IN December, global equity markets endured the worst performance since the Great Depression. However, with the new year came some respite and the markets recovered significantly after the Fed blinked. Top Fed officials have pledged patience and the willingness to be cautious about pushing ahead with further interest rate-increases given that inflationary pressures have remained moderate.
Part of the reason for the Fed’s dovish reaction is that the US economy has become more sensitive to asset prices than interest rates. The past three decades of financialisation have resulted in an increase of the value of financial assets from two to six times global GDP. It remains to be seen, however, whether the Fed will continue follow a more cautious approach or whether it will resort to a more hawkish tone again, should equity markets continue to rebound.
It is evident that the global economic outlook has deteriorated as major leading indicators have eased. Although an economic slowing is on the cards, the US economy remains on a solid footing and the growth rate is likely to remain superior to those in other industrialised countries.
Leading economic indicators in the eurozone have tailed off, signalling a sharp deceleration in growth. This presents a dilemma for the ECB which is willing to normalise its monetary policy but is faced with a slowing economy and has few policy tools in the locker to provide additional economic stimulus.
In China, economic data has surprised on the downside although the effects from the trade conflict with the US have been relatively moderate so far; this suggests that the slowdown is more pronounced than anticipated. The outcome of the ongoing trade negotiations as well as further fiscal and monetary stimulus measures will be crucial for Chinese as well as global growth.
There are a number of policy uncertainties, potentially affecting global growth and therefore weighing on investor sentiment. While the US central bank has signalled patience, it could be tempted to continue its gradual monetary tightening process if equity markets recover, which could prove to be a policy mistake. Concerning the US-China trade conflict, both countries have voiced optimism on an agreement, but the negotiations have not yielded any concrete results yet. In Europe, the ongoing Brexit saga is the most pressing issue.
We believe that high quality equities can generate superior returns than the overall broad equity market in the long-run. Higher quality companies are those judged to have sustainable business models able to generate high returns on invested capital along with strong free cash flows.
The sustainability and level of those high returns is supported by aspects like strong brands, intellectual property, low costs, distribution advantages, and limited risk of technological obsolescence. Typically, these companies have financial stability, prudent capital management, and financial statements that prove past economic success.
High quality companies have many reinvestment opportunities and the compounding power is often underestimated by the market. Compounding capital is the eighth wonder of the world.
Companies with the ability to generate consistent, long-term growth in sales and cash flows deserve to trade at a significant premium to companies with inherent cyclicality or low profit margins. Those who understand the power of compounding also minimise the common mistake of selling too early.
Whilst a high quality equity strategy is conceived to outperform across a broad range of market environments, historical performance has shown it performs particularly well in times of heightened risk aversion.
As we enter the latter the stages of a 10 year old bull market and as risk factors mount, we believe our focus on investing in higher quality companies, coupled with safe haven assets as part of a well-diversified portfolio will stand us in good stead to generate superior risk adjusted returns in the years ahead.
:: Jonathan Dobbin is managing director at Julius Baer in Northern Ireland
