The most remarkable feature of market performance in the first eight months of the year has been bifurcation. US equity market performance has easily outpaced the global peer group, with select information technology stocks leading the way. In fixed income markets, the long end of bond markets has hardly budged, even as the Fed has clearly presented the case for further rate hikes and the ECB has edged in the direction of ‘normalisation’. Emerging markets have borne the brunt of trade disputes and dollar strength, but some parts of the complex (Mexico) have fared better than others (Turkey, Brazil and Argentina).
In part, we believe US equity outperformance can be explained by the positive impact on cash earnings from last year’s tax cuts. Equally, a solid rebound of US economic activity around mid-year – in contrast to soggier numbers in Europe or emerging economies – seems to have bolstered the case for US equities. Underpinning much of the market performance has been a clear investor preference for reliability, which translates into companies and countries where cash flows and growth are more predictable. Whereas in 2017 markets were characterised by momentum, value and expanding multiples, 2018 seems to have seen a return to global quality as the favoured attribute for investors.
The question, with which the committee grappled, is whether bifurcation, preference for predictability and US outperformance will remain the market narrative through year end. Much of the discussion focused first on why the market dynamic switched early this year.
In part, we believe investors have taken a more guarded approach due to the return of market volatility in the first quarter of 2018, even if the proximate cause of the February sell off (fears of higher US inflation) proved unfounded. In our view, another factor pushing investors toward a more defensive stance has been the poor performance of emerging equities and emerging local currency debt strategies, which were undermined by fears of global trade conflict and by the arrival of a stronger US dollar earlier this year. After their strong performance in 2017, many investors came into 2018 overweight emerging markets and thus were caught off guard by their sharp reversal. Similarly, concerns about escalating trade conflict, political uncertainty in Italy and sluggish growth undermined the case for European equities, another early 2018 favourite.
Looking ahead, we believe the key questions are whether rotation and fresh leadership will drive equity markets higher and, if not, whether the combination of ‘global quality’ and ‘tech’ can continue to deliver adequate returns for the remainder of 2018.
We believe rotation to non-US equity markets will require a more supportive global backdrop for growth and earnings. That, in turn, should demand a combination of a stable (or weaker) US dollar, the absence of contagion from the most at-risk emerging economies to EM as a whole, as well as a more tangible acceleration of non-US growth. At present, however, none of these preconditions are sufficiently in place to change investor sentiment.
US and global markets could also falter if protectionism becomes more pronounced, US inflation accelerates (re-introducing the risk of a more aggressive Fed tightening) or global growth slows unexpectedly. We believe each of those risks is non-negligible, with the concern that a tightening of financial conditions in emerging markets (given rising risk premiums) might spill over and undermine developed market earnings and growth.
Overall, therefore, we believe the investment landscape does not appear ripe for rotation. If anything, concerns are mounting. Hence, the committee feels it is premature to position for a recovery of ‘value’, whether in global equities or emerging debt and currency markets. In our view, the catalysts for such a reversal are not sufficiently present.
Instead, the committee retains a preference for predictability in various dimensions. Within equity portfolios we remain overweight global quality as a style, accompanied by selective exposure to information technology, with more limited exposure to emerging markets, Europe and Japan. We retain a preference for shorter duration fixed income strategies, including in US mortgage-backed securities, insurance-linked debt and US Treasury notes. We continue to hold non-directional strategies, among others target return and long / short earnings momentum and merger arbitrage strategies.