This time last year, markets were marvelling at how well underpinned the global economy was with all 45 countries tracked by the OECD growing together for the first time in over a decade. Fast forward to today, and the market’s demeanour has soured. According to Deutsche Bank, the vast majority of financial assets have delivered negative returns in 2018, the worst performance in years.
Total Returns in USD and local currency have reversed the trend in 2017
So what changed and why have markets performed poorly? First, growth has started to slow, impacted global trade where US and Chinese tariffs have checked investment and capex. Second, real interest rates have turned positive. The chart below highlights how the rate of change in interest rates this year has outpaced that of inflation. Third, after years of asset price reflation, central banks are reducing the size of their balance sheets by reducing or stopping their bond purchase programs. All of which has upset the “unstable equilibrium” of ever-increasing asset prices and a benign growth outlook.
US Fed Funds Target Rate and US Inflation
Heading into 2019, we see a broad deceleration in trend growth but no recession. This is evidenced by our model which plots economic activity against credit conditions. The interplay of the two suggests that global growth is challenged but that US activity remains robust. Risk factors, however, have increased and we note the increase in spreads * this year across credit markets, both in high grade (see chart below) and high yield bonds. This may suggest tighter credit conditions ahead.
*spread = the aggregate yield difference between corporate bonds and government bonds
Global Investment Grade credit spreads have increased across the year
With a deceleration in growth rather than contraction in mind, we see no reason to reduce our absolute exposure to equity markets. A recession is unlikely to occur without some supply or demand shock or either a sharp acceleration or deceleration in inflation. Nonetheless the range of potential outcomes has widened and we acknowledge this by redeploying some of our regional exposure away from Japan to other developed markets. This effectively sets us back to a more neutral weighting geographically, while retaining an overweight to Emerging Markets and an underweight to UK and Europe.
In Fixed Income, bond yields have generally widened this year but remain expensive. Much has been made of the shape of yield curves and whether they represent an early indication of a slowdown or recession. Two observations we would make are that : it is the short-end of bond markets that matters more for recessionary signals – and these are not flashing red; and any inversion in yield curves only matters with a lag, the shortest of which is around nine months. Hence we maintain underweight to the asset class, with a preference for less interest rate and less corporate credit sensitive areas of the market.
US Treasury Bond Yields – 1yr bonds vs 10 yr bonds
For US equity markets we reiterate our neutral view. The pullback in valuations, which might have been expected given the significant outperformance of US versus the rest of the world this year, has reset p/e ratios but the margin of safety remains slim. Federal Reserve Chairman Powell’s comments on the likely policy response to a slowing economy is also encouraging, raising the potential for a pause in interest rate increases. But the challenges of managing a late cycle fiscal stimulus, a tight labour market and slowing trade are not without risks. Hence our neutral view.
We have persisted with our Emerging Market (EM) overweight and would restate the case for outperformance; the potential for a Federal Reserve bank “pause” arrests the rise in the US Dollar which has been a negative for Emerging economies. Any diffusion in trade tensions between the US and China will be supportive, as will a lower oil price, and the underperformance of EM this year means relative valuations remain attractive.
To achieve a balance in risks within our equity exposures, we concluded that reducing our Japan exposure and retaining our underweights to the UK and Europe was appropriate. Although we continue to see improvement in shareholder returns in Japan and policy remains accommodative, GDP forecasts and consumer confidence have turned noticeably lower. Temporary factors such as recent natural disasters may explain some of this but the economy may be showing signs of vulnerability to the effects of the US/China trade dispute. The UK remains unloved as Brexit negotiations and political risks place a check on investment. In Europe, as we highlighted in November, the central bank is withdrawing liquidity just as inflation moderates and domestic activity fades. Political risks are also rising not just in Italy but now in France. While markets have cheapened, valuations are not compelling enough versus the rest of the world.
The Investment Committee also reflected on the style bias inherent in portfolios. We concluded that reducing the growth bias was appropriate and that this would be best effected by reducing some small cap fund exposure and redeploying cash in a global index of companies that have lower volatility characteristics.
These changes in aggregate should allow portfolios to better withstand a more challenging environment in 2019. US growth is unlikely to stall but markets are untested when it comes to a prolonged trade war and what happens when central banks stop buying financial assets. The risks and the opportunities that arise from these two themes will be our focus next year.
Kevin Corrigan, CIO