Market Review

The third quarter of 2018 was an interesting quarter consisting of a buildup of pressures, which were most evident in the emerging markets, especially in relation to certain countries including Argentina and Turkey. Trade war tensions, primarily between China and the USA, continue to dominate financial headlines. As these issues develop, market participants have become increasingly concerned that the current tit-fortat tariff approach could escalate into something more serious. Meanwhile, in Europe, Brexit negotiations continued to be one of the major news issues, though the political landscape and budget process in Italy also has wide-ranging implications and has attracted justifiable attention. Geopolitical issues, including those on the Korean Peninsula, have remained relatively subdued during the period, but the potential for some of these to resurface remains. There were also some natural disasters, including severe flooding in Japan, though those are not expected to have any material long-term financial impact.

The US economy remains very robust as indicated by the 4.2% annualised growth rate for the second quarter of 2018, released during the third quarter. However, while this has been spurred by the Trump tax cuts at the turn of the year, the signs of US wage growth have been very slow to emerge, but there are incremental signs they are building. In the absence of material wage growth and other inflationary pressures, inflation remains contained, though in response to the strength of the US economy the US Federal Reserve raised interest rates by a further 0.25% during the quarter, bringing the rate to 2.25% (the upper bound). Elsewhere, the UK’s Bank of England saw Mark Carney extend his appointment until post the UK exit from the European Union, and there was a 0.25% interest rate rise in August, which many market participants believe is unwarranted. The European Central Bank has not yet formally raised interest rates but remains on a path of reducing liquidity, while the Bank of Japan is further behind that with monetary policy remaining very accommodative. In contrast, the People’s Bank of China continued on its easing path during the third quarter to fend off the current slowdown in China.

During the quarter global equity markets, as measured by the MSCI World Index, rose by 4.98%. This made the third quarter the strongest quarter of the year so far for equities. For the calendar months during the quarter, the MSCI World Index produced positive returns for all months of the quarter with July leading August and September as the pace of progress diminished over the quarter. As a result, global developed equities are up 5.43% for 2018 to the end of September. Examining the regional differences, in US Dollars, North America continues to lead the way and rose 7.01% during the quarter. Japan was the next best performing market and gained 3.68%, while Europe only returned 0.80% and the Pacific ex Japan region declined 0.55%. The weakness in emerging markets, referred to above, saw them decline by 1.09% for the quarter, and thus there was a second consecutive quarter of material underperformance versus developed markets. However, the market continued to see US Dollar strength and so in local terms all the major developed regions posted positive absolute returns, while emerging markets were effectively flat, being only 0.04% down.

At a sector level, all 11 sectors produced positive absolute returns for the quarter, except for the Materials sector, which returned -0.53%. The Real Estate, Energy and Utilities sectors were also relatively weak, as while all produced a positive absolute return, none of them managed to return more than 1%. In contrast, the Health Care sector returned 11.50% tolead all the other sectors, and Information Technology rose 8.14%. This was followed by Industrials and Telecommunication Services, which both outperformed the wider market, while the other remaining sectors underperformed the market.

Market Review

Following the relative calm and strong performance of 2017, 2018 has started quite differently. January saw markets perform very strongly, but fears around inflation, sparked by US data, spooked markets, as they became concerned that the strength of economic data may cause the US Federal Reserve to raise interest rates more aggressively than previously anticipated. This then led to equity markets selling off in February, which spilled over into March, though perhaps for other reasons. March saw fears of a global trade war given some of President Trump’s announcements surrounding tariffs, which have been mostly aimed at China, while China has retaliated by imposing tariffs on certain US goods. The market has become concerned that this will escalate into a full-blown trade war, which almost all agree is not positive for the overall global economy and economic growth. Trump himself appears to be seeking to rebalance the trade balance between the US and other countries, primarily China. With such a backdrop volatility has picked up noticeably, although most investors had been expecting this at some point, given the unsustainably low levels volatility had reached. Volatility is not high by historical levels, but appears relatively high compared to very recent history.

Many of the concerns from 2017 have been carried into 2018, although the issues on the Korean peninsula have attracted significantly fewer headlines since early January, given some of the more constructive tone between the parties involved. Perhaps the major change for markets from the US during the quarter was the appointment of the new Federal Reserve Chair, Jerome Powell, in February. This has attracted relative little attention given the continuation of the former Chair’s approach and policies. In China, Xi Jinping took his consolidation of power to new highs, by changing the country’s constitution to allow him to rule for life, by abolishing term limits on how long a president may serve for. In Japan, President Abe faced fresh scandals, which may ultimately challenge his ability to implement reforms. Meanwhile the Governor of the Bank of Japan, Haruhiko Kuroda, was reappointed for a second term. In Europe, the Italian elections have led to an inconclusive outcome and uncertainty remains about how a government might be formed. The UK continued its Brexit negotiations with the European Union, with some progress being made on the transitional timetable through to the end of 2020.

