both cases we think the worries are overdone, and are now more positive about the ability to produce sustainable long term returns over the years ahead.
Political developments in the UK certainly caught most of the headlines, as our government moved closer to the Brexit deadline without a consensus. The lack of progress is certainly frustrating, but it was always going to be a challenging fix given the closely fought vote and diverse set of opinions from different segments of the population.
Whilst it has of course weighed on UK markets, the main reason for the negative returns seen in Q4 was not Brexit, but wider concerns about the state of global growth, and the possibility of a global recession in the near term.
It is always important to retain some context, and it is now more than 10 years since the last recession. Markets have performed very strongly across that period, supported by low interest rates and supportive policy from Central Banks. But policymakers are now more conscious that at some point there will be another downturn, so whilst the sun shines and growth is good they are trying to make hay.
Markets become vulnerable in this environment, and a variety of indicators are now pointing to growth that is not quite as good as the lofty heights set in 2017. Add to this continual trade tensions between the US and China, a collapsing oil price, and Brexit concerns, and you create a recipe for uncertainty. UK equities therefore (as benchmarked by the FTSE 100 Index), returned -9.47% in Q4, only to be surpassed by their global counterparts (benchmarked by the MSCI World) who returned -11.49%.
Investing is a long-term game though, and drawdowns over short term periods are not unusual by any stretch… in fact, it is healthy to have them from time to time. What really matters is whether we truly are heading to recession or not. Whilst the data hasn’t been as strong as in the past, the majority has still been robust. Unemployment remains low in the developed world, wages are rising and inflation is stable – these are all good things for households. Even in the UK, where Brexit uncertainty has been rife, economic data has remained solid… it certainly looks like we are a resilient bunch!
Importantly, in this highly financialised world, where markets help to determine people’s confidence (i.e. people spend more money when their pensions are doing well), policymakers understand that healthy markets help the economy, so the recent volatility is likely to cause them to become more supportive. We would also point out that this is not the first time since 2008 that there has been a correction of this magnitude. Both 2011 and 2015 saw similar falls, and neither preceded a recession.
So investors have become overly pessimistic in our view, and assets have become significantly cheaper than they were even 3 months ago. There are of course still hurdles to overcome, but this bodes well for future portfolio returns, and our Investment Committee have been working hard to use the opportunity to benefit our clients over the long term.
All-encompassing, 2018 was the first year of negative returns for the portfolio range since 2011. Still, we are still extremely disappointed to have suffered a fall in capital value for clients in 2018 even if it is understandable given the market environment.
To reaffirm, Brexit has only had a marginal impact on portfolio returns. As we have stated in various blogs over the last 12 months, we have been working extremely hard to ensure clients are not disadvantaged whatever the outcome on March 29th. As such, we remain well balanced holding assets that will offset each other in either scenario.
The equity portion of each portfolio has been the biggest detractor (comprising just over 25% of the Low Risk Portfolio and just over 65% of the Medium to High Portfolio for your reference), dragged by worries about a global recession. As we will cover in more detail in our outlook, we think these fears are overdone, and given that this portion is always invested for the longer term (10 years or more), we need to be patient for the time being.
In contrast, the defensive portion of each portfolio (again around 70% of the Low Risk Portfolio and 35% of the Medium to High Portfolio) performed solidly across the year. Within this allocation, UK commercial property was the standout performer, finishing the year with returns of around 4%.
There have been only a small handful of periods since the launch of our model portfolios where we have underperformed our respective benchmarks, however, the last quarter was one of those. Five of our six portfolios lagged their benchmarks, due mainly to underlying differences in the views on government bond markets which rallied heavily as concerns about a global recession and Brexit came to the fore. This market remains well overvalued in our view, and given that we think fears on both accounts are overdone, we believe that time will show this to be just a short term benefit to our benchmarks, with us continuing to outperform over the longer term.
We often say that ‘volatility breeds opportunity’, and what the numbers don’t show yet is the benefits of the hard work we have been conducting through this period. In 2018 we made more changes to the portfolios than in any year since launch, using market selloffs as opportunities to add to areas we favour.
Actions like these have been crucial to the achievement of our long term figures, as displayed on the chart below. We are absolutely committed to ensuring our portfolios continue their longer-term success. To do so we have to ignore behavioural biases and remember that you invest for the long term, and it is what you do in the difficult times that sets the foundation for future sustainable growth.
We would characterise the market environment in the last 12 months as the journey on a rollercoaster. On the slow grind upwards you are looking at the sky thinking “this is great”, and then when you roll over the top and start to fall you are looking at the ground thinking you are about to hit it. It is important not to get too excited on the ups or the downs, as history tells us you rarely touch the sky or hit the ground. We expect volatility to remain elevated, and whilst it forms part of the journey, it does not necessarily decide the longer term outcome.
One of the fallouts of a deep recession, such as the one seen in 2008, is that investors become nervous about the next one. This cycle has now been going for over 10 years, which is long by historical standards, but that doesn’t mean it has to stop. There is no doubt we are closer to the end of the cycle than the start, but equally we do not yet see the typical recession indicators. As such, it feels like we are beginning the 5th set at Wimbledon… we are close to the end, but there is no tie-break so this could go on for some time!
The old adage to “be greedy when others are fearful” has often been rewarded across investment history. Global investor sentiment is now the most negative it has been for many years, which means there is a lot of room for improvement should things change. Many clients will ask what do we expect to change? The answer is not much in the short term. At the end of 2018 we felt that markets were pricing in too much doom and gloom, as amongst other reasons, in both the UK and the US, unemployment levels are high and inflation is low (both are good for households). Economic data is slowing, though the downward trend is slight, and forecasts are still for positive growth. In our view this backdrop has provided an opportunity to pick up some better value. Of course, there is potential for a trade deal to boost sentiment, or some certainty either way after Brexit, amongst many other possibilities. But in actual fact, when people are fearful, often you just need things to be slightly less bad for sentiment to shift upwards.
Timing this shift is extremely hard, so we need to be patient whilst holding an increased allocation to equities. Importantly for our clients, these assets have been bought at cheaper valuations, which gives them a greater chance of upside over the months and years ahead. Within our equity bucket we are heavily diversified across regions, including good allocations to the UK, US, Japan and Emerging Markets. One area we are concerned about is Europe, where Italian political risk remains, but otherwise we remain positive about the opportunity set.
To cover the rest of the portfolio allocations, we remain cautious on bond markets which are likely to continue to reprice. Typically, the bond market would make up around 40% of our Low and Low to Medium Portfolio’s. It would provide a stable contribution to our annual returns and help offset the volatility referred to above. At this time our bond holdings remain very light, as we wait for the right valuation point. As such we are now holding a greater allocation to cash than we otherwise would be. In the short term this cash reduces risk, but also gives us the option to inject it into the relevant market when opportunities are created.
To summarise, we are more positive about the potential for long term returns from here, given that valuations are cheaper and investors are very cautious. Often when news is negative you find the best subsequent investment outcome and vice versa, but patience and diligence is required. Remaining active is therefore crucial to replicating the excellent long term performance clients have seen over the last 10 years. We are absolutely committed to that cause.