Q4 2018 Fund Commentary
Equities experienced a material sell-off during the fourth quarter of 2018. The MSCI ACWI Index (Gross) lost 12.65%. For the full year, the MSCI ACWI Index (Gross) lost 8.93%. The S&P 500 Index was hit especially hard, losing 13.5% during the quarter. For the full year, the S&P 500 Index lost 4.56%.
The market sell-off was initially triggered by two issues: very hawkish messages in late September and early October in reaction to strong U.S. economic growth, and rising concern over the escalating trade war between the U.S. and China. This drove the October sell-off, but things appeared to stabilize by late November after the Fed sent out more dovish signals. At the start of December, we were hopeful that a more dovish Fed and progress on the Sino-U.S. trade negotiation would calm investors and provide some seasonal strength. While there were positive developments on the trade front and the Fed indeed turned more dovish, investors appeared to have become petulant like President Trump in demanding an about-face from the Fed to suspend further rate hikes. When the Fed indicated that “some further gradual increases” were in the offing and that the pace of its balance sheet reduction was not to be altered, the stock market collapsed as if the economy would soon degenerate into recession. As fear evolved into the primary market driver, selling begot more selling and a downward market spiral became a self-fulfilling prophecy.
For the global equity market, as measured by the MSCI ACWI Index, the best performing sectors during the fourth quarter 2018 were sectors with least economic sensitivity: utilities, REITS, and consumer staples. On the other hand, cyclical sectors were the big laggards: energy, information technology and industrials. It appeared that the rotation into the so-called defensive sectors had a much greater impact than stock selections. These were also moves typical of portfolio positioning in anticipation of a recessionary environment, but we believe it is premature to position now for a recession.
The Fund lagged the benchmark during the 4Q and gave up the YTD gain achieved through the first three quarters of 2018. The main reason for the underperformance was our decision to refrain from repositioning the portfolio to take a very defensive posture. In fact, we added to some economically sensitive positions during the fourth quarter as prices pulled back materially. We believed that the market’s defensive shift was an over-reaction to the fear of an imminent recession. We believe that these moves will likely reverse in 2019 after investors realize that the risk of a U.S. recession in 2019 remains rather subdued.
Consumer discretionary and consumer staples were the largest detractors on a sector basis. The underperformance from consumer staples was due to the Fund’s lack of exposure to the sector. Two of the largest detracting stocks were Southwest Airlines and Royal Caribbean Cruises. We believe that Royal Caribbean’s stock price is likely to recover because of solid booking trends and lower oil prices. Helping relative performance was our exposure in communication services and an underweight to information technology. American Water Works was the largest contributing stock, in part due to the outperformance of the Utilities sector.
We initiated new positions BeiGene, a Chinese Biotechnology firm, KDDI, a telecommunications company based in Japan, and Treasury Wine, which is based in Australia.
We exited our position Galapagos NV, Spark Therapeutics, Shire PLC and Taiwan Semiconductor Manufacturing in favour of better opportunities.
We believe the U.S. economic expansion will remain intact in 2019, although the pace of growth will decelerate from the stimulus-fueled 2018. Given the severe market sell-offs and elevated investor pessimism, we believe equities are poised for a rebound.
Drowned out in the market carnage were several positive developments. First, lower oil prices should boost U.S. consumer’s discretionary spending power, second China has reduced tariffs on 700 items as a sign of good faith in the trade negotiations and finally, lower Treasury yields have led to a decline in mortgage rates.
It is unusual for the S&P 500 Index to suffer a 20% drawdown in the absence of an incoming recession. A recent instance took place in 2011, between the completion of the Fed’s second round of QE and the start of Operation Twist. It took five months after the market bottom for the Index to recover all its lost ground. Presently, the combination of a still healthy U.S. economy, more attractive valuations, and elevated fear makes us more sanguine about equities than we have been in quite a while. Of course, the market will need a little help from various institutions – the Fed should refrain from further rate hikes, China needs to move stimulus into higher gear, and the US politicians assuming a more bipartisan approach.
Outside the U.S., the most important development will be China’s reflation policy to restore business confidence and rekindle animal spirits. Many investors are worried that the policy tools of the past – increased lending, infrastructure spending, and more relaxed control over the property market – may not be as effective. However, our base case remains that the Chinese government will find a way to turn things around. While it will take time for the stimulus to work its way into the economy, we believe markets will start to react favorably to signs of any “green shoots”.
A recovering Chinese economy should have positive impacts on its trading partners, especially those countries with heavy export dependency (e.g., Germany, South Korea). A more dovish Fed would also alleviate some of the capital market pressure that have confronted many emerging market countries. In short, the combination of Chinese growth re-acceleration, a move dovish Fed, and continued expansion of the U.S. economy should propel equities higher in 2019, in our opinion.