A common refrain used to explain the challenging market conditions of 2018 is the struggle for supremacy between solid fundamentals and rising geopolitical risk.
To be sure, that characterisation has merit. Much of the fundamental economic backdrop remains well underpinned. Global growth has not been this synchronised since the late 1980s. The number of advanced economies operating at trend growth and near full employment is at a level that is unprecedented in a generation. Advanced economy inflation is returning to norms associated with price stability, but as yet without signs of overshooting. And corporate profits in the US and Japan are near post-war peaks, as measured by various metrics.
Alone, these factors would power advances in equity, credit and emerging markets. Indeed, that was a key driver of superior returns achieved last year. In 2018, however, geopolitical risk has intruded. This has mostly been in the form of trade conflicts, recently via sanctions. Both have taken their toll on emerging debt, currency and equity markets.
Compounding matters is a general sense that the politics driving international economic conflict – at least on the part of the US – are unlikely to change until after the mid-term US elections in November, and perhaps not even then. Similarly, the perception that the US administration appears unwilling to reciprocate to overtures from trading partners for negotiated solutions, which could ratchet down concerns of escalation, is also not helping.
Yet for all the veracity that market participants are paralysed between opportunity and fear, the narrative is neither complete nor a fully robust guide to what choices are on offer for the second half of the year.
Beneath the perception of directionless markets is a more meaningful bifurcation of them. In equities, the US market is back at its January and cyclical highs, whereas European and Emerging equity markets have been trampled. Japan is somewhere in between. In foreign exchange markets, the US dollar reigns supreme. But not all emerging currencies are beaten up – the Mexican peso has more than held its own, for example.
Nor is it true to say that US equities owe their good fortune to FAANGs (Facebook, Apple, Amazon, Netflix and Alphabet’s Google) alone. True, that group has posted another half year of stellar performance, but US consumer discretionary stocks are also at their highs for the year. And even sectors that are still well off their January peaks, such as US staples, healthcare or financials, have been part of the recent summer rally.
In short, the narrative of ‘good versus evil’, while a clear contributing factor, is not a useful enough explanation to account for where we are now and how we should position portfolios for the remainder of 2018.
So what’s missing? For one thing, a preference among investors for quality rather than value. This is not simply a statement about equity factors, but a broader characterisation of investor sentiment. As an equity factor, quality has done well, but this year’s outperformance reflects a more general shift from pure ‘risk on’ investing, which typified 2017 market performance, to a search for demonstrated or credible business models. The former includes companies with above average return on equity and below average debt – in short, firms with sound sources of operating earnings. The latter includes companies built to succeed tomorrow – the technology disruptors and cloud computing providers – who may or may not generate a lot of cash flow today, but are poised with a high probability to do so in the future.
Similarly, the inability of European equities to enjoy their long forecasted outperformance is only partly down to fears of trade conflict. Europe screens as ‘value’ rather than ‘quality’ because its economic recovery from the Q1 2018 ‘soft spot’ remains tepid and unconvincing, hence its corporate earnings story lags. In the regional equity space, the US and significant chunks of Japan more closely represent ‘quality’, where quality implies confidence in the delivery of earnings.
But, equally, the notion that ‘value’ alone is not capturing the investor zeitgeist can be seen in emerging currency bifurcation. Brazil may offer an undervalued currency accompanied by high cash yields, but its fundamental and political backdrop remains in question. For now, the Mexican peso represents the relative ‘quality’ choice.
So how does that help us position portfolios for the second half of the year? If investors wrongly assume that markets are listless, trendless and prone to volatility, the result is investor paralysis. That is all too common at the moment, accentuated by seasonal de-risking. But if the approach is to see bifurcation for what it is, the question becomes: Will quality continue to trump value? Or, alternatively, when will it be safe to rotate back to what is cheap, particularly in the emerging universe?
To answer that question we must return to the economic fundamentals and political backdrop. To put it succinctly, cheap is only going to become dear if the following occur:
So what’s the verdict?
In reverse order, the odds favour some pick-up in non-US growth. Globally, financial conditions remain supportive. Feedbacks from rising income, demand and investment are also supportive.
Moreover, if rest of world growth picks up, dollar appreciation will probably be capped.
The real wild card, therefore, is trade conflict resolution. While it is possible to ponder many scenarios, as well as the motives of those involved, the root of the challenge is distressingly familiar to those following Brexit talks. Specifically, it is impossible to come to a negotiated agreement if one party does not know what the other wants. In the context of Brexit, the UK government’s inability to offer terms backed by a government majority renders negotiation with the EU fruitless.
For Europe or China negotiations with the US are equally unproductive if they cannot discern US priorities. Is it the elimination of barriers to trade, the enforcement of intellectual property rights or the elimination of bilateral trade deficits that the US administration seeks? It could be one, all or none of these possibilities based on Washington’s shifting rhetoric.
Moreover, the US stance appears to be predicated on a deeply flawed assumption that trade is a zero sum game – winner takes all – rather than mutually beneficial. The administration’s stance also has clear political aims of mobilising key constituencies ahead of the November mid-term elections.
If the above scenarios are correct then it follows that the preconditions for a rotation from quality to value – in the broadest sense – will not be met, at least not before November and perhaps not for even longer.
Accordingly, our conclusion is to stick with quality, even if it is expensive. Cheap is cheap for a reason and is not something we see changing soon. Capital preservation and the achievement of modest incremental returns remains, for us, the appropriate portfolio objective, which we implement by selective equity exposure to companies with proven track records, modest allocations to credit fixed income and greater engagement in non-directional investment strategies (relative value and arbitrage).