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Chief Investment Officer's team, 07.01.2019
After a brilliant 2017, there was almost no place to hide for investors in 2018. In USD and round numbers, equities were down -9% in developed markets, and -15% in emerging markets, after respectively +22% and +37% in 2017. Fixed income was overall negative, following the risk hierarchy of the sub-segments: DM government bonds were almost flat, while High Yield posted -4%, with EM Govies and Investment Grade credit between the two at respectively -2.5% and -3%.
The key feature of 2018 was however not the performances themselves, giving back part of the extraordinary returns of 2017, but the come-back of volatility. Monthly, weekly, daily price variations were comparable to 2008-09, especially at the end of the year and as we write, at the beginning of 2019. This shouldn’t have come as a surprise (cf our 2018 Year Ahead publication titled “Eyes Wide Open”) given the combination of tightening liquidity and heightened political risk everywhere, hitting monolithic investors’ positioning. We started the year with the hope of a strong and synchronized global growth, and we ended it with doubts everywhere: from the sustainability of US economic growth, to the ravages of trade tensions and strong Dollar on the rest of the world, not to mention a dramatic reversal in Oil prices, an erratic Brexit process, US government shutdown, pressure on the Fed and legal challenges to the President of the USA.
Volatility was not only high but also unpredictable. Hedge Funds performance is one of the worst of the decade, underperforming cash, fixed income and US equities: even with the best process, teams, algorithms and discipline, short-term trading was perilous in 2018.
Fortunately, wealth management is not about short-term. We have strengthened our investment framework to navigate the next decade. Our current positioning is cautious, with a modest allocation to the riskiest assets across profiles. We, however, think that markets undershot fundamentals. We wrote in mid-December that “this period of the year is not appropriate to take new positions”, but 2019 might be different as long as the fundamentals hold. We wish you all a healthy, happy - and probably profitable new year.
We hold the view that the past year marked an important pivot across asset classes and investment styles, alerting investors to the importance of changing their attitude towards cash, once a non-yielding asset, passive investing, the widely-held post-Great Financial Crisis mantra, and absolute return strategies, deemed superfluous in trending markets. Cash is back with a vengeance, at least in dollar terms, offering competitive risk-adjusted returns even against some risk assets; passive investing is not expected to work as nicely in a more volatile environment; institutional investors are adding to absolute return strategies to stabilize portfolio returns amidst rising uncertainty.
This transition is an end-of-cycle hallmark, underlying a higher-volatility backdrop driven by peak global growth and liquidity recorded in 2018. Last year some economies, in particular, the US and Europe, were running unsustainably above trend and are currently slowing down. Also, in the same year the tide of rising liquidity was brought to a halt in the US by Quantitative Tightening and rising Fed rates, alongside the announcement of the end of Quantitative Easing made by the European Central Bank.
The US 3-month Libor rose above the S&P500 dividend yield in 2018 for the first time since the Great Financial Crisis, a sign that the ‘new normal’ of post-crisis depressed cash rates was drawing to an end. Unbridled passive investing, combined with a paucity of value investors supporting markets, showed its dark side last December. Retail flows show that risk assets were offloaded by means of ETFs when volatility was rising, amplifying the rout in a vicious circle.
Rough markets and less dovish central banks coupled with stretched long-term valuations in traditional asset classes saw demand for hedged funds run at a three-year high in 2018. The fact that the absolute return strategies did not fare well at all last year as a group doesn’t mean that all single hedge funds failed – some did very well, and they are the one which survive. We hold the view that absolute-return funds should take up a structural share in client portfolios, as long as a thorough selection process supports this allocation.
Fixed income update
The Fixed Income asset class staged a strong comeback towards the end of 2018 taking cues from policymakers and global trade tensions. The bouts of volatilities and idiosyncratic country-specific risks throughout the year challenged returns across the bond markets. We witnessed how central banks fine-tuned monetary policies to curtail outflows and stabilize their currencies from the strengthening of the US dollar. Argentina and Turkey did provide text-book style economics and set a good example. The ongoing theme, however, was tighter monetary policies and central bank’s balance sheet normalization. The Federal Reserve hiked four times in 2018 bringing their fed funds rate to 2.50%, which reflects and are closer to our assumption that FED is now reaching the end of the tightening cycle. Interestingly, the US yield curve has been flirting close to the zero bound throughout the year although certain parts of the curve (Short-end) have inverted. The investor concerns and market gyrations did shape the direction of US bond yields to close the year at levels where it began (2.68%). The big question on every investor’s mind remains the interpretation of the inverted yield curve and if a recession is imminent. We do acknowledge a few things on the fundamentals front and sponsor the fact that growth remains intact – although no longer above-trend, benign inflation, and that cost of capital are seemingly getting expensive while cash remains an attractive place to park money from a risk-adjusted basis. Falling real yields in EM and DM reflect a re-pricing of inflation expectations, as spread compression between emerging and developed market economies reduces the relative attractiveness of EM local currency debt. Ten-year real yields have declined across both EM and DM over the past few months, as weaker oil prices cause inflation expectations to consolidate.
