We entered 2018 retaining our preference for equities over bonds across our MPS range. This was based on the view that the strong earnings performance from US equities would continue and be further boosted by President Trump’s US tax reforms. We also believed that there was no need for the central banks in the US, Europe, UK and Japan to tighten policy aggressively due to low inflation. In addition, it seemed important to look outside of the UK for returns, most notably to Japan, Asia and Emerging Markets (the latter two boosted by a weaker US dollar), as investor concerns surrounding the shape of the final Brexit deal and the ramifications of a potential Labour government were likely to continue to weigh on UK growth expectations. In addition, we were conscious that various equity market records were set in 2017, and with the S&P in its second longest bull run in history, we would need to remain vigilant.
Despite background noise regarding European politics and Sino-American trade tensions, the equity markets continued their upward trend through to the autumn, which marked the 10th anniversary of the global financial crisis. However, having seen developed markets, most notably the US, outperform their Emerging and Asian counterparts for the first three quarters of the year, there was a significant turnaround of sentiment in the fourth quarter. This was primarily driven by comments made by Jerome Powell, the Chairman of the Federal Reserve, that the market was underestimating the neutral level of short term interest rates in the US. The uncertainty as to what impact such tightening monetary policy might have on economic growth, company profits and financial conditions, on top of a market already volatile due to the escalating trade rhetoric between China and the US, led to a sharp sell-off that erased all gains made for the year up to that point, and more. Indeed, on a global basis, 2018 was the worst year for equity markets since 2011. The performance of fixed income asset classes over the year was more mixed, with conventional gilts making small positive gains, but corporate bonds falling as yield spreads over those safer sovereign bonds widened.
Against this backdrop, our long-standing overweight to equities was, unsurprisingly, a drag on relative performance. This was partially offset by the overweight to index-linked bonds, as well as the allocation to alternative assets. Within the equity allocation, our relatively defensive positioning in UK equities proved useful. Overall, the relative performance of the six portfolios varied. The two lower risk models, Defensive and Defensive Income, with their higher allocation to fixed income and alternatives outperformed their benchmarks and their respective IA sectors. Balanced Income and Balanced Growth underperformed their benchmarks but outperformed their IA sectors. Finally, Growth and Dynamic Growth, the two which are managed with the highest risk, underperformed with the majority of the poorer performance attributable to moves in developed markets in the fourth quarter. Turnover was again low, with only four rebalances of the portfolios being conducted throughout the year; two of these (January and December) were driven by changes in the Distribution Technology asset allocation frameworks.
With investors focussed on the pace of US interest rate rises the environment in bond markets was challenging, especially in corporate bonds which spent most of the year falling. Having come into the year with the portfolios positioned mostly in shorter dated and index linked government bonds and significantly underweight in corporate bonds, we were well positioned for fund selection to add value at the edges. Sequoia Economic Infrastructure Income, a listed investment company, stood out with a return of over 7.5%. Its strong performance record since its launch in 2015 has been rewarded with its market capitalisation moving comfortably through £1bn, driven by its success in raising further capital.
There was also a solid showing from our alternative assets, most notably the listed hedge fund BH Macro. We have held BH Macro as portfolio insurance since mid-2014 and up until last year it had neither added nor detracted from performance, but was retained on the premise that it has historically performed well during times of market stress. Its portfolio diversification benefits shone through in 2018, as it rose by over 18%, helped by its strongest ever month in June as the result of betting against Italian government bonds. Our holding in Picton Property Income also added considerable value, with a positive return of almost 6%, helped by its relatively low exposure to UK retail property assets.
It is perhaps no surprise that within our UK equity list, the strongest performers from 2017 were the chief laggards in 2018; Artemis UK Select and MAN GLG Undervalued Assets struggled thanks to their bias to domestic stocks. As expected, Troy Income & Growth Trust and Janus Henderson UK Absolute Return minimised losses, joined more surprisingly, by Blackrock Smaller Companies Trust. However, RWC Enhanced Income topped the table with a positive return that was over 9% ahead of the index. The only significant change within the UK equity allocation during 2018 was the sale of IP UK Strategic Income following poor performance and concerns over the volume of redemptions that the manager was facing across his range of funds. Some profits were also taken from BlackRock Smaller Companies as its discount to net asset value narrowed to historically tight levels.
In overseas developed equity markets, the stand out relative performance contributor was the overweight allocation to the US, which benefitted from sterling’s weakness against the US dollar. Pleasingly, within this, Artemis US Extended Alpha had another strong year. This fund has been held for a number of years now in the belief that a skilled manager with the ability to ‘go short’ certain stocks could add material value to portfolios were the US market to falter. In Japan, Baillie Gifford Japan Trust again stood out, despite the retirement of its long-standing lead manager in April.
Asia and Emerging Markets struggled for much of the first half of the year due to US dollar strength, though they held up remarkably well in the fourth quarter sell-off. With such a diverse array of economies and drivers, performance from our list of holdings was varied, and all sadly failed to make positive ground. Our more defensive Asian holdings in Edinburgh Dragon and Asian Total Return Investment Company performed relatively well in contrast to our core Emerging Market holdings in Hermes Global Emerging Markets and Fidelity Emerging Markets. Our individual country picks in this space were mixed, with Goldman Sachs India and Fidelity China Special Situations disappointing whilst Pictet Russian Equities held up well.
Global economic outlook
The global economy is suffering from growing pains; the fundamental growth backdrop has weakened as the Federal Reserve has sought to tighten monetary policy. These less supportive macro conditions have resulted in analyst consensus earnings expectations being downgraded. At the same time, equity valuations have become less demanding and global equities are now trading at a lower earnings multiple than when markets last wobbled in early 2016. We still believe that equities can recover from these oversold levels but note that risks to this scenario have increased. We therefore retain our preference for equities over fixed Interest, though we have reduced our overweight to the former moderately. We have generally increased our underweight to UK corporate bonds, added to the overweight in index-linked bonds and have increased the allocation to Emerging Market debt through the M&G Emerging Market Bond Fund, which now features in all portfolios. Finally, we have moved to overweight within the property allocation, as we continue to like the yields on offer, particularly for those portfolios at the lower end of the risk spectrum which have a desire for higher income.
As at 24th January 2019. *All data sourced from Morningstar and Factset
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
This article was previously published on www.smithandwilliamson.com prior to the launch of Evelyn Partners.