Jonathan Marriott, Chief Investment Officer
In contrast to 2017, 2018 proved to be a volatile year for equity markets. This has been most acute towards the back end of 2018 in the final quarter, which produced one of the largest market falls since the financial crisis.Over the Christmas holiday period, when markets are thin as many investors are away, we saw some of the sharpest moves in both directions. The MSCI World Equity Index fell 13.4% in Q4 and ended the year down 8.7% in dollar total return terms. While the talk here in the UK has been focussed on Brexit, broader market moves had little to do with our negotiations with the European Union. The prospects for global economic growth next year was called into question as President Trump's erratic approach to trade policy, paired with a tightening of monetary conditions, raised fears of a more pronounced slowdown. Given the falls equity markets have already experienced, current valuations account for slower growth prospects and a lot of negative news appears priced in.
With US growth above trend and improving labour markets, the Federal Reserve pressed ahead with its fourth rate rise of the year, despite increasing criticism from the President. Markets expected a more accommodative stance ahead of the policy change, so were unimpressed with the somewhat hawkish tone from the Fed. However, with reduced growth estimates for the upcoming year, they reduced the speed and scope of rate rises expected in the year to come. Following further falls in equity markets, the futures market has now priced out rate rises for 2019 as inflationary pressures appear to have abated much faster than previously expected. The partial US shutdown has not aided sentiment and highlighted the difficulty Trump will face, given a divided house, to implement further significant policy changes.
Chinese growth has been slowing as the government has prioritised debt reduction over stimulus. This policy is facing significant headwinds as US tariffs have brought supply chains into question and stymied expenditure plans. In December, at the G20 summit, Presidents Trump and Xi appeared to agree a way forward in trade negotiations but any improvement was short lived as there was little detail forthcoming. Matters were complicated further by the arrest of a senior Chinese executive in Canada at the request of the US. It is in the interests of both sides to agree a deal and, while we believe it is likely that they will get an agreement in the first quarter of the new year, the pathway towards one will not be without a great deal of rhetoric. The unintended consequence of Trump's trade policies may be to widen Chinese influence in other countries. If growth continues to slow, we can expect more stimulus from the Chinese government and deleveraging to be put on the backburner.
In Europe, the protests in France have questioned the future of Macron's planned economic reforms. The end of the Merkel era in Germany adds uncertainty for the year ahead. On the positive side, the Italians have finally agreed a budget with the European Union. Back to Brexit, a messy departure from the European Union would not be good for European manufacturers. The path to Brexit remains unclear but the UK market is made up of international companies with the bulk of earnings in many cases coming from outside the country. As such, a dividend yield of nearly 5% and a price earnings ratio of below 12x is supportive for the market at these levels.
The oil price fell sharply and persistently throughout the quarter. The proposed sanctions by the US on Iran were slightly eased, with some countries allowed to continue to take Iranian oil while US Production also rose. The US now produces more oil than Saudi Arabia or Russia, resulting in OPEC, while still important to the oil market, being less dominant than it has been in the past. Energy company bond issues are a large part of the high yield bond market and with the prospects of economic growth moderating, credit spreads have moved sharply wider.
While markets can be moved by comments on Twitter and shifts in sentiment, it is important to look through the noise and observe what the companies that make up the indices are actually doing. In 2018, US corporate earnings grew over 20% and the free cash flow also grew. While the US earnings growth was supported by tax cuts, sales were also up. We still see global leaders in the US market and continue to find it attractive.
We believe that equity markets are well supported at current valuations, but expect wide disparity in performance between different companies, sectors and countries in the year to come. With volatility likely to continue, we suggest holding on to positions and looking through short term noise for longer term gains.
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