n the primary bond sales, EM borrowers fell short of 2017 volumes printing just over half a trillion of new debt as compared to USD670bn in 2017. The total bond issuance was dominated by Asian issuers which stood at $270bn. That said, we expect to see a flurry of issuance this year as almost $312bn of global EM redemptions are due this year. Asian redemptions account for $155bn followed by CEEMEA ($90bn) and LATAM ($68bn)
Equities in 2018
Global market rhetoric in 2018 centered on Pres. Trump and his tweets, protectionism, populism, trade tariff ramifications, global growth, the Fed and interest rate direction, reduction of liquidity by global Central banks, Brexit, growing debt in China and falling oil prices. After very strong returns from all markets globally in 2017, coupled with record low volatility, 2018 began with a rally in January which fizzled into bear market territory, for most global indices by the end of 2018. The MSCI World Index (total returns USD) ended the year down -9.4%. Healthcare and utilities were the only two global sectors that closed positively, however with just 2% of gains for the year. The worst sector performers were material and financial, the former on an expected slowdown of demand from China. The inversion of the 3-5 year yield curve led to a sharp selloff in bank stocks in the US in Q4. European banks, a number of which suffered structural issues throughout 2018, did not have the benefit of higher rates and fared worse, closing 2018 down -34% (SX7E total returns USD).
Amongst the major markets, the US was the outperformer with the S&P 500 total returns for 2018 at -4.4%. Tech outperformed in spite of the selloff in semiconductors (-6%) and the FANG Index, which gave up all its gains to close flat for the year. The Nasdaq Index ended 2018 down -2.8%. Crowded positioning in volatility products led to a market meltdown in the US in early February as volatility short sellers were forced to sell the S&P 500 to unwind short Vix positioning. US markets whilst volatile were up 10% till end Sept and then in Q4 recorded one of the worst quarterly performances in the last decade. The US outperformance vs. the rest of the world can be ascribed to the 24% earnings growth seen in the first three quarters of 2018 of which c. 8 to 10% was on account of tax cuts but the balance was clearly driven by revenue growth of 9% and margins for US companies at record levels. Strong buybacks and dividends too, have aided US company EPS numbers.
Emerging markets followed the US sell off and stabilized only in October. A stronger US Dollar along with a tightening Fed exacerbated by trade tariff escalations led to the MSCI China Index being the worst performer in 2018 –18.9% (total returns USD). The US crackdown on technology patents led to the China tech sector seeing one of its worst years (the MSCI China Tech Index was -27%). The European car industry, tracked China performance and closed the year down -20%. The major European automakers Volkswagen, Daimler and BMW, get over two thirds of their revenue from exports to the US and China. Other emerging markets like India fared better, but forthcoming elections led to outflows from foreign institutional investors.
In the GCC, the KSA which will be included in the FTSE and MSCI EM indices from 2019, was the outperformer with the Tadawul Index closing the year +12%. Saudi banks which benefit from US rate hikes as the SAIBOR is linked to the LIBOR ended the year +38%. M&A activity in the banking sector in the UAE and KSA was a further fillip to banking sector performance.
In the UAE the Abu Dhabi Index which has a high weight of banks ended the year +18%whilst the Dubai Index which is real estate heavy ended the year down -20.5%. Fears of oversupply in the UAE real estate market along with falling rentals led to the UAE developers having a dismal year. A lack of trading liquidity with the UAE bourses averaging less than $ 100mn of trading on a daily basis was not helpful to flows.
The heightened market volatility in 2018 came with a backdrop of strong global and earnings growth, which surprised investors and analysts who had higher expectations on market returns. The 5% rally in US markets on Dec 26th, whether it was algorithm programs placing trades or pension funds rebalancing, was characteristic of the elevated volatility seen throughout 2018. The Vix Index averaged 17 in 2018 compared to 10 for 2017. The few trading days so far in 2019, continue to see sharp swings in markets, with US indices closing down -2.5% one day and up 3% the next day. Dovish direction from the Fed and a resolution of the tiff between the US and China remain critical catalysts for markets. We can already see the onslaught of downgrades with Apple lowering revenue guidance and the estimated 2019 EPS projections for the S&P 500 lowered from $ 179 to $ 174 in the space of a few weeks. We are entering 2019 with global valuations (price to earnings) below historical averages, coupled with earnings growth estimated in 2019 at +8% for the US, and in the mid to high teens for emerging markets, which so far bode well for market returns.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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