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Archived News  07/02/2019

Why 2018 wasn’t a repeat of 2015

Cornelian’s Chief Investment Officer Hector Kilpatrick explains why we did not derisk the Funds in the final quarter of 2018, comparing the market signals with those we observed back in March 2015, when we de-risked the Funds aggressively.

As widely reported, global equity market performance in the final month of 2018 was the worst December witnessed since the MSCI World index was launched in 1988. This rounded off a very poor quarter for risk assets.

Whilst Cornelian’s Risk Managed funds were not taking excessive risk versus their respective risk ‘bands’ going into the final quarter of the year, we did not derisk the portfolios significantly ahead of the December sell off.

Below, I set out why we decided not to derisk and compare this decision with the environment in March 2015 when we derisked the portfolios aggressively such that we broke the lower limits of each of our funds’ risk bands meaningfully in order to protect our clients’ wealth ahead of a significant market downturn.  

Equity markets were weak during the first two weeks of October 2018. However, it was only after these moves, that we started to observe economically sensitive companies’ share prices beginning to underperform on the day that they were announcing strong results. We view such moves as important indicators of investor sentiment which had clearly weakened in response to rising concerns that the Federal Reserve was set on a course of tightening monetary policy too swiftly at a time when global economic growth is slowing. Political concerns surrounding a possible trade war between China and the US were also elevated.
Despite equity markets performing poorly in October, credit spreads did not widen materially.Despite equity markets performing poorly in October, credit spreads did not widen materially and the interbank funding rate (which is a measure of stress within the bank sector) was well behaved. The oil price (West Texas Intermediate) which had reached a new cycle high of $76/barrel in early October fell back to the lower end of its trading range ($64/barrel), but importantly hadn’t broken below it. None of this suggested anything other than an equity market squall.

Furthermore, employment growth in the United States was strong, real wages were growing and consumers’ balance sheets are robust. This suggests to us that the US domestic economy will be much more resilient in the face of a global economic slowdown than in 2015.
A US recession in 2020, let alone in 2019, seems wide of the mark.We also believed that the Federal Reserve would alter their stance on monetary policy if the markets demanded it as inflation expectations remained well anchored. Subsequently, this has proven to be the case and, therefore, a US recession in 2020, let alone in 2019, seems wide of the mark despite the impact of President Trump’s fiscal stimulus fading as the year progresses. Elsewhere in developed economies labour markets are also in much better shape than in 2015.

Interestingly (and unlike 2015) few other signals were corroborating a risk off stance in the lead up to the final quarter of 2018. The Citi US economic surprise index was indicating that macro-economic data releases were inline with expectations, the trade weighted US Dollar was broadly stable as was the 10 year Treasury yield. Furthermore, Chinese iron ore prices had been steady for the last two years.

This was in sharp contrast to the early part of 2015 when we were becoming increasingly concerned that stocks were priced for ‘perfection’ however warning signs were building that suggested the outlook was far from perfect.

The US 10 year Treasury yield had fallen from 3.0% to 1.8% and the Citi US Economic Surprise index had gone dramatically into reverse indicating that economic releases, in aggregate, were coming in substantially below forecasts.

The oil price had fallen nearly 60% as OPEC had announced and implemented a policy of deliberately over-supplying the market with crude in order to drive the oil price down and reclaim market share. As a result, it was becoming clear that debt defaults in the US onshore oil sector were likely to rise and we were concerned that this could deter US banks’ from lending to businesses more generally.

Elsewhere the Chinese iron ore price had halved suggesting a material slowdown in activity in that country.

Furthermore, the US Dollar had strengthened by almost 25% in the nine months to the end of March 2015 and this meant that financial conditions had tightened across the globe.  

Combined, the factors described above gave us a high conviction to take risk off the table during the first quarter of 2015 and this proved to be a successful move.

Fast forward to today and it was only when the oil price broke below $60/barrel in mid-November 2018 that fixed income investors really took note and credit spreads started to widen. We felt the break in the oil price was not due to fundamental problems with the global economy, but rather the mismanagement by the United States of the application of sanctions on Iranian oil sales, which resulted in a glut of oil on the market. 

However, many investors capitulated in the final six weeks of the year and sold down their risk assets following the collapse of the oil price.

We chose to maintain positions as we believed that OPEC would implement oil supply curtailments in order to support the oil price, and these were duly delivered.

We chose to maintain positions as we believed that OPEC would implement oil supply curtailments in order to support the oil price, and these were duly delivered.

In December we top sliced our UK equity relative winners and add to our UK equity relative losers as a nod to the fact that we felt the market sell off had gone too far.

Since the start of the 2019 we have seen a significant bounce back in markets such that the December’s losses have been recouped. The Federal Reserve has capitulated on quantitative tightening and further interest rate rises and the fourth quarter earnings season hasn’t been as bad as feared. Indeed, in contrast to October 2018, company share prices have been rising strongly in reaction to relatively dull but reassuring trading updates.  This is a good sign and we anticipate further equity market recovery.

We remain committed to enhancing and protecting our clients’ real wealth through time and will not hesitate to derisk portfolios meaningfully should we believe the investment outlook warrants it. However, we believe this investment cycle has further to run. Whilst we are circumspect as to the amount of risk we wish to take given how long in the tooth this investment cycle has become, the conditions which would necessitate a significant derisking of portfolios have yet to materialise.  

Sources: Bloomberg, MSCI, New York Mercantile Exchange, Citigroup Global Markets, Bank of America Merrill Lynch.

Hector Kilpatrick, Chief Investment Officer

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