Slowing Growth Raise Amber Warning Signs

Backdrop

Given the market volatility over the 2018 year-end, we held an ad hoc, Interim Asset Allocation meeting on 21st January 2019. At that interim meeting, the team made three decisions: (a) reduce our allocation to European equities from Underweight to Strong

Underweight; (b) reduce our allocation to Small-Cap Strategies from Overweight to Neutral; and (c) reduce our allocation to Leveraged Loans across portfolios. The capital released by all three changes were reallocated across remaining equity portfolios, retaining our Neutral allocation to Equity but with a more defensive profile.

Since the mid-January Interim Asset Allocation meeting, global markets have been markedly more muted than observed in December 2018 and January 2019, with equities, fixed income and credit market prices moderately higher. Volatility metrics, such as the VIX index, have been range bound around 15 points – less than half the 35 peak observed in mid-December 2018.

What has changed since our last interim Asset Allocation meeting in mid-January 2019?

  • Global economic growth metrics are visibly slowing in several major economies, such as Japan, Germany, Italy and the United States.
  • Whilst 4Q 2018 corporate earnings were strong, market consensus for 1H 2019’s corporate profitability show a material downgrade to Earnings Per Share (EPS) forecasts across many sectors and regions.
  • Valuations are slightly higher on a nominal basis and slightly lower on a multiple-of-earnings basis.
  • Both the Federal Reserve (Fed) and the European Central Bank (ECB) have pivoted to more dovish language in response to slower global growth measures. This has resulted in higher valuations (lower yields) for fixed income and, to a lesser degree, for equities.
  • Discussions between the US and China on tariffs and trade barriers appear to be progressing, but with no visible conclusion as of yet.
  • Discussions between the UK and the EU on changes to the proposed Brexit Deal have stalled, with the 29th March 2019 deadline approaching.
  • Political rhetoric is becoming increasingly populist, anti-elite, and anti-corporate in the US and other European countries (e.g. Italy, France).
  • China growth continues to slow, but from still high levels. The Chinese government have been implementing fiscal stimulus into the economy across several avenues.

Update: 1Q 2019 Asset Allocation Meeting

Against this backdrop, we held our 1Q 2019 Asset Allocation meeting last week. The review went into depth on the economic, market and technical drivers of each geographic region – both inter-market and intra-market.

The key take-away was that we are not changing any asset allocation view at this time. We remain comfortable with our existing tactical asset allocation views and believe that many of the fundamental drivers and investment themes that we have identified remain intact, if not progressing as expected. A ‘no change’ outcome is not unexpected given that we had an interim asset allocation review on 21st January and that the majority of the metrics that we monitor have behaved as expected.

Importantly, the debate throughout the day highlighted those areas where the team’s opinions are shifting – and consequently, those asset classes (or regions) where we will be monitoring development more closely. These included our Underweight view on UK Equities and our Neutral view on Japanese Equities, both of which have seen valuations cheapen in the face of deteriorating fundamentals. The debate, in both markets, centred on whether valuations have cheapened sufficiently enough to offset the weakening fundamentals – or, what we have to see change in the macro-economic data to make current valuations more appealing to us.

The discussion also confirmed support for the team’s strongest asset allocation views – namely, Overweight Emerging Market Equities, Underweight Fixed Income (Duration) and Strong Underweight European Equities. In all three cases, we have strong views on the implications of global trade (and, implicitly, US & China tariff discussions) and global growth dynamics on each market that are not fully reflected in current valuations. In each market, we will be closely monitoring economic data, valuations and geo-political factors and will have more interim asset allocation meetings as appropriate should these factors change.

We remain Neutral overall on Global Equity and on US Equities given valuations, current risk-free rates and geo-political factors. We note that US Equities have seen very strong earnings growth over the last year, but that earnings growth going forward is expected to slow meaningfully. Current valuations are in line with historical averages but are also the most expensive across global markets.

We remain comfortable owning minimal Corporate Bonds (Credit). While corporate bond valuations are in line with historic averages, we do not believe that market liquidity is appropriately priced into current spreads.

We continue to like US TIPS (inflation-protected government bonds) and Gold as attractively priced hedges against stronger-than-expected inflation in the US market, which is consistent with our Underweight Fixed Income (Duration) view.

We also did not make any changes to allocations across Styles, continuing to reduce slowly our allocation to Growth and Small-Cap Strategies and to recycle proceeds into the Global Equities Min Volatility ETF to maintain a neutral allocation to global equities but within a lower risk profile.

Looking ahead: greater divergence and slowing growth

Across many of the models that we actively monitor, global growth continues to slow across regions. The US market is still showing healthy growth metrics, but even this trend has been decelerating over the last few months. The pace of deceleration in economic growth is more pronounced in Japan, Italy, Germany and (less so) in China. Importantly, economic growth is becoming increasingly concentrated in fewer regions – reliant upon both the US and the Chinese economy. The fact that these two economies are also engaged in a trade war is not helpful.

We remain concerned over the expected trajectory of corporate earnings across many regions on two levels.   First, consensus forecasts show a slowdown in earnings which is troubling. Second, the same consensus forecasts are expecting (hoping?) for a sharp recovery in earnings in 2H 2019. Historically, this has proven elusive absent any one-off factor.

Looking away from economic trends, the world continues to face many important geo-political events that will impact market volatility over the next few months – e.g. Brexit (deal, no-deal, or defer), trade discussions with the US, apparent changes in policy paths by the ECB and the Fed, and increasing populist rhetoric from politicians.

Our next Asset Allocation meeting is scheduled for mid-June 2019. However, we do meet frequently throughout the week to discuss broader market trends, geo-political developments as they impact our portfolios, and current market valuations. As demonstrated in January, if necessary, we will convene an Interim Asset Allocation meeting to review current recommendations in the face of significant changes to market prices, economic developments or geo-political factors.

We continue to view the heightened volatility in markets as an opportunity, particularly for unconstrained capital that retains ‘dry powder’ and long-term investment horizons. In this light, we strongly believe that forward-looking top-down asset allocation alongside in-depth bottom-up portfolio construction should generate attractive long-term real returns.

Sandaire’s Investment Committee