Global markets saw a significant increase in volatility over the last three weeks of 2018, particularly in US equities, US rates and global currencies. As our last Quarterly Asset Allocation meeting was in early December 2018, we felt it prudent to hold an ad hoc Asset Allocation meeting to re-evaluate our views given new macro-economic events and different price levels.
What has changed since early December 2018? There were several factors that negatively impacted US financial markets, which were the dominant drivers of risk sentiment over the final weeks of the year:
- The US Federal government shutdown on 22nd December 2018;
- US leading indicators continue to show slowing, albeit positive, economic growth (e.g. ISM Manufacturing dropped to 54.1, the lowest point in two years) while other global leading indicators show a more pronounced slowdown;
- The Federal Reserve (the Fed) hiked rates by 25 basis points to 2.5% (as expected) but said that future hikes would be data-dependent (unexpected); and
- Specific company earnings announcements (e.g. Apple) indicate that China trade disputes are having meaningful negative implications.
As a result, markets sold off steadily and sharply between 7th December and year end. For context, the S&P500 – which was already -9.6% from its 2018 peak – fell another -11.3% between 7th December and year end. The sell-off in the US equity market was more pronounced than in other markets. During the same period, non-US equity markets – similarly, already -4.8% from the 2018 peak – sold off another -5.5%. Emerging market equities outperformed by losing less, selling off -3.2% over the same December period. In the risk-off move, US rates rallied – 56bp tighter for 10y US government bonds (UST) and 48bp tighter for 2y UST. (Note: All numbers are in local currency terms.)
It was a bumpy and volatile end to the year for asset prices.
Against this backdrop of negative items, there were some positive developments in the first week of January 2019 that led to a retracement of much of December’s losses. These included (a) softer language from the Fed, indicating fewer rate hikes and a more flexible approach; (b) a halt in the decline in oil prices, which had fallen 40% over the prior three months; and (c) a surprisingly strong US employment report for December 2018.
Consequently, markets rallied over the first week of 2019, retracing nearly two-thirds of the sell-off over December.
Results of this January 2019 Asset Allocation Meeting
The Asset Allocation team revisited several of the geo-political and macro-economic themes that concerned us in the early-December meeting. Most remained unchanged and confirmed our outlook of slowing trend global growth with potential for more extreme positive or negative returns given events. The next month will see ongoing but critical news on US-China trade policy; UK-EU Brexit approval; fiscal and political challenges in France, Italy, Germany and the US.
Our largest new concern is the US Federal government shutdown, which appears to be extending far longer than anticipated and could have potentially meaningful economic implications . Given prior evidence that economic growth is slowing in the US and globally, we view the US Federal shutdown to be another weight on any upside shown by December’s employment data.
On 7th January, the Asset Allocation team made the following decisions.
- We will reduce from Underweight to Strong Underweight our allocation to European equities. We remain uncomfortable with the geo-political risk factors across Europe.
- We will reduce from Overweight to Neutral our allocation to Small-Cap Strategies. The strategy is implicitly higher beta (more volatile) and more susceptible to tighter credit conditions and slower economic growth.
The capital released by both actions will be reallocated across remaining equity portfolios, retaining our Neutral allocation to global equities, but with a slightly more defensive profile.
Separately, the Asset Allocation team re-evaluated our Overweight allocation to Emerging Market Equities. The primary drivers for our view remain intact – lower oil prices, near the end of US rate hikes, low multiples and more upside return if growth is positive. If anything, many of these factors are more attractive today. However, China remains a key driver for Emerging Market returns. We believe that potential outcomes to a US-China trade policy as well as more clarity on China’s growth slowdown will be important factors to reconcile before any increase to an Emerging Market allocation.
The Asset Allocation team also re-evaluated our Strong Underweight allocation to Interest Rate Risk (e.g. longer maturity government bonds), given recent moves wider in US nominal and real yields. There was discussion as to reducing the Strong Underweight allocation to Underweight, given the more even balance of upside and downside macro-economic risk facing the US market. Should more evidence emerge that a US recession in 2019 is meaningfully probable, we would look to reduce this Underweight.
The Asset Allocation team re-evaluated global credit markets, given the significant widening in credit spreads. The team unanimously rejected the argument that spreads (over government bonds) were cheap at current levels. Moreover, the tradable liquidity and structural dynamics of credit markets remain unattractive.
Finally, the Asset Allocation team re-evaluated our Overweight allocation to Gold (where permitted), given the recent market volatility. We noted that the allocation worked as a hedge against market volatility and we did not see any reason to change it at the moment.
Treading Carefully into 2019
Looking forward, we believe that this quarter will be similarly bumpy and driven by several geo-political events. We are monitoring closely developments in the UK (the Brexit process), Europe (France, Italy and Germany) and the US (Federal government shutdown, US-China negotiations, the Fed).
I would note FedEx Chairman & CEO Smith’s quote during the 19th December earnings’ call as appropriate: “I’ll just conclude by saying most of the issues that we’re dealing with today are induced by bad political choices. I mean, making a bad decision about a new tax, creating a tremendously difficult situation with Brexit, the immigration crisis in Germany, the mercantilism and state-owned enterprise initiatives in China, the tariffs that the United States put in unilaterally. So you just go down the list, and they’re all things that have created macroeconomic slowdowns.”
Our next Quarterly Asset Allocation meeting is scheduled for mid-March 2019. However, we do meet frequently to discuss portfolio specifics and broader market trends. Should the current volatile market conditions continue, we will re-evaluate asset allocation frameworks more frequently.
We continue to view market volatility as an opportunity, particularly for less-constrained capital which can afford a longer investment horizon. We continue to believe that an effective top-down asset allocation framework accentuates our bottom-up portfolio construction to generate long-term real returns.
Sandaire’s Investment Committee