Maintaining a Long-Term Perspective Through Short-Term Volatility

Holden & Partners Investment Outlook 2019

At the start of 2018 we issued a message of cautious optimism to investors. A key tenet of this was that the synchronised global growth of 2017 was unlikely to continue indefinitely and that, as downside risks to the economy increased, higher valuations may be a sign of complacency in equity markets that were becoming progressively more expensive. We believed that a slowing global economy presented a more nuanced environment that would create ‘winners’, but also ‘losers’, and the disparity between the parts of the market delivering and disappointing on expectations would be stark. Clients needed to adjust to a more volatile environment, albeit one which would still be broadly supportive for risk assets.

Whilst we were correct in our assumption that global markets would become more unforgiving, we failed to anticipate just how great the regional divergence in growth would become, as well as how much weight would be placed on the words and actions of politicians and central bankers. The ability of investors to ‘brush off’ the noise caused by political rhetoric appeared to evaporate as equities hung in the balance, awaiting the next word from prominent figures in in Washington, the Federal Reserve (Fed), or the Chinese authorities. The focus on economic data and earnings expectations, meanwhile, diminished significantly.

Optimism quickly turned to pessimism, most notably in the wide market sell-offs triggered in February and October as investors, perhaps unsettled by the prospect of an extended business cycle and the longest bull market in history, appeared to be searching for signs of a slowdown. The fourth quarter of 2018 (Q4) provided the evidence they were expecting; the fourth US interest rate rise of the year lead to concerns that the Fed may be tightening too fast and strangling global growth, company reporting on earnings was distinctively lacklustre, trade aggression exacerbated weakness in China, adding to the issues for emerging markets already suffering from the effects of US Dollar strength. In the end, only US indices concluded a tumultuous year in positive territory.

Although market movements would suggest otherwise, at Holden & Partners we remain relatively sanguine about the prospects for 2019. Global growth is moderating but not to the extent that it signals an absolute end to expansion, nor eradicates earnings growth for corporates. World GDP growth (the total value of goods produced, and services provided) is unlikely to differ dramatically from expectations at the start of the year, but even minimal downgrades are perceived as a disappointment by investors who were seduced by ‘Goldilocks’ environment of 2017. Whilst we now have greater evidence that the global economy has started to slow, there is scarcely more clarity over when this slowdown will become recessionary, although there is little sign of this occurring imminently.

The UK environment perhaps presents the greatest challenge for investors, with Sterling fluctuating on the basis of whether a ‘hard’ or ‘soft’ Brexit appears more likely. A resolution to the current stalemate would prove beneficial for the economy but result in an appreciation of the currency that would challenge the more globally-focused stocks in the index (earnings generated in foreign currencies decrease in value as Sterling strengthens), although it would provide a more favourable backdrop for domestic companies which have sold-off heavily in the past year. The opposite would be true in the event of a ‘no-deal’, with further Sterling depreciation favouring international cashflow generating firms.

Uncertainty will continue to burden global markets for the foreseeable future, with fluctuations in value depending on the probability of a US recession or escalation of political risk at any given moment in time. On a positive note, more accommodative policy from the Fed and the Chinese, as well as clarification on trade negotiations between the world’s two biggest economies, would serve to allay investors’ fears somewhat. Slower but steady growth, with limited inflation and interest rate rises will provide a favourable environment for equities, many of which are now trading on lower multiples than at any point in the last few years.

Holden & Partners continue to advocate taking a longer-term perspective. We do not attempt to predict the timing of the next recession, but instead seek to increase the resilience of portfolios against market downturns, whilst ensuring that we do not miss out on growth opportunities at the latter stage of the cycle. The following strategies are instrumental in achieving this:

Broad diversification amongst asset classes, regions and investment styles –because of the ability for equity markets to perform relatively strongly towards the end of the economic cycle, we possess a neutral position to the asset class, but avoid any large regional or style over- or under-weights to prevent favouring certain markets based on short-term divergence. This strategy was not rewarded in 2018 as the US market outperformed strongly. It is not a trend we expect to persist however, given the diminishing effect of US fiscal stimulus and a pause in monetary tightening which should prevent further strengthening of the US Dollar. The portfolios we construct for clients comprise various asset classes (and underlying holdings) to aid diversification and potentially limit the volatility experienced, compared to that from being invested in a single instrument. This is often the most appropriate way to lower overall volatility within a portfolio, and smooth out the experience of investing in today’s capital markets.

Exposure to high-quality funds and securities – the Q4 sell-off was most strongly felt in cyclical growth stocks which became less attractive due to rising costs of capital and declining economic growth. As growth around the world becomes harder to come by, quality companies that exhibit earnings resilience and are still able to generate returns for shareholders should be rewarded. Our ethical, sustainable, and thematic (EST) investment philosophy advocates investment in areas which can deliver strong underlying growth and identify opportunities and risks that may be underappreciated by the market. It is primarily about identifying societal challenges, changing consumer preferences, opportunities for innovation, and analysing how an investment may capitalise upon them to generate a sustainable business advantage. This approach gives our portfolios an inherent quality bias which we believe will lead to outperformance in the current market environment.

An allocation to alternative asset classes – in times past, investors traditionally flocked to developed-market government bonds to safeguard against volatility due to the downside protection characteristics they exhibited versus equities. As a result of ultra-low level of interest rates in many developed economies today, the correlations with equities have increased meaning these securities no longer fulfil their roles as ‘safe-haven’ assets, nor do they offer attractive risk-reward profiles. This became evident in 2018 when fixed interest assets failed to offer protection from equity market falls. Short-term US government debt may be relatively attractive, but in Europe and the UK we make heavy use of property and infrastructure assets as alternatives. This is due both to their yield superiority over traditional fixed income, and diversification characteristics which ensure a low correlation to both equity and bond markets.

We take comfort from the fact that our model portfolios have proved relatively resilient to recent volatility, supported, at least in part, by these measures. We attempt to avoid short-termism and do not advocate implementing wide-reaching asset allocation changes based on near-term instability, but instead reiterate the importance of maintaining a long-term view, possessing a diversified portfolio, and using the current volatility to take advantage of any value opportunities it may present. Systemic risk (market risk which cannot be avoided through diversification) means it is virtually impossible to avoid the market fluctuations completely, but clients who remain invested in accordance with their financial plan are better placed to meet their long-term goals and achieve the appropriate inflation-linked returns over time.