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Outlook 2019: key themes

8 January 2019

We asked a number of our fund managers to highlight the key themes they are looking out for in 2019 and what the impact is likely to be for their respective asset class.

The financial impacts of climate change

John Seo, Co-Founder and Managing Director of Fermat Capital Management LLC

We believe the insurance-linked securities (ILS) market is at the forefront of monitoring for the impacts of climate change on economies and on markets. New or unexpected impacts from climate change, particularly in the US, are likely to show first in the prices of ILS, in our view. There are a number of reasons for this.

Putting aside other complex societal considerations, from a purely financial point of view climate change acts on investments just like inflation: by potentially eroding long-term real return expectations. Currently, expectations for climate change and inflation are both at relatively mild levels, but it is expectations regarding the future that drive much of the concern in both climate change and monetary policy. Yet, inflation happens on a time scale that is 10 times shorter than climate change – witness how inflation is typically forecast for no more than 10 years, while climate change is commonly forecast for up to 100 years. With this in mind, we believe it is important to focus on asset duration when it comes to climate change vulnerability. Most ILS have a one-year term, while the longest dated have a three- to five-year term at issuance. In contrast, cities and large-scale infrastructure exist on a decadal timescale. While some traditional investments are highly vulnerable to the long-term impacts of climate change, ILS can reprice their returns to climate change "inflation" in the relative near-term.

What we have seen over the last two decades is that the ILS market has been responsive to climate change and this has largely been priced in on a forward-looking basis. More generally, we believe this means the architecture of the ILS market is that of a "climate linker" and / or "climate-indexed floating rate bond."

US Dollar may weaken in 2019

Adrian Owens, Investment Director, Global Macro & Currency Fixed Income

The US dollar is facing a variety of competing forces. In the near term, we believe the dollar is supported by still relatively impressive growth, interest rate differentials and an indifferent growth outlook in Europe, China and Japan. That said, as we look into 2019, the US growth differential with the rest of the world is likely to narrow, in our view, and if the US economy slows more meaningfully the US deficit could become a real concern given Mr Trump’s pro-cyclical fiscal policy. Mr Trump’s rhetoric could also become more of a negative for the currency; he is already trying to influence the Federal Reserve and it would not be a great surprise to us if he actively started to promote a weaker currency to support exports. Given such concerns, we believe the risks over the course of 2019 are towards a weaker US dollar.

The oil price and commodities

Fabien Weber, Portfolio Manager, Currencies and Commodities

We currently have a situation where there is overcapacity of oil and, in our view, that is why the price collapsed in the last couple of months of 2018. There is often some seasonality to the oil price: it is normal for demand to be lower in October and November due to maintenance work at refineries, yet we were surprised by the extent of this correction and believe this has been a typical overreaction and overcorrection.

We believe the market is too negative in terms of expectations as there has been some positive momentum in the market. Prior to the introduction of new sanctions against Iran in early November, orchestrated by the US administration, waivers were issued to eight importing countries including Turkey, China, Japan and South Korea. This means they can continue to import without limitations for the next six months.

Overall, we expect the market to have a slightly positive edge in the first half of 2019 and, from a technical perspective, could easily have a 5% to 10% positive correction. This has been helped by the announcement, in early December, that oil production would be cut by 1.2 million barrels per day by the OPEC+ countries, led by Saudi Arabia. Nonetheless 2019 could potentially be a repeat 2014, in light of the ever increasing supply out of the US and the softening of the demand, and much depends on whether Saudi Arabia will fight market share or the price level.

Outside the energy sector, commodities are currently being driven by geopolitics and macro factors like the ongoing trade war between China and the US. This particularly impacts industrial and agricultural products. If they can resolve the situation we believe it would be very positive for commodities and the focus would turn again to fundamentals, which for industrial metals are far less negative than what is currently priced in, especially in light of generally low inventories. Precious metals and gold in particular should also start to benefit from the perception that the US Federal Reserve is not so far from a neutral monetary policy. Finally, the agricultural sector had a difficult 2018 due to a highly supplied market - in our view 2019 will likely not be any different and should depend very much on weather patterns.

Any progress in US-China trade talks beneficial to Chinese equities

Jian Shi Cortesi, Portfolio Manager, Asia/China Growth Equities

Sentiment towards Chinese equities turned negative in 2018 as investors became increasingly unsure about how the Chinese economy would be hurt by the US-China trade war. The US administration slapped tariffs on almost 50% of imported goods from China in 2018 in order to balance out a trade deficit between the countries, but also to tackle head on what were dubbed to be unfair trade policies from China towards the US.

We believe that the trade war will continue to be a major theme driving investor sentiment and stock market moves in 2019. That said, investors have shunned Chinese stocks and valuations have come down to very low levels, at 11x price / earnings including internet stocks, and 8x price / earnings without. Therefore, if we see any progress in trade talks in 2019 between the two countries, it could be a strong catalyst for Chinese equities. In our view, market sentiment turning from ‘very pessimistic’ to just ‘less pessimistic’ could be enough for Chinese equities to rebound from their current low levels.

Credit risk and new opportunities

Gary Singleterry, Investment Director, Asset Backed Fixed Income

Two of the key exposures for mortgage-backed securities (MBS) are credit risk and mortgage prepayment risk – in our view they are the sources of both opportunity and risk in our market. Since 2011 we believe credit risk in the US MBS market has been a significantly more attractive area than taking the mortgage prepayment risk, which is a phenomenon that is more important to the agency market.

We continue to see the credit side of the MBS market as being attractive for the foreseeable future. While we believe mortgage prepayment risk has been relatively unattractive for several years that, too, is starting to look more interesting. We will continue to watch it closely and if we see a good entry point we will likely look to participate.

For us, one of the attractions of the MBS market is the fact there are so many different pockets of opportunity. Some of those opportunities today are around financing mortgages which have been non-performing, or have been modified and are now re-performing. There have been some interesting developments in this area and the securities markets are now being used to finance those portfolios. We are also finding interesting opportunities in the agency financing of big apartment buildings. Rental demand has been strong and we think it will continue.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a specific security is not a recommendation to buy or sell that security. Past performance is not an indicator of future performance and current or future trends.