By Fisher Funds
We have a shorter newsletter this month while we work on making some improvements. You may have noticed a few changes around the website lately. Next month there will be a few more, as we enhance your communications so that we can share more with you.
From December we’ll send you a mid-month email with the same in-depth investment news and views from our team, plus some new content formats to help you be a better informed investor.
Markets take a tumble
October was a volatile month for global share markets. While falling prices were the dominant theme, there were also days where prices rose dramatically. Volatility like this is confusing, and can be downright scary for some investors.
Read on for insight into what was behind this market turmoil, what might come next and some thoughts on how we tend to think about bouts of volatility like we have experienced. Our Chief Investment Officer, Frank Jasper has written an in-depth piece on this.
It’s always about the economy.
The economic cycle is an important driver of company profits, and profits ultimately drive the share market. This doesn’t mean the economy leads the market but that market participants obsess about what’s happening in the economy and buy or sell shares accordingly.
They don’t always get this right: there’s an old market saying that the share market has predicted eight out of the last four recessions. Either way, the direction of the economic winds, fair or foul, foretell an important story about financial market sentiment.
In October, the US share market sold off by 11.2% at its lowest point. It’s always hard to pinpoint the exact causes for a sharp correction like we have experienced. There were definitely some technical factors contributing. In particular market participants had become excessively optimistic leading to overbought conditions that, like a tinder-dry forest, are ripe for a fire. While important contributors they are not the main act. In this case the expected pace of economic growth lurks in the background as the primary fear driving market participants.
The United States economy has enjoyed strong growth in 2018. This has been built on a continuation of the long slow economic recovery since the global financial crisis (GFC), with lower unemployment driving consumer sentiment and boosted by a recovery in business investment
What has marked 2018 out as special is the powerful fiscal stimulus provided by corporate and personal tax cuts. This saccharine hit boosted growth in the last quarter to a heady 3.5% (coming on top of last quarter’s 4.2% growth). Strong growth and lower taxes have been a boon to corporate earnings, driving aggregate company earnings higher by 22.5% over the last quarter. This has, until recently, been supportive of higher share prices.
Stronger economic growth presents its own challenges. US unemployment has fallen to a cycle low of 3.7%, industrial capacity utilisation has tightened, and consequently, the US Federal Reserve has begun normalising interest rates, increasing them three times this year to 2.25%. Higher interest rates tend, like the pull of gravity, to exert downward pressure on economic growth. This is strike one in many investor’s minds reducing the outlook for US growth in 2019.
Strike two comes from slowing growth in the rest of world and the negative effects of the ongoing trade wars that have been a feature of Donald Trump’s presidency. Nowhere is this more evident than in China where growth expectations continue to be revised lower, leading to a bear market in Chinese shares. The rest of the world is not helping with leading indicators of growth weaker in Europe and ongoing budget negotiations in Italy hardly adding to positive sentiment.
Of course the benefits of tax cuts don’t last forever and, at least on a year over year basis, the positive growth impact of lower taxes will roll out of the data leading to lower numbers. This for many investors is strike three.
We have some sympathy with this perspective. There is no doubt, in our mind, that economic growth will be lower in 2019 than it has been in 2018. Similarly, the earnings growth enjoyed by US companies will not continue at the current clip with slower revenue growth and increasing costs seeing to that.
Slower growth does not mean recession
This distinction between these two is important. We are of the view that growth in the United States is likely to return to a cadence in line with the post GFC recovery, low, but very importantly, positive.
While this has been a formula for good financial market performance over the past decade we are less sure that the environment will be as friendly for investors going forward. Things have changed. Interest rates are higher, wage and raw material costs have been rising, which will pressure company profit margins, and inflation is less well contained.
This leads us to be cautiously positioned. The expectation that interest rates will rise is our most strongly held view. This leads us to investing materially less in global fixed income markets than we would normally expect to.
We also have less shares than we would normally hold although this is a less significant position. While slower corporate earnings growth is not a great backdrop for share market performance, valuations are now below long term averages with real opportunities beginning to emerge, particularly outside of the United States. In the absence of an outright corporate profit recession we are not of the view that this is a time to be too pessimistic about share markets.
Caution not panic is warranted
So at this stage of the cycle, and despite market volatility, we believe that there is more to fear from inflation rising rather than a slump in growth. Trade wars, the fiscal spend up and a row that has been brewing between the US President and the Fed Chairman complicate this but still point in the direction of inflation concerns first and foremost.
As a result of this, caution not outright pessimism, is our catch cry.
Volatility is normal
Share markets don’t always go up. Volatility is the cost that goes hand in hand with the higher long term returns we expect from shares. Just because we might know that, doesn’t make it any less uncomfortable when the inevitable bouts of volatility hit. It is natural to be worried.
Our worries don’t stop the share market from rising. Those of you who have attended our roadshows have seen the chart above. It shows the performance of the Standard and Poors 500, the best barometer of the performance of the US share market, over the past decade. This period, like most, has been full of things to worry about; a European sovereign debt crisis, banking problems in Greece, Spain and Portugal, a possible credit rating downgrade in the United States and a new US President that most commentators thought would be a financial markets disaster, yet the market more than doubled over these years.
Very often our worst fears are short lived and if we responded every time we would have missed a decade of wonderful investment performance.
