Is the sky really falling?

SG Hiscock & Company
Tim Gough
Tim Gough
SG Hiscock Portfolio Manager
We feel like Christmas could not come quickly enough in 2018. Normally, equity and debt markets quieten down before the festive season. With executives off to their holiday homes, economic releases, corporate transactions and earnings updates to all reduce in number. This results in typically thinner market volumes, and a gentle rise in risk assets into the New Year.

While there is still (little) time for the so-called Christmas rally to occur, there are also a number of issues holding the attention of investors, with little sign of closure beckoning. 

Ongoing Brexit discussions in the UK leave us with a sense of standstill, while the ‘yellow vest’ revolt is putting a hold on things over the ditch in France. This is compounded by burgeoning budgetary issues in Italy and political leadership uncertainty in Germany. Most importantly, the constant cacophony of China and US trade talk hangs over the world’s largest and second largest economies. This is exacerbated by the recent arrest of a key Chinese executive in Canada. Closer to Washington, President Trump looks to be fighting his own battle to avoid becoming a ‘lame duck’ until the next Presidential election. This has been brought about by the Republicans losing control of the House at the recent mid-term elections.

These issues have taken the wind out of investors’ sails at a time when global central bank policy (the availability of money) has tightened and the well-anticipated peak in global activity has passed. Add targeted deleveraging of the corporate sector in China, and we appear to have a crisis of confidence emerging among investors. 

In Australia, talk of an imminent collapse in house prices, a high probability of change of Government at the next Federal election along with changes to franking credit rebates, negative gearing and the final report on the Banking Royal Commission into misconduct are all providing investors with more reasons to sit on the sidelines than to participate.

In an effort to create more hits or sell more newspapers, Press reports focusing on negative news ignore many of the positive drivers. However, as long-term investors and with the knowledge that equity markets have more positive years than negative we look at what could turn this around in the near term. While no one has a transparent lens through which to view the world, we do have experience of working through a number of large market drawdowns over the last 20 years. These include the Asian and Russian currency crisis, the dotcom bubble, the GFC and European Financial crisis. At the time, all of these events seemed like the sky was about to fall in. This time is likely to be no exception.

Firstly, we reiterate our view that we see the current sell-off as overdone relative to the current level of economic data and the outlook for 2019. Basically, value doesn’t reflect fundamentals. We see this divergence as based less on fundamentals and technicals (human decisions), and driven more by algorithms and trading patterns (artificial intelligence). However, a number of historical indicators in the US that point towards a recession have increased over the year; including flatter yield curves, narrowing output gap (a measure of an economy's spare capacity) and an economy closing in on full employment. We are yet to see the full set of ingredients, including inflation and inverted yield curves (where short rates exceed long-term rates). Although there is a specific probability of a recession sooner, these indicators leave us feeling that the likelihood of a recession before late 2020 is remote.   

US monetary policy was in the spotlight this week with the final Fed meeting for the year. New Chairperson, Jerome Powell, followed expectations in raising rates for the fourth time this year, and at the same time reduced expectations for 2019 from three increases to two. We see this as broadly constructive. While the market was looking for one or less increase next year, we note a number of global research houses still have more optimistic expectations in their forecasts. The FED actions provide a degree of comfort that the US economy is on track to deliver above-trend growth in 2019, albeit at a lower level than 2018, and that the recent drawdowns in equity markets are yet to impact the broader economy.  

Current uncertainty reflects concerns of policy error, with softening conditions post the peak in economic activity. For the period 2008 through 2016, interest rates only went down, providing a transparent playing field for investors. As economic growth has improved, particularly in the US, the clarity around future monetary policy has become murky. This market has become accustomed to loose policy and supportive central banks. A period of adjustment is therefore required, and any insight the Fed provides for 2019 should ultimately provide comfort, albeit some volatility on announcement.

In addition, a period of stable economic data over the next few months will also provide the clarity that growth has come back from its highs but still remains above trend. Europe has seen a month or two of activity blurred by structural change in the auto sector and political posturing. Any stabilisation in Europe’s situation should provide welcome relief. As will any data showing recent China stimuli taking effect. Much of this can only be seen in the rear vision mirror, so may only become clearer into the first quarter of 2019.

It is our observation that weakness in both bond and equity markets at the same time has been a function of the late cycle nature, and cash has become a proxy for defence. Rates remain low by historical standards, such that any signals of a more positive outlook should allay the current malaise and see a rotation away from this low-return status quo. In other words, investors need encouragement to take on risk again in a world where fiscal or Government policy is taking over from central banks. To us, equities are particularly reflecting more attractive entry points than they have for some years, while we would be cautious on fixed interest if inflation picks up from here.

Legendary hedge fund manager Stanley Druckenmiller says that to make money today, investors must exercise incredible emotional control. "I’ve never made a buy at a low that I didn’t just feel terrible and scared to death making it," he said.

Fortune favours the brave. Equity markets are no different.

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OUR PROCESS

We believe in buying great companies at good prices. We are firm believers in co-investment, demonstrated by our significant investment in our own funds. Our confidence in our investment approach means we always seed new funds with our own money. We have made the decision to cap our Funds Under Management at modest levels, to ensure that the funds retain greater flexibility to generate strong investment returns across varying market conditions. In order to identify the best opportunities for our clients, we undertake a broad fundamental research program which incorporates an extensive company visitation schedule. With an experienced team of investment professionals, our approach to analysing companies is designed to ensure no stone remains unturned.

We engage with a hand-picked team of external research providers to complement our insights in the macroeconomic landscape (both locally and abroad) and general investment trends. We also have an exclusive joint advisory arrangement with one of the world’s largest commercial real estate investors; LaSalle Investment Management Securities, LLC is a subsidiary of global property giant, Jones Lang LaSalle. This provides our property team access to LaSalle’s research capabilities.

OUR ENVIRONMENTAL, SOCIAL AND GOVERNANCE POLICY

SG Hiscock & Company has a formal board-endorsed environmental, social and governance (ESG) policy. This incorporates the key principles of the Australian Council of Superannuation Investors, as well as the framework provided under the United Nations’ Principles for Responsible Investment. SG Hiscock & Company is a responsible investor and we take an active approach to integrating ESG considerations into our investment decision-making process. We believe that the effective governance and management of business risks has a direct impact on a company’s intrinsic value over the long term and helps to reduce investment risk. In order to identify the best opportunities for our clients, we undertake a broad fundamental research program which incorporates an extensive company visitation schedule. With an experienced team of investment professionals, our approach to analysing companies is designed to ensure no stone remains unturned.

We engage with a hand-picked team of external research providers to complement our insights in the macroeconomic landscape (both locally and abroad) and general investment trends. We also have an exclusive joint advisory arrangement with one of the world’s largest commercial real estate investors; LaSalle Investment Management Securities, LLC is a subsidiary of global property giant, Jones Lang LaSalle. This provides our property team access to LaSalle’s research capabilities.