During the quarter global equity markets, as measured by the MSCI World Index, declined by 1.28%. For the calendar months during the quarter the MSCI World produced a positive return of 5.28% in January, but this was followed by the declines in February and March of -4.14% and -2.18% respectively. Despite the negative returns more recently, equity markets remain up over six months. Using MSCI indices, within the Developed Markets Japan was the strongest region, bucking the market downturn and rising 0.83%, while all the other major regions declined. North America fell 1.13%, Europe fell 1.98% and Pacific ex Japan fell 3.73%. Emerging Markets also managed to produce a positive return of 1.42% and therefore continue their recent run of out-performing Developed Markets. Over 12 months Emerging Markets have returned almost 25% while Developed Markets have risen almost 13.6%.

Examining sector performance, eight of the eleven sectors posted negative absolute returns for the quarter. The best performing sector was Information Technology, which rose 3.41%, and this was despite being one of the weakest sectors in March following some challenges for some of the FANG stocks. The second best sector was Consumer Discretionary, which also rose, posting a gain of 1.80%. The best of the rest was Health Care, but this fell by 1.23%, with the remaining sectors all rest was Health Care, but this fell by 1.23%, with the remaining sectors all underperforming the broader market. The weakest sector was Telecommunication Services, which declined by 5.85%, while Real Estate fell 5.43% and Energy by 5.41%. Consumer Staples fell 5.28%, and while those were expected to be more protective on the downside, the run up in valuations meant that they were more susceptible to the market decline. Utilities was a defensive sector that offered relative protection but even that decreased by 1.71% and underperformed the wider market.

Market Review

Political events were never far from headlines during the quarter. The Catalan struggle for independence from Spain continued into the quarter, while elsewhere in Europe, German Chancellor Angela Merkel, having been victorious in September’s election, still struggled to form a coalition and government. This remained unresolved during the quarter, and is a growing concern if some solution is not able to be achieved shortly. By contrast, Prime Minister Shinzo Abe of Japan successfully pulled off a snap election in October and this consolidated his power, including alongside his party’s coalition partner seats won, obtaining a two-thirds majority in the lower house, which enables him to bring about constitutional reform. During October, China also held its 19th National Congress and Communist Party leader Xi Jinping strengthened his own position and control on the world’s most populous country. He has now become the country’s strongest ruling leader since Mao Zedong, and has been elevated to a position that effectively enables him to act as supreme leader. Turning to the world’s most powerful country, the US, President Donald Trump continued to progress with his agenda and this culminated in the US tax reform towards the end of the quarter. This is likely to be good for US equities as US corporations are now encouraged to repatriate their offshore cash piles they have acquired over many years. How extensively this will be taken up remains to be seen, but some progress has been made here. President Trump also continued with his tit -for-tat rhetoric with North Korean leader Kim Jong-un, which had potential to easily escalate out of control although, surprisingly, early 2018 has seen some reversal within North Korea, including commencing talks with South Korea. This should at least allow the Peninsula to ‘cool off’ for a period of time. The US also saw the Federal Reserve raise interest rates during the quarter, at their December meeting, to a range of 1.25% to 1.50%, while also recognising the broad strength of the US economy. In a more controversial decision, the Bank of England also raised interest rates at its November meeting, by 0.25%, in what many have seen as a reversal of the cut in the immediate aftermath of the Brexit vote in mid- 2016. Meanwhile, the UK’s Brexit negotiations stumbled on, though progress was made during the quarter, and the next stage of the negotiations can proceed. Elsewhere, after 37 years Robert Mugabe was finally forced to rescind power in Zimbabwe, as the army pushed him out.

During the quarter, global equity markets, as measured by the MSCI World Index, rose 5.51%. For the calendar months during the quarter the index produced positive returns in all months with returns of 1.89%, 2.17% and 1.35% for October, November and December respectively. The fourth quarter topped off a year that saw the index produce positive absolute returns in every calendar month of the year (one has to go back to October 2016 for the last negative absolute return month). With such a backdrop, unsurprisingly then all major regions produced positive returns for the quarter. Using MSCI indices, within the developed markets Japan was the strongest region, rising 8.49%, while the Pacific ex Japan region rose just over 7%, and North America 6.27%; Europe was the laggard with a return of 2.21%. Emerging markets (EMs) delivered strongly, generating a return of 7.44%, and thus outperformed their developed market (DM) peers. EMs also outperformed DMs for 2017 as a whole, and for the second calendar year in succession. That said, DMs rose 22.40% in 2017 led by the Pacific ex Japan region, followed by Europe and then Japan, with North America being the weakest region, but still delivering just shy of a 21% return.

Turning to sector performance for the quarter, 10 of the 11 sectors produced positive absolute returns, with only the Utilities sector, with a return of -0.44%, failing to register a positive return. Health Care was the return of -0.44%, failing to register a positive return. Health Care was the next weakest sector not quite gaining 1%, while Telecommunications did not deliver a 2% return. Real Estate was the next weakest sector, with a return of 3.73%, but then it was Industrials, which rose over 5%. Consumer Discretionary and Materials each rose more than 7% for the period, while Information Technology gained 8.32% to lead all the other sectors. The pro-cyclical bias in the market was therefore clearly evident for the quarter. A similar pattern for 2017 as a whole is also evident. Information Technology led the way with a rise of 38.23%, followed by Materials, Industrials, Consumer Discretionary and Financials, returning 28.94%, 25.23%, 23.69% and 22.74% respectively. The weakest sector for the year was Energy, only gaining 4.97%, while Telecommunication Services rose 5.82%, Real Estate 10.28% and Utilities 13.66%.