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Quarterly Market Review

International equities experienced meaningful declines during the fourth quarter as the sharp sell-off experienced in US financial markets spilled over into the global sphere. Developed markets were hit particularly hard, shedding more than 13% during the quarter. Emerging markets held up somewhat better than developed markets, experiencing losses of approximately 7% for the period.

Before diving into our outlook, it is helpful to provide context on how we are thinking about financial market risk at this stage in the economic cycle. More specifically, toward the end of last year, we held the view that international equity markets were in a higher risk regime, and in the fourth quarter, several of those risks manifested in significant realized volatility.

The fourth quarter’s drawdown was, in many regards, an extension of the selling pressure experienced throughout the entire year. We believe the implications of decelerating global growth was a key driving force behind the volatility; and that underlying concern was exacerbated by mounting investor fears over escalating trade tensions, geopolitical uncertainty, and the potential for yield curve inversion.

Going forward, the current investment climate is likely to be highly dynamic. While our economic indicators do not yet suggest that a global recession is imminent, our view is that a cautious stance is warranted. Now more than ever, we believe that an active approach is appropriate to navigate today’s turbulent market environment.

Opportunity in Exchanges

During the volatile fourth quarter, our actively-managed investment processes led us to add two new names to some of our portfolios: London Stock Exchange (LSE LN) and Deutsche Börse (DB1 GR). We are attracted to the financial exchange industry through a mixture of our top-down and bottom-up processes.

Beginning with the macro, we believe rising interest rates and a pickup in volatility are likely to act as tailwinds for an upturn in trading frequency, encouraging an acceleration in revenues and earnings growth. In general, these revenue characteristics imbue the financial exchanges with a counter-cyclical dynamic, making them a good fit for our more cautious macroeconomic overview.

From a bottom-up perspective, there are over a dozen mid- to large-cap global exchanges, and they make money in several ways. We find that those exchanges whose revenues are reliant on market & index data licensing and/or derivatives trading are good Strategic Profile strategy fits because their revenue streams have higher barriers to entry, their expenses are largely fixed, and they have lower capital intensity needs. Both LSE and DB1 fit these criteria.

LSE and DB1 have similar characteristics that we believe make them compelling. Both companies have massive scale, and each are among the largest non-US exchange operators. Exchanges naturally benefit from network effects: The more participants that use an exchange, the more liquidity there is on that exchange, and the more attractive it becomes to trade on that exchange.

Additionally, both firms derive a significant portion of revenues from derivatives trading and clearing, a stronger business than other exchange business models. For most derivatives, trading costs are very low compared to the margin costs that are required to be held against it. Therefore, clearing efficiency (the ability for an investor to reduce clearinghouse margin by netting off positions) is very important. It encourages investors to do all of their trades on a single exchange and usually makes derivatives clearing a terrific business for the incumbent.

Regarding key differences, LSE also has a robust index licensing business. Index licensing is a particularly attractive subset of market data as secular ETF growth increases demand. Now that the company’s primary drivers have evolved into derivatives and index licensing, we believe LSE is well-positioned for the years ahead.

For DB1, they too have an index licensing business, but their European settlement services are particularly noteworthy. The German-exchange operator participates in an effective duopoly as customer desire to settle trades and post collateral at only one place provides a strong barrier to entry. With strong competitive dynamics in its key businesses, we view DB1 as potentially a strong investment opportunity.

The data presented is for informational purposes only. It is not to be considered a specific stock recommendation. Unless otherwise noted, figures shown are based in USD.

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The MSCI Emerging Markets Index (MSCI EM) is a free float-adjusted market capitalization index designed to measure large and mid-cap representation across 24 Emerging Markets countries. The Index returns do not reflect any fees or expenses. The Index is denominated in U.S. dollars. The Index returns are net of withholding taxes. They assume daily reinvestment of net dividends thus accounting for any applicable dividend taxation.

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