So what does post-peak mean? Post-peak is a world of weaker economic activity, slower earnings growth, somewhat higher inflation and a normalisation of monetary policy. Those things occur because economies at full employment firstly cannot grow much faster than they are already; secondly companies? will face pressure on costs, which can eat into profit margins; and the combination of weaker growth and profit margin compression is the story of the weaker earnings environment that we expect to see. Fully employed economies tend to generate a bit more inflation and that can lead to some normalisation of monetary policy.
This combination of factors is likely to result in markets that are a little more unsettled; investors in that world are also likely to worry a bit more about things they have previously ignored, such as trade conflict or geopolitical uncertainty.
For portfolio construction this means both lower returns and higher volatility, while Sharpe ratios will be lower. The ‘free lunch’ of relying on market index tracking offered by passives may not look quite so attractive in a post-peak environment.
In the technology sector we think that investing in a post-peak environment is particularly interesting. Technology shares tend to fall quicker and then bottom out before other sectors of the market. We saw this in the Great Financial Crisis where the technology sector bottomed out a full five months before the broader market, which bottomed in March 2009. Therefore we actually relish a post-peak environment because we see an opportunity to pick-up great growth names at very cheap prices once the bottom has set in.
In a post-peak environment I think stock selection plays a more important role than normal. When the market is booming across the board it makes sense to invest in an index, which is just the average of the market, but in a post-peak environment stock selection makes a lot of sense. For example, companies that have strong bargaining power to suppliers, pricing power to clients and robust financials allows the company to be managed more flexibly. These factors are all very important in determining the winners as not all companies will gain business so this is why stock selection is very important to us.
People are currently speaking about a post-peak environment, but the benefit of investing systematically is that we do not need to have a view on this. I do not need to know if we are in a post peak or not or if we are going to have a bear market in equities or in bonds; we do not know because we do not really care and this is again the benefit of investing systematically. You extract stuff –returns from capital markets which are independent of directional movements in traditional asset classes. Therefore we are actually looking to 2019 just as we looked at 2018, ie where are our risk premia? They continue to be there and are likely to stay and we're likely to benefit from them.
I think the whole idea of a peak is much more of a developed markets theme than for emerging markets (EM). Because while we have seen rates go up in the US, and we will probably see them go up in Europe next year, rates have been much more volatile in EMs therefore we are not seeing the same adjustment to a period of higher rates, of changing equity valuations, etc. I think what we are seeing is a resumption of flows to emerging markets. Therefore, while I think the peak is probably quite a significant deal for the major markets, I think for emerging markets we have got a slightly different narrative ahead of us.
Asian and Chinese equity markets have already corrected about 25 to 35% from the peak. If we look at individual stocks some of them have fallen more than 50%, while the valuation of Asian equities are trading at a 40% discount to US equities from a price to book or price to earnings perspective. This suggests a lot of negative factors have already been priced in and I believe now could be a good time to start bottom fishing in Asian equities.
The housing market is quite resilient at the moment and we are still very positive on the US mortgage market. We are maintaining our credit exposure at a very safe level because of the potential for a decline in the economy. We are not sure how extensive a recession will be, if we actually end up in a recessionary scenario, but we're prepared for it. I think the housing market and the credit market in the mortgage industry will survive it very nicely because we have learned a lot of lessons since the last crisis. The mortgage industry was a big cause of the crisis, but it will not be the cause of the next crisis for sure.
Whether we are in a post-peak environment or not is very important but perhaps more important is what central banks around the world are doing in terms of monetary policy. Now clearly 2018 has been a very difficult year for most asset classes and this is largely because the Federal Reserve has been raising interest rates and reducing the size of its balance sheet. Looking ahead, I think the outlook for markets is going to be very influenced by what the major central banks are doing. While we think growth may have peaked, we are still seeing low levels of unemployment and reduced levels of spare capacity so it looks to us that we will be in an environment where central banks will generally be looking to tighten rather than loosen monetary policy and in such an environment we believe that it is going to be another difficult year for a lot of traditional asset classes.