Portfolio Manager Archie Hart talks about the need to distinguish between the signal and the noise in markets and what this means for his portfolios.
Hello. It is Archie Hart. I run the 4Factor Emerging Market Equity Strategy for Investec.
Today I would like to talk about something a little different and that is about signal and noise. A significant part of a fund manager’s job is really trying to distinguish between the two. Is something a ‘signal’, which needs to be potentially reflected by changes in the portfolio, or is something just ‘noise’, which we can safely ignore, and how do we distinguish between the two?
Markets seem increasingly noisy in recent quarters. The first quarter of 2019 was incredibly strong for asset classes generally. If we annualise first quarter returns for commodities, for example, that would imply an 85% return for the year. That would be the best-ever year for commodities, better than 1973, which is the previous best year. If you annualise Q1 returns for global equities, you would end up with a 68% return for the year, which would be the best year ever for global stocks, better than the previous best year which was way back in 1933.
Clearly, it would be wrong to annualise these returns, but a commentator may look at the first quarter in isolation and say that a new bull market is emerging. However, if you look at the fourth quarter of 2018, what you saw was very significant weakness in markets, capitulation selling, volatility and disorder and one of the worst quarters in markets for many years. Q3 2018 was different again. We saw very flat markets.
So each of the last three quarters has been completely different. But if you look at the end of June 2018 and the end of March 2019, actually emerging market equities were within 1% on both dates. So you can argue that markets have actually been fairly flat and that much of the market volatility we have seen has been largely noise. I think it is quite possible to argue that, in a world where political leadership seems to be largely absent and central banks have surrendered policy to financial markets, equity and emerging markets are essentially trendless.
What does this mean for our portfolios and how we think about them? Remember our investment approach with the very high focus on behavioural finance has always intensely focused on seeking out signal around company valuations, quality and operational momentum, while trying to filter out the daily market noise. We believe it is foolhardy in current conditions to rely on positive macroeconomic tailwinds to drive portfolios. Thus, we focus intently on individual corporate situations where either managements are delivering differentiated performance, where industry environments are improving (for example, consolidation of markets and a lot of businesses in China has given companies pricing power)b or companies which are operating in specific growth market niches or business franchises operating within defensible economic modes.
Three months I made a relatively positive argument for markets. I believed that the Fed needed to stop tightening, China needed to stimulate and trade negotiations needed a successful conclusion but, if we got all that, I thought we had a good chance for a better year of returns. Well, most of that come true and markets are up 10% in Q1 and China particularly is up 18% and the Shanghai A-share market is up 27%. Now, much of that good news may be priced in.
This means we need to be fairly cautious going forward as the market is now pricing in some of that good news. We should also not ignore one very significant signal in Q1 (and I think it is a signal) and that is the inversion of the US yield curve, where 10-year rates went below 3-month rates. Typically, this happens only rarely and when it does, it usually signals US recession a year or two out. So this is going to continue to be a pretty volatile period I think.
That means that it becomes critically important to focus on businesses which are generating free cash flow in what could be a potentially difficult environment. These should at least partially be distributing that to shareholders as dividends, which are likely to be an important source of shareholder return in this environment. The good news is we are seeing increasing dividends coming out of emerging markets. If we just pick the a UAE example, Aldar Properties, a property investment company there, is now yielding over 8% distribution. A chain of petrol stations there is now yielding over 7%. So there is actually some very significant yield there.
Lastly, in this environment, it means we need to focus on managing risks effectively, whether those risks are in relation to governance, environmental and social issues, operational, financial, economic, currency, regulatory or liquidity. I think it is going to be important to stay on top of that.
Looking forward, I think one of the more positive issues that has come through is corporate earnings. Markets were under pressure last year, essentially because corporate earnings in emerging markets were under significant pressure as well. If we look at Q4 2018, as a whole, with about 70% of companies reported now, emerging market equities have only missed by about 1% versus consensus. China actually beat consensus by about 3%.
So what does that imply? I think that analysts’ expectations are more muted, companies are performing more in line with those muted expectations and an environment where valuations are still relatively attractive versus history or versus developed markets. It’s not an environment where we should be very pessimistic but, equally, I don’t think we should just extrapolate a very extraordinarily good Q1.
The value of investments, and any income generated from them, can fall as well as rise.