We focus more on companies than on headlines
So far we have focussed on the big picture – the things driving the market in aggregate.
Of course at Fisher Funds we are a very selective investor, hand picking a portfolio of investments in New Zealand, Australia and the rest of the world that we believe will generate attractive returns over the long term.
During bouts of volatility we tend to focus more on the micro than the macro; are our companies well positioned for the future, are the business models they have robust, sustainable and getting stronger, will they keep growing profits? Viewed through this lens fluctuating prices become more an opportunity than something to be worried about.
Jeff Bezos, the founder and CEO of internet retail behemoth Amazon.com, talks about building business strategy on things that won’t change. In his case it’s unlikely that customers will want slower deliveries, less choice and higher prices. Focus on delivering those things and Amazon will be successful is his view. This is a good approach when thinking about financial markets.
What do we know to know to be true about financial markets? In ten years’ time we are pretty sure:
- Western populations will be older and sicker – portfolio companies Edwards Lifesciences, Ryman Healthcare, Summerset, Abbot Laboratories and Nanosonics will all have larger potential customer bases and should be materially larger companies.
- We will all be buying more online then we are today – our investments in PayPal, Mastercard, eBay, UPS and Freightways will be huge beneficiaries of this.
- Trade and the need for cross border logistics will continue to grow – Mainfreight, Wisetech and Descartes have decade long growth runways.
- Individuals and businesses will keep wanting to find more efficient ways to get things done – companies like Xero, Seek, Carsales, Vista Group and Cerner make things more efficient. Customers are already voting with their feet and will continue to adopt these solutions.
- The Emerging economies, and Asia, in particular, will be larger – market leaders like Alibaba and new portfolio addition Tencent, will be at the vanguard of this growth.
Volatility isn’t fun and right now a sensibly cautious position is warranted. With investments in some of the best companies in the world - companies with powerful long term growth drivers - sleeping well at night is not a challenge for us. Your money is in good hands.
Your KiwiSaver portfolios: Highlights and lowlights
The New Zealand share market suffered its largest fall since May 2010 in October slipping 6.4%. Similar to last month it was the defensive sectors like utilities and telecommunications that were the strongest relative performers.
The New Zealand Growth Fund was down 7.9% for the month. The top portfolio performer in our portfolio was Restaurant Brands. Restaurant Brands was boosted by news that Mexican financial investor Finaccess may make a partial bid for the firm. Finaccess is a private equity fund that has a shareholding in a similar business to Restaurant Brands, AmRest Holdings, a large Polish- fast food operation and is, in our view, a credible player. We are currently waiting for Finaccess to formalise its offer. It is important to note that there is no certainty that this final offer will materialise.
During the month we exited our position in Abano Healthcare. Ongoing disappointing sales growth from its Australian dental business, Maven, and limited margin improvement has ultimately dented our confidence in the business, leading to our decision to exit.
Volatile markets provided the opportunity for us to add to positions in some of our favourite companies over month including A2 Milk, Fisher & Paykel Healthcare and Xero. Buying quality companies in times of turmoil is one way to seek to boost portfolio returns over time.
Concerns around higher interest rates, slowing global growth, the spectre of rising cost pressures and a tit for tat trade war seemed to weigh as much on the Australian share market as they did on international share markets. Our Australian portfolio was down 8.0% for the month.
Global logistics software firm Wisetech was the portfolio’s worst performer over the month falling over 25%. Despite its price fall it was notable the company increased revenue and profit guidance over the month highlighting that demand for its software solutions continues to increase.
While watching share prices fall can be tough, we remain confident in the longer term investment case underpinning portfolio companies and we used weak share prices in October to top up investments in a number of companies as well as adding Aristocrat Leisure to the portfolio.
The International Equity Fund significantly outperformed its benchmark in October by 0.6%. However, Global Markets had their worst monthly return since 2008 and in absolute terms, the portfolio returned -5.5% versus a benchmark return of -6.1%. Value was added by having a lower than benchmark exposure to Industrials and Consumer Discretionary. Consumer Discretionary was hit hardest during the sell-off and fell by 10%. The Utilities sector was the best performer, and was the only to provide (a small) positive return for the month of 0.7%. The fund was mainly helped by holding more Value (cheaper) stocks, as the contrasting style of stock, or Growth stocks (which are relatively more expensive) were laggards. Cash drag was also a significant contributor to returns as the portfolio has relatively higher levels of cash than the benchmark, which has no cash exposure.
Most currencies depreciated against the US Dollar, and the New Zealand Dollar was no exception, falling by -1.5%. However, the volatility seen in equity markets generally did not spill over into the currency markets which were relatively not as turbulent.
The largest contributor to benchmark-relative returns was Comcast, which rose almost 10% after announcing both earnings per share and revenue figures which exceeded expectations. Another major contributor was having a lower than benchmark exposure to Amazon, which had a tough month, falling by 19% in local terms.
The solid run of outperformance for our global fixed income portfolios was retained in October. Again the source of this outperformance was quite diverse across each fund, suggesting each manager continues to generate uncorrelated returns from the other.
Rising interest rate expectations again put downward pressure on high grade, safe-haven fixed income assets in October. But rather than this being due to greater optimism surrounding the outlook for global growth, concerns are now growing about the impact higher rates will have on company profitability. This caused corporate bond valuations to also weaken.