Ardevora Annual Review - 2018

Rational Trump?

The brutal fact is, being a fund manager means making predictions and predicting is hard, especially in financial markets. Not only do you need to predict which companies will prosper or wither, but also how other investors’ views on these companies will change. You need to get both parts right to win. There is no short cut. It can be tempting to believe, by buying this or that factor, you can avoid the need to predict. This is wrong: behind every mindless factor decision is a prediction of persistency; that a factor will keep winning (for whatever reason).

In the world of relentless prediction and error it is easy to get lost and confused. But you must never stop predicting. Stale predictions are dangerous; they encourage lethargy or belligerent denial. An annual review is an opportunity to contemplate, to evaluate yours and others’ predictions, to hunt for the errors and to reframe the debates for the coming year. And what a year 2018 turned out to be.

The Setup

2018 began with obsessions about inflation/reflation, Trump’s agenda on healthcare and his relationship with traditional international allies (and foes). Around the edges, Bitcoin, Brexit, the rise of populists in Europe, Amazon’s crushing impact on traditional retailing and the length of the bull market grabbed attention, whenever stock price moves confirmed a particular source of anxiety. Inflation/reflation tended to anchor most of Wall Street’s predictions for 2018. Most expected inflationary pressure to build, mainly via wages from a tight US labour market, and debated how late we were in the economic cycle and what would happen to bonds when QE ended (which most predicted would happen during 2018). Conclusions (outside of bonds) were generally benign: global growth would accelerate, driven by business investment and the momentum of an EU recovery; the yield curve would steepen; the dollar would weaken; stocks would beat cash, which in turn would beat bonds. Most expected stock markets in Europe to lead, followed by Japan; both were viewed as “cheap” with good growth. Risks were framed to the upside – growth could be too fast, inflation too strong, which could cause the Fed to tighten more quickly than expected. There were a few nods to a possible trade war escalation and to the impact of Chinese attempts to clean up their financial system. So, in sum, investors expected stronger for longer and worried about inflation and bonds.

What unfolded in 2018

2018 began with a stock market melt-up and a Bitcoin melt-down. Trump was preoccupied by North Korea. Anxiety was focused on bonds as Treasury yields advanced towards 3% and the Fed raised rates again. By April, what was to be the most significant event of 2018 had happened: Trump started a trade war. It opened on two fronts: new tariffs and trading restrictions on Chinese technology firms (the first was ZTE). Its early impact was dismissed. It was assumed both sides would behave “rationally”. Much debate focused on who would blink first (the consensus was, the US; democratic governments are more easily and quickly swayed by swings in public opinion, which are often linked to the economy). Trade war rhetoric was to dominate news for the rest of the year, but not in the way most expected. Instead of Trump claiming a quick victory from Chinese bland commitments to stop intellectual property theft (which China repeatedly made), he extended the scale and scope of attack way beyond initial expectations. Stock markets were quite happy to believe in a benign form of “Rational Trump” until the late summer. Other worrying news mounted. Tech started to wobble in the smartphone supply chain as smartphone sales began to disappoint. Anxiety over peak corporate profitability built as cost pressures outstripped pricing power for a host of companies. But anxiety still remained mostly centred on the impact of inflation on bonds.

The first signs of trouble appeared in Japan and then Emerging markets. In Japan in May, despite a largely unperturbed overall stock market, defensives outperformed cyclicals for the first time. Emerging markets were less nuanced. By June they had started to break down, led by previous high fliers. The setup for the second half of the year had a very different feel to the first. Politics had become a lot more unstable, first in Europe (Italian Populists) and then in Emerging Markets (Turkey). By September there were metaphorical fires everywhere: numerous companies complained of the impact of the trade war, the Chinese economy slowed sharply, the dollar surged and the intensity of the trade war increased. By the end of the year, everything apart from bonds and the dollar was tumbling – stock markets, industrial commodity prices and confidence.

The year ended with a flat yield curve in the US and a strong dollar. Cash beat bonds, which beat stock markets and Europe certainly wasn’t a beacon of growth.

