European long/short outlook
25 January 2019
2019 may be the proverbial
game of two halves… if the
market materially corrects,
this could present a great
opportunity for the second
After an exceptionally low period of volatility during 2017, financial
markets around the world became increasingly fragile in 2018, with
losses in most major asset classes – something that didn’t happen
even in the global financial crisis year of 2008. Investors have had
to cope with a whole raft of macro factors influencing the markets
in the past 12 months, most notably: the impact of President
Trump’s actions and rhetoric over trade; the ongoing uncertainty
around the UK Brexit; and the formation of a fiscally radical Italian
government; as well as a weakening Chinese economy. All these
influences have added considerable uncertainty during a period of
tightening global liquidity. What’s more, economic data in recent
months (notably in the US) has yielded both very strong and very
weak signals, further stoking the market’s confusion.
Having peaked in February, our proprietary ‘macro matrix’
indicator deteriorated into ‘impairment risk’ territory by October.
The credit markets worsened early in the second quarter due to
worries regarding the effect of US Federal Reserve (Fed)
tightening and this acted as a lead indicator for macro numbers
that contracted more sharply in the second half of 2018. Looking
back, an early sign that 2018 was likely to be a ‘risk-off’ year
started with the collapse of bitcoin, as well as crises with key
emerging market currencies, notably the Turkish lira and
Argentinian peso. This, in our view at the time, was not a great
surprise as the Fed-driven liquidity squeeze was always likely to be
first felt by indebted emerging markets and speculative financial
assets. However, this correction then rolled through risk assets,
eventually leading to the correction in US equities in December.
ETF flows were negative all year as investors became more
defensive, raising cash and investing in quality debt. This constant
selling has weighed heavily on European equities and other risk
Returns & Valuations:
European indices de-rated materially during 2018. The Stoxx
Europe 600 price/earnings ratio peaked around 17x in 2015, driven
by the European Central Bank announcement regarding its
quantitative-easing programme and later at 16x after the 2016-17
rally. By comparison, in 2018 the Stoxx Europe 600 fell to below
12x*. Across Europe’s markets it was a similar story of losses for the
year: FTSE -9%; Dax -18%; CAC -11%; and SMI -10%. The main
drivers of this were growth companies, many of which de-rated by
20–30%†, and industrials which are now trading at, or below, their
2012-15 range in terms of price/earnings multiples. It is notable,
however, that quality defensives continue to trade at all-time-high
There were very few places to hide and defend in 2018:
Cyclicals (including steel -25%, building materials -23%,
autos -28%, and industrials -15%) were down
- Eurozone banks (-33%) also had a very tough year*.
- Meanwhile, growth stocks finished the period flat having
peaked at +24%*.
- The top-10 mega caps were the only notable place to
hide and materially outperformed from March helped
by pharma (Novartis +6%, Roche +2%, Sanofi +10%) &
food producers (Nestle -2%, Unilever +4%)†.
- Elsewhere, the MSCI top-10 market caps were up +3%#.
In 2018, profitable stockpicking was extremely difficult,
particularly on the long side as a vast majority of
companies de-rated, often despite there being a lack of
negative, company-specific news. Having performed well
for much of the year, our long investments were negatively
affected more than we had anticipated in the final
quarter’s capitulation. In particular, the high-margin, high
free cashflow growth stocks were significant laggards.
Overall, our stock selection did not have a materially
negative affect during the year and maintaining a low net
exposure certainly helped limit the downside.
The first nine months of the year were nicely positive for
the portfolio, capturing 2.7% in alpha. However, the
collapse in growth stocks and cyclicals in the fourth
quarter led to negative alpha of 4.1%. Overall, this left us
with a small negative alpha for the year.
Longs -1.3% (fourth quarter -2.5%)
Shorts -0.2% (fourth quarter -1.6%)
Total portfolio -1.4% (fourth quarter -4.1%)‡
Due to maintaining a low net exposure throughout most
of the year, we only captured 21% of the market downside.
Our reduction of net exposure during January materially
added to the beta performance of the portfolio as did
increasing net into September lows.
