Over the past year we have suggested that caution was the right tone to adopt in this market. This caution meant that we have been positioned for rising interest rates and, where we have discretion, we have been holding less in shares than we typically would. We have been focussing on two main things to give us a sense of just how cautious to be; the pace of economic growth in the United States and on how other investor’s attitudes to risk are unfolding. Developments, both in the strength of the United States economy and investor behaviour, continue to suggest that caution is warranted. Before delving into these developments our cautious tone might seem strange given the performance of your investments in 2018. It has been a great year so far.
While performance has been superb, and I hate to be a party pooper, all is not exactly as rosy as it seems.
1. Without the US and New Zealand share markets being so strong things would look very different.
It is only a small handful of markets that have posted positive returns over the year with the shining lights being United States (admittedly a big component of both the global share market and your portfolio) and New Zealand. Most other markets are down for the year, and in the case of the emerging markets, 2018 has been very challenging with the market in countries like China, down 19.3%, and Turkey and Argentina down 45.3% and 48.6% respectively.
2. A weak New Zealand dollar has boosted returns for New Zealand based investors.
Over the year the New Zealand dollar has fallen against the major global currency blocs, 6.8% down versus a resurgent USD (more on that later), 3.6% against the Euro, 6.0% against the Japanese yen and even against the Brexiting UK we are down 3.3%. The fall in the value of the New Zealand dollar has not only boosted the returns of international shares for Kiwi investors, it has also been beneficial for New Zealand companies that are either exporters or have significant offshore operations. This has boosted the return of New Zealand shares. The weak Kiwi has both protected and enhanced returns so far this year.
3. Value added by Fisher Funds has cushioned returns.
Our job as an active investment manager is to deliver better returns than just investing in the market. We have been able to do that across the board in 2018 with every strategy either matching or beating the market and, in some cases, by a wide margin. Like the falling Kiwi dollar this has helped mitigate the impact of the more challenging market environment.
So while we should be smiling about the returns this year it is not cause for rampant celebration. Nor is it reason for us to throw caution to the wind. In our view the catch cry of moving forward with patience and caution should be redoubled.
There are two factors we have focussed on to help gauge the appropriate level of caution when building portfolios – the strength of the US economy and investor risk appetites. There is no doubt that the US economy has been strong this year, and while a strong economy is good, an overheating one is not. Economic growth last quarter, admittedly flattered by President Trump’s tax cuts, was a lofty 4.2% (real quarter on quarter). Unemployment has fallen to a cycle low of 3.7% and wage pressures are beginning to build. The US Federal Reserve is conscious of this strength and is normalising short term interest rates having increased them 3 times this year to 2.25%, now a full 0.5% higher than New Zealand’s.
The financial markets have responded to this, pushing up the value of the US dollar. Similarly US long term interest rates, which tend to reflect concerns of higher inflation, are now at seven year highs, a whole 1.9% above the level reached in July 2016. The price of money, which is what interest rates are, is the most important variable in financial markets. Rising rates are rarely good for investors particularly if they continue to climb too high and for too long. While this has yet to have had a major impact in the United States, the canary in the coal mine, the Emerging Markets, have suffered a sharp bear market correction this year. These less stable economies are often poorly positioned to absorb higher borrowing costs and this, coupled with a stronger US dollar, have led to precipitous falls.
Caution is warranted.