The 2018 post-mortem

When we look back at 2018 we see three big mistakes the market made: the framing of Rational Trump and his impact on growth; beliefs on where the risks of inflation lay (stocks or bonds); and China’s growth.

The biggest mistake by far in 2018 was the belief of what drives Trump and what it means for growth. In our view, it was widely assumed Trump was unpredictable and irrational, but whatever he did would be pro-growth (we admit to the same error, but we see things differently now).

If we suspend our belief system and allow the concept of Rational Trump to exist, what could “rational” (and hence, predictable) Trump mean. Trump was elected on a set of promises. The main ones were: cut taxes, quit the Paris Climate Deal, withdraw from the Iran Nuclear Deal, appoint conservative supreme court judges, bomb ISIS, bring US troops home, renegotiate trade deals, correct the trade deficit with China, stop China manipulating currencies, repeal Obamacare, build a border wall paid for by Mexico, make NATO members pay more, rebuild US infrastructure, prosecute Hillary Clinton, and drain the swamp of lying politicians. He has attempted and, in most cases, succeeded in fulfilling his promises. His focus has shifted as he has achieved fulfilment of a particular promise. In 2017 he focused on healthcare reform, climate change and taxes. In 2018 he shifted to China. This makes Trump’s behaviour eminently rational: he is attempting to be a politician who “keeps his promises”, in stark contrast to how he perceives the political establishment. This, presumably, will form a major plank of his argument for why he deserves a second term. The manner in which he has tried to fulfil his promises also matches a pattern of behaviour we are all too familiar with: he is behaving like a classic “boss”. We spend a lot of our time attempting to read the behaviour of bosses. In a simple sense, we don’t trust them. We believe the average boss is risk loving, highly confident, self-serving, and likes power (and so enjoys “bossing people around”). Some are more extreme than others. Trump is on the more extreme end of this spectrum. When we view Trump as a boss, rather than as a politician, he looks a lot more predictable. Most bosses, unlike most politicians, do not try to get their way through persuasion, but through diktat.

So we would frame Rational Trump as a diktat-driven boss who wants to win a second term by seeming to be a politician who keeps his promises and “can be trusted”. This places greater weight on non-economy drivers of popular opinion – “America First” and “the first politician who keeps his promises”. A classic dictator tactic to maintain popular support, regardless of the economy, is to divert attention through acts of blame and aggression, orientated around nationalism and identity. This is why we now think it is dangerous to assume that Rational Trump naturally implies he is pro-economic growth.

It was widely assumed inflation would begin to creep back into the system in 2018 and it would be bad for bonds. It turned out to be worse for stocks. Bond anxiety remains, but in a reminder of why forecasting is so tough for a system which reacts to its own predictions, stock anxiety is higher. Inflation has returned and from the source most expected – a tight US labour market. The unexpected repercussions have been twofold. First, the policy response of ending QE and US rate rises has, in a basic sense, been more successful than expected for bonds. Second, the transmission of inflationary pressures has been more damaging on profitability expectations for stocks; peak profitability concerns now abound.

Chinese economic growth is also important. Since 2009, we believe China has directly contributed almost 50% of global economic growth, and that emerging markets have contributed a further 25%. If the world cannot benefit from growth in China, growth becomes very hard. Chinese growth, while well above developed economies, has been slowing. Two related factors have been at play. First, China’s struggle to avoid the Developing Economy Low-Income Trap. After an initial burst of industrialisation, developing economies have historically struggled to transition to more consumer and higher “value-added” led growth. Second, China is now attempting to clean up its shadow banking system and this is holding back growth. Most of us were reasonably relaxed about China’s ability to navigate both through 2018, albeit at a slower rate than the past. What we didn’t envisage was the clash between America’s and China’s view of how to break the low-income trap: America wants China to consume more American goods, China wants to compete with America in IP and high, value-added industries. The result is a trade war.

There has been a significant reframing of how America views its relationship with China during 2018. For 20 years China has been viewed as an opportunity. Now it is viewed as a competitive threat. This is a fundamental shift. It has just cause, and herein lies a paradox. China cannot easily break the low-income trap without striving to become a competitive threat. Rational Trump would argue competition is fine as long as it is “fair”, hence the trade war rhetoric. However we are pretty sure every successful developed country has resorted to distorting trade practices at some time to allow their chosen industries the chance to win.