Total portfolio -2.2% vs market -10.6%‡
BALANCE SHEET MANAGEMENT
Having initially cut net exposure on the day of the
market peak in January, we maintained a lower-than-average
net (between 0–45% for the last 11 months),
guided by our macro matrix model. We increased our
net exposure in September to 44%, which rose to
48% in October as we saw the credit market had
improved and stocks we had sold at the peak had
fallen significantly. This, however, proved to be a
short, false dawn and we therefore reduced net
exposure. In hindsight, we should have been more
aggressive in cutting higher-beta names and
maintaining a very low net throughout the second
half of the year.‡
OUTLOOK: SCENARIOS FOR 2019
As we start 2019, Sino-US trade talks have resumed,
Chinese authorities are stimulating the economy
through a variety of channels and Fed chair Jerome
Powell seems to have provided the assurance needed
that Fed policy is not going to choke the US economy
via ‘auto pilot’ interest rate rises. Investors should take
some comfort from the fact that valuations are much
lower now than at the start of last year. The question
for investors in 2019 is whether global economic
growth will continue to slow down or even halt with
corporate earnings materially affected, or will we see
2019 as the culmination of a soft patch for growth and
a great opportunity for equity investors.
In the past few years, our outlook has generally been
constructive towards European equities. In 2019, we
have a more balanced view, as this year is likely to be
either very good or very bad depending on how the
macro environment develops. The year may be the
proverbial game of two halves, with the first six
months being highly uncertain and volatile as the
market sentiment swings around depending on
incremental data. If the market materially corrects, this
could present a great opportunity for the second half.
The question for investors in 2019 is whether global economic growth will continue to slow down or even halt with corporate earnings materially affected
Bull Market 40% likelihood
This would involve markets remaining cheap and the
‘Goldilocks’ scenario of growth plus low inflation playing out
in 2019, which would be supportive of risk assets. The
opportunity here would prompt us to maintain a high net
exposure focusing on quality industrials and mid-cap growth
companies which exhibit strong business models, high
barriers to entry, value creation and that were overly de-rated
Trading Range 20% likelihood
Markets could rebound in early 2019 given they became so
oversold in late 2018. With deteriorating global economic
growth in early 2019 the market upside is likely to be limited
and equities trade within a 15% range. Under this scenario we
would reduce exposure into rallies and buy into weakness
until there was clarity on the direction of the economic cycle
and central bank policy.
Bear Market 30% likelihood
The Fed will be seen to have over tightened, global growth
suffers more than expected, deflationary pressures re-appear.
Risk assets including European equities perform badly.
Eventually the Fed cuts interest rates and stops reducing its
balance sheet. Should this happen, we would maintain a low,
or short, net exposure until the credit and macro indicators
stabilise. Positive returns will only be generated from short
positions where the focus would be companies with high
operational and financial leverage. As the huge majority of
share prices fall and de-rate, the long positions will aim to
outperform the index.
Collapse 10% likelihood
As we have mentioned in previous outlooks, the bear market
outlined above could become a full-blown crisis with a
breakdown in global trade, debt defaults and/or the break-up
of the European Union. Opportunities to short will be high,
with many stocks falling dramatically and many requiring
refinancing. We would remain net short until all central banks
begin returning to materially expansionary policies.
Past performance is not a guide to future returns. The return may increase or decrease as a result of currency fluctuations.
The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be
assumed that any of the security transactions discussed here were, or will prove to be, profitable.
*Source: Bloomberg as at 31 December 2018. †Source: FactSet as at 31 December 2018. #Source: Martin Currie and FactSet as at 31 December 2018.
‡Source: Martin Currie over twelve months to 31 December 2018. Strategy figures in Euro from representative account using official NAVS calculated by the administrator and net of all fees and
expenses. This data is presented net of investment advisory fees, broker commissions, and all other expenses borne by investors. The figures provided includes the reinvestment of dividends.
The annual fee rate used is 1.50% with a 20% performance fee. The strategy is not constrained by a benchmark but is shown versus the MSCI Europe (LC) for illustration purposes only.