1. Are you getting paid for the risk?

The most important determinant of your investment return (or at least the one you have some control over) is the price you pay at the outset. Over-paying is a short-cut to disappointment. Paying a reasonable price, or even better picking an asset up for less than its intrinsic value, stacks the odds in your favour. Sometimes, everything is either cheap or expensive. That’s not the case today - being selective has never been so important. In my comments on the different regions elsewhere in this report, I’ve highlighted the increasing value in the UK and Japan. Picking up blue-chip stocks with a near-5% yield (see the chart below) will probably look obvious with the benefit of hindsight in a few years’ time. Cash, for the first time in years, is beating inflation - with no risk to capital. Property on the other hand is not even compensating investors for the erosion of value from depreciation and obsolescence - let along the risk of tenants going bust.

UK shares – rewarding investors

Source: Refinitiv, total returns in local currency as at 31.12.18.

Past performance is not a reliable indicator of future returns.  

2. Trade wars - who blinks first?

The rising tension between the US and China is probably the most important theme for investors in 2019. The battle between the world’s two largest economies is about much more than trade, of course. It is a fight for supremacy, which fortunately is still being played out only via the proxy of tariffs. The significance for investors is that trade has underpinned economic growth for the past 40 years since China rejoined the global economy in the 1970s. Rolling back the tide of globalisation may make geo-political sense to Donald Trump but it threatens the growth on which stock market valuations depend. 2018 saw tensions build steadily. If they can be resolved in 2019, markets will breathe a sigh of relief, especially those in emerging markets, Europe and Japan that are most at risk. If the mood darkens further, investors will most likely prefer defensive ports in the storm - like the US.

3. When does the Fed stop squeezing?

The second most important question for investors in 2019 is whether the Federal Reserve sticks to its expected interest rate tightening path. The Fed’s forecasts are for two or three more quarter point hikes. This is clearly the central bank’s preferred outcome, because it will ensure that when the next downturn arrives it will have some ammunition in the shape of potential interest rate cuts. The markets are less convinced, thinking that a slowing economy and volatile markets will prompt a more cautious approach. The trajectory of US interest rates matters for a few reasons: it drives the value of the dollar, which has been a headwind for overseas, especially emerging, markets; it has a direct impact on US consumer sentiment, via the mortgage market; and it determines the relative attraction of riskier income streams, like company dividends.

4. What is the yield curve telling us?

It is unusual for stock markets to fall far in the absence of a recession. So, the ability to predict when the next downturn will arrive is a useful tool for an investor. It’s not that easy, but one warning sign of impending recession that has a good track record is called the ‘yield curve’. This measures the difference in the yield paid by bonds due to mature many years hence with those that are due to pay out much sooner or cash equivalents like Treasury bills. Usually, longer-dated bonds pay a higher yield to compensate investors for the risks involved in locking up their money, such as inflation. At a time of rising interest rates, like today, however, this picture changes. Shorter yields rise in line with interest rates while longer yields fall in anticipation of lower growth and inflation. In extremis, rates on longer bonds can fall below those on shorter ones (below the 0% line in the chart below). In the jargon, it’s called an ‘inverted yield curve’. It doesn’t happen often, but when it does a recession is usually on its way. Currently, long and short yields are almost the same so this reliable recession signal could be triggered soon. One to watch.

The yield curve – recession warning

Source: Refinitiv, as at 3.12.18.

Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment.

5. Does OPEC matter anymore?

Donald Trump marched them up to the top of the hill and he marched them down again. Re-imposing oil sanctions on Iran at the end of 2018 threatened to push the oil price back towards the $100 a barrel mark at which energy costs have a significant negative impact on economic activity. Faced with rising fuel costs ahead of the mid-term elections, the US President twisted the arm of his Middle Eastern ally, Saudi Arabia, to keep the pumps open and so to cap the oil price. When he simultaneously gave big oil importers like Japan and India a waiver so they could keep buying Iranian oil, a glut ensued and the oil price fell in short order from $86 a barrel to below $60. Why does this matter? Because the cost of oil is a key driver of inflation and so interest rates. If OPEC has lost the power to hold the world to ransom, the oil price may be one thing we don’t have to worry about in 2019.

6. Brexit: who cares?

The intuitive answer is that we should all care. Whether Britain stays in the EU, achieves a soft exit with continuing close economic ties to Europe or leaves without a deal will obviously have an economic impact. What its influence on the stock market turns out to be is harder to predict, however. Forecasting the twists and turns of the Brexit saga has become so hard that many investors, particularly overseas, have simply given up the unequal task. They are choosing instead to leave the UK market out of their portfolios. This is great news for investors who are prepared to look through the short-term noise and focus on the longer-term opportunity. On a medium to long-term time horizon, this looks like a good entry point to the UK, in particular the internationally-focused FTSE 100 which is less vulnerable to the ups and downs of the British economy.

7. Where next for the High Street?

No part of the UK economy was under more pressure in 2018 than the High Street. The retail sector faced a quadruple whammy of Brexit uncertainty, a weak pound, high property taxes and the relentless assault on bricks and mortar shopping from the internet. The UK stock market looks unfairly out of favour but the same cannot really be said of the High Street. The perfect storm of adverse influences on retail profits makes the sector look like a classic value trap. That describes a situation where investors are tempted by apparently cheap valuations only to realise that cheap can get cheaper still. An even bigger value trap may turn out not to be shop chains themselves but the property companies which house them. I suspect this part of the market is some way from hitting the bottom.

8. Does diversification still work?

Diversification is the most important word in investment. Putting your eggs in a variety of baskets is the surest route to sleep-filled nights during the market’s periodic difficult years. We have looked at the returns from a range of different asset classes over the past two decades and there hasn’t been a single year when every asset has fallen in value. In the jargon, they are uncorrelated - some rise when others fall and vice versa. This was even the case in 2018, a particularly challenging year in which returns were poor pretty much across the board. A key factor last year for UK-based investors was the fact that the pound’s weakness boosted the returns from overseas assets. So, for example, the S&P 500 had an indifferent year in dollar terms but a respectable one after translation back into sterling.

9. Value or growth?

In the long run, the returns from cheap and unloved shares have outperformed those of high-growth companies because the latter tend to become over-priced. The tendency for things to revert to the mean ensures that investors live to regret paying up for apparent quality as valuations swing back to the average. Since the financial crisis, that has not been the case. In a low-growth environment, investors have been rewarded for sticking to the best. Will that continue in 2019? I suspect it might. If, as expected, growth starts to moderate in the face of rising interest rates then quality and growth potential will still attract a premium.

10. Where to invest in 2019?

The value versus growth question has informed the first of my fund picks for 2019. Although I see considerable opportunities in the UK market, the continuing Brexit uncertainty means I am hedging my bets by investing in it via a quality-focused fund. Nick Train’s Lindsell Train UK Equity Fund will do well if the UK bounces back and should be defensive if it does not.

With the Fed likely to pause and other central banks yet to even begin to tighten monetary policy, investors will continue to chase income. Dan Roberts runs a very defensive global equity income fund, the Fidelity Global Dividend Fund. This is another way of tapping into what growth is available in 2019 while remaining focused on capital preservation.

As I explain more fully elsewhere, Japan is unfairly out of favour so this is where I’m making my third recommendation. The Baillie Gifford Japanese Fund is one of the highest-quality funds in this category.

Finally, I’m playing the diversification theme with the Fidelity Select 50 Balanced Fund. Ayesha Akbar’s multi-manager fund invests across different asset classes and geographical regions to deliver a smoother voyage through choppy waters.

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