What Wall St expects for 2019

Despite a disappointing 2018, most forecasters are cautiously optimistic for 2019, but for rather different reasons than their 2018 optimism. Most still don’t like bonds and prefer stocks. They prefer stocks mainly because they were wrong last year and so, following sharp falls in stock markets, they believe stocks now look “cheap”. What constitutes “cheap” is reliant on a prediction of low global growth, but no recession. Within stocks they prefer Emerging Markets and Europe (cheaper and better growth). Economic growth is expected to slow (rather than accelerate, as they forecasted a year ago), but inflationary pressures are still expected to build, from wages and a rebound in the oil price. The Fed is expected to continue to raise rates, but only until the middle of the year. Most have a benign view of China and Europe. Anxiety is focused on the likelihood of a US recession in 2020. Our interpretation is there is a lot of denial and dislocation over the trade war. Most do not believe it will end quickly, but are quick to entertain what would happen if it does. Most believe its economic impact will be offset by policy responses in China and trauma will be confined to tech. There also appears to be dislocation and denial over EU politics. Most are pessimistic on EU politics, but do not allow this to infect their positive view on EU stock markets and growth. EU and US economic growth are expected to converge, but EU monetary policy is expected to continue to “normalise” (i.e. tighten) with no ill-effect.

Conclusion

We are not fancy hedge fund managers. We invest our clients’ money in the stock market, trying to give them a better outcome than an index fund. We attempt to achieve this by picking better stocks, not by trying to decide when to be in markets and when to be in cash. When we are nervous about life we like to spread our bets and focus on what can go wrong. After over 30 years in stock markets, we still believe there are plenty of good companies out there which can survive almost any conditions and prosper in most. We will stick to trying to find those where not everyone else thinks the same as us. As for a “market” view, for what it’s worth we think the outlook for 2019 hinges on one key thing: what constitutes “success” for Trump in his trade war with China. If he can claim victory quickly then there will be growth and markets will be fine. Regardless, the world will not be the same. We think a new cold, economic war has started with China which will create a more fragile general environment for global growth. Stock markets are already worried. But the negative impact of a prolonged trade war has not, in our view, really been felt yet. We suspect some economies will flirt with recession and more companies will miss profit forecasts. Until this happens we don’t think stock markets will truly bottom. But we expect this to happen in 2019, so the end of the year is going to feel very different to the start.

 

GLOBAL REVIEW

2018 was not a good year. The portfolio value fell. There was modest comfort that it fell slightly less than MSCI ACWI, but the emphasis is on “modest”. The second half of the year was the problem. Not only did pretty much every type of stock fall, but also having an equally weighted approach to portfolio construction meant we got buffeted badly by a market cap effect (mega-caps performed relatively better). Having started the year well, both absolutely (comfortably up) and relatively (ahead of the benchmark by around 5% by mid-year), we spent the second half of the year watching all of our good performance disappear. This is especially frustrating, as by the summer we were pretty sure something was wrong with stock markets.

We carried a skew to growth stocks into the start of 2018, but we had already decided, in the last quarter of 2017, to say goodbye to some of our more successful stocks of 2017. We had become uncomfortable with how far and fast their stock prices had moved during 2017 and fretted they had become over-liked by other investors. It is tricky to gauge what other investors believe. Unlike analysts or company managers, you cannot ask them directly, or read about what they think from research or company reports. You have to rely on the patterns of stock prices and valuations to infer whether they are anxious or hopeful, and make some inferences from analysts’ reports and recommendations (which can influence investors).

We look for, essentially, two types of stock opportunities: IB (Investor Bias) or AB (Analyst Bias). IB stocks are where we see an opportunity for potentially irrational anxiety or scepticism to dissipate; often they have value-like factors (like low valuation or poor past stock price performance) associated with them. AB stocks are where we see an opportunity for potentially irrational scepticism from analysts over the growth properties of a stock, which can give an unusual error skew to their forecasts; often these stocks have more growth-like factors associated with them. We like to have a mix of both types, as it generally makes for a more consistently performing overall portfolio and dampens down some of the risk associated with an equally weighted approach (which increases our exposure to mid-cap stocks), but we are happy to tolerate a skew towards one type or the other. We have found we can face different types of debates within each stock type.

