Headline asset class statistics for Q1 2018 (GBP returns):
- Equities: FTSE 100 -7.2%, S&P 500 -4.3%, MSCI World -4.8%, MSCI Emerging Markets -2.3%,
- Bonds: FTSE All Gilts Index: +0.3%
- Currencies: GBP/USD +3.7%, GBP/EUR +1.0%, GBP/JPY +1.5%
- Commodities: Gold -1.3%, Bloomberg Commodity Index -2.3%
First quarter review
It’s easy to forget this, but 2017 was really an investment anomaly. Global equity markets made strong gains, while barely experiencing any drawdowns at all. Fast forward to 2018 and volatility has returned, but no more so than during instances in 2013, 2015, and 2016. While no one likes seeing the value of their investments fall, markets have a habit. Just when it seems that everyone can make easy money, they illustrate that investing is a long-term game.
On the surface, the global economy is doing well. Strong employment data in the US and Europe, US tax cuts and solid manufacturing numbers across the major markets point to a global economy that is robust. So what has caused equities to sell-off?
In February, the market became concerned when the US 10-year bond yield approached 3%, having started the year at 2.4%. Normally, rising yields are associated with economic confidence, but after years of promising to raise rates (and not delivering) the market appears to be adjusting to the fact that short-term interest rates are rising and this is feeding into equity valuation models, having a larger impact on the present value of some of the more richly valued ‘growth’ stocks that have made strong gains over the past three years.
Sentiment has also taken a bit of a knock, with President Donald Trump announcing $50 billion of tariffs against Chinese imports. While $50 billion is a rounding error in terms of the Chinese economy, some fear that this could escalate into a fully-fledged trade war. And lastly some of the tech stocks, such as Facebook, have seen their share prices fall due to user privacy concerns.
While many developed equity markets are down more than 10% from the peak highs, emerging markets have fared rather better, and lost just 2.3% in the quarter. This suggests a market correction, rather than anything to get too concerned about. Corporate bond spreads (the compensation you get over and above government bonds from taking on company default risk) have risen very slightly to 1.07%, from 0.94% at the beginning of the year. Gold drifted slightly lower too, down 1.3%, while the yen (usually a bellwether for a risk off environment) actually lost a bit of value against the pound. These are all positive signs for investors; the market shows no signs of panic.
Smart Portfolios review
In this environment, our five Smart Portfolio profiles performed as we hoped, with the net of fees client composite recording modest losses that ranged between –0.6% and –3.8%.
As is to be expected, the more risk-seeking portfolios performed worse than the lower risk allocations. Each portfolio is designed to offer broad diversification so that when one part of the portfolio performs poorly, another area will experience more favourable returns.
Indeed, this is what we saw over the quarter. While equity market returns were uniformly negative, our currency hedged exposures combined to cushion the portfolios from larger losses. Notably this was because the pound gained 3.7% against the US dollar, which meant that rather than falling by 4.3%, a substantial portion of the US exposure instead barely dipped into negative territory, recording a loss of just 0.8%.
Corporate bonds recorded modest losses, but government bonds made a small gain, as did the iShares GBP Ultrashort Bond exchange traded fund (ETF) which returned 0.1% and acts as source of ‘dry powder’ across our allocations, and could be sold when an opportunity arises. Within commodities, the 4% exposure to gold (down 1.3%) offers some diversification against inflation and held up quite well even in the face of sterling strength.
In the long term, returns are always going to be determined by how bond and equity markets perform, but by reducing concentration risk to any one part of the market we hope to shield portfolios from excessive volatility and deliver smoother returns to our clients.
While short-term returns have disappointed, rising corporate earnings have allowed equity markets to de-rate quite sharply, making them significantly less expensive. Heading into US earnings season, analysts are still bullish, with expectations that US profits are growing around 15% year on year.
Closer to home, the FTSE 100 now has a 4.5% dividend yield and trades on 13.2 times forward earnings, compared with 17.5 times midway through 2016. This is a valuation level last seen in 2012.
In the near term, the direction of equity markets is, as always, more or less unknown. Yet this pattern of de-rating equity valuations has occurred across all major equity markets, and should give investors confidence that money put to work for the medium term is well placed to make investment gains from here.