For IB stocks, the most common debates are around two aspects. First, management behaviour and business model: has management behaviour changed; is it realistic given the more difficult environment; is the business model robust and can it survive trauma; can the business model change? Second, analyst behaviour: are they gloomy enough; has the intensity of their disappointment peaked?

For AB stocks, the most common debates are also twofold. First, management behaviour and business model: are management growth plans realistic; how easy is the growth; are they straining for growth; how unusual is the business model? Second, investor behaviour: is it over-loved?

Often we frame debates about the portfolio around the mix of these two types of stock opportunities. If we are not careful, it is easy to drift into debates over the relative merits of “value” vs. “growth”. We think this was one of our mistakes last year. We started the year struggling to find IB stocks, so the proportion of them in the portfolios remained well below 50%. In the summer, we began to struggle a bit more with AB stocks – we were getting more nervous on two counts. First, we became worried about some of the “better” stocks becoming over-loved. Second we became more concerned growth was getting harder. Hence we looked to reduce our exposure to AB stocks. For us, the default is to increase our exposure to IB stocks. This was not a good move. While almost all of the AB stocks we sold went down after we sold them, the stocks we bought did not go up, and IB stocks in general tended to fall more than average. In hindsight, the smart thing to do would have been to move to cash, or to stocks in defensive sectors. As is often the case in stock market investing, being most of the way right in a view (growth is getting harder, risks are going up) was not enough to perform well.

The current portfolio is still skewed to growth, but less so than the start of 2017. We have our eye on quite a few potential AB stocks and believe we will get an opportunity to enter them at some stage during 2019. We think, like most, that 2019 will be a volatile year, so we are expecting periods of both vigorous stock price rises and declines. We have a strategic view as to how we want the portfolio to look by the end of 2019, and expect to shift our mix of AB and IB through the year as investor behaviour swings. Thank you for sticking with us. We hope we can deliver a better year in 2019.

 

UK REVIEW

2018 was not a good year. The portfolio value fell. Relatively, performance was similar to the UK benchmark. The second half of the year was the problem. Not only did pretty much every type of stock fall, but also having an equally weighted approach to portfolio construction meant we got buffeted badly by a market cap effect (mega-caps performed noticeably less awfully than everything else). Having started the year well, both absolutely (comfortably up) and relatively (ahead of the benchmark by mid-year), we spent the second half of the year watching all of our good performance disappear. This is especially frustrating, as by the summer we were pretty sure something was wrong with stock markets.

The UK stock market was especially challenging in the second half of the year. Not only were risks to global growth rising rapidly, but the fog of uncertainty over BREXIT thickened considerably. We have been gloomy about BREXIT for some time, and some of this gloomy view helped our shorts in the second half of the year for the UK Equity portfolio, but not enough to offset the impact of being equally weighted on the long book. There was nowhere to hide (in the long book) in the second half of the year and we struggled to find any stocks capable of bucking the combination of Sterling volatility, building BREXIT anxiety and rapidly rising fears over global growth.

By the end of the year, however, we finally felt that a lot more UK-centric stocks were more adequately reflecting BREXIT risks, while at the same time the possible outcomes of BREXIT were beginning to look a little less frightening. As a result we have shifted the portfolio somewhat. We still have a core of unusual AB growth type stocks, but we have entered into a few more positions in areas of potential extreme investor anxiety. The UK now looks to be one of the few markets where the generally building risks out there may have a chance of being adequately reflected in market sentiment. This provides the scope for possible “not as bad as expected” news to move stock prices. We believe 2019 will be a pretty wild year, but there is a fair chance of making some acceptable returns in the UK. So thank you to those who have stuck with us during a difficult 2018. We think 2019 will be better.

 


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Previous Commentaries

Quarterly Commentary Period ending June 2018
Quarterly Commentary Period ending March 2018
Annual Commentary Period ending December 2017
Quarterly Commentary Period ending September 2017
Quarterly Commentary Period ending